Expanded Introduction to Accounting

Class Notes
 Lesson 1
Problem 1-1

Respond briefly to the following questions:

A. Why is accounting sometimes referred to as the "language

Lesson 1 of business?"

Review of Accounting B. Financial accounting information is provided through general-

Environment and the purpose financial statements.
Basic Accounting Cycle i. What are the three general-purpose financial statements
required under generally accepted accounting principles?

ii. What are the "notes to the financial statements?"

iii. Who uses financial statement information and why?

C. What is managerial accounting information and who uses it?

1 2

Problem 1-1 - Answer Problem 1-1 - Answer

B. Financial accounting information is provided through general-

A. Why is accounting sometimes referred to as the "language purpose financial statements.
of business?"

Answer: Language exists to provided a means of communication.

i. What are the three general-purpose financial statements
Accounting is referred to as the "language of business" because its sole required under generally accepted accounting principles?
purpose is to communicate business information.
Answer:
Balance Sheet (sometimes referred to as a Statement of Financial
Position)

Income Statement (sometimes referred to as a Statement of Earnings,

Statement of Operations, Statement of Profits and Losses, or P&L
Statement)

Statement of Cash Flows

Although not required, most companies also provide a Statement of

Retained Earnings or a more complete Statement of Owners' Equity, which
provides information as to the causes of changes in retained earnings and
other elements of owners' equity over a period of time.

3 4

Problem 1-1 - Answer Problem 1-1 - Answer

B. Financial accounting information is provided through general-

B. Financial accounting information is provided through general-
purpose financial statements.
purpose financial statements.
iii. Who uses financial statement information and why?
ii. What are the "notes to the financial statements?"
Answer: The primary users of financial statement information are current
Answer: The notes to a company's financial statements provide
or potential investors and creditors, analysts providing investment advice
supplemental information that; (1) explains certain key accounting policies
and government regulatory bodies such as the Securities and Exchange
used in the preparation of the financial statements, (2) provides additional
Commission ("SEC") and Federal Trade Commission ("FTC"). In
detailed information in support of financial statement amounts and (3)
addition, employee unions, suppliers, prospective employees and the media
discloses other important information not reflected in the financial
are among other frequent users of financial statement information.
statements. Most notes to the financial statements are provided in
Although management personnel require much more detailed information
compliance with requirements under generally accepted accounting
in administering a company's day-to-day operations, the summarized results
principles.
provided through a company's financial statements can be helpful to
managers in evaluating progress in reaching a company's overall goals.
Managers are especially interested in financial statement results if bonuses
and raises are predicated on overall performance measures.

5 6

1-1
 Problem 1-1 - Answer Problem 1-2

C. What is managerial accounting information and who uses it? Respond briefly to the following questions:

Answer: Managerial accounting information refers to all of the various A. What is the SEC and what is its role?
other kinds of information, above and beyond the information found in a
company's general-purpose financial statements, which may be used by B. What is GAAP and why is it important to financial statement
managers and other company employees in their efforts to successfully users?
operate a company. This information is generally restricted to use by
company employees and is not subject to public dissemination. Managerial C. Who is legally authorized to determine GAAP?
accounting often involves budgeting and the forecasting of future
operations as well as the use of historical data. D. What is the FASB and what is its role?
E. How do the SEC and the FASB relate to one another?
F. What is the IASB and what is its role?
G. Why are international accounting standards not allowed for
companies whose securities trade in the United States and what
would be the benefit if they were allowed?

7 8

Problem 1-2 - Answer Problem 1-2 - Answer

A. What is the SEC and what is its role? B. What is GAAP and why is it important to financial statement
users?
Answer: The SEC (Securities and Exchange Commission) is a federal
regulatory agency charged with the responsibility of regulating the stock Answer: Generally accepted accounting principles ("GAAP") are the
and bond ("securities") markets of the United States to insure their fairness methods of accounting and the financial statement disclosures required
and integrity for purposes of protecting the investing public. The SEC's of SEC-regulated companies. The purpose of GAAP is to improve the
authority extends only to larger businesses that seek capital from large comparability and usefulness of financial statement information.
numbers of investors in the United States ("publicly-held businesses"). Although not required, companies not subject to SEC regulation will also
Many companies in the U.S. today are publicly-held and subject to the typically prepare financial statements in accordance with GAAP to add
SEC's regulations. The SEC seeks to guarantee that investors and credibility for current or potential investors and creditors.
creditors have adequate and accurate information to make informed
decisions and that rules of fairness in the marketplace are enforced. It does
not guarantee that quality decisions are made or guarantee the ultimate C. Who is legally authorized to determine GAAP?
success of any business investment. SEC regulations and oversight extend
not only to publicly-held companies but to stock exchanges, broker-dealers,
Answer: The SEC has the legal authority to determine GAAP for
investment advisers and others involved in the public capital markets.
companies required to file financial statements with the SEC; however,
the SEC currently allows the FASB to function in this capacity.

9 10

Problem 1-2 - Answer Problem 1-2 - Answer

D. What is the FASB and what is its role? F. What is the IASB and what is its role?

Answer: The Financial Accounting Standards Board (FASB) is a private Answer: The International Accounting Standards Board (IASB) is a private
non-profit organization currently responsible for the establishment of organization headquartered in London and committed to developing a
GAAP in the United States. The SEC recognizes the pronouncements of the single set of high quality global accounting standards. In addition, the
FASB as authoritative. Funding for the organization's operations come Board cooperates with national accounting standard setters in an attempt to
from donations from the accounting profession, industry and the financial achieve convergence in accounting standards around the world.
community along with revenues from the sale of its publications.
G. Why are international accounting standards not allowed for
E. How do the SEC and the FASB relate to one another? companies whose securities trade in the United States and what
would be the benefit if they were allowed?
Answer: Because the SEC has the ultimate power to determine GAAP, the Answer: At this time, the SEC requires the use of FASB accounting
FASB exists and functions at the SEC's pleasure. As a result, when the standards (GAAP) because it currently deems FASB standards superior in
SEC talks the FASB listens. The SEC has considerable influence over the providing fuller and fairer disclosure of financial information. As the IASB
pronouncements issued by the FASB. continues to develop and improve their standards it is possible that the SEC
could modify its position. A clear benefit in the application of international
standards among countries is the breakdown of a significant investment
and trade barrier. Capital markets will never be truly global until common
accounting standards are applied to companies world wide.

11 12

1-2
 Problem 1-3 Problem 1-3 - Answer

Respond briefly to the following questions: A. Who is responsible for financial statement accuracy and
compliance with GAAP?
A. Who is responsible for financial statement accuracy and
Answer: A company's management is primarily responsible for financial
compliance with GAAP? statement accuracy and compliance with GAAP. In fact, management
B. What are internal controls and provide examples of common failure to provide accurate financial information may constitute a crime
controls over a company's cash. under the Foreign Corrupt Practices Act. This act requires management
of public companies to safeguard company assets and maintain accurate
C. How does a person become a CPA and what do CPAs do besides financial records through the implementation of internal controls. Public
audits of financial statements? companies subject to SEC regulation must also have an annual financial
statement audit performed by an independent CPA firm. Such an audit,
D. What is the AICPA and what is its role? however, does not relieve management of their primary reporting
responsibilities.
E. Why aren't auditors completely independent in the
performance of an audit?
F. What risks does a CPA face if they knowingly misrepresent the
accuracy of a company's financial statements and its
compliance with GAAP or are negligent in their performance of
an audit.

13 14

Problem 1-3 - Answer Problem 1-3 - Answer

B. What are internal controls and provide examples of common C. How does a person become a CPA and what do CPAs do besides
controls over a company's cash. audits of financial statements?
Answer: Internal controls are policies and procedures designed to Answer: CPA certification is administered by each state. CPAs licensed to
safeguard a company's assets, produce accurate accounting records, practice in a state may be able to practice in other states if reciprocal
and promote the effective and efficient operation of the company's licensing agreements exist. All states require CPA candidates to be college
business. Some common controls designed to safeguard and improve graduates with credit earned in designated accounting courses. Candidates
the management of cash are: (1) segregation of duties in the handling must also pass a uniform CPA exam administered by the American Institute
of cash transactions, (2) the use of pre-numbered checks for all cash of Certified Public Accountants (AICPA). In addition, certain supervised
expenditures, (3) dual-signatures required for all checks written over a work experience with a licensed CPA firm is also required. Subsequent to
certain dollar amount, (4) the monthly preparation of a bank initial certification, a CPA must complete continuing professional education
reconciliation, and (5) the use of cash flow budgets to project future (CPE) requirements to maintain the right to practice.
cash needs.

15 16

Problem 1-3 - Answer Problem 1-3 - Answer

D. What is the AICPA and what is its role? E. Why aren't auditors completely independent in the performance of
an audit?
Answer: The AICPA is a private professional organization made up of CPAs
across the nation. In addition to the administration of the CPA exam, the Answer: CPA firms conducting financial statement audits are paid by the
AICPA also determines generally accepted auditing standards (GAAS), companies they audit creating an inherent conflict of interest. In most
which govern the practices and procedures to be used by CPA firms in the cases, a company's management team is motivated to prepare financial
conduct of a certified audit of financial statements. Common audit statements that present the most favorable financial impression possible.
procedures include interviewing of employees, observation of assets, If management/auditor disagreements arise on financial statement
verification of transactions and analytical analysis. The AICPA is also presentation, management may threaten to change auditors. As a result,
involved in establishing practice standards for CPAs providing tax, CPA firms may be tempted to compromise the integrity of their audit work
consulting, personal financial planning and other services. in order to preserve the engagement and resulting fee income. Auditors
also create financial conflicts when they engage in consulting projects for
the companies they audit. As a result, auditors are now prohibited from
performing certain kinds of consulting services for their audit clients.

17 18

1-3
 Problem 1-3 - Answer

F. What risks does a CPA face if they knowingly misrepresent the

accuracy of a company's financial statements and its compliance
with GAAP or are negligent in their performance of an audit.
Answer: CPAs who certify misleading financial statements expose
themselves to potential investor and creditor lawsuits that may result in the
payment of significant financial damages. In addition, the loss of license
and professional censure are probable consequences for CPAs who fail the
public trust.

13

1-4
 Problem 1-4

In the "Introduction to Accounting: The Language of Business" a

financial practice set was provided for a fictional company referred to as
Hot Cars, Inc (HCI), a wholesale distributor of miniature model cars.
This review problem continues the HCI story for an additional year
through 20X3.

HCI's income statement, statement of retained earnings and balance

sheet for the years 20X1 and 'X2 (a blank column is left for the 'X3
amounts to be determined in this problem), along with a simplified
general ledger reflecting balances in all of the company's accounts as of
1/1/X3 are provided herein for use in completing this problem. More
formal ledger formats, special journals and subsidiary ledgers used in
the previous Financial Practice Set will not be used in this review.
Problem Requirements:
1. On a blank sheet of paper record the following summarized 'X3 transactions for HCI
in basic general journal form as shown below:

Account Name XXX

Account Name XXX

A. Inventory purchased on account totaled $201,922.

B. Customer sales on account and the cost of inventory sold totaled $318,432 and
$206,145, respectively.
C. Cash purchases of office supplies totaled $4,677.
D. Cash payments of utility bills amounted to $7,607 of which $400 had been
previously recorded as an expense of the prior year.
E. Cash of $50,000 was paid down and a $250,000 mortgage note payable executed in
the purchase of land and a building on 10/1/X3. The 30-year fully amortizing
mortgage note bears 8% annual interest with monthly payments of $1,834.
Monthly cash payments on the note totaled $5,502 for the year of which $507 was
applied to principal and the rest to interest. The amount of principal due over the
next 12 months amounts to $2,130.
F. Paid off a $10,000 note payable (bank loan) plus interest of $1,500 of which $99
had been previously recorded as an expense in 20X2.
G. Paid off $4,000 of principal on a note payable (equipment loan) plus interest of
$1,440, of which $79 had been previously recorded as an expense in 20X2. The
remaining $8,000 of principal on this note is due in two equal $4,000 installments
over the next two years.
H. Cash payments of employee salaries totaled $53,409. (Ignore payroll withholdings
and employer payroll taxes for this problem.)
14
1-5
Continued...

I. Insurance premiums prepaid during the year totaled $4,313.

J. Cash collections of accounts receivable amounted to $310,406.
K. Paid the $6,408 of 20X2 income taxes payable at 1/1X3.
L. Cash payments on accounts payable totaled $163,407.
M. Cash dividends paid to stockholders amounted to $12,000.
N. Payments of miscellaneous expenses totaled $617.
O. Payments of postage expenses totaled $373.
P. Cash purchases of warehouse equipment totaled $13,456.
Q. Warehouse equipment having an original cost of $10,000 and associated
accumulated depreciation of $2,000 was sold for $10,000 cash.
2. Post the 20X3 summarized journal entries to the HCI general ledger.
3. Prepare the 12/31/X3 year-end adjusting entries given the following information:
a. Unpaid and unrecorded December, 20X3 salaries payable in January, 20X4
totaled $7,280.
b. Unpaid and unrecorded December 20X3 utility costs payable in January, 20X4
totaled $937.
c. Unearned rent revenue totaling $280 as of 12/31/X2 was earned in 20X3.
d. Unpaid and unrecorded 20X3 interest costs payable in the following year totaled
$53.
e. Prepaid insurance applicable to 20X4 operations totals $2,368 at 12/31/X3
f. Depreciation on warehouse equipment and the newly purchased building amount
to $6,985 for the year.
g. All 12/31/X2 prepaid rent expired in 20X3.
h. Unpaid and unrecorded 20X3 income taxes payable in the following year totaled
$4,747.
i. A physical count of office supplies on hand at 12/31/X3 totaled $1,962.
4. Post the 12/31/X3 adjusting entries to the HCI general ledger and determine the
12/31/X3 balance for each account.
5. Prepare a 12/31/X3 adjusted trial balance.
6. Extend the enclosed HCI income statements, statements of retained earnings and
balance sheets for the additional year ended 12/31/X3 so the statements reflect
comparative amounts for the last three years.
7. Prepare the required closing entries at 12/31/X3 and post the entries to the general
ledger.

15
1-6
 Problem 1-4

Hot Cars, Inc.

Income Statement
for the years ended December 31, 20X1, 20X2 and 20X3
20X1 20X2 20X3

Sales Revenues $ 185,043 $ 261,950

Cost of Goods Sold 111,026 164,026
Gross Margin 74,017 97,924
Operating Expenses:
Salaries Expense 49,500 53,600
Office Supplies Expense 3,893 3,958
Rent Expense 4,150 4,800
Utilities Expense 6,345 6,850
Depreciation Expense 1,436 1,640
Insurance Expense 1,055 1,105
Miscellaneous Expense 900 312
Postage Expense 298 321
Operating Expenses 67,577 72,586
Operating Income 6,440 25,338
Other Revenue and (Expense)
Rental Revenue 0 420
Interest Revenue 135 52
Interest Expense ( 0) (178)
Income Before Income Taxes 6,575 25,632
Income Tax Expense 1,644 6,408
Net Income $ 4,931 $ 19,224
Earnings Per Share $ 2.05 $ 4.52

Hot Cars, Inc.

Statement of Retained Earnings
for the years ended December 31, 20X1, 20X2 and 20X3
20X1 20X2 20X3

Balance at beginning of year $ 7,821 $ 11,502

Net Income for the year 4,931 19,224
Less: Dividends (1,250) (675)
Balance at end of year $ 11,502 $ 30,051

16
1-7
 Problem 1-4
Hot Cars, Inc.
Balance Sheet
December 31, 20X1, 20X2 and 20X3

12/31/X1 12/31/X2 12/31/X3

Assets
Current Assets:
Cash $ 12,665 $ 21,808
Accounts Receivable 11,750 34,315
Inventory 11,432 25,000
Office Supplies 470 750
Prepaid Insurance 350 400
Prepaid Rent 4,400 4,400
Notes Receivable 750 0
41,817 86,673
Building 0 0
Warehouse Equipment 18,466 42,800
Less: Accumulated Depreciation (3,766) (5,406)
Total Assets $ 56,517 $ 124,067

12/31/X1 12/31/X2 12/31/X3

Liabilities & Equity
Current Liabilities:
Accounts Payable $ 13,511 $ 22,250
Salaries Payable 4,125 0
Income Tax Payable 1,644 6,408
Dividend Payable 1,250 0
Unearned Rent Revenue 0 280
Utilities Payable 485 400
Interest Payable 0 178
Current Portion of Long-Term Debt 0 14,000
21,015 43,516
Equipment Note Payable 0 8,000
Mortgage Note Payable 0 0
Total Liabilities 21,015 51,516

Equity
Capital Stock (2,400 and
4,250 shares, respectively) 24,000 42,500
Retained Earnings 11,502 30,051
Total Equity 35,502 72,551
Total Liabilities & Equity $ 56,517 $ 124,067

17
1-8
 Cash Office Supplies
1/1/X3 21,808 1/1/X3 750

Prepaid Insurance
1/1/X3 400

Prepaid Rent
1/1/X3 4,400

Notes Receivable
1/1/X3 0
Accounts Receivable
1/1/X3 34,315

Land & Building

1/1/X3 0

Inventory
1/1/X3 25,000

Warehouse Equipment
1/1/X3 42,800

18

1-9
Accumulated Depreciation Utilities Payable
5,406 1/1/X3 400 1/1/X3

Accounts Payable Interest Payable

22,250 1/1/X3 178 1/1/X3

Salaries Payable
0 1/1/X3 Bank Note Payable
10,000 1/1/X3

Income Tax Payable

6,408 1/1/X3 Equipment Note Payable
12,000 1/1/X3

Dividend Payable
0 1/1/X3 Mortgage Note Payable
0 1/1/X3

Unearned Rent Revenue

280 1/1/X3

19

1-10
 Capital Stock Interest Revenue
42,500 1/1/X3 0 1/1/X3

Retained Earnings
Cost of Goods Sold
30,051 1/1/X3
1/1/X3 0

Dividends
Salaries Expense
1/1/X3 0
1/1/X3 0

Sales Revenues Office Supplies Expense

0 1/1/X3 1/1/X3 0

Rental Revenue Rent Expense

0 1/1/X3 1/1/X3 0

20

1-11
 Utilities Expense Interest Expense
1/1/X3 0 1/1/X3 0

Depreciation Expense
1/1/X3 0 Gain on Sale
0 1/1/X3

Miscellaneous Expense
1/1/X3 0 Income Tax Expense
1/1/X3 0

Insurance Expense
1/1/X3 0

Postage Expense
1/1/X3 0

21

1-12
 Problem 1-4 - Answer Problem 1-4 - Answer

1. DR CR 1. (continued) DR CR
A. Inventory 201,922 E. Land and Building 300,000
Accounts Payable 201,922 Cash 50,000
Mortgage Note Payable 250,000
B. Accounts Receivable 318,432
Sales Revenues 318,432 Interest Expense 4,995
Cost of Goods Sold 206,145 Mortgage Note Payable 507
Inventory 206,145 Cash 5,502
C. Office Supplies 4,677 F. Bank Note Payable 10,000
Cash 4,677 Cash 10,000
D. Utilities Payable 400 Interest Expense 1,401
Utilities Expense 7,207 Interest Payable 99
Cash 7,607 Cash 1,500

22 23

Problem 1-4 - Answer Problem 1-4 - Answer

1. (continued) DR CR 1. (continued) DR CR
G. Equipment Note Payable 4,000 L. Accounts Payable 163,407
Cash 4,000 Cash 163,407
Interest Expense 1,361 M. Dividends 12,000
Interest Payable 79 Cash 12,000
Cash 1,440
N. Miscellaneous Expense 617
H. Salaries Expense 53,409 Cash 617
Cash 53,409
O. Postage Expense 373
I. Prepaid Insurance 4,313 Cash 373
Cash 4,313
P. Warehouse Equipment 13,456
J. Cash 310,406 Cash 13,456
Accounts Receivable 310,406
Q. Cash 10,000
K. Income Tax Payable 6,408 Accumulated Depreciation 2,000
Cash 6,408 Warehouse Equipment 10,000
Gain on Sale 2,000

24 25

Problem 1-4 - Answer Problem 1-4 - Answer

2. 2. (continued)
Cash Accounts Receivable Prepaid Insurance Land & Building
1/1/X3 21,808 1/1/X3 34,315 1/1/X3 400 1/1/X3 0
J. 310,406 4,677 C. B. 318,432 310,406 J. I. 4,313 E. 300,000
Q. 10,000 7,607 D.
50,000 E.
5,502 E.
10,000 F. Inventory Prepaid Rent Warehouse Equipment
1,500 F. 1/1/X3 25,000 1/1/X3 4,400 1/1/X3 42,800
4,000 G. A. 201,922 206,145 B. P. 13,456 10,000 Q.
1,440 G.
53,409 H.
4,313 I.
6,408 K. Office Supplies Notes Receivable Accumulated Depreciation
163,407 L. 1/1/X3 0 5,406 1/1/X3
1/1/X3 750
12,000 M. Q. 2,000
C. 4,677
617 N.
373 O.
13,456 P.

26 27

1-13
 Problem 1-4 - Answer Problem 1-4 - Answer
2. (continued) 2. (continued)
Accounts Payable Dividend Payable Interest Payable Mortgage Note Payable
22,250 1/1/X3 0 1/1/X3 178 1/1/X3 0 1/1/X3
L. 163,407 201,922 A. F. 99 250,000 E.
G. 79 E. 507

Unearned Rent Revenue

Salaries Payable 280 1/1/X3
0 1/1/X3 Bank Note Payable Capital Stock
10,000 1/1/X3 42,500 1/1/X3
F. 10,000

Utilities Payable
Income Tax Payable 400 1/1/X3 Retained Earnings
6,408 1/1/X3 Equipment Note Payable 30,051 1/1/X3
K. 6,408 12,000 1/1/X3
G. 4,000

28 29

Problem 1-4 - Answer Problem 1-4 - Answer

2. (continued) 2. (continued)
Dividends Rental Revenue Salaries Expense Rent Expense
1/1/X3 0 0 1/1/X3 1/1/X3 0 1/1/X3 0
M. 12,000 H. 53,409

Interest Revenue Utilities Expense

Sales Revenues 0 1/1/X3 Office Supplies Expense 1/1/X3 0
0 1/1/X3 1/1/X3 0 D. 7,207
318,432 B.

Cost of Goods Sold

1/1/X3 0
B. 206,145

30 31

Problem 1-4 - Answer Problem 1-4 - Answer

2. (continued) 2. (continued)
Depreciation Expense Postage Expense Gain on Sale Income Tax Expense
1/1/X3 0 1/1/X3 0 0 1/1/X3 1/1/X3 0
O. 373 2,000 Q.

Miscellaneous Expense Interest Expense

1/1/X3 0 1/1/X3 0
N. 617 E. 4,995
F. 1,401
G. 1,361

Insurance Expense
1/1/X3 0

32 33

1-14
 Problem 1-4 - Answer Problem 1-4 - Answer

3. DR CR 3. (continued) DR CR
a. Salaries Expense 7,280 f. Depreciation Expense 6,985
Salaries Payable 7,280 Accumulated Depreciation 6,985

b. Utilities Expense 937 g. Rent Expense 4,400

Utilities Payable 937 Prepaid Rent 4,400

c. Unearned Rent Revenue 280 h. Income Tax Expense 4,747

Rental Revenue 280 Income Tax Payable 4,747

d. Interest Expense 53 i. Office Supplies Expense 3,465

Interest Payable 53 Office Supplies 3,465

e. Insurance Expense 2,345

Prepaid Insurance 2,345

34 35

Problem 1-4 - Answer Problem 1-4 - Answer

4. 4. (continued)
Cash Accounts Receivable Prepaid Insurance Land & Building
1/1/X3 21,808 1/1/X3 34,315 1/1/X3 400 1/1/X3 0
J. 310,406 4,677 C. B. 318,432 310,406 J. I. 4,313 2,345 e. E. 300,000
Q. 10,000 7,607 D.
50,000 E. 12/31/X3 42,341 12/31/X3 2,368 12/31/X3 300,000
5,502 E.
10,000 F. Inventory Prepaid Rent Warehouse Equipment
1,500 F. 1/1/X3 25,000 1/1/X3 4,400 1/1/X3 42,800
4,000 G. A. 201,922 206,145 B. 4,400 g. P. 13,456 10,000 Q.
1,440 G.
53,409 H. 12/31/X3 20,777 12/31/X3 0 12/31/X3 46,256
4,313 I.
6,408 K. Office Supplies Notes Receivable Accumulated Depreciation
163,407 L. 1/1/X3 0 5,406 1/1/X3
1/1/X3 750
12,000 M. 3,465 i. Q. 2,000 6,985 f.
C. 4,677
617 N. 12/31/X3 0
373 O. 10,391 12/31/X3
12/31/X3 1,962
13,456 P.
12/31/X3 3,505

36 37

Problem 1-4 - Answer Problem 1-4 - Answer

4. (continued) 4. (continued)
Accounts Payable Dividend Payable Interest Payable Mortgage Note Payable
22,250 1/1/X3 0 1/1/X3 178 1/1/X3 0 1/1/X3
L. 163,407 201,922 A. F. 99 250,000 E.
0 12/31/X3 G. 79 53 d. E. 507
60,765 12/31/X3
Unearned Rent Revenue 53 12/31/X3 249,493 12/31/X3
Salaries Payable 280 1/1/X3
0 1/1/X3 c. 280 Bank Note Payable Capital Stock
7,280 a. 10,000 1/1/X3 42,500 1/1/X3
0 12/31/X3 F. 10,000
7,280 12/31/X3 42,500 12/31/X3
Utilities Payable 0 12/31/X3
Income Tax Payable 400 1/1/X3 Retained Earnings
6,408 1/1/X3 d. 400 937 b. Equipment Note Payable 30,051 1/1/X3
K. 6,408 4,747 h. 12,000 1/1/X3
937 12/31/X3 G. 4,000
4,747 12/31/X3
8,000 12/31/X3

38 39

1-15
 Problem 1-4 - Answer Problem 1-4 - Answer
4. (continued) 4. (continued)
Dividends Rental Revenue Salaries Expense Rent Expense
1/1/X3 0 0 1/1/X3 1/1/X3 0 1/1/X3 0
M. 12,000 280 c. H. 53,409 g. 4,400
280 12/31/X3 a. 7,280 12/31/X3 4,400
12/31/X3 12,000 12/31/X3 60,689

Interest Revenue Utilities Expense

Sales Revenues 0 1/1/X3 Office Supplies Expense 1/1/X3 0
0 1/1/X3 0 12/31/X3 1/1/X3 0 D. 7,207
318,432 B. i. 3,465 b. 937
318,432 12/31/X3 12/31/X3 3,465 12/31/X3 8,144

Cost of Goods Sold

1/1/X3 0
B. 206,145
12/31/X3 206,145

40 41

Problem 1-4 - Answer Problem 1-4 - Answer

4. (continued) 4. (continued)
Depreciation Expense Postage Expense Gain on Sale Income Tax Expense
1/1/X3 0 1/1/X3 0 0 1/1/X3 1/1/X3 0
f. 6,985 O. 373 2,000 Q. h. 4,747
12/31/X3 6,985 12/31/X3 373 2,000 12/31/X3 12/31/X3 4,747

Miscellaneous Expense Interest Expense

1/1/X3 0 1/1/X3 0
N. 617 E. 4,995
12/31/X3 617 F. 1,401
G. 1,361
d. 53
12/31/X3 7,810
Insurance Expense
1/1/X3 0
e. 2,345
12/31/X3 2,345

42 43

Problem 1-4 - Answer Problem 1-4 - Answer

6. Hot Cars, Inc.
[Link] Trial Balance Income Statement
for the years ended December 31, 20X1, 20X2 and 20X3
Accounts: DR CR Accounts (cont): DR CR
20X1 20X2 20X3
Cash 3,505 Sales Revenues 318,432
Accounts Receivable 42,341 Rental Revenue 280 Sales Revenues $ 185,043 $ 261,950 $ 318,432
Inventory 20,777 Interest Revenue 0 Cost of Goods Sold 111,026 164,026 206,145
Office Supplies 1,962 Cost of Goods Sold 206,145 Gross Margin 74,017 97,924 112,287
Prepaid Insurance 2,368 Salaries Expense 60,689 Operating Expenses:
Prepaid Rent 0 Office Supplies Expense 3,465 Salaries Expense 49,500 53,600 60,689
Notes Receivable 0 Rent Expense 4,400 Office Supplies Expense 3,893 3,958 3,465
Warehouse Equipment 46,256 Utilities Expense 8,144 Rent Expense 4,150 4,800 4,400
Land and Building 300,000 Depreciation Expense 6,985 Utilities Expense 6,345 6,850 8,144
Accumulated Depreciation 10,391 Misc. Expense 617 Depreciation Expense 1,436 1,640 6,985
Accounts Payable 60,765 Insurance Expense 2,345 Insurance Expense 1,055 1,105 2,345
Salaries Payable 7,280 Postage Expense 373 Miscellaneous Expense 900 312 617
Income Tax Payable 4,747 Interest Expense 7,810 Postage Expense 298 321 373
Dividend Payable 0 Gain on Sale 2,000 Operating Expenses 67,577 72,586 87,018
Unearned Rent Revenue 0 Income Tax Expense 4,747 Operating Income 6,440 25,338 25,269
Utilities Payable 937 Other Revenue and (Expense)
Totals 734,929 734,929
Interest Payable 53 Gain on Sale 0 0 2,000
Bank Note Payable 0 Rental Revenue 0 420 280
Equipment Note Payable 8,000 Interest Revenue 135 52 0
Mortgage Note Payable 249,493 Interest Expense ( 0) (178) (7,810)
Capital Stock 42,500 Income Before Income Taxes 6,575 25,632 19,739
Retained Earnings (1/1/X3) 30,051 Income Tax Expense 1,644 6,408 4,747
Dividends 12,000 Net Income $ 4,931 $ 19,224 $ 14,992
Earnings Per Share $ 2.05 $ 4.52 $ 3.53

44 45

1-16
 Problem 1-4 - Answer Problem 1-4 - Answer
6. (continued) Hot Cars, Inc. Hot Cars, Inc.
Statement of Retained Earnings Balance Sheet
for the years ended December 31, 20X1, 20X2 and 20X3 December 31, 20X1, 20X2 and 20X3
20X1 20X2 20X3 12/31/X1 12/31/X2 12/31/X3 12/31/X1 12/31/X2 12/31/X3
Assets Liabilities & Equity
Balance at beginning of year $ 7,821 $ 11,502 $ 30,051 Current Assets: Current Liabilities:
Net Income for the year 4,931 19,224 14,992 Cash $ 12,665 $ 21,808 $ 3,505 Accounts Payable $ 13,511 $ 22,250 $ 60,765
Less: Dividends (1,250) (675) (12,000) Accounts Receivable 11,750 34,315 42,341 Salaries Payable 4,125 0 7,280
Inventory 11,432 25,000 20,777 Income Tax Payable 1,644 6,408 4,747
Balance at end of year $ 11,502 $ 30,051 $ 33,043
Office Supplies 470 750 1,962 Dividend Payable 1,250 0 0
Prepaid Insurance 350 400 2,368 Unearned Rent Revenue 0 280 0
Prepaid Rent 4,400 4,400 0 Utilities Payable 485 400 937
Notes Receivable 750 0 0 Interest Payable 0 178 53
41,817 86,673 70,953 Current Portion of Long-Term Debt 0 14,000 6,130
Building 0 0 300,000 21,015 43,516 79,912
Warehouse Equipment 18,466 42,800 46,256 Equipment Note Payable 0 8,000 4,000
Less: Accumulated Depreciation (3,766) (5,406) (10,391) Mortgage Note Payable 0 0 247,363
Total Assets $ 56,517 $ 124,067 $ 406,818 Total Liabilities 21,015 51,516 331,275

Equity
Capital Stock (2,400 and
4,250 shares, respectively) 24,000 42,500 42,500
Retained Earnings 11,502 30,051 33,043
Total Equity 35,502 72,551 75,543
Total Liabilities & Equity $ 56,517 $ 124,067 $ 406,818

46 47

Problem 1-4 - Answer Problem 1-4 - Answer

7. (continued)
7. Closing Entires: DR CR Cash Accounts Receivable
Sales Revenues 318,432 1/1/X3 21,808 1/1/X3 34,315
Rental Revenue 280 J. 310,406 4,677 C. B. 318,432 310,406 J.
Gain on Sale 2,000 Q. 10,000 7,607 D.

Cost of Goods Sold 206,145 50,000 E. 12/31/X3 42,341

Salaries Expense 60,689 5,502 E.

Office Supplies Expense 3,465 10,000 F. Inventory

1,500 F.
Rent Expense 4,400 1/1/X3 25,000
4,000 G.
Utilities Expense 8,144 A. 201,922 206,145 B.
1,440 G.
Depreciation Expense 6,985
53,409 H.
Misc. Expense 617 12/31/X3 20,777
4,313 I.
Insurance Expense 2,345
6,408 K. Office Supplies
Postage Expense 373
163,407 L.
Interest Expense 7,810 1/1/X3 750
12,000 M.
Income Tax Expense 4,747 C. 4,677 3,465 i.
617 N.
Retained Earnings 14,992
373 O.
12/31/X3 1,962
Retained Earnings 12,000 13,456 P.
Dividends 12,000 12/31/X3 3,505

48 49

Problem 1-4 - Answer Problem 1-4 - Answer

7. (continued) 7. (continued)
Prepaid Insurance Land & Building Accounts Payable Dividend Payable
1/1/X3 400 1/1/X3 0 22,250 1/1/X3 0 1/1/X3
I. 4,313 2,345 e. E. 300,000 L. 163,407 201,922 A.
0 12/31/X3
12/31/X3 2,368 12/31/X3 300,000 60,765 12/31/X3
Unearned Rent Revenue
Prepaid Rent Warehouse Equipment Salaries Payable 280 1/1/X3
1/1/X3 4,400 1/1/X3 42,800 0 1/1/X3 c. 280
4,400 g. P. 13,456 10,000 Q. 7,280 a.
0 12/31/X3
12/31/X3 0 12/31/X3 46,256 7,280 12/31/X3
Utilities Payable
Notes Receivable Accumulated Depreciation Income Tax Payable 400 1/1/X3
1/1/X3 0 5,406 1/1/X3 6,408 1/1/X3 d. 400 937 b.
Q. 2,000 6,985 f. K. 6,408 4,747 h.
12/31/X3 0 937 12/31/X3
10,391 12/31/X3 4,747 12/31/X3

50 51

1-17
 Problem 1-4 - Answer Problem 1-4 - Answer
7. (continued) 7. (continued)
Interest Payable Mortgage Note Payable Dividends Rental Revenue
178 1/1/X3 0 1/1/X3 1/1/X3 0 0 1/1/X3
F. 99 250,000 E. M. 12,000 280 c.
G. 79 53 d. E. 507 280 12/31/X3
12/31/X3 12,000 close 280
53 12/31/X3 249,493 12/31/X3 12,000 close 0 1/1/X4
1/1/X4 0
Bank Note Payable Capital Stock Interest Revenue
Sales Revenues 0 1/1/X3
10,000 1/1/X3 42,500 1/1/X3
F. 10,000 0 1/1/X3 0 12/31/X3
318,432 B. close 0
42,500 12/31/X3
0 12/31/X3 318,432 12/31/X3 0 1/1/X4
Retained Earnings close 318,432
0 1/1/X4 Cost of Goods Sold
Equipment Note Payable 30,051 1/1/X3
1/1/X3 0
12,000 1/1/X3 14,992 close
B. 206,145
G. 4,000 Dividends 12,000
12/31/X3 206,145
33,043 12/31/X3
206,145 close
8,000 12/31/X3
1/1/X4 0

52 53

Problem 1-4 - Answer Problem 1-4 - Answer

7. (continued) 7. (continued)
Salaries Expense Rent Expense Depreciation Expense Postage Expense
1/1/X3 0 1/1/X3 0 1/1/X3 0 1/1/X3 0
H. 53,409 g. 4,400 f. 6,985 O. 373
a. 7,280 12/31/X3 4,400 12/31/X3 6,985 12/31/X3 373
12/31/X3 60,689 4,400 close 6,985 close 373 close
60,689 close 1/1/X4 0 1/1/X4 0 1/1/X4 0
1/1/X4 0
Miscellaneous Expense Interest Expense
Utilities Expense
Office Supplies Expense 1/1/X3 0 1/1/X3 0
1/1/X3 0
N. 617 E. 4,995
1/1/X3 0 D. 7,207
12/31/X3 617 F. 1,401
i. 3,465 b. 937
617 close G. 1,361
12/31/X3 3,465 12/31/X3 8,144
1/1/X4 0 d. 53
3,465 close 8,144 close
12/31/X3 7,810
1/1/X4 0 1/1/X4 0 Insurance Expense
7,810 close
1/1/X3 0
1/1/X4 0
e. 2,345
12/31/X3 2,345
2,345 close
1/1/X4 0

54 55

7. (continued)
Problem 1-4 - Answer
Accounting for Adjustments of
Gain on Sale
0 1/1/X3 1/1/X3
Income Tax Expense
0
Prepaid Expenses and Unearned Revenues
2,000 Q. h. 4,747
2,000 12/31/X3 12/31/X3 4,747 Example: Assume on 10/1/X1, Berry, Inc. prepays a $1,200 insurance
close 2,000 4,747 close premium providing fire insurance coverage through 9/30/X2.
0 1/1/X4 1/1/X4 0
Previously discussed accounting:

10/1/X1 Original Entry:

Prepaid Insurance Expense 1,200
Cash 1,200

12/31/X1 Adjusting Entry:

Insurance Expense 300
Prepaid Insurance Expense 300
$300 Insurance Expense $900 Prepaid Insurance

56 57

1-18
Now, assume that the original entry made on October 1st to record Example: Assume Jones Real Estate Company receives $24,000 rent in
the $1,200 prepayment was made to insurance expense rather than advance from a tenant on a one year lease beginning at the
to the asset, prepaid insurance. time of the rent receipt, 8/1/X1.

10/1/X1 Original Entry: 8/1/X1 Original Entry:

Insurance Expense 1,200 Cash 24,000
Cash 1,200 Unearned Rent Revenue 24,000

In this case what adjusting entry could be made on 12/31, three 12/31/X1 Adjusting Entry:
months later, to properly adjust the books and accurately reflect the
company's expenses for the year and prepaid insurance at the end of Unearned Rent Revenue 10,000
the year? Rent Revenue 10,000
$10,000 Rent Revenues $14,000 Unearned Revenues
12/31/X1 Adjusting Entry:
Prepaid Insurance Expense 900
Insurance Expense 900
$300 Insurance Expense $900 Prepaid Insurance

58 59

Problem 1-5 Problem 1-5

A. Cobb Industries prepays 3-month warehouse rental costs on B. On 12/15/X1 Cobb collects $10,000 in advance on a customer order
12/1/X1 amounting to $15,000. for goods to be shipped as soon as possible. Assume that 30% of the
ordered goods are actually shipped by Cobb on 12/31/X1 with the
1. Prepare the original and 12/31/X1 adjusting entries assuming remainder to be shipped the first week of January.
the payment is originally recorded as an asset.
1. Prepare the original and 12/31/X1 adjusting entries assuming
2. Prepare the original and 12/31/X1 adjusting entries assuming the cash receipt is originally recorded as unearned revenue.
the payment is originally recorded as an expense.
2. Prepare the original and 12/31/X1 adjusting entries assuming
3. Assuming the original entry was made to an expense what would the payment is originally recorded as revenue.
be the effect on Cobb's financial position if no adjusting entry
was made? What principle of accounting mandates an 3. What principle of accounting mandates an adjusting entry in
adjusting entry in this case? Which approach to the original this case?
entry and resulting adjustment is preferred?

60 61

Problem 1-5 - Answer Problem 1-5 - Answer

A. Cobb Industries prepays 3-month warehouse rental costs on 2. Prepare the original and 12/31/X1 adjusting entries assuming
12/1/X1 amounting to $15,000. the payment is originally recorded as an expense.

1. Prepare the original and 12/31/X1 adjusting entries assuming

the payment is originally recorded as an asset. 12/1/X1 Original Entry:
Rent Expense 15,000
Cash 15,000
12/1/X1 Original Entry:
Prepaid Rent Expense 15,000 12/31/X1 Adjusting Entry:
Cash 15,000 Prepaid Rent Expense 10,000
Rent Expense 10,000
12/31/X1 Adjusting Entry:
Rent Expense 5,000
Prepaid Rent Expense 5,000

62 63

1-19
 Problem 1-5 - Answer Problem 1-5 - Answer

3. Assuming the original entry was made to an expense, what B. On 12/15/X1 Cobb collects $10,000 in advance on a customer order
would be the effect on Cobb's financial position if no adjusting for goods to be shipped as soon as possible. Assume that 30% of the
entry was made? ordered goods are actually shipped by Cobb on 12/31/X1 with the
remainder to be shipped the first week of January.
Expenses Overstated
Net Income Understated
1. Prepare the original and 12/31/X1 adjusting entries assuming
Retained Earnings Understated
Owners' Equity Understated
the cash receipt is originally recorded as unearned revenue.
Assets Understated 12/15/X1 Original Entry:
What principle of accounting mandates an adjusting entry in Cash 10,000
this case? Unearned Sales Revenue 10,000
Answer: The matching principle of accrual basis accounting
mandates the year-end adjusting entry to properly record 12/31/X1 Adjusting Entry:
expenses in both 'X1 and 'X2.
Unearned Sales Revenue 3,000
Which approach to the original entry and resulting adjustment Sales Revenue 3,000
is preferred?
Answer: Both approaches produce the same financial statement Cost of Goods Sold ?
results at year-end…..no preference. Inventory ?

64 65

Problem 1-5 - Answer

2. Prepare the original and 12/31/X1 adjusting entries assuming

the payment is originally recorded as revenue.
12/15/X1 Original Entry:
Cash 10,000
Sales Revenue 10,000

12/31/X1 Adjusting Entry:

Sales Revenue 7,000
Unearned Sales Revenue 7,000

Cost of Goods Sold ?

Inventory ?

3. What principle of accounting mandates an adjusting entry in

this case?
Answer: The revenue recognition principle mandates the
adjusting entry in this case.

66

1-20
 Lesson 2

Users of Financial Statements

1. Financial analysts and managers who work for… banks,
investment companies, insurance companies, broker/dealers,
financial advisors, mutual funds and other companies that
provide investment advice or actually make their own stock
market investments.
Lesson 2 2. SEC and other government agencies. The SEC's Division of
Expanded Financial Corporate Finance reviews the annual and quarterly financial
Statement Analysis statements included in the 10-K (annual) and 10-Q (quarterly)
filings of publicly held companies.
3. Management.
4. The media.
5. Suppliers, employees, and union officials.
6. Individual investors like you and me.

1 2

Technical Analysts:
Rely almost exclusively on complicated mathematical models
using market data, such as trading volume and interest rates.
In this approach, a company's intrinsic or real value and its
financial statements are pretty much ignored.

Fundamental Analysts: Utilizing a company's financial statements

The bottom line in fundamental analysis is to make accurate
forecasts of a company's future EPS as the basis for evaluating a to try and predict a company's future is
company's current stock price and its prospects for the future.
Some of the techniques used in fundamental analysis involve:
what this lesson is all about.
1. Hands on evaluations of a company's products and services.
Market research can be an important tool.
2. Research on general and industry economic trends.
3. Meet and communicate with key management personnel.
4. Review and analyze financial statements - ratios and other
calculations and comparisons of numbers that are found in the
financial statements.

3 4

Problem 2-1

Review of Liquidity Measures

Using the HCI financial statements prepared in Lesson 1 and provided

Liquidity, or the extent of working capital, refers on the pages that follow:
to a company's ability to pay its obligations in the A. Calculate HCI's current ratio at 12/31/X2 and 'X3.
short-term.
B. Calculate HCI's acid-test ("quick") ratio at 12/31/X2 and 'X3.

Working Capital = Current Assets - Current Liabilities C. Calculate the percentage increase (decrease) in total current
assets and total current liabilities from 12/31/X2 to 12/31/X3.

D. What is an adequate current and acid-test ratio and can a

company operate effectively at a less than 1 to 1 current ratio?

5 6

2-1
 Problem 2-1 Problem 2-1
Hot Cars, Inc. Hot Cars, Inc.
Income Statement Balance Sheet
for the years ended December 31, 20X1, 20X2 and 20X3 December 31, 20X1, 20X2 and 20X3
20X1 20X2 20X3
12/31/X1 12/31/X2 12/31/X3 12/31/X1 12/31/X2 12/31/X3
Sales Revenues $ 185,043 $ 261,950 $ 318,432
Assets Liabilities & Equity
Cost of Goods Sold 111,026 164,026 206,145
Current Assets: Current Liabilities:
Gross Margin 74,017 97,924 112,287 Cash $ 12,665 $ 21,808 $ 3,505 Accounts Payable $ 13,511 $ 22,250 $ 60,765
Operating Expenses: Accounts Receivable 11,750 34,315 42,341 Salaries Payable 4,125 0 7,280
Salaries Expense 49,500 53,600 60,689 Inventory 11,432 25,000 20,777 Income Tax Payable 1,644 6,408 4,747
Office Supplies Expense 3,893 3,958 3,465 Office Supplies 470 750 1,962 Dividend Payable 1,250 0 0
Rent Expense 4,150 4,800 4,400 Prepaid Insurance 350 400 2,368 Unearned Rent Revenue 0 280 0
Utilities Expense 6,345 6,850 8,144 Prepaid Rent 4,400 4,400 0 Utilities Payable 485 400 937
Depreciation Expense 1,436 1,640 6,985 Notes Receivable 750 0 0 Interest Payable 0 178 53
Insurance Expense 1,055 1,105 2,345 41,817 86,673 70,953 Current Portion of Long-Term Debt 0 14,000 6,130
Land and Building 0 0 300,000 21,015 43,516 79,912
Miscellaneous Expense 900 312 617
Warehouse Equipment 18,466 42,800 46,256 Equipment Note Payable 0 8,000 4,000
Postage Expense 298 321 373
Less: Accumulated Depreciation (3,766) (5,406) (10,391) Mortgage Note Payable 0 0 247,363
Operating Expenses 67,577 72,586 87,018 Total Assets $ 56,517 $ 124,067 $ 406,818 Total Liabilities 21,015 51,516 331,275
Operating Income 6,440 25,338 25,269
Other Revenue and (Expense) Equity
Gain on Sale 0 0 2,000 Capital Stock (2,400 and
Rental Revenue 0 420 280 4,250 shares, respectively) 24,000 42,500 42,500
Interest Revenue 135 52 0 Retained Earnings 11,502 30,051 33,043
Interest Expense ( 0) (178) (7,810) Total Equity 35,502 72,551 75,043
Income Before Income Taxes 6,575 25,632 19,739 Total Liabilities & Equity $ 56,517 $ 124,067 $ 406,818
Income Tax Expense 1,644 6,408 4,747
Net Income $ 4,931 $ 19,224 $ 14,992
Earnings Per Share $ 2.05 $ 4.52 $ 3.53

7 8

Problem 2-1 - Answer Problem 2-1 - Answer

Review of Liquidity Measures

C. Calculate the percentage increase (decrease) in total current
A. Calculate HCI's current ratio at 12/31/X2 and 'X3. assets and total current liabilities from 12/31/X2 to 12/31/X3.

Total Current Assts Change in Total Current Assets

Total Current Liabilities Base Year Amount of Total Current Assets

12/31/X2: Total Current Assets: $ 70,953 - $ 86,673

$ 86,673 12/31/X3: $ 70,953
= 1.99 = 0.89 $ 86,673
$ 43,516 $ 79,912
($ 15,720)
B. Calculate HCI's acid-test ("quick") ratio at 12/31/X2 and 'X3. = 18% decrease
$ 86,673
Selected Current Assets
(Cash, Marketable Securities, Accounts Receivable) Total Current Liabilities: $ 79,912 - $ 43,516
Total Current Liabilities $ 43,516
12/31/X2: $ 56,123 12/31/X3: $ 45,846 $ 36,396
= 1.29 = 0.57 = 84% increase
$ 43,516 $ 79,912 $ 43,516

9 10

Problem 2-1 - Answer

Acid-Test (Quick) Ratio:

D. What is an adequate current and acid-test ratio and can a
company operate effectively at a less than 1 to 1 current ratio?
Answer: A current ratio of "1 to 1" is considered adequate liquidity for most
companies and an acid-test (quick) ratio of "1 to 1" is probably more than
12/31/X2 12/31/X3
adequate. The higher the ratios, the greater a company's liquidity; however, 1.25 0.57
excessive liquidity may actually indicate poor management of a company's assets
and financing. In some cases excess current assets may be more productively
used if converted to cash and used to payoff interest bearing debts or purchase
capital assets (buildings, equipment, etc.). A company's goal should be to Current Assets 18%
maximize profits, not liquidity. On the other hand, companies must be able to
meet obligations as they come due to retain credibility with suppliers and other
provider's of capital. Adequate liquidity is essential for effective operations and Current Liabilities 84%
should be monitored closely.

Whether a company can operate effectively at a less than 1 to 1 current ratio

depends on the nature of the company's business. If a company sells its A company's statement of cash flows, which reports sources
inventory at high margins and turns its inventory frequently, significant and uses of cash during the year, can be really helpful in
additional cash can be generated to meet current obligations. In other words,
profits can be a new and constant source of cash to supplement existing current understanding the causes of changing liquidity and can help
assets in satisfying current debts. Highly profitable companies with frequent spot dangerous trends that could impact a company's future.
inventory turnover can usually operate effectively at relatively low current ratios.

11 12

2-2
 Hot Cars, Inc. Problem 2-2
Balance Sheet
December 31, 20X1, 20X2 and 20X3
Review of A/R and Inventory Turnover Measures
12/31/X1 12/31/X2 12/31/X3 12/31/X1 12/31/X2 12/31/X3
Assets Liabilities & Equity
Current Assets:
Cash $ 12,665 $ 21,808 $ 3,505
Current Liabilities:
Accounts Payable $ 13,511 $ 22,250 $ 60,765
Using HCI's financial statements provided on the following pages:
Accounts Receivable 11,750 34,315 42,341 Salaries Payable 4,125 0 7,280
Inventory 11,432 25,000 20,777 Income Tax Payable 1,644 6,408 4,747
Office Supplies 470 750 1,962 Dividend Payable 1,250 0 0 A. Calculate HCI's A/R turnover and days sales in A/R for
Prepaid Insurance 350 400 2,368 Unearned Rent Revenue 0 280 0
Prepaid Rent 4,400 4,400 0 Utilities Payable 485 400 937 20X2 and 20X3 and interpret the results.
Notes Receivable 750 0 0 Interest Payable 0 178 53
41,817 86,673 70,953 Current Portion of Long-Term Debt 0 14,000 6,130
Land and Building 0 0 300,000 21,015 43,516 79,912 B. Calculate HCI's inventory turnover and days sales in inventory
Warehouse Equipment 18,466
Less: Accumulated Depreciation (3,766)
42,800
(5,406)
46,256
(10,391)
Equipment Note Payable
Mortgage Note Payable
0
0
8,000
0
4,000
247,363
for 20X2 and 20X3 and interpret the results.
Total Assets $ 56,517 $ 124,067 $ 406,818 Total Liabilities 21,015 51,516 331,275

Equity
Capital Stock (2,400 and
4,250 shares, respectively) 24,000 42,500 42,500
Retained Earnings 11,502 30,051 33,043
Total Equity 35,502 72,551 75,043
Total Liabilities & Equity $ 56,517 $ 124,067 $ 406,818

13 14

Problem 2-2 Problem 2-2

Hot Cars, Inc. Hot Cars, Inc.
Income Statement Balance Sheet
for the years ended December 31, 20X1, 20X2 and 20X3 December 31, 20X1, 20X2 and 20X3
20X1 20X2 20X3
12/31/X1 12/31/X2 12/31/X3 12/31/X1 12/31/X2 12/31/X3
Sales Revenues $ 185,043 $ 261,950 $ 318,432
Assets Liabilities & Equity
Cost of Goods Sold 111,026 164,026 206,145
Current Assets: Current Liabilities:
Gross Margin 74,017 97,924 112,287 Cash $ 12,665 $ 21,808 $ 3,505 Accounts Payable $ 13,511 $ 22,250 $ 60,765
Operating Expenses: Accounts Receivable 11,750 34,315 42,341 Salaries Payable 4,125 0 7,280
Salaries Expense 49,500 53,600 60,689 Inventory 11,432 25,000 20,777 Income Tax Payable 1,644 6,408 4,747
Office Supplies Expense 3,893 3,958 3,465 Office Supplies 470 750 1,962 Dividend Payable 1,250 0 0
Rent Expense 4,150 4,800 4,400 Prepaid Insurance 350 400 2,368 Unearned Rent Revenue 0 280 0
Utilities Expense 6,345 6,850 8,144 Prepaid Rent 4,400 4,400 0 Utilities Payable 485 400 937
Depreciation Expense 1,436 1,640 6,985 Notes Receivable 750 0 0 Interest Payable 0 178 53
Insurance Expense 1,055 1,105 2,345 41,817 86,673 70,953 Current Portion of Long-Term Debt 0 14,000 6,130
Land and Building 0 0 300,000 21,015 43,516 79,912
Miscellaneous Expense 900 312 617
Warehouse Equipment 18,466 42,800 46,256 Equipment Note Payable 0 8,000 4,000
Postage Expense 298 321 373
Less: Accumulated Depreciation (3,766) (5,406) (10,391) Mortgage Note Payable 0 0 247,363
Operating Expenses 67,577 72,586 87,018 Total Assets $ 56,517 $ 124,067 $ 406,818 Total Liabilities 21,015 51,516 331,275
Operating Income 6,440 25,338 25,269
Other Revenue and (Expense) Equity
Gain on Sale 0 0 2,000 Capital Stock (2,400 and
Rental Revenue 0 420 280 4,250 shares, respectively) 24,000 42,500 42,500
Interest Revenue 135 52 0 Retained Earnings 11,502 30,051 33,043
Interest Expense ( 0) (178) (7,810) Total Equity 35,502 72,551 75,043
Income Before Income Taxes 6,575 25,632 19,739 Total Liabilities & Equity $ 56,517 $ 124,067 $ 406,818
Income Tax Expense 1,644 6,408 4,747
Net Income $ 4,931 $ 19,224 $ 14,992
Earnings Per Share $ 2.05 $ 4.52 $ 3.53

15 16

Problem 2-2 - Answer Problem 2-2 - Answer

Review of A/R and Inventory Turnover Measures This is a negative trend. Generally speaking higher turnover is preferred unless
profits are compromised in the process. The timeliness of cash collections from
A. Calculate HCI's A/R turnover and days sales in A/R for customers could be improved by refusing to make credit sales, but that would be
20X2 and 20X3 and interpret the results. foolish if the company lost half of its customers as a result. The ultimate goal
should always be to maximize profit not A/R turnover, but all things being equal,
Accounts Receivable Turnover: Sales Revenues the collection of receivables sooner rather than later is a good thing.
(Beginning A/R + Ending A/R) 2 The increase in days sales in A/R (average collection period) from 32 days in 20X2
20X2: $ 261,950 to 44 days in 20X3 may reflect the following:
= 11.4 times
($ 11,750 + $34,315) 2 1. Management's failure to properly enforce existing credit policies.
2. Implementation of liberalized credit policies put in place in an attempt to increase
20X3: $ 318,432 customers and improve sales volume.
= 8.3 times
($ 34,315 + $42,341) 2 3. Less aggressive collection efforts or poor management of the collection process.
4. Customer cash flow problems arising from a slowing economy or other customer
Days Sales in Accounts Receivable: 365 problems.

A/R Turnover 5. Customer dissatisfaction with products or services.

20X2: 365
= 32.1 days Generally speaking, a 30 day collection period is good and a 43 day period may still
11.37 be acceptable; however, a more useful evaluation would result from comparison of
these numbers against those of competitors and companies in a similar business.
20X3: 365 Certainly the trend for HCI is of some concern and direct questioning of
= 43.9 days management as to the cause would be appropriate under the circumstances.
8.31
17 18

2-3
 Problem 2-2 - Answer Problem 2-2 - Answer

By pure coincidence, HCI's days sales in inventory (average inventory holding

B. Calculate HCI's inventory turnover and days sales in inventory period) was exactly the same in 20X2 and 20X3. This means that on average HCI
has maintained fairly consistent inventory levels relative to sales volume.
for 20X2 and 20X3 and interpret the results.
Generally speaking, the higher the inventory turnover the better as long as efforts
Inventory Turnover: Cost of Goods Sold to improve turnover do not negatively affect a company's profits. The ultimate goal
(Beginning Inventory + Ending Inventory) / 2 is to maximize profits not inventory turnover, however, financing and maintaining
inventory can be expensive and the sooner inventory is sold the better.
20X2: $ 164,026
= 9.0 times In most cases improving inventory turnover should increase a company's profits
($ 11,432 + $25,000) / 2 unless customer sales are lost in the process. By the way, this can actually happen.
One way to improve inventory turnover is to simply reduce inventory levels, but if
20X3: $ 206,145 customers become dissatisfied with limited product selection or delays in delivery,
= 9.0 times
($ 25,000 + $20,777) / 2 then sales and profits might suffer.
Generally speaking, a 41-day inventory holding period would not seem excessive
Days Sales in Inventory: 365 for a toy wholesaler; however, 41 days for a grocery store would probably spell
Inventory Turnover disaster. For an automobile dealership, a 41-day holding period might indicate
20X2: 365 exceptional inventory management.
= 40.6 days
9 In order to really evaluate HCI inventory management,
comparison with other companies in its industry and analysis of the effect of
20X3: 365 changing inventory levels on sales volume would probably be necessary.
= 40.6 days
9

19 20

Accounts Payable Turnover:

Inventory Purchases Inventory

(Beginning A/P + Ending A/P) / 2
1/1/X2 11,432
Purchased ?
20X2:
164,026 Sold
Accounts Payable Turnover:
12/31/X2 25,000
$ 177,594
= 9.9 times
($ 13,511 + $22,250) / 2
11,432 + X - 164,026 = 25,000
Days Purchases in Accounts Payable: X = 177,594
365
= 36.9 days
9.9

21 22

Hot Cars, Inc.

Balance Sheet 20X3:
December 31, 20X1, 20X2 and 20X3
Accounts Payable Turnover:
12/31/X1 12/31/X2 12/31/X3 12/31/X1 12/31/X2 12/31/X3
Assets Liabilities & Equity $ 201,922
Current Assets: Current Liabilities: = 4.9 times
C as h $ 12,665 $ 21,808 $ 3,505 Accounts Payable $ 13,511 $ 22,250 $ 60,765 ($ 22,250 + $ 60,765) / 2
Accounts Receivable 11,750 34,315 42,341 Salaries Payable 4,125 0 7,280
Inventory 11,432 25,000 20,777 I n c om e T ax P aya b l e 1,644 6,408 4,747
Office Supplies 470 750 1,962 Dividend Payable 1,250 0 0
Prepaid Insurance 350 400 2,368 Unearned Rent Revenue 0 280 0
Prepaid Rent 4,400 4,400 0 Utilities Payable 485 400 937 Days Purchases in Accounts:
Notes Receivable 750 0 0 Interest Payable 0 178 53
41,817 86,673 70,953 Current Portion of Long-Term Debt 0 14,000 6,130
365
Land and Building
Warehouse Equipment 18,466
0 0
42,800
300,000
46,256 Equipment Note Payable
21,015
0
43,516
8,000
79,912
4,000 = 74.5 days
Less: Accumulated Depreciation (3,766) (5,406) (10,391) M o r tg a g e N o te P a y a b l e 0 0 247,363 4.9
Total Assets $ 56,517 $ 124,067 $ 406,818 Total Liabilities 21,015 51,516 331,275

Equity
Capital Stock (2,400 and
4,250 shares, respectively) 24,000 42,500 42,500
Retained Earnings
Total Equity
Total Liabilities & Equity
11,502
35,502
$ 56,517
30,051
72,551
$ 124,067
33,043
75,043
$ 406,818
Liquidity Problem!

23 24

2-4
 Operating Cycle Operating Cycle
Pay for
Inventory
Cash Cash
Inventory Inventory Collections Inventory Inventory Collections
Purchase Sales on Sales Purchase Sales on Sales

41 days 41 44 days 85 41 days 41 44 days 85

# day's sales in inventory days # day's sales in recievables days # day's sales in inventory days # day's sales in recievables days

85 days 75 days 10 days

# day's purchases in A/P Required Financing

25 26

All companies engage in

three kinds of business activities.
Inventory TM
Financing Activities - The raising of capital through either borrowing, or
Sales debt financing, or through the contributions of owners, which is referred to
Inventory Pay for as equity financing. Any transactions involving payoffs of loans, or return
Purchase Inventory
of capital to owners, or the payment of dividends to shareholders is also
part of a company's financing activities.
3-5 days
30
days Investing Activities - The acquisition of any long-term assets such as
Cash property, plant and equipment. Any subsequent disposition of those assets
Collections is also part of a company's investing activities.

Operating Activities - The recurring day-to-day providing of goods or

services to customers. All transactions involving sales and any collections
No Financing Required! of cash from sales along with all incurring and payment of expenses
constitute a company's operating activities.

The business process in a nutshell: Obtaining financing to invest in assets

that allow you to operate and provide goods or services to customers.

27 28

Hot Cars, Inc.

Balance Sheet
December 31, 20X2 and 20X3
12/31/X2 12/31/X3 12/31/X2 12/31/X3
A s s e ts Liabilities & Equity
Current Assets: Current Liabilities:
C as h $ 21,808 $ 3,505 Accounts Payable $ 22,250 $ 60,765
Accounts Receivable 34,315 42,341 Salaries Payable 0 7,280
Inventory 25,000 20,777 Income Tax Payable 6,408 4,747
Office Supplies 750 1,962 Dividend Payable 0 0

Statement of Cash Flows Prepaid Insurance

Prepaid Rent
Notes Receivable
400
4,400
0
86,673
2,368
0
0
70,953
Unearned Rent Revenue
Utilities Payable
Interest Payable
Current Portion of Long-Term Debt
280
400
178
14,000
0
937
53
6,130
Land and Building 0 300,000 43,516 79,912
Warehouse Equipment 42,800 46,256 Equipment Note Payable 8,000 4,000
Less: Accumulated Depreciation (5,406) (10,391) Mortgage Note Payable 0 247,363
Total Assets $ 124,067 $ 406,818 Total Liabilities 51,516 331,275

Equity
Capital Stock (2,400 and
4,250 shares, respectively) 42,500 42,500
Retained Earnings 30,051 33,043
Total Equity 72,551 75,043
Total Liabilities & Equity $ 124,067 $ 406,818

29 30

2-5
 Hot Cars, Inc. Problem 2-3
Statement of Cash Flows
for the year ended December 31, 20X3 Accounts Payable Turnover
Cash flows from operating activities: 20X3
Cash Receipts from:
Customer sales $310,406 Calculate Z Corporation's accounts payable turnover and days
Rental revenues 0
Interest revenues 0 purchases in accounts payable for the year 20X7 given the
Cash payments for:
Inventory (163,407) following information:
Salaries expense (53,409)
Rent expense 0
Utilities expense (7,607)
Office supplies expense (4,677) 12/31/X6 12/31/X7
Insurance expense (4,313)
Postage and misc. expense (990) Cash $ 54,000 $ 72,000
Income tax expense (6,408)
Interest expense (7,935)
Accounts Receivable $122,000 $145,000
Net cash flows provided from operating activities 61,660 Inventory $156,000 $184,000
Cash flows from investing activities:
Cash receipt from sale of warehouse equipment 10,000 Accounts Payable $177,000 $204,000
Cash payments for purchase of land and building (50,000)
Cash payment for purchase of warehouse equipment (13,456) Sales Revenues $888,000 $958,000
Net cash flows used in investing activities
Cash flows from financing activities:
(53,456) Cost of Goods Sold $722,000 $782,000
Cash payments for:
Dividends (12,000)
Equipment note principal (4,000) Is a higher accounts payable turnover typically a good or a bad sign
Mortgage note principal
Bank note principal
(507)
(10,000) for a company?
Net cash flows used in financing activities (26,507)
Net increase (decrease) in cash (18,303)
Cash and cash equivalents at beginning of year 21,808
Cash and cash equivalents at end of year $ 3,505

31 32

Problem 2-3 - Answer Problem 2-3 - Answer

Accounts Payable Turnover
Question:
Inventory Purchases
Accounts Payable Turnover:
(Beginning A/P + Ending A/P) 2 Is a higher accounts payable turnover typically a good or a bad
Inventory Purchases: Inventory sign for a company?
1/1/X7 156,000
Answer: This depends. A higher accounts payable turnover means
Purchases ?
payables are being paid off over a shorter period of time. This
782,000 Cost of Goods Sold
usually results in happier suppliers and a better credit rating for
12/31/X7 184,000
the company. Generally speaking, higher turnover and the lower
156,000 + X - 782,000 = 184,000 the # of days purchases in accounts payable reflects an improving
liquidity position for a company. On the other hand, slower
X = 810,000 payments allow companies to keep their own cash longer and is, in
20X7: effect, free financing until suppliers begin to charge penalties and
Accounts Payable Turnover: $ 810,000 interest on delinquent accounts.
= 4.3 times
($177,000 + $204,000) / 2 (rounded)

Days Purchases in Accounts Payable : 365

= 85 days (rounded)
4.3
33 34

Problem 2-4 Problem 2-4 - Answer

Statement of Cash Flows Statement of Cash Flows
Categories: Transaction Category
Identify the statement of Transaction Category
1. Cash received from sale of building I
cash flow category to 1. Cash received from sale of building I "O" = Operating activities 2. Cash payments on inventory purchases O
which each of the 2. Cash payments on inventory purchases O
"I" = Investing activities 3. Cash collected on issuance of bonds F
following transactions or 3. Cash collected on issuance of bonds F 4. Utilities payable recorded N/A
events would be assigned: 4. Utilities payable recorded N/A "F" = Financing activities 5. Cash payments on utility bills O
5. Cash payments on utility bills O 6. Cash collections on customer accounts O
"N/A" = Not on cash flow
6. Cash collections on customer accounts O 7. Cash sales to customers O
Categories: 7. Cash sales to customers O
statement
8. Cash payments of interest O
8. Cash payments of interest O 9. Cash payments of principal on notes payable F
"O" = Operating activities 9. Cash payments of principal on notes payable F 10. Cash payments in purchase of equipment I
"I" = Investing activities 10. Cash payments in purchase of equipment I 11. Depreciation expense N/A
11. Depreciation expense N/A 12. Cash collections of tenant rent O
"F" = Financing activities 12. Cash collections of tenant rent O 13. Cash payment of employee salaries O
"N/A" = Not on cash flow 13. Cash payment of employee salaries O 14. Cash purchase of copyrights I
statement 14. Cash purchase of copyrights I 15. Cash received from issuance of stock F
15. Cash received from issuance of stock F 16. Cash payment made on loans to employees I
16. Cash payment made on loans to employees I 17. Cash prepayment of insurance premium O
17. Cash prepayment of insurance premium O 18. Expiration of prepaid insurance N/A
18. Expiration of prepaid insurance N/A 19. Land acquired with mortgage loan N/A*
19. Land acquired with mortgage loan N/A* 20. Cash payment of dividends F
20. Cash payment of dividends F * To be disclosed in notes to the financial statements.

35 36

2-6
 Problem 2-5 Problem 2-5 - Answer
Statement of Cash Flow Analysis Statement of Cash Flow Analysis
Given the following statement of cash flow information for five X Y Q R Z
companies (Company X, Y, Q, R and Z), summarize in your own Cash flows from or used in operating activities + + - - +
words what happened for each company during the year. Look to the Cash flows from or used in investing activities - - + - +
sample solution for "X" below for an example. Cash flows from or used in financing activities - + + + -
Net cash flows for the period + - + - +
X Y Q R Z
Cash flows from or used in operating activities + + - - + Company X: Sufficient cash was generated from operations to finance increased
Cash flows from or used in investing activities - - + - + investment in buildings, land or other assets, make dividend payments to
stockholders and/or reduce debts, and build its cash balance during the period.
Cash flows from or used in financing activities - + + + -
This is probably the most favorable situation possible for a company.
Net cash flows for the period + - + - +
Company Y: Cash flows from operations and additional debt or equity financing
Sample Solution were used up in the purchase of buildings, equipment and/or long-term assets. In
Company X: Sufficient cash was generated from operations to finance fact, the company's investment in long-term assets also consumed a portion of the
company's existing cash. Obviously, this is a profitable growing company, but it
increased investment in buildings, land or other assets, make dividend appears that continued growth at the current rate will depend on the availability of
payments to stockholders and/or reduce debts, and build its cash balance additional future financing.
during the period. This is probably the most favorable situation possible
for a company.

37 38

Problem 2-5 - Answer

X Y Q R Z
Cash flows from or used in operating activities + + - - + A company's ability to obtain additional financing
Cash flows from or used in investing activities - - + - + for investing and operating activities usually depends
Cash flows from or used in financing activities - + + + -
to a great extent on its existing financial position.
Net cash flows for the period + - + - +

Company Q: Cash flows from the sale of land, buildings and/or other long-term Companies that are highly leveraged, or burdened
assets plus additional debt or equity financing were used to finance operations and
build the company's cash balance. Anytime a company fails to generate positive cash
with considerable debt relative to their assets will
flows from operations it's a cause for concern. When that's combined with the sale or usually have problems finding additional financing.
liquidation of long-term assets there is probable cause for concern.
Company R: Cash flows from debt or equity financing were used to increase Debt can be a useful tool in the financing of a
investments in building, land or other long-term assets and finance negative cash business and it can enhance profits as long as the
flows from operations. This situation is very common in start up companies that rely
on outside financing to grow assets until the company becomes profitable.
borrowed assets generate earnings in excess of
interest costs, but too much debt can often put
Company Z: Cash flows from operations and the sale of assets were used to make companies at risk.
dividend payments to stockholders and/or reduce debts, and build its cash balance
during the period. This is probably a positive situation although the liquidation of
long-term assets may precede slower future growth.

39 40

Problem 2-6 Problem 2-6

Hot Cars, Inc.
Review of Leverage Measures Income Statement
for the years ended December 31, 20X2 and 20X3
Using the HCI financial statements prepared in Lesson 1 and 20X2 20X3
provided on the pages that follow: Sales Revenues $ 261,950 $ 318,432
Cost of Goods Sold 164,026 206,145
Gross Margin 97,924 112,287
A. Calculate HCI's debt ratio (total debt to total assets) at Operating Expenses:
Salaries Expense 53,600 60,689
12/31/X2 and 'X3. Office Supplies Expense 3,958 3,465
Rent Expense 4,800 4,400
Utilities Expense 6,850 8,144
B. Calculate HCI's debt to equity ratio as of 12/31/X2 and 'X3. Depreciation Expense 1,640 6,985
Insurance Expense 1,105 2,345
Miscellaneous Expense 312 617
Postage Expense 321 373
C. Calculate the percentage increase (decrease) in total assets Operating Expenses 72,586 87,018
from 12/31/X2 to 12/31/X3. Operating Income
Other Revenue and (Expense)
25,338 25,269

Gain on Sale 0 2,000

Rental Revenue 420 280
D. How should these results be interpreted? Interest Revenue 52 0
Interest Expense (178) (7,810)
Income Before Income Taxes 25,632 19,739
E. Can a company operate effectively at a high debt ratio? Income Tax Expense
Net Income
6,408
$ 19,224
4,747
$ 14,992
Earnings Per Share $ 4.52 $ 3.53

41 42

2-7
 Problem 2-6 Problem 2-6 - Answer
Hot Cars, Inc. Review of Leverage Measures
Balance Sheet
December 31, 20X2 and 20X3 A. Calculate HCI's debt ratio (total debt to total assets) at
12/31/X2 12/31/X3 12/31/X2 12/31/X3 12/31/X1, 'X2 and 'X3.
A s s e ts
Current Assets:
Liabilities & Equity
Current Liabilities: Total Liabilities
C as h $ 21,808 $ 3,505 Accounts Payable $ 22,250 $ 60,765
Accounts Receivable 34,315 42,341 Salaries Payable 0 7,280 Total Assets
Inventory 25,000 20,777 Income Tax Payable 6,408 4,747
Office Supplies 750 1,962 Dividend Payable 0 0
$ 51,516 $ 331,275
Prepaid Insurance 400 2,368 Unearned Rent Revenue 280 0 12/31/X2: = 0.42 12/31/X1: = 0.81
Prepaid Rent
Notes Receivable
4,400
0
0
0
Utilities Payable
Interest Payable
400
178
937
53
$ 124,067 $ 406,818
86,673 70,953 Current Portion of Long-Term Debt 14,000 6,130
Land and Building 0 300,000 43,516 79,912
Warehouse Equipment 42,800 46,256 Equipment Note Payable 8,000 4,000
Less: Accumulated Depreciation
Total Assets
(5,406)
$ 124,067
(10,391)
$ 406,818
Mortgage Note Payable
Total Liabilities
0
51,516
247,363
331,275
B. Calculate HCI's debt to equity ratio as of 12/31/X2 and 'X3.
Equity Total Liabilities
Capital Stock (2,400 and
4,250 shares, respectively)
Retained Earnings
42,500
30,051
42,500
33,043
Total Equity
Total Equity 72,551 75,043
Total Liabilities & Equity $ 124,067 $ 406,818 $ 51,516 $ 331,275
12/31/X2: = 0.71 12/31/X1: = 4.41
$ 72,551 $ 75,043

43 44

Problem 2-6 - Answer Problem 2-6 - Answer

C. Calculate the percentage increase (decrease) in total assets from

12/31/X2 to 12/31/X3. D. How should these results be interpreted?
Answer: HCI experienced a huge growth in total assets in 20X3 primarily
as a result of the purchase of land and building ($300,000). This purchase
Change in Total Assets was financed principally through debt, a $250,000 mortgage loan. The
Base Year Amount of Total Assets cash required for the down payment on the building ($50,000) was financed
primarily from operations by deferring payments to suppliers on accounts
payable explaining the large increase in days purchases in accounts
$ 406,818 - $ 124,067 payable and the company's declining liquidity. The company's current high
level of leverage may limit the company's ability to raise capital in the
$ 124,067 future through either additional debt or equity financing and could affect
its ability to grow.

$ 282,751 E. Can a company operate effectively at a high debt ratio?

= 2.27 or 227%
$ 124,067 Answer: Companies can operate effectively at a high debt ratio as long as
they can generate sufficient cash flow from operations to cover the interest
costs. Some companies, like banks and other financial institutions, are
actually designed to operate with a high debt ratio.

45 46

Hot Cars, Inc.

Income Statement
for the years ended December 31, 20X2 and 20X3
20X2 20X3
Sales Revenues $ 261,950 $ 318,432
Cost of Goods Sold 164,026 206,145
Times Interest Earned Ratio: Gross Margin 97,924 112,287
Operating Expenses:
Salaries Expense 53,600 60,689
Income before Interest Expense and Income Taxes Office Supplies Expense 3,958 3,465
Rent Expense 4,800 4,400
Interest Expense Utilities Expense 6,850 8,144
Depreciation Expense 1,640 6,985
Insurance Expense 1,105 2,345
Miscellaneous Expense 312 617
12/31/X3: $ 14,992 + $ 7,810 + $ 4,747 Postage Expense 321 373
= 3.5 times Operating Expenses 72,586 87,018
$ 7,810 Operating Income 25,338 25,269
Other Revenue and (Expense)
Gain on Sale 0 2,000
Rental Revenue 420 280
Interest Revenue 52 0
Interest Expense (178) (7,810)
Income Before Income Taxes 25,632 19,739
Income Tax Expense 6,408 4,747
Net Income $ 19,224 $ 14,992
Earnings Per Share $ 4.52 $ 3.53

47 48

2-8
 Problem 2-7
Times Interest Earned

Calculate Z Corporation's times interest earned given the following

income statement for the year ended 12/31/X7:
Times Interest Earned Ratio:
Sales Revenues $ 355,000
Cost of Goods Sold (178,000)
Income plus Interest Expense and Income Taxes Gross Margin 177,000
Interest Expense Operating Expenses 122,000
Operating Income 55,000
Interest Expense 21,000
12/31/X3: $ 14,992 + $ 7,810 + $ 4,747 Income Before Income Taxes 34,000
= 3.5 times Income Tax Expense 10,000
$ 7,810
Net Income $ 24,000

Question: Does the company's 20X7 times interest earned seem adequate?

49 50

Problem 2-7 - Answer

Times Interest Earned

Income before Interest Expense and Income Taxes

Interest Expense
How effectively is the company utilizing
12/31/X2: $ 24,000 + $ 21,000 + $ 10,000
= 2.6 times
its assets to create sales of goods and
$ 21,000
services to customers and produce
profits for the company's owners?
Question: Does the company's 20X7 times interest earned seem adequate?

Answer: Obviously, the higher a company's times interest earned the better.
What's adequate will depend on the expectations of each individual investor.
Investors who prefer leveraged investments will often have a lower threshold in
their expectation of times interest earned.

51 52

Ratios commonly used in evaluating a Ratios commonly used in evaluating a

company's profit performance company's profit performance
Net Income Net Income
Total Assets Total Assets
"Return on Assets" "Return on Assets"
(ROA) (ROA)

12/31/X2: $ 19,224 12/31/X2: $ 19,224

= 0.155 or 15.5% return on assets = 0.155 or 15.5% return on assets
$ 124,067 $ 124,067

12/31/X3: $ 14,992 12/31/X3: $ 14,992

= 0.037 or 3.7% return on assets = 0.077 or 7.7% return on assets
$ 406,818 $ 194,755

Weighted average balance of total assets:

(9 x $124,067) + (3 x $406,818)
= $194,755
12 months

53 54

2-9
 "Return on Equity" Why is HCI's return on equity in both 20X2 and 20X3 so much
(ROE) higher than the company's return of assets?

Net Income
Net Income
Total Equity = % Return
$ XXX
12/31/X2: $ 19,224
= 0.265 or 26.5%
$ 72,551 Owners are better off if equal or greater profits can be
achieved with less invested capital. Using other peoples' money
12/31/X3: $ 14,992 to produce profits for yourself is what's going on here.
= 0.20 or 20%
$ 75,043
Leverage
If a company can borrow assets and produce a return on those
assets in excess of the costs of borrowing those assets, then
owners benefit and the company's return on equity goes up.

55 56

DuPont Framework
(Performance Analysis)
HCI ROE = Profitability x
(profit margin)
Efficiency
(sales on assets)
x Leverage
(use of borrowed assets)

ROA ROE Net Income Sales Revenues Total Assets

Sales Revenues Total Assets Total Equity

20X2: 15.5% 26.5% 20X2: $19,224 $261,950 $124,067

$261,950 $124,067 $72,551
26.5 % = 0.073 x 2.11 x 1.71
20X3: 7.7% 20.0%
20X3: $14,992 $318,432 $406,818
$318,432 $406,818 $75,043
20.0% = 0.047 x 0.78 x 5.42
Improvements: Improvements:
Product price increases Increase sales volume
Cuts in expenses Downsize assets

57 58

EPS Diluted EPS: Calculated the same way as earning per share
(Earnings Per Share) except that any common shares that could have
been issued during the year through existing stock
options or any other commitment, are added to the
Basic EPS: Net Income weighted average number of shares outstanding in
# Shares of Stock Outstanding the denominator. Diluted EPS will always be lower
than basic EPS and reflects what EPS would have
Net Income - Preferred Dividends been if all commitments to issue common stock had
been fulfilled during the year.
# Shares of Common Stock Outstanding
(weighted average)
HCI's 20X3 EPS:
Example of weighted average - Assume a company has 100,000
shares of common stock outstanding as of 1/1/X6 and an additional $ 14,992
20,000 shares are issued at 4/1/X6. The weighted average to be used = $3.53 per share
4,250 shares
in the EPS calculation for the year ended 12/31/X6 would be:

(100,000 x 3 mo.) + (120,000 x 9 mo.)

= 115,000 shares
12 mo.

59 60

2-10
Shareholders generate profits on their stock investments in _ Increase or Decrease in Stock Price
Stockholder's Return Dividends +
two ways: =
on Investment Original Stock Purchase Price
Dividends
Gains on the subsequent sale of their stock. Because stock prices change daily, an investor's return
on investment is a constantly fluctuating amount. In
fact, stockholder returns are never actually realized
Dividend Payout Ratio: until a stock is finally sold.
Dividends
Net Income

Dividend Yield: When should a stock be sold?

Dividends per Share
Price Paid per Share

61 62

Price Earnings or P/E Ratio:

Market Price Per Share
EPS
Stock prices will always move based
upon changing investor expectations HCI's 12/31/X3 P/E Ratio:
of a company's future earnings. $ 60
= 17 times P/E multiple
$3.53

Is $60 per share or a 17 to 1 price earnings multiple

too high for HCI stock, and why do some stocks sell
at much higher multiples, in some cases, in excess of
30 or even 60 times a dollar of earnings?

63 64

Problem 2-8
The stock of stagnant companies with no expectation of future Performance and Value Measures
increased earnings will often be priced at P/E ratios of 10 to 1,
or less. Given the information for Staley Industries for the year ended 12/31/X5:
$1 of EPS Staley Industries
= 10% return on investment
$10 Investment 12/31/X5 1. Calculate:
The stock of companies with declining prospects for earnings Cash $ 32,000 A. Return on Assets
will probably sell at a P/E ratio of less than 10 to 1. Total Current Assets $125,000
B. Return on Equity
Total Assets $743,000
20X2 20X3 Total Current Liabilities $ 94,000 C. Return on Equity using the
HCI's EPS $4.52 $3.53 Total Liabilities $450,000 DuPont Framework
Retained Earnings (beginning) $148,000 D. EPS (Assume no new shares
What would HCI's stock price be at a 10 times P/E ratio? Common Stock (10,000 shares) $100,000 were issued in 20X5.)
Sales Revenues $997,000
Price Per Share Gross Margin $367,000
E. Dividends Per Share
= 10
$ 3.53 Operating Income $ 94,000 F. Dividend Payout Ratio
Net Income $ 65,000
Price Per Share = $35 G. Dividend Yield
Retained Earnings (ending) $193,000
H. P/E Ratio
Where are HCI's future profits headed? Current Stock Price per Share $ 91

65 66

2-11
 Problem 2-8 Problem 2-8 - Answer
Performance and Value Measures
1. Calculation of ratios:
2. Respond to the following questions:
A. Given Staley's ratio results in Part 1, A. Return on Assets: Net Income $ 65,000
= 8.7%
Total Assets $743,000
i. Evaluate the company's 20X5 operating performance, to the
extent possible. B. Return on Equity: Net Income $65,000
= 22.2%
ii. How do you think investors view the company's prospects Total Equity $293,000
for the future.
C. Return on Equity using the DuPont Framework:

B. What conclusions can be drawn from the company's dividend Profitability Efficiency Leverage
ROE = (profit margin) x (sales on assets) x (use of borrowed assets)
payout ratio?
Net Income Sales Revenues Total Assets
x x
C. Which of the following is a good measure of a stock investor's Sales Revenues Total Assets Total Equity
real return on investment; (a) return on assets, (b) return on
equity, or (c) dividend yield. $65,000 $997,000 $743,000
x x
$997,000 $743,000 $293,000
22.2 % = 0.0652 x 1.342 x 2.536

67 68

Problem 2-8 - Answer Problem 2-8 - Answer

D. EPS: Net Income 2. Respond to the following questions:

# Shares of Stock Outstanding A. Given Staley's ratio results in Part 1,
$65,000
= $6.50 per share i. Evaluate the company's 20X5 operating performance, to the
10,000 shares extent possible.
E. Dividends Per Share: Dividends Answer: Without prior year information, ratios of other companies
# of Shares of Stock Outstanding in a similar business, or industry averages, it is difficult to reach
meaningful conclusions on Staley's operating performance in 20X5.
$20,000 We know the company's profitable with $6.50 of EPS, and the return
= $2.00 on equity of 22.2% seems good, but is that up or down from the prior
10,000
year? If the company's 20X4 return on equity was 50%, then the
F. Dividend Payout Ratio: Dividends Per Share $ 2.00 20X5 return of 22% would probably be a major disappointment.
= 31%
EPS $ 6.50
The DuPont framework helps us note that a big part of Staley's 22%
G. Dividend Yield: Dividends per Share return on equity is its leverage. About 60% of the company's assets
$ 2.00 have been financed by debt, but again, it's difficult to evaluate the
= 2.2%
Market Price per Share $ 91 company's profitability and efficiency in the use of assets without
comparative data.
H. P/E Ratio: Market Price per Share $ 91
= 14
EPS $ 6.50
69 70

Problem 2-8 - Answer Problem 2-8 - Answer

ii. How do you think investors view the company's prospects B. What conclusions can be drawn from the company's dividend
for the future. payout ratio?
Answer: Stock values are based on investor expectations for future Answer: In 20X5, Staley paid out 31% of it earnings as a dividend
profits. The fact that Staley's P/E ratio is only 14 does not suggest to stockholders. Without comparative information from prior years
high expectations for future growth in profits. High growth it's impossible to establish the company's historical or ongoing
companies often trade at P/E multiples of 30 or more. The modest dividend policy. Fast growing companies often pay no dividends,
investor expectation's for Staley's future earnings may be a result of retaining all of their earnings to help finance their growth. A 31%
one or a number of things including the following: dividend payout may be consistent for a company experiencing
modest growth, however, there really isn't sufficient data to draw
a. A trend of slow or unstable earnings growth. any real conclusions in this case.
b. Slowing growth or recession in Staley's industry.
c. Slowing growth or recession in the country's overall
economy.
d. Some national, industry or company event that has created
uncertainty in investors minds relative to the future.

71 72

2-12
 Problem 2-8 - Answer

C. Which of the following is a good measure of a stock investor's The ultimate goal of financial statement
real return on investment; (a) return on assets, (b) return on analysis is to utilize a company's financial
equity, or (c) dividend yield.
statements to predict its future.
Answer: A stock investor's real return on investment includes any dividends
received plus or minus any gain or loss on the sale of the stock (the difference
between the stock's purchase and subsequent sales price). This return on
investment cannot be determined until the stock is ultimately sold. Prior to For Stock Investors:
actual sale a tentative return on investment would be the amount of any
dividends received plus or minus any increase or decrease in the stock's
current value relative to its original purchase price. None of the measures The goal is to predict a company's future
provided in this question reflect this return on stock investment.
dividends and stock value to assess its
Return on assets (ROA) reflects a company's earnings on its total assets. It is potential return on investment.
not a measure of investor or stockholder returns.

Return on equity (ROE) measures the company's earnings

on the assets provided through capital contributions and retained earnings. It
The key to good predictions of future
is not a measure of investor or stockholder returns. dividends and stock values are good
Dividend yield measures only a portion of an investor's return based on the predictions of a company's future earnings.
stock's current pricing rather than the amount of a stockholder's actual
investment.

73 74

Problem 2-9
Review of Income Statement Analysis
Using the HCI financial statements prepared in Lesson 1 and provided
on the following pages:
One of the better tools available to analysts in trying
to formulate forecasts of a company's future earnings A. Calculate HCI's cost of goods sold, gross margin, operating
expenses, operating income, interest expense, income before
is vertical analysis of its past earnings, which is income taxes, income taxes and net income, each as a
sometimes referred to as the use of a common-sized percentage of sales revenues for the years 20X1, 'X2 and 'X3.
income statement. It's done by taking each element
of the income statement as a percentage of net sales B. What might be the cause of the declining gross margin
revenues and then analyzing those results over time. percentage over the years?

C. Calculate the percentage growth in sales revenues in 20X2 and

20X3. What might be the cause of the declining growth of sales
revenues and discuss the significance of the results relative to
HCI's future.

D. What is your opinion on the outlook for future HCI earnings

given this income statement analysis?

75 76

Problem 2-9 Problem 2-9 - Answer

Hot Cars, Inc. Review of Income Statement Analysis
Income Statement A.
for the years ended December 31, 20X1, 20X2 and 20X3 Hot Cars, Inc.
Income Statement
20X1 20X2 20X3
for the years ended December 31, 20X1, 20X2 and 20X3
Sales Revenues $ 185,043 $ 261,950 $ 318,432 20X1 20X2 20X3
Cost of Goods Sold 111,026 164,026 206,145 Sales Revenues $ 185,043 $ 261,950 $ 318,432
Gross Margin 74,017 97,924 112,287 Cost of Goods Sold 111,026 .60 164,026 .63 206,145 .65
Operating Expenses: Gross Margin 74,017 .40 97,924 .37 112,287 .35
Salaries Expense 49,500 53,600 60,689 Operating Expenses:
Office Supplies Expense 3,893 3,958 3,465 Salaries Expense 49,500 53,600 60,689
Rent Expense 4,150 4,800 4,400 Office Supplies Expense 3,893 3,958 3,465
Utilities Expense 6,345 6,850 8,144 Rent Expense 4,150 4,800 4,400
Depreciation Expense 1,436 1,640 6,985 Utilities Expense 6,345 6,850 8,144
Depreciation Expense 1,436 1,640 6,985
Insurance Expense 1,055 1,105 2,345
Insurance Expense 1,055 1,105 2,345
Miscellaneous Expense 900 312 617
Miscellaneous Expense 900 312 617
Postage Expense 298 321 373
Postage Expense 298 321 373
Operating Expenses 67,577 72,586 87,018 Operating Expenses 67,577 .37 72,586 .28 87,018 .27
Operating Income 6,440 25,338 25,269 Operating Income 6,440 .03 25,338 .10 25,269 .08
Other Revenue and (Expense) Other Revenue and (Expense)
Gain on Sale 0 0 2,000 Gain on Sale 0 0 2,000
Rental Revenue 0 420 280 Rental Revenue 0 420 280
Interest Revenue 135 52 0 Interest Revenue 135 52 0
Interest Expense ( 0) (178) (7,810) Interest Expense ( 0) .00 (178) .00 (7,810) .02
Income Before Income Taxes 6,575 25,632 19,739 Income Before Income Taxes 6,575 .03 25,632 .10 19,739 .06
Income Tax Expense 1,644 6,408 4,747 Income Tax Expense 1,644 .01 6,408 .02 4,747 .01
Net Income $ 4,931 .02 $ 19,224 .07 $ 14,992 .05
Net Income $ 4,931 $ 19,224 $ 14,992
Earnings Per Share $ 2.05 $ 4.52 $ 3.53
Earnings Per Share $ 2.05 $ 4.52 $ 3.53

77 78

2-13
 Problem 2-9 - Answer Problem 2-9 - Answer

B. What might be the cause of the declining gross margin percentage C. Calculate the percentage growth in sales revenues in 20X2 and 20X3.
over the years? Growth in Sales Revenues:
Answer: The declining gross margin percentage could be the result of the following:
20X2: $ 261,950 - $ 185,043
1. The company's product costs increased and the company elected to hold back = 0.42
on a corresponding price increase to customers. In fact, the company may $ 185,043
have actually reduced, left unchanged, or increased their customer pricing
and generated this percentage trend as long as any price increase was less 20X3: $ 318,432 - $ 261,950
than the increase in costs. = 0.22
$ 261,950
2. The company's product costs have not changed over time, but the company
has reduced its sales pricing to improve sales volume. What might be the cause of the declining growth of sales revenues
3. The company's product costs may have actually gone down over the years but
and discuss the significance of the results relative to HCI's future.
the company has implemented even larger price reductions for its customers.
Answer: The declining growth in sales revenues could be the simple result of
Further information from HCI management would be necessary to understand the slowing growth in the volume of sales, sales price reductions, or some
precise cause for this decline in the gross margin percentage and its impact on the combination of the two. In any case, declining growth in sales revenues is a
company's future. In any case, a decreasing gross margin percentage is usually a sign of increased competition or slowing growth in customer demand.
sign of increasing competition or decreasing customer demand, neither of which is a Hopefully this trend can be reversed through product improvements or better
good sign for future growth in profits. marketing, if not, the only hope for increased growth in future earnings will
be through better management of the company's costs, which can only go so
far.

79 80

Problem 2-9 - Answer

$60/share x 4,250 shares = $255,000
D. What is your opinion on the outlook for future HCI earnings given
this income statement analysis? Market Capitalization
Answer: HCI's declining net income in 20X3 was caused primarily by its
(Market Cap)
lower gross margin percentage and increased interest costs associated
with the purchase of land and building. The prospects for improved Book Value = Assets - Liabilities
earnings in 20X4 are not good given the expected increases in interest and
depreciation, even though rent expenses will be eliminated. The decision = $406,818 - $331,275
to purchase the land and building in the face of declining growth in sales = $75,043
and lower margins seems, at best, questionable. Maybe management can
provide some explanation and offer a plan for improved performance, but
the results from this last year are not encouraging. Book Value Per Share:

Book Value
# Shares of Stock Outstanding
$75,043
= $17.66 per share
4,250

81 82

Hot Cars, Inc.

Income Statement
for the years ended December 31, 20X1, 20X2 and 20X3
20X1 20X2 20X3
Sales Revenues $ 185,043 $ 261,950 $ 318,432
Cost of Goods Sold 111,026 .60 164,026 .63 206,145 .65
Gross Margin 74,017 .40 97,924 .37 112,287 .35
Operating Expenses:
Salaries Expense 49,500 53,600 60,689
Office Supplies Expense 3,893 3,958 3,465
Rent Expense 4,150 4,800 4,400
Utilities Expense 6,345 6,850 8,144
Depreciation Expense 1,436 1,640 6,985
Insurance Expense 1,055 1,105 2,345
Miscellaneous Expense 900 312 617
Postage Expense 298 321 373
Operating Expenses 67,577 .37 72,586 .28 87,018 .27
Operating Income 6,440 .03 25,338 .10 25,269 .08
Other Revenue and (Expense)
Gain on Sale 0 0 2,000
Rental Revenue 0 420 280
Interest Revenue 135 52 0
Interest Expense ( 0) .00 (178) .00 (7,810) .02
Income Before Income Taxes 6,575 .03 25,632 .10 19,739 .06
Income Tax Expense 1,644 .01 6,408 .02 4,747 .01
Net Income $ 4,931 .02 $ 19,224 .07 $ 14,992 .05
Earnings Per Share $ 2.05 $ 4.52 $ 3.53

83

2-14
 Lesson 3

A statement of cash flows can be useful

to investors, creditors and analysts in

Lesson 3 1. Understanding the causes of a company's

changing cash position and overall liquidity.
The Statement
of Cash Flows 2. Helping to understand the extent and nature of a
company's financing and investing activities.

3. Evaluating a company's ability to generate cash

from its operations.

1 2

Hot Cars, Inc.

Statement of Cash Flows
for the year ended December 31, 20X3 Profitable and growing companies:
20X3
Cash flows from (used in ) operating activities:
Cash Receipts from:
Customer sales $310,406
Cash payments for:
Inventory (163,407)
Cash from operating activities
Salaries expense (53,409)
Rent expense
Utilities expense
0
(7,607)
Cash used in investing activities
Office supplies expense (4,677)
Insurance expense (4,313)
Postage and misc. expense (990)
Income tax expense (6,408)
Interest expense
Net cash flows provided from operating activities
(7,935)
61,660
Companies that generate enough net cash
Cash flows from (used in) investing activities:
Cash payment for purchase of land and building (50,000) flow from operations to not only fund their
Cash payment for purchase of warehouse equipment
Cash receipt from sale of warehouse equipment
Net cash flows used in investing activities
(13,456)
10,000
(53,456)
investments, but also pay down debts and
Cash flows from (used in) financing activities:
Payment of mortgage note principal (507)
distribute dividends to owners are the best
Payment of equipment note principal
Payment of dividends
(14,000)
(12,000) cash performers and are often referred to
Net cash flows used in financing activities (26,507)
Net increase (decrease) in cash
Cash and cash equivalents at beginning of year
(18,303)
21,808
as "cash cows."
Cash and cash equivalents at end of year $ 3,505

3 4

Hot Cars, Inc.

Statement of Cash Flows
for the year ended December 31, 20X3 Cash: Coins, paper currency, immediately depositable
Cash flows from (used in ) operating activities:
20X3
instruments such as checks, money orders,
Cash Receipts from:
Customer sales $310,406 cashiers checks and traveler's checks on-hand,
Cash payments for:
Inventory (163,407) plus, the balances of any demand deposits, which
Salaries expense
Rent expense
(53,409)
0
include checking, savings and money market
Utilities expense
Office supplies expense
(7,607)
(4,677)
accounts.
Insurance expense (4,313)
Postage and misc. expense (990)
Income tax expense
Interest expense
(6,408)
(7,935)
Cash Equivalents: Short-term, highly liquid investments
Net cash flows provided from operating activities 61,660 that can be easily converted to cash with no real
Cash flows from (used in) investing activities:
Cash payment for purchase of land and building (50,000) risk of changing values. These include such things
Cash payment for purchase of warehouse equipment (13,456)
Cash receipt from sale of warehouse equipment 10,000 as certificates of deposit, savings certificates, U.S.
Net cash flows used in investing activities
Cash flows from (used in) financing activities:
(53,456)
Treasury bills and commercial paper with a less
Payment of mortgage note principal
Payment of equipment note principal
(507)
(14,000) than three-month maturity.
Payment of dividends (12,000)
Net cash flows used in financing activities (26,507)
Net increase (decrease) in cash (18,303)
Cash and cash equivalents at beginning of year 21,808
Cash and cash equivalents at end of year $ 3,505

5 6

3-1
 Hot Cars, Inc.
Cash
Statement of Cash Flows
1/1/X3 21,808 for the year ended December 31, 20X3
Customer sales 310,406 4,677 Office supplies expense 20X3
Cash flows from (used in ) operating activities:
Sale of warehouse equip. 10,000 7,607 Utilities expense
Cash Receipts from:
50,000 Purchase land & building Customer sales $310,406
Cash payments for:
507 Payments on mortgage note Inventory (163,407)
4,995 Payment of mortgage interest Salaries expense (53,409)
Rent expense 0
10,000 Payment of bank note Utilities expense (7,607)
1,500 Payment of bank note interest Office supplies expense (4,677)
Insurance expense (4,313)
4,000 Payment on equipment note Postage and misc. expense (990)
1,440 Payment of equip. note interest Income tax expense (6,408)
Interest expense (7,935)
53,409 Salaries expense Net cash flows provided from operating activities 61,660
4,313 Insurance expense Cash flows from (used in) investing activities:
Cash payment for purchase of land and building (50,000)
6,408 Income tax expense Cash payment for purchase of warehouse equipment (13,456)
163,407 Purchase of inventory Cash receipt from sale of warehouse equipment 10,000
Net cash flows used in investing activities (53,456)
12,000 Payment of dividends Cash flows from (used in) financing activities:
617 Miscellaneous expense Payment of mortgage note principal (507)
Payment of equipment note principal (14,000)
373 Postage expense Payment of dividends (12,000)
13,456 Purchase of warehouse equip. Net cash flows used in financing activities (26,507)
Net increase (decrease) in cash (18,303)
12/31/X3 3,505 Cash and cash equivalents at beginning of year 21,808
Cash and cash equivalents at end of year $ 3,505

7 8

Problem 3-1 Problem 3-2 - Answer

Interpreting a Statement of Cash Flows A is a business in distress. The company is selling assets and
Given the following information for companies A, B, C and D: accessing additional financing to fund its negative cash flows
from operations.
Net cash flows
from (used in) A B C D B is a mature cash cow. Relatively large cash flows from
Operations ($102,000) $144,000 ($53,000) $150,000 operations are sufficient to fund modest growth in assets but are
used primarily for debt reduction, return of capital or the
Investing Activities $60,000 ($25,000) ($433,000) ($505,000) payment of dividends.
Financing Activities $75,000 ($205,000) $750,000 $370,000
C is a start-up company. Large infusions of capital are required
to acquire necessary assets and fund operations until the
Identify which of the four companies is
company begins to generate positive cash flows from profitable
a start-up business. operations on its own.
a mature cash cow.
a profitable growing business. D is a profitable growing business. Cash flows from operations
and additional debt or equity financing is used to fund a major
a business in distress. increase in the company's capital assets.

9 10

Problem 3-2 Problem 3-2 - Answer

Harrison Furniture Co.
Preparing a Statement of Cash Flows: Direct Method Statement of Cash Flows
Given the summarized general ledger cash account for Harrison Furniture Co., for the year ended December 31, 20X3
prepare the company's statement of cash flows for the year-ended 12/31/X3. Cash flows from (used in) operating activities: 20X3
Cash receipts from:
Cash Customer sales (85,327 + 494,572) $579,899
Interest income 3,288
1/1/X3 15,733 583,187
Cash payments for:
Cash sales 85,327 15,432 Cash purchases of inventory Inventory (15,432 + 275,387) (290,819)
Cash collections on A/R 494,572 275,387 Payments on A/P Salaries and wages (136,905)
Utilities (22,875)
Interest income 3,288 3,512 Purchase of office supplies Insurance (8,736)
Proceeds on equipment sale 38,355 25,489 Interest payments Office supplies (3,512)
Other operating costs (18,366)
Proceeds on issuance of stock 100,000 104,995 Principal payments on note payable Interest (25,489)
Proceeds from issuance of bonds 500,000 22,875 Utility payments Income taxes (22,400)
(529,102)
456,025 Purchase of equipment Net cash flows from operating activities 54,085
136,905 Salary and wage payments Cash from (used in) investing activities:
Cash receipt from equipment sale 38,355
8,736 Insurance payments Cash payments on purchase of equipment (456,025)
Cash loans made to employees (15,000)
50,000 Payment of dividends
Net cash flows used in investing activities (432,670)
22,400 Income tax payments Cash flows from(used in) financing activities:
Cash received from issuance of stock 100,000
15,000 Loans made to employees Cash received from issuance of bonds 500,000
18,366 Payments on other operating costs Dividends paid (50,000)
Cash payment on principal of note payable (104,995)
12/31/X3 82,153 Net cash flows from financing activities 445,005
Net increase (decrease) in cash 66,420
Question: What is your general reaction if Harrison asked you for a $300,000 Cash and cash equivalents at beginning of year 15,733
loan ? Cash and cash equivalents at end of year $ 82,153

11 12

3-2
 Problem 3-2 - Answer

Question: What is your general reaction if Harrison asked you Indirect Method:
for a $300,000 loan?
A way to come up with the same net cash flow results by
Answer: The statement of cash flows indicates that Harrison is a growing
company. That's evidenced by the large expenditure of cash in investing relying primarily on the information already provided in the
activities, which totaled almost $433,000 on a net basis. The company other two general purpose financial statements, the income
bought a substantial amount of equipment during the year. This growth statement and the balance sheet.
was financed primarily through capital contributions from owners and a
large amount of new debt, the issuance of over $500,000 of bonds. The
company generated positive cash flows from operations during the year, Cash flows from operating activities: Cash inflows
and that's good, but what really matters most to new potential creditors is less outflows resulting from activities that produce a
the company's ability to generate operating cash flows in the future. Will
all that newly purchased equipment create enough additional profits to
company's revenues and expenses.
cover the increasing interest costs associated with the newly issued bonds?
At this point, that's not really clear, but that would certainly be a major Since all of a company's revenues and expenses appear on
concern for any potential new creditor. Additional review and analysis of
the company's balance sheet to determine the company's overall financial
its income statement, the indirect method takes the net
position and liquidity would also be a necessary part of any decision to income amount from that statement and adjusts it to reflect
extend a $300,000 loan. net cash flows from operations.

13 14

Hot Cars, Inc. Hot Cars, Inc.

Income Statement Income Statement
for the years ended December 31, 20X3 for the years ended December 31, 20X3
20X3 20X3

Sales Revenues $ 318,432 Sales Revenues $ 318,432

Cost of Goods Sold 206,145 Cost of Goods Sold 206,145
Gross Margin 112,287 Gross Margin 112,287
Operating Expenses: Operating Expenses:
Salaries Expense 60,689 Salaries Expense 60,689
Office Supplies Expense 3,465 Office Supplies Expense 3,465
Rent Expense 4,400 Rent Expense 4,400
Utilities Expense 8,144 Utilities Expense 8,144
Depreciation Expense 6,985 Depreciation Expense 6,985
Insurance Expense 2,345 Insurance Expense 2,345
Miscellaneous Expense 617 Miscellaneous Expense 617
Postage Expense 373 Postage Expense 373
Operating Expenses 87,018 Operating Expenses 87,018
Operating Income 25,269 Operating Income 25,269
Other Revenue and (Expense) Other Revenue and (Expense)
Gain on Sale 2,000 Gain on Sale 2,000
Rental Revenue 280 Rental Revenue 280
Interest Expense (7,810) Interest Expense (7,810)
Income Before Income Taxes 19,739 Income Before Income Taxes 19,739
Income Tax Expense 4,747 Income Tax Expense 4,747
Net Income $ 14,992 Net Income $ 14,992
Earnings Per Share $ 3.53 Earnings Per Share $ 3.53

15 16

Hot Cars, Inc. Sales Revenues

Balance Sheet
December 31, 20X2 and 20X3
318,432
12/31/X2 12/31/X3 12/31/X2 12/31/X3
318,432 12/31/X3
Assets Liabilities & Equity
Current Assets: Current Liabilities:
Cash $ 21,808 $ 3,505 Accounts Payable $ 22,250 $ 60,765 Accounts Receivable
Accounts Receivable 34,315 42,341 Salaries Payable 0 7,280
Inventory 25,000 20,777 Income Tax Payable 6,408 4,747 1/1/X3 34,315
Office Supplies 750 1,962 Unearned Rent Revenue 280 0
Prepaid Insurance 400 2,368 Utilities Payable 400 937
318,432
Prepaid Rent 4,400 0 Interest Payable 178 53 310,406 Collected
86,673 70,953 Current Portion of Long-Term Debt 14,000 6,130
Land and Building 0 300,000 43,516 79,912 12/31/X3 42,341
Warehouse Equipment 42,800 46,256 Equipment Note Payable 8,000 4,000
Less: Accumulated Depreciation (5,406) (10,391) Mortgage Note Payable 0 247,363
Total Assets $ 124,067 $ 406,818 Total Liabilities 51,516 331,275 Cash
Equity
Capital Stock
(4,250 shares outstanding) 42,500 42,500 310,406
Retained Earnings 30,051 33,043
Total Equity 72,551 75,043
Total Liabilities & Equity $ 124,067 $ 406,818

17 18

3-3
 Hot Cars, Inc. Assume that of the $318,432 of total sales revenues for the year, $124,516
Income Statement were from cash sales and the remaining $193,916 were from sales made
for the years ended December 31, 20X3 on account.
Sales Revenues

Net cash flows from (used in) operations:

318,432
Net income (loss) $ 14,992 318,432 12/31/X3
Adjustments (accrual to cash basis):
Accounts Receivable
(8,026) 318,432
310,406 1/1/X3 34,315
193,916
8,026
Net cash flows from operating activities ? 185,890 Collected
12/31/X3 42,341

Recorded Customer Cash

Sales Revenues Cash Collections
$318,432 $310,406 310,406
124,516
185,890

($8,026)

19 20

When determining the adjustment to convert a company's net income to Hot Cars, Inc.
its net cash flows from operations for the difference between accrual and Income Statement
cash basis sales revenues the basic rule is this: for the years ended December 31, 20X3
20X3

A/R = Adjust net income Sales Revenues

Cost of Goods Sold
$ 318,432
206,145
Gross Margin 112,287
A/R = Adjust net income Operating Expenses:
Salaries Expense 60,689
Office Supplies Expense 3,465
Think of it this way: Rent Expense 4,400
Utilities Expense 8,144
There is no difference in accrual and cash basis sales revenues for a Depreciation Expense 6,985
Insurance Expense 2,345
company's cash sales. Miscellaneous Expense 617
Postage Expense 373
The only difference comes from sales made on account, and Operating Expenses 87,018
Operating Income 25,269
A/R means recorded sales on account exceeded cash collections, Other Revenue and (Expense)
and net income must be adjusted down to reflect the lower cash Gain on Sale 2,000
Rental Revenue 280
flows. Interest Expense (7,810)
Income Before Income Taxes 19,739
A/R means more cash was collected than sales made on account Income Tax Expense 4,747
and net income must be adjusted up to show the higher resulting Net Income $ 14,992
Earnings Per Share $ 3.53
cash flows.

21 22

Cost of Goods Sold Accounts Payable Hot Cars, Inc.

Income Statement
1/1/X3 0 22,250 1/1/X3
for the years ended December 31, 20X3
206,145 201,922 Purchases
12/31/X3 206,145 Cash Paid 163,407
60,765 12/31/X3
Inventory
Net cash flows from (used in) operations:
1/1/X3 25,000 Cash Net income (loss) $ 14,992
Purchases 201,922 Adjustments (accrual to cash basis):
206,145 Goods Sold 163,407 Paid A/P
Increase in A/R (8,026)
12/31/X3 20,777
42,738

Net cash flows from operating activities ?

Cash vs. Accrual difference = $42,738
Increase in A/P $38,515
Decrease in Inventory 4,223
$42,738
Basic Rules: A/P NI , A/P NI
Inventory NI , Inventory NI

23 24

3-4
 Hot Cars, Inc.
Income Statement
for the years ended December 31, 20X3 Salaries Expense
1/1/X3 0
20X3
60,689
Sales Revenues $ 318,432 12/31/X3 60,689
Cost of Goods Sold 206,145
Gross Margin 112,287
Operating Expenses:
Salaries Payable
Salaries Expense 60,689 0 1/1/X3
Office Supplies Expense 3,465
60,689 Salaries incurred
Rent Expense 4,400
Utilities Expense 8,144 Paid salaries 53,409
Depreciation Expense 6,985 7,280 12/31/X3
Insurance Expense 2,345
Miscellaneous Expense 617 Cash
Postage Expense 373
Operating Expenses 87,018
Operating Income 25,269
Other Revenue and (Expense)
53,409 Paid salaries
Gain on Sale 2,000
Rental Revenue 280
Interest Expense (7,810)
Income Before Income Taxes 19,739
Income Tax Expense 4,747 Accrual over Cash = $7,280
Net Income $ 14,992
Earnings Per Share $ 3.53
Basic Rules: Salaries Payable NI , Salaries Payable NI

25 26

Salaries Expense
Hot Cars, Inc.
1/1/X3 0
Income Statement
60,689
for the years ended December 31, 20X3
12/31/X3 60,689

Salaries Payable
Net cash flows from (used in) operations:
0 1/1/X3
60,689 Salaries incurred Net income (loss) $ 14,992
Paid salaries 53,409 Adjustments (accrual to cash basis):
7,280 12/31/X3 Increase in A/R (8,026)
Cash Increase in A/P 38,515
Decrease in Inventory 4,223
7,280
53,409 Paid salaries

Net cash flows from operating activities ?

Accrual over Cash = $7,280

Basic Rules: Salaries Payable NI , Salaries Payable NI

27 28

Hot Cars, Inc.

Hot Cars, Inc.
Income Statement
Balance Sheet
for the years ended December 31, 20X3
December 31, 20X2 and 20X3
20X3

Sales Revenues $ 318,432 12/31/X2 12/31/X3 12/31/X2 12/31/X3

Cost of Goods Sold 206,145 Assets Liabilities & Equity
Gross Margin 112,287 Current Assets: Current Liabilities:
Operating Expenses: Cash $ 21,808 $ 3,505 Accounts Payable $ 22,250 $ 60,765
Salaries Expense 60,689 Accounts Receivable 34,315 42,341 Salaries Payable 0 7,280
Office Supplies Expense 3,465 Inventory 25,000 20,777 Income Tax Payable 6,408 4,747
Rent Expense 4,400 Office Supplies 750 1,962 Unearned Rent Revenue 280 0
Utilities Expense 8,144 Prepaid Insurance 400 2,368 Utilities Payable 400 937
Depreciation Expense 6,985 Prepaid Rent 4,400 0 Interest Payable 178 53
Insurance Expense 2,345 86,673 70,953 Current Portion of Long-Term Debt 14,000 6,130
Miscellaneous Expense 617 Land and Building 0 300,000 43,516 79,912
Postage Expense 373 Warehouse Equipment 42,800 46,256 Equipment Note Payable 8,000 4,000
Operating Expenses 87,018 Less: Accumulated Depreciation (5,406) (10,391) Mortgage Note Payable 0 247,363
Operating Income 25,269 Total Assets $ 124,067 $ 406,818 Total Liabilities 51,516 331,275
Other Revenue and (Expense)
Gain on Sale 2,000 Equity
Rental Revenue 280 Capital Stock
Interest Expense (7,810) (4,250 shares outstanding) 42,500 42,500
Income Before Income Taxes 19,739 Retained Earnings 30,051 33,043
Income Tax Expense 4,747 Total Equity 72,551 75,043
Net Income $ 14,992 Total Liabilities & Equity $ 124,067 $ 406,818
Earnings Per Share $ 3.53

29 30

3-5
 Hot Cars, Inc.
Balance Sheet
December 31, 20X2 and 20X3

Adj. Adj.

Under this indirect approach to preparing Assets

12/31/X2 12/31/X3 Change NI
Liabilities & Equity
12/31/X2 12/31/X3 Change NI

Current Assets: Current Liabilities:

a statement of cash flows, a company's net Cash
Accounts Receivable
$ 21,808
34,315
$ 3,505
42,341 8,026
Accounts Payable
Salaries Payable
$ 22,250
0
$ 60,765
7,280
38,515
7,280

cash flows from operations can be easily Inventory

Office Supplies
25,000
750
20,777
1,962
4,223
1,212
Income Tax Payable
Unearned Rent Revenue
6,408
280
4,747
0
1,661
280

determined by taking a company's net

Prepaid Insurance 400 2,368 1,968 Utilities Payable 400 937 537
Prepaid Rent 4,400 0 4,400 Interest Payable 178 53 125
86,673 70,953 Current Portion of Long-Term Debt 14,000 6,130

income for the period and adjusting it for Land and Building
Warehouse Equipment
0
42,800
300,000
46,256 Equipment Note Payable
43,516
8,000
79,912
4,000

changes in the company's balance sheet Less: Accumulated Depreciation (5,406)

Total Assets $ 124,067
(10,391)
$ 406,818
Mortgage Note Payable
Total Liabilities
0
51,516
247,363
331,275

accounts associated with the company's Equity

Capital Stock

operating activities. (4,250 shares outstanding)

Retained Earnings
42,500
30,051
42,500
33,043
Total Equity 72,551 75,043
Total Liabilities & Equity $ 124,067 $ 406,818

31 32

Basic Rules: Hot Cars, Inc.

Assets Net income Balance Sheet
December 31, 20X2 and 20X3
Assets Net income
Liabilities Net income 12/31/X2 12/31/X3 Change
Adj.
NI 12/31/X2 12/31/X3 Change
Adj.
NI
Liabilities Net income Assets
Current Assets:
Liabilities & Equity
Current Liabilities:
Cash $ 21,808 $ 3,505 Accounts Payable $ 22,250 $ 60,765 38,515
Accounts Receivable 34,315 42,341 8,026 Salaries Payable 0 7,280 7,280
* Assume that all asset changes arise from the cash purchase or cash sale of the asset. Inventory 25,000 20,777 4,223 Income Tax Payable 6,408 4,747 1,661
Office Supplies 750 1,962 1,212 Unearned Rent Revenue 280 0 280
Prepaid Insurance 400 2,368 1,968 Utilities Payable 400 937 537
Given this assumption, an increasing asset balance during the year means that more Prepaid Rent 4,400 0 4,400 Interest Payable 178 53 125
86,673 70,953 Current Portion of Long-Term Debt 14,000 6,130
assets were purchased with cash than were sold Cash purchases of assets use up cash Land and Building 0 300,000 43,516 79,912
Warehouse Equipment 42,800 46,256 Equipment Note Payable 8,000 4,000
and reduce a company's cash balance. Increasing assets have a decreasing effect on Less: Accumulated Depreciation (5,406) (10,391) Mortgage Note Payable 0 247,363
cash because you are in effect buying assets with cash. Decreasing assets result from Total Assets $ 124,067 $ 406,818 Total Liabilities 51,516 331,275

asset sales which produce cash and increase a company's cash balance. Decreasing Equity
Capital Stock
assets have an increasing effect on cash. (4,250 shares outstanding) 42,500 42,500
Retained Earnings 30,051 33,043
Total Equity 72,551 75,043

* Assume that all increasing liabilities occur from additional cash borrowings, which Total Liabilities & Equity $ 124,067 $ 406,818

increase a company's cash balance, and decreasing liabilities reflect cash payoffs of
debt, which decreases a company's cash.

33 34

Hot Cars, Inc.

Hot Cars, Inc.
Statement of Cash Flows
Statement of Cash Flows
for the year ended December 31, 20X3
for the year ended December 31, 20X3
20X3
Cash flows from (used in ) operating activities:
Net cash flows from (used in) operations: Cash Receipts from:
Customer sales $310,406
Net income (loss) $ 14,992 Cash payments for:
Inventory (163,407)
Adjustments (accrual to cash basis): Salaries expense (53,409)
Rent expense 0
Increase in A/R (8,026) Utilities expense (7,607)
Increase in A/P 38,515 Office supplies expense (4,677)
Insurance expense (4,313)
Decrease in inventory 4,223 Postage and misc. expense (990)
Increase in salaries payable 7,280 Income tax expense (6,408)
Interest expense (7,935)
Increase in prepaid insurance (1,968) Net cash flows provided from operating activities 61,660
Increase in office supplies (1,212) Cash flows from (used in) investing activities:
Cash payment for purchase of land and building (50,000)
Decrease in prepaid rent 4,400 Cash payment for purchase of warehouse equipment (13,456)
Cash receipt from sale of warehouse equipment 10,000
Decrease in income taxes payable (1,661) Net cash flows used in investing activities (53,456)
Decrease in unearned rent revenue (280) Cash flows from (used in) financing activities:
Payment of mortgage note principal (507)
Increase in utilities payable 537 Payment of equipment note principal (14,000)
Decrease in interest payable (125) Payment of dividends (12,000)
Net cash flows used in financing activities (26,507)
Net increase (decrease) in cash (18,303)
Net cash flows from operating activities $ 56,675 Cash and cash equivalents at beginning of year 21,808
Cash and cash equivalents at end of year $ 3,505

35 36

3-6
 Hot Cars, Inc. Hot Cars, Inc.
Income Statement Statement of Cash Flows
for the years ended December 31, 20X3 for the year ended December 31, 20X3

20X3 Net cash flows from (used in) operations:

Sales Revenues $ 318,432
Cost of Goods Sold 206,145
Net income (loss) $ 14,992
Gross Margin 112,287 Adjustments (accrual to cash basis):
Operating Expenses:
Increase in A/R (8,026)
Salaries Expense 60,689
Office Supplies Expense 3,465 Increase in A/P 38,515
Rent Expense 4,400 Decrease in inventory 4,223
Utilities Expense 8,144
Depreciation Expense 6,985 Increase in salaries payable 7,280
Insurance Expense 2,345 Increase in prepaid insurance (1,968)
Miscellaneous Expense 617
Postage Expense 373
Increase in office supplies (1,212)
Operating Expenses 87,018 Decrease in prepaid rent 4,400
Operating Income 25,269
Other Revenue and (Expense)
Decrease in income taxes payable (1,661)
Gain on Sale 2,000 Decrease in unearned rent revenue (280)
Rental Revenue 280 Increase in utilities payable 537
Interest Expense (7,810)
Income Before Income Taxes 19,739 Decrease in interest payable (125)
Income Tax Expense 4,747 Depreciation expense 6,985
Net Income $ 14,992
Earnings Per Share $ 3.53
Net cash flows from operating activities $ 56,675

37 38

Hot Cars, Inc.

Hot Cars, Inc.
Statement of Cash Flows
Income Statement
for the year ended December 31, 20X3
for the years ended December 31, 20X3
20X3 Net cash flows from (used in) operations:
Sales Revenues $ 318,432
Net income (loss) $ 14,992
Cost of Goods Sold 206,145
Gross Margin 112,287 Adjustments (accrual to cash basis):
Operating Expenses: Increase in A/R (8,026)
Salaries Expense 60,689
Office Supplies Expense 3,465 Increase in A/P 38,515
Rent Expense 4,400 Decrease in inventory 4,223
Utilities Expense 8,144
Depreciation Expense 6,985
Increase in salaries payable 7,280
Insurance Expense 2,345 Increase in prepaid insurance (1,968)
Miscellaneous Expense 617
Increase in office supplies (1,212)
Postage Expense 373
Operating Expenses 87,018 Decrease in prepaid rent 4,400
Operating Income 25,269 Decrease in income taxes payable (1,661)
Other Revenue and (Expense)
Gain on Sale 2,000 Decrease in unearned rent revenue (280)
Rental Revenue 280 Increase in utilities payable 537
Interest Expense (7,810)
Income Before Income Taxes 19,739
Decrease in interest payable (125)
Income Tax Expense 4,747 Depreciation expense 6,985
Net Income $ 14,992
Gain on sale (2,000)
Earnings Per Share $ 3.53
Net cash flows from operating activities $ 63,660

39 40

Problem 3-3

Basic Steps and Rules of the Indirect Method Indirectly Determined Cash Flows from Operating Activities
Given the following information for Jordan Enterprises provided from their
1. Under this indirect approach to preparing a statement of cash flows, a balance sheet and income statement:
company's net cash flows from operations can be easily determined 12/31/X6 12/31/X7
by taking a company's net income for the period and adjusting it for
changes in the company's balance sheet accounts associated with the Cash $ 15,355 $ 17,382
company's operating activities. Accounts receivable $ 37,962 $ 51,362
Inventory $ 87,444 $ 76,263
2. Any increase in an asset should be deducted from net income and Sales revenues $316,793 $344,211
any decrease should be added back. Any increase in a liability Accounts payable $ 45,686 $ 42,543
should be added back to net income and any decrease should be Cost of goods sold $158,432 $175,488
deducted. Prepaid insurance $ 7,494 $ 8,646
Insurance expense $ 15,764 $ 16,468
3. Add back any non-cash expenses such as depreciation or
amortization expense. Determine Jordan's 20X7:
A. Total cash collections from customers.
4. Deduct any gains on sale or add back any losses on sale of long-term
B. Total cash payments on inventory purchases.
assets such as property plant and equipment that are otherwise noted
in investing cash inflows or outflows. C. Total cash payments of insurance premiums.

41 42

3-7
 Problem 3-3 - Answer Problem 3-3 - Answer
A. B.
Sales Revenues Cost of Goods Sold
175,488
344,211
12/31/X7 175,488
344,211 12/31/X7
Inventory
Accounts Receivable 12/31/X6 87,444
164,307
12/31/X6 37,962 175,488
344,211 12/31/X7 76,263
330,811
Accounts Payable
12/31/X7 51,362 45,686 12/31/X6
164,307
Cash 167,450
42,543 12/31/X7
12/31/X6 15,355
Cash collections from customers 330,811 Cash
12/31/X7 17,382 12/31/X6 15,355
167,450 Cash payments on inventory purchases
Alternative approach: 12/31/X7 17,382
Sales revenues $344,211 Alternative approach:
Cost of goods sold ($175,488)
Less increase in A/R (51,362 - 37,962) ( 13,400) Adjust for decrease in inventory (87,444 - 76,263) 11,181
$330,811 Adjust for decrease in A/P (45,686 - 42,543) ( 3,143)
($167,450)

43 44

Problem 3-3 - Answer Problem 3-4

C. Cash Flows from Operations: Indirect Method
Insurance Expense Given the following balance sheet and supplemental information for Morris, Inc.:
16,468 A. Prepare the cash flows from operating activities section of a statement of
cash flows for the year ended 20X3.
12/31/X7 16,468
B. Describe the major causes for the difference in Morris' net income and
Prepaid Insurance cash flows from operations in 20X3.
Morris, Inc.
12/31/X6 7,494 Balance Sheet
17,620 December 31, 20X2 and 20X3
Assets 12/31/X2 12/31/X3 Liabilities & Equity 12/31/X2 12/31/X3
16,468 Current Assets: Current Liabilities:
12/31/X7 8,646 Cash $ 37,818 $ 42,368 Accounts Payable $ 96,155 $ 125,919
Accounts Receivable 90,166 68,122 Salaries Payable 20,673 17,280
Inventory 254,567 300,468 Other Payables 16,996 20,144
Cash
Prepaid Insurance 5,202 6,000 Unearned Revenues 12,465 15,686
12/31/X6 15,355 Other Assets 12,456 12,368 Current Portion of Notes Payable 20,000 20,000
400,209 429,326 166,280 199,029
17,620 Cash payments of insurance Property, Plant and Equipment 588,324 602,256 Notes Payable 400,000 380,000
12/31/X7 17,382 Less: Accumulated Depreciation (168,044) (192,166) Total Liabilities 566,280 579,029
Total Assets $ 820,489 $ 839,416 Equity
Capital Stock 150,000 150,000
Alternative approach: Retained Earnings 104,209 110,387
Insurance expense ($ 16,468) Total Equity 254,209 260,387
Deduct: Increase in Prepaid (8,646 - 7,494) ( 1,152) Total Liabilities & Equity $ 820,489 $ 839,416
($ 17,620) Net income for the year ended 12/31/X3 totaled $56,178 after $24,122 of depreciation expense and
a $1,000 loss on sale of property, plant and equipment.

45 46

Problem 3-4 - Answer

A. Cash flows from (used in) operating activities:

Net income (loss)
Add (deduct) adjustments to cash basis:
$ 56,178 What is the best measure of a
Decrease in accounts receivable
Increase in inventory
22,044
(45,901)
company's profit?
Increase in prepaid insurance (798)
Decrease in other assets 88
Increase in accounts payable 29,764
Decrease in salaries payable (3,393)
Increase in other payables 3,148 Accrual Basis Net Income
Increase in unearned revenues 3,221
Depreciation expense 24,122
Loss on sale 1,000 or
Net cash flows from operating activities $ 89,473

B. Describe the major causes for the difference in Morris' net income and cash
flows from operations in 20X3. Net Cash Flows from Operations
Answer: Morris, Inc. generated $89,473 of cash flows from operating activities, yet recorded
only $56,178 of net income. The higher actual cash flows from operations were due primarily
to higher cash collections of A/R, deferrals of payments on A/P and the $24,122 non-cash
depreciation expense that was deducted in determining net income. The effect of these items
were significantly offset by the cash used in the company's build-up of inventory.

47 48

3-8
 Hot Cars, Inc.
Statement of Cash Flows
for the year ended December 31, 20X3
Cash flows from (used in) operating activities:
Net income $ 14,992
Adjustments:
Increase in accounts receivable (8,026)
Increase in accounts payable 38,515
Decrease in inventory 4,223
EBITDA Increase in salaries payable 7,280
Increase in prepaid insurance (1,968)
(Earnings before interest, taxes, depreciation and amortiazation) Increase in office supplies (1,212)
Decrease in prepaid rent 4,400
Decrease in income taxes payable (1,661)
Decrease in unearned rent revenue (280)
Increase in utilities payable 537
Decrease in interest payable (125)
Depreciation expense 6,985
Gain on sale (2,000)
Net cash flows from operating activities $ 61,660

Which number is a better measure of HCI's operating performance for the year,
the $14,992 of net income or the $61,660 of net cash flows from operations?

49 50

Hot Cars, Inc.

Balance Sheet
December 31, 20X2 and 20X3

12/31/X2 12/31/X3 12/31/X2 12/31/X3

The presentation of the indirect adjustment of net Assets
Current Assets:
Liabilities & Equity
Current Liabilities:
income to net cash flows from operations is required Cash
Accounts Receivable
$ 21,808
34,315
$ 3,505
42,341
Accounts Payable
Salaries Payable
$ 22,250
0
$ 60,765
7,280
either in the body of the statement of cash flows, or, Inventory 25,000 20,777 Income Tax Payable 6,408 4,747
Office Supplies 750 1,962 Unearned Rent Revenue 280 0
if the direct approach is used, then in the notes to the Prepaid Insurance 400 2,368 Utilities Payable 400 937

financial statements or a supplemental disclosure at

Prepaid Rent 4,400 0 Interest Payable 178 53
86,673 70,953 Current Portion of Long-Term Debt 0 0

the bottom of the cash flow statement. Land and Building

Warehouse Equipment
0
42,800
300,000
46,256 Equipment Note Payable
43,516
22,000
79,912
8,000
Less: Accumulated Depreciation (5,406) (10,391) Mortgage Note Payable 0 247,363
Total Assets $ 124,067 $ 406,818 Total Liabilities 51,516 331,275

Almost all publicly held companies use the indirect Equity

method in the body of their statement of cash flows. Capital Stock

(4,250 shares outstanding) 42,500 42,500
Retained Earnings 30,051 33,043
Total Equity 72,551 75,043
Total Liabilities & Equity $ 124,067 $ 406,818

51 52

Hot Cars, Inc.

Land & Building Statement of Cash Flows
for the year ended December 31, 20X3
1/1/X3 0
Net cash flows from (used in) operations:
Purchase 300,000 Net income (loss) $ 14,992
Sale Adjustments:
Increase in A/R (8,026)
12/31/X3 300,000 Increase in A/P 38,515
Decrease in inventory 4,223
Increase in salaries payable 7,280
Mortgage Note Payable Increase in prepaid insurance (1,968)
Increase in office supplies (1,212)
0 1/1/X3 Decrease in prepaid rent 4,400
Decrease in income taxes payable (1,661)
250,000 Land & Bldg. purchase Decrease in unearned rent revenue (280)
Increase in utilities payable 537
Principal payment 507 Decrease in interest payable (125)
249,493 12/31/X3 Depreciation expense 6,985
Gain on sale (2,000)
Net cash flows from operating activities $ 61,660
Cash Cash flows from (used in) investing activities:
Cash payment for purchase of land and building (50,000)
Cash flows from (used in) financing activities:
Payment of mortgage note principal (507)
50,000 Down payment
Supplemental Information
507 Principal payment
Non-cash flow investing and financing activities:
Land and building totaling $300,000 was purchased with a $50,000 cash down payment and the execution
of a $250,000 mortgage note payable.

53 54

3-9
 Hot Cars, Inc. Warehouse Equipment
Balance Sheet 1/1/X3 42,800
December 31, 20X2 and 20X3 Purchases 13,456
10,000 Disposal or sale
12/31/X2 12/31/X3 12/31/X2 12/31/X3 12/31/X3 46,256
Assets Liabilities & Equity
Current Assets: Current Liabilities:
Cash $ 21,808 $ 3,505 Accounts Payable $ 22,250 $ 60,765
Accumulated Depreciation
Accounts Receivable 34,315 42,341 Salaries Payable 0 7,280 5,406 1/1/X3
Inventory 25,000 20,777 Income Tax Payable 6,408 4,747
Office Supplies 750 1,962 Unearned Rent Revenue 280 0
6,985 Depreciation Expense
Prepaid Insurance 400 2,368 Utilities Payable 400 937 Disposal or sale 2,000
Prepaid Rent 4,400 0 Interest Payable 178 53
10,391 12/31/X3
86,673 70,953 Current Portion of Long-Term Debt 0 0
Land and Building 0 300,000 43,516 79,912
Warehouse Equipment 42,800 46,256 Equipment Note Payable 22,000 8,000 To determine the total amount of cash received on the sale of equipment, we have to
Less: Accumulated Depreciation (5,406) (10,391) Mortgage Note Payable 0 249,493 go back into HCI's accounting records and identify the specific transaction(s) involving
Total Assets $ 124,067 $ 406,818 Total Liabilities 51,516 331,275 equipment sales. In HCI's case, there was only one such transaction: a $10,000 cash
Equity
sale of equipment that had an original cost of $10,000 and accumulated depreciation of
Capital Stock $2,000.
(4,250 shares outstanding) 42,500 42,500 Journal entry to record the sale of equipment:
Retained Earnings 30,051 33,043
Total Equity 72,551 75,043 Cash 10,000
Total Liabilities & Equity $ 124,067 $ 406,818 Accumulated Depreciation 2,000
Warehouse Equipment 10,000
Gain on Sale 2,000

55 56

Hot Cars, Inc.

Warehouse Equipment
Statement of Cash Flows
1/1/X3 42,800 for the year ended December 31, 20X3
Purchases 13,456 Net cash flows from (used in) operations: Cash flows from (used in) investing activities:
10,000 Disposal or sale Net income (loss) $ 14,992 Cash payment for purchase of land and building (50,000)
12/31/X3 46,256 Adjustments: Cash payment for purchase of warehouse equipment (13,456)
Increase in A/R (8,026) Cash receipt from sale of warehouse equipment 10,000
Increase in A/P 38,515
Accumulated Depreciation
Decrease in inventory 4,223 Cash flows from (used in) financing activities:
5,406 1/1/X3 Increase in salaries payable 7,280 Payment of mortgage note principal (507)
Increase in prepaid insurance (1,968)
6,985 Depreciation Expense
Increase in office supplies (1,212)
Disposal or sale 2,000 Decrease in prepaid rent 4,400
10,391 12/31/X3 Decrease in income taxes payable (1,661)
Decrease in unearned rent revenue (280)
Cash Increase in utilities payable 537
Decrease in interest payable (125)
Equipment sale 10,000 Depreciation expense 6,985
13,456 Equipment purchases Gain on sale (2,000)
Net cash flows from operating activities $ 61,660

Journal entry to record the sale of equipment:

Cash 10,000
Accumulated Depreciation 2,000 Supplemental Information
Warehouse Equipment 10,000 Non-cash flow investing and financing activities:
Gain on Sale 2,000 Land and building totaling $300,000 was purchased with a $50,000 cash down payment and the execution
of a $250,000 mortgage note payable.

57 58

Hot Cars, Inc. Hot Cars, Inc.

Balance Sheet Statement of Cash Flows
December 31, 20X2 and 20X3 for the year ended December 31, 20X3
Net cash flows from (used in) operations: Cash flows from (used in) investing activities:
12/31/X2 12/31/X3 12/31/X2 12/31/X3 Net income (loss) $ 14,992 Cash payment for purchase of land and building (50,000)
Assets Liabilities & Equity Adjustments: Cash payment for purchase of warehouse equipment (13,456)
Current Assets: Current Liabilities: Increase in A/R (8,026) Cash receipt from sale of warehouse equipment 10,000
Cash $ 21,808 $ 3,505 Accounts Payable $ 22,250 $ 60,765 Increase in A/P 38,515
Accounts Receivable 34,315 42,341 Salaries Payable 0 7,280 Decrease in inventory 4,223 Cash flows from (used in) financing activities:
Inventory 25,000 20,777 Income Tax Payable 6,408 4,747 Increase in salaries payable 7,280 Payment of mortgage note principal (507)
Office Supplies 750 1,962 Unearned Rent Revenue 280 0 Increase in prepaid insurance (1,968) (14,000)
Payment of equipment note principal
Prepaid Insurance 400 2,368 Utilities Payable 400 937 Increase in office supplies (1,212)
Prepaid Rent 4,400 0 Interest Payable 178 53 Decrease in prepaid rent 4,400
86,673 70,953 Current Portion of Long-Term Debt 0 0 Decrease in income taxes payable (1,661)
Land and Building 0 300,000 43,516 79,912 Decrease in unearned rent revenue (280)
Warehouse Equipment 42,800 46,256 Equipment Note Payable 22,000 8,000
Increase in utilities payable 537
Less: Accumulated Depreciation (5,406) (10,391) Mortgage Note Payable 0 249,493
Decrease in interest payable (125)
Total Assets $ 124,067 $ 406,818 Total Liabilities 51,516 331,275
Depreciation expense 6,985
Gain on sale (2,000)
Equity
Net cash flows from operating activities $ 61,660
Capital Stock
(4,250 shares outstanding) 42,500 42,500
Retained Earnings 30,051 33,043
Total Equity 72,551 75,043
Total Liabilities & Equity $ 124,067 $ 406,818
Supplemental Information
Non-cash flow investing and financing activities:
Land and building totaling $300,000 was purchased with a $50,000 cash down payment and the execution
of a $250,000 mortgage note payable.

59 60

3-10
 Hot Cars, Inc.
Balance Sheet Retained Earnings
December 31, 20X2 and 20X3 30,051 1/1/X3
14,992 Net Income
12/31/X2 12/31/X3 12/31/X2 12/31/X3 Dividends 12,000
Assets Liabilities & Equity
Current Assets: Current Liabilities: 33,043 12/31/X3
Cash $ 21,808 $ 3,505 Accounts Payable $ 22,250 $ 60,765
Accounts Receivable 34,315 42,341 Salaries Payable 0 7,280
Inventory 25,000 20,777 Income Tax Payable 6,408 4,747
Cash
Office Supplies 750 1,962 Unearned Rent Revenue 280 0
Prepaid Insurance 400 2,368 Utilities Payable 400 937
Prepaid Rent 4,400 0 Interest Payable 178 53 12,000 Dividends payments
86,673 70,953 Current Portion of Long-Term Debt 0 0
Land and Building 0 300,000 43,516 79,912
Warehouse Equipment 42,800 46,256 Equipment Note Payable 22,000 8,000
Less: Accumulated Depreciation (5,406) (10,391) Mortgage Note Payable 0 249,493
Total Assets $ 124,067 $ 406,818 Total Liabilities 51,516 331,275

Equity
Capital Stock
(4,250 shares outstanding) 42,500 42,500
Retained Earnings 30,051 33,043
Total Equity 72,551 75,043
Total Liabilities & Equity $ 124,067 $ 406,818

61 62

Hot Cars, Inc.

Statement of Cash Flows Basic Steps and Rules of the Indirect Method
for the year ended December 31, 20X3
Net cash flows from (used in) operations: Cash flows from (used in) investing activities: 1. Begin with net income for the year and adjust it to reflect net cash flows from
Net income (loss) $ 14,992 Cash payment for purchase of land and building (50,000) operations.
Adjustments: Cash payment for purchase of warehouse equipment (13,456) Adjust NI for current assets and current liabilities .
Increase in A/R (8,026) Cash receipt from sale of warehouse equipment 10,000
Increase in A/P 38,515 Net cash flows used in investing activities (53,456)
Adjust NI for current assets and current liabilities .
Decrease in inventory 4,223 Adjust NI for any non-cash expenses (depreciation).
Increase in salaries payable 7,280 Cash flows from (used in) financing activities: Adjust NI for any gains on sale of L/T assets.
Increase in prepaid insurance (1,968) Payment of mortgage note principal (507) Adjust NI for any losses on sale of L/T assets.
Increase in office supplies (1,212) Payment of equipment note principal (14,000)
Decrease in prepaid rent 4,400 Payment of dividends (12,000)
Decrease in income taxes payable (1,661) Net cash flows used in financing activities (26,507) 2. Next all of the other asset, liability and owner's equity accounts must be
Decrease in unearned rent revenue (280) Net increase (decrease) in cash (18,303) analyzed to determine the changes in those accounts resulting from cash
Cash and cash equivalents at beginning of year 21,808
Increase in utilities payable 537
$ 3,505
transactions. Those cash flows are then classified under either investing or
Decrease in interest payable (125) Cash and cash equivalents at end of year
Depreciation expense 6,985
financing activities. In addition, any changes in the accounts arising from non-
Gain on sale (2,000) cash transactions must be supplementally disclosed in the financial statement
Net cash flows from operating activities $ 61,660 notes or at the bottom of the actual cash flow statement.

3. Finally, net cash flows from operating, investing and financing activities are
subtotaled and added together to determine the net increase or decrease in cash
Supplemental Information for the period. That amount is then summed with the beginning balance of
Non-cash flow investing and financing activities: cash to determine the ending cash balance, which must agree with the balance
Land and building totaling $300,000 was purchased with a $50,000 cash down payment and the execution
of a $250,000 mortgage note payable.
shown on the company's balance sheet.

63 64

Problem 3-5 Problem 3-5 - Answer

Analyzing Long-Term Assets A. Cash received on the sale of equipment = $13,000

Journal entry to record sale of equipment:
Given the following information for ABA, Inc.:
Cash 13,000
12/31/X6 12/31/X7 Accumulated Depreciation 25,000
Loss on Sale 12,000
Equipment $ 305,000 $ 375,000 Equipment 50,000
Accumulated Depreciation (100,000) (105,000)
T-account analysis:
Equipment
For the year ended 12/31/X7:
12/31/X6 305,000
Depreciation expense $ 30,000
Cash purchase 20,000
Loss on sale of equipment $ 12,000
Debt purchase 100,000
Cash purchases of equipment $ 20,000
50,000 Equipment sale
12/31/X7 375,000
A. Determine the amount of cash received on the sale of equipment
Accumulated Depreciation
during the year ended 12/31/X7 assuming $100,000 of equipment
was purchased with debt financing during the year. 100,000 12/31/X6
30,000 Depreciation expense

B. Describe the impact of the information provided in this problem Equipment sale 25,000

on ABA's statement of cash flows and associated disclosures. 105,000 12/31/X7

65 66

3-11
 Problem 3-6 - Answer Problem 3-6

B. Describe the impact of the information provided in this problem on ABA's Preparing a Statement of Cash Flows, Indirect Method
statement of cash flows and associated disclosures. Given the following income statement, balance sheet and supplemental
information for WRM Corporation, prepare the company's statement of cash
Answer: ABA's depreciation expense (($30,000) and loss on sale ($12,000) flows for the year ended 12/31/X5 using the indirect method. Provide any
would be added back to net income in order to determine the amount of net required supplemental disclosures.
cash flows derived from or used for operating activities under the indirect WRM Corporation
method. If the indirect method was not used in the actual statement of cash Income Statement
flows, it would be provided as supplemental information at the end of the for the years ended December 31, 20X4 and 20X5
statement or in the notes to the financial statements. 20X4 20X5
Sales Revenues $ 757,904 $ 910,987
The $20,000 cash expenditure made in the purchase of equipment and the Cost of Goods Sold 227,371 255,076
$13,000 cash receipt from the sale of equipment would both be reflected in Gross Margin 530,533 655,911
the "investing activities" section of the statement of cash flows. Operating Expenses:
Salaries Expense 254,887 273,684
Other Operating Expenses 223,056 235,993
Supplemental disclosure, either in the notes to the financial statements or at Operating Income 52,590 146,234
the end of the cash flow statement, must be made of the $100,000 purchase of Interest Expense 10,255 12,646
equipment through debt financing. Income Before Income Taxes 42,335 133,588
Income Tax Expense 4,266 26,717
Net Income $ 38,069 $ 106,871
Earnings Per Share $ 3.81 $ 10.69

67 68

Problem 3-6 Problem 3-6 - Answer

WRM Corporation
WRM Corporation
Balance Sheet
Statement of Cash Flows
December 31, 20X4 and 20X5
for the year ended December 31, 20X5
12/31/X4 12/31/X5 12/31/X4 12/31/X5
Assets Liabilities & Equity
Current Assets: Current Liabilities: Cash flows from operating activities: Cash flows from (used in) investing activities:
Cash $ 12,045 $ 35,821 Accounts Payable $ 24,404 $ 29,678 Net income $ 106,871 Cash payments for:
Accounts Receivable 58,466 72,321 Other Payables 18,044 21,548 Add (Deduct) adjustments: Trucks (6,176)
Inventory 194,608 206,544 Current Portion of Long-Term Notes 100,000 100,000 Increase in accounts receivable (13,855) Equipment (3,456)
Other Assets 8,366 8,806 142,448 151,226 Increase in inventory (11,936) Net cash flows used in investing activities (9,632)
173,485 23,492 Long-Term Notes Payable 150,000 200,000 Increase in other assets (440)
Trucks 184,368 220,544 Total Liabilities 292,448 351,226 Increase in accounts payable 5,274 Cash flows from(used in) financing activities:
Equipment 42,800 46,256 Increase in other payables 3,504 Cash receipt from bank loan 120,000
Less: Accumulated Depreciation (64,032) (88,022) Equity Depreciation expense 23,990 Cash payments for:
163,136 178,778 Common Stock (10,000 shares) 100,000 100,000 Net cash flows from operating activities 113,408 Dividends (100,000)
Total Assets $ 436,621 $ 502,270 Retained Earnings 44,173 51,044 (100,000)
Notes payable
Total Equity 144,173 151,044 Net cash flows used in financing activities (80,000)
Total Liabilities & Equity $ 436,621 $ 502,270 Net increase (decrease) in cash 23,776
Cash and cash equivalents at beginning of year 12,045
Supplemental information for the year: Cash and cash equivalents at end of year $ 35,821

Depreciation expense for the period amounted to $23,990.

Supplemental disclosure:
Trucks purchased through the incurring of notes payable totaled $30,000. Trucks purchased through the incurring of notes payable amounted to $30,000 for the period.
No trucks or equipment were sold or disposed of.
Cash payments on principal of notes payable totaled $100,000

69 70

Problem 3-7 Problem 3-6 - Answer

Analysis of the Statement of Cash Flows What do you know about WRM Corporation by reviewing its
What do you know about WRM Corporation by reviewing its statement of statement of cash flows.
cash flows.
WRM Corporation Answer: WRM is a profitable company that generated significant
Statement of Cash Flows
cash flows from operations, almost all of which was paid out to
for the year ended December 31, 20X5
shareholders in the form of a dividend. The company also modestly
Cash flows from operating activities: Cash flows from (used in) investing activities: increased its long-term assets financed primarily through some
Net income
Add (Deduct) adjustments:
$ 106,871 Cash payments for:
Trucks (6,176)
additional debt. It also appears the company did some refinancing
Increase in accounts receivable (13,855) Equipment (3,456) of its debt during the year. $120,000 was borrowed on a bank loan,
Increase in inventory (11,936) Net cash flows used in investing activities (9,632)
Increase in other assets (440)
the proceeds of which were used to pay down $100,000 of existing
Increase in accounts payable 5,274 Cash flows from(used in) financing activities: debt.
Increase in other payables 3,504 Cash receipt from bank loan 120,000
Depreciation expense 23,990 Cash payments for:
Net cash flows from operating activities 113,408 Dividends (100,000) The fact that the company chose to pay shareholders a substantial
Notes payable (100,000)
Net cash flows used in financing activities (80,000) dividend rather than retain earnings may indicate that the company
Net increase (decrease) in cash
Cash and cash equivalents at beginning of year
23,776
12,045
is in a more mature, non-growth oriented business.
Cash and cash equivalents at end of year $ 35,821
Supplemental disclosure:
Trucks purchased through the incurring of notes payable amounted to $30,000 for the period.

71 72

3-12
 Transaction Register
Date Ck. # Description Payment Deposit Balance
Balance forward $ 577
1/3 Check from Mom $ 1,000 $ 1,577
1/5 1022 Provo Utilities $ 58 $ 1,519
1/6 1023 Jones Apartment (Rent) $ 550 $ 969
1/8 Debit Harmon's Groceries $ 68 $ 901

Bank Reconciliation
Many people get lazy and end up simply relying on the bank to determine
their balance of cash.
Problems
1. The bank's reported balance will not reflect the impact of any deposits in
transit or outstanding checks. Without knowing the amount of deposits in
transit and outstanding checks, it's impossible to really know exactly
where you stand in terms of available cash.

2. Any bank errors or mistakes will probably end up going undetected.

73 74

Internal Controls
Bank Reconciliation Policies and procedures designed and implemented
by management to safeguard a company's assets
and ensure accurate accounting records.

Compares the cash balance you have per your records Some controls over cash:
with the amount reflected in bank's records to identify The required use of checking, savings and other bank accounts
differences and make any necessary corrections or for the holding and administration of cash.
adjustments. Segregation of employee duties in the handling and recording
of cash transactions.
For a business, a bank reconciliation identifies any
differences in a company's general ledger cash balance The requirement that all disbursements over a certain amount
be made by pre-numbered check with more than one signature.
at the end of each month with the balance reflected in
the corresponding monthly bank statement. Preparation of a monthly bank reconciliation by a person not
involved in the handling and recording of cash transactions.

75 76

General Ledger
12/1/X3 8,800
Cash
The bank statement is prepared by the bank from
400 Ck 3499 the bank's perspective and is a reflection of the
12/7 Deposit 7,332 12,398 Ck 3500
3,357 Ck 3501 amount the bank owes the depositor if the account
12/15 Deposit 8,455
455
3,789
Ck 3502
Ck 3503 is closed.
2,777 Ck 3504
1,532 Ck 3505
984 Ck 3506 On the bank's books, the journal entry to record:
12/23 Deposit 12,000 5,212 Ck 3507
1,777 Ck 3508
1,245 Ck 3509
12/31 Deposit 3,389 545 Ck 3510 The receipt of a deposit:
12/31/X3 5,505
Cash XXX
Bank Statement Payable to Depositor XXX
Balance 12/1/X3: $ 3,411 Balance 12/31/X3: $14,520
Deposits and Other Credits
12/7 7,332 12/15 8,455 12/23 12,000 Checks written against the account:
12/28 5,000 12/31 3,389 12/31 (a) 16
Checks and Other Debits Payable to Depositor XXX
#3499 400 #3500 12,398 #3501 3,357 #3503 3,789 Cash XXX
12/12 (b) 400 #3504 2,577 12/15 (c) 100 #3506 984
#3507 5,212 #3509 1,245 12/31 (d) 10
(a) Interest earned on account (b) ATM withdrawal (c) NSF check (d) Bank charge

77 78

3-13
 General Ledger Bank Reconciliation
Cash
12/1/X3 8,800 True Cash Balance Approach:
400 Ck 3499
12/7 Deposit 7,332 12,398 Ck 3500 Balance per books: $ 5,505
3,357 Ck 3501
455 Ck 3502
Add: Customer direct deposit 5,000
12/15 Deposit 8,455 3,789 Ck 3503 Interest earned on account 16
2,777 Ck 3504 200
1,532 Ck 3505 Less:
984 Ck 3506
12/23 Deposit 12,000 5,212 Ck 3507
1,777 Ck 3508
1,245 Ck 3509 True cash balance
12/31 Deposit 3,389 545 Ck 3510
12/31/X3 5,505 Balance per bank: $ 14,520
Bank Statement Add:
Balance 12/1/X3: $ 3,411 Balance 12/31/X3: $14,520
Deposits and Other Credits
12/7 7,332 12/15 8,455 12/23 12,000 Less:
12/28 5,000 12/31 3,389 12/31 (a) 16
Checks and Other Debits
#3499 400 #3500 12,398 #3501 3,357 #3503 3,789
12/12 (b) 400 #3504 2,577 12/15 (c) 100 #3506 984
#3507 5,212 #3509 1,245 12/31 (d) 10
(a) Interest earned on account (b) ATM withdrawal (c) NSF check (d) Bank charge
True cash balance

79 80

General Ledger Bank Reconciliation

Cash
12/1/X3 8,800 True Cash Balance Approach:
400 Ck 3499
12/7 Deposit 7,332 12,398 Ck 3500 Balance per books: $ 5,505
3,357 Ck 3501
455 Ck 3502
Add: Customer direct deposit 5,000
12/15 Deposit 8,455 3,789 Ck 3503 Interest earned on account 16
2,777 Ck 3504 Error in recording ck # 3504 200
1,532 Ck 3505 Less:
984 Ck 3506
12/23 Deposit 12,000 5,212 Ck 3507
1,777 Ck 3508
1,245 Ck 3509 True cash balance
12/31 Deposit 3,389 545 Ck 3510
12/31/X3 5,505 Balance per bank: $ 14,520
Bank Statement Add:
Balance 12/1/X3: $ 3,411 Balance 12/31/X3: $14,520
Deposits and Other Credits
12/7 7,332 12/15 8,455 12/23 12,000 Less:
12/28 5,000 12/31 3,389 12/31 (a) 16
Checks and Other Debits
#3499 400 #3500 12,398 #3501 3,357 #3503 3,789
12/12 (b) 400 #3504 2,577 12/15 (c) 100 #3506 984
#3507 5,212 #3509 1,245 12/31 (d) 10
(a) Interest earned on account (b) ATM withdrawal (c) NSF check (d) Bank charge
True cash balance

81 82

General Ledger Bank Reconciliation

Cash
12/1/X3 8,800 True Cash Balance Approach:
400 Ck 3499
12/7 Deposit 7,332 12,398 Ck 3500 Balance per books: $ 5,505
3,357 Ck 3501
455 Ck 3502
Add: Customer direct deposit 5,000
12/15 Deposit 8,455 3,789 Ck 3503 Interest earned on account 16
2,777 Ck 3504 Error in recording ck # 3504 200
1,532 Ck 3505 Less:
984 Ck 3506
12/23 Deposit 12,000 5,212 Ck 3507
1,777 Ck 3508
1,245 Ck 3509 True cash balance
12/31 Deposit 3,389 545 Ck 3510
12/31/X3 5,505 Balance per bank: $ 14,520
Bank Statement Add:
Balance 12/1/X3: $ 3,411 Balance 12/31/X3: $14,520
Deposits and Other Credits
12/7 7,332 12/15 8,455 12/23 12,000 Less: Outstanding checks:
12/28 5,000 12/31 3,389 12/31 (a) 16 #3502 $ 455
Checks and Other Debits #3505 1,532
#3499 400 #3500 12,398 #3501 3,357 #3503 3,789 #3508 1,777
12/12 (b) 400 #3504 2,577 12/15 (c) 100 #3506 984 #3510 545 (4,309)
#3507 5,212 #3509 1,245 12/31 (d) 10
(a) Interest earned on account (b) ATM withdrawal (c) NSF check (d) Bank charge
True cash balance

83 84

3-14
 General Ledger
Cash
Bank Reconciliation
12/1/X3 8,800
400 Ck 3499
12/7 Deposit 7,332 12,398 Ck 3500
3,357 Ck 3501 Balance per books: $ 5,505
455 Ck 3502 Add: Customer direct deposit 5,000
12/15 Deposit 8,455 3,789 Ck 3503 Interest earned on account 16
2,777 Ck 3504
1,532 Ck 3505
Error in recording ck # 3504 200
984 Ck 3506 Less: ATM withdrawal (400)
12/23 Deposit 12,000 5,212 Ck 3507 Bank service charge (10)
1,777 Ck 3508 NSF check ( 100)
1,245 Ck 3509
12/31 Deposit 3,389 545 Ck 3510 True cash balance $ 10,211
12/31/X3 5,505
Balance per bank: $ 14,520
Bank Statement Add:
Balance 12/1/X3: $ 3,411 Balance 12/31/X3: $14,520
Deposits and Other Credits
12/7 7,332 12/15 8,455 12/23 12,000 Less: Outstanding checks:
12/28 5,000 12/31 3,389 12/31 (a) 16
#3502 $ 455
Checks and Other Debits
#3505 1,532
#3499 400 #3500 12,398 #3501 3,357 #3503 3,789
12/12 (b) 400 #3504 2,577 12/15 (c) 100 #3506 984 #3508 1,777
#3507 5,212 #3509 1,245 12/31 (d) 10 #3510 545 (4,309)
(a) Interest earned on account (b) ATM withdrawal (c) NSF check (d) Bank charge True cash balance $ 10,211

85 86

Problem 3-8
Balance per books: $ 5,505
Bank Reconciliation
Add: Customer direct deposit 5,000
Interest earned on account 16 A comparison of Davar, Inc.'s 1/31/X1 checking account bank statement with
Error in recording ck # 3504 200 an ending balance of $10,489 to its corresponding general ledger account with
Less: ATM withdrawal (400) an ending balance of $6,305 revealed the following reconciling items:
Bank service charge (10)
NSF check (100) 1. A $126 NSF check from a cash customer who could not be subsequently
True cash balance $ 10,211 located.
2. A $30 NSF check from a cash customer who agreed to pay the amount in full
Customer direct deposit: ATM withdrawal for employee Christmas gifts: plus a $10 penalty within by 2/28/X1.
Cash 5,000 Employee Gift Expense 400
3. Outstanding checks totaling $10,144.
A/R 5,000 Cash 400
4. Bank service charges for December amounting to $25.
Interest earned: Bank service charge: 5. December interest earned on the account amounting to $86.
Cash 16 Bank Charge Expense 10 6. Deposits in transit totaling $5,665.
Interest Revenue 16 Cash 10 7. A bank error from the under-recording of a deposit by $500. The bank
acknowledged and agreed to correct the account.
Error in recording check #3504 NSF check: 8. A $300 customer direct deposit unrecorded in Davar's books.
Cash 200 Accounts Receivable 100
Utilities Expense 200 Cash 100 Determine Davar's true cash balance at 1/31/X1 for this checking account
and prepare the appropriate correcting entries.
87 88

Problem 3-8 - Answer Problem 3-8 - Answer

Correcting entries:
Balance per books: $ 6,305
Add: Direct deposit 300 1. Direct deposit:
Cash 300
Interest earned 86
A/R 300
Less: Bank service charge (25)
NSF check (126) 2. Interest earned:
NSF check ( 30) Cash 86
Interest Revenue 86
True cash balance $ 6,510
3. Bank service charge:
Balance per bank: $10,489
Miscellaneous expense 25
Add: Deposit in transit 5,665 Cash 25
Bank error 500
Less: Outstanding checks (10,144) 4. NSF check:
True cash balance $ 6,510 Bad check expense 126
Cash 126

5. NSF check:
A/R 40
Cash 30
NSF fee income 10

89 90

3-15
 Lesson 4

Sales Revenues
Definition: The amount of assets received on the sale of goods or
services to customers. Those assets typically come in the
form of cash or accounts receivable.

Lesson 4 Revenue Recognition Principle: Revenues are to be recognized in

the period earned and not necessarily when cash is
received from customers.
Sales and Receivables
When are revenues earned?
When are revenues earned on sales that offer customers a full refund
for up to a year if they aren't completely satisfied with the product?

What about a fitness center's revenues on the sale of a two-year

membership contract?

1 2

Under current accounting standards, revenues are to be recorded when When merchandise is shipped to a customer, whether
earned, and revenues are earned when both of the following have revenues are recognized at the time of shipment or at the time
occurred:
of subsequent customer receipt, will depend on the contract
1. The acts associated with the providing of goods or services have terms of shipment.
been substantially completed.
FOB destination ("free on board" delivery): Ownership
2. The collection of cash or other assets from the customer is doesn't transfer and revenues are deferred until the
reasonably assured. goods are actually received by the customer.
This means a company has to actually finish doing something that
legally obligates a financially capable customer to pay now or in the FOB shipping point: Ownership transfers and revenues are
future. recognized when goods are loaded for shipment from
the company's dock.
With the sale of goods, this usually takes place when product
ownership actually transfers to the customer, which is usually when
the customer takes physical possession of the goods.

3 4

Consignment Sales
Supplier Merchandiser Customer
(Consignor) (Consignee)

Traveling to Customer

12/31/X7
Sales Revenues 1/3/X8
FOB FOB
Shipping Point ? Destination

5 6

4-1
 Consignment Sales Consignment Sales
Supplier Merchandiser Customer Supplier Merchandiser Customer
(Consignor) (Consignee) (Consignor) (Consignee)
For
Sale!

No legal ownership No legal ownership

No obligation No obligation

No sales revenues are recognized until

the sale is made to the final customer.

7 8

Long-Term Construction or Service Contracts

Companies that are involved in consulting or other service

contracts, or major projects involving the construction of When should revenues be recognized
bridges, dams and other facilities that take a number of on sales that guarantee customer
years to complete, may be allowed to recognize a portion of
the total contract revenue at the end of each year based on a
satisfaction for up to a year?
percentage of the completed work, as long as:
Is revenue earned and recorded at, during
1. The percentage of completion can be reasonably or one year following the date of sale?
estimated.

2. Collection of the revenues recognized can be

reasonably assured.

9 10

It depends! What about a fitness center's revenues on a

two-year membership contract?
For companies that can estimate returns with reasonable Should that revenue be recognized at the time:
accuracy, then revenues are typically recognized upon Contract is signed?
sale and any end-of-the-year estimate of future returns Payment is received?
on current period sales are deducted through a year-end Equal amounts over the 24-month contract?
adjusting entry.
Generally speaking revenues should be recognized over
If, however, reasonable estimates of returns aren't the period services are rendered regardless of the timing
possible, then simply deferring revenue recognition of cash receipts.
until the end of the one-year guarantee period is If the customer pays $480 up front for a 24-month
appropriate. membership, then

$480 24 months = $20/month

11 12

4-2
 Problem 4-1
What if the fitness company really needs to increase revenues
in the current period and decides to designate $240 of the $480
Revenue Recognition
received as an upfront sign up fee?
Describe the two key criteria for revenue recognition and then respond
Can $240 be immediately recognized as revenues? to the following:
NO A. A dam construction company has a contract to build a dam for
Such fees can be recognized as revenues upfront only if an $200 million over a three-year period. Collections under the
contract are scheduled at the end of each year based on the
identifiable service that can be sold separately has been percentage completed with 10% withheld until 30 days following
rendered at the time. the full and satisfactory completion of the dam. At the end of the
Example: If a fitness center separately offers customers an initial first year, the project stands at 30% completion and $54 million is
fitness evaluation and personal weight loss seminar for collected under the contract. How much revenue do you think
$240 and that service is included in the $480 deal, then should be recognized in the first year?
$240 of the $480 can be recognized as revenues up front
B. A CPA firm agrees to prepare an office supply company's tax
at the time the evaluation and seminar are provided, with return over the next three years in exchange for a copy machine
the remaining $240 spread out evenly over the 24-month received today that retails for $1,500. How much, if any, revenue
period. should the CPA firm recognize upon receipt of the copy machine?
Revenues are recognized when services are provided.
13 14

Problem 4-1 Problem 4-1 - Answer

Revenue Recognition
C. An appliance company sells a TV for $500 along with a $50 service The two criteria for revenue recognition are:
contract for any parts and labor on repairs not covered under the 1. The providing of goods or services is substantially complete.
manufacturer's warranty for two years from the date of sale. Cash
amounting to $550 was received at the time of sale. How much 2. Collection from the customer is reasonably assured.
revenue do you think should be recognized on this transaction and A. Assuming the 30% estimate of the percentage of completion has
when? been dependably determined at the end of the first year, the
maximum amount of revenue to be recognized is $60 million.
D. Should revenues on goods shipped to a customer "FOB Whether the $60 million, $54 million of cash actually received to
destination" be recognized as revenue on the date of shipment or date, or some lesser amount is actually recognized will depend on
the date delivered to the customer? Why? the specific terms of the contract and the confidence of
management and the company's independent auditors regarding
E. If a wholesale distributor makes sales to a retail merchandiser on the contractor's ability to complete the contract according to its
account agreeing that payment is not required until the product is terms and the customer's likelihood of future payment.
subsequently sold to a customer, should sales revenues be
recorded at the time of shipment to the retailer? B. No revenue should be recognized until services have been
performed. Upon receipt of the copier, the firm has a liability
equal to the value received, or $1,500. When the first of the three
tax returns has been completed, then 1/3 of the value of the asset
received should be recognized as revenue.
15 16

Problem 4-1 - Answer

C. The $500 received on the TV sale should be recognized as revenue Sales of Goods or Services on Account
at the time of sale, but the $50 received on the service contract
should be recognized over the two-year term of the contract. If
service repairs typically occur equally over the two-year period
following sale then an equal monthly recognition would probably
be appropriate. If, on the other hand, prior experience indicates
that most service repairs are performed in the last few months of
such contracts, then it may be more appropriate to defer
Accounts Receivable XXX
recognition until those final months. Sales Revenues XXX
D. Revenues on goods shipped to a customer "FOB destination"
should be recognized as revenue on the date the goods are
delivered to the customer. FOB destination means that
ownership has not transferred and the sale is not complete until
delivery has been made.
E. The answer is no! This is similar to a consignment. Even if legal
ownership of a product is transferred, if an agreement exists that
payment is not required unless a subsequent event takes place,
then revenues are not earned until that event occurs. In this case,
goods or services were provided but collection of the sales price is
contingent on a future event and not reasonably assured.
17 18

4-3
 Problem 4-2 Problem 4-2

Review of Accounting for Uncollectible Accounts Receivable

Review of Accounting for Uncollectible Accounts Receivable
An aging of Jordan, Inc.'s $85,300 of accounts receivable as of 12/31/X7
An aging of Jordan, Inc.'s $85,300 of accounts receivable as of 12/31/X7 and Jordan's estimate of future uncollectibility of those accounts is
and Jordan's estimate of future uncollectibility of those accounts is reflected below:
reflected below: Estimate of
Estimate of Days Past Due Amount Uncollectibility
Days Past Due Amount Uncollectibility
Current $40,300 3%
Current $40,300 3%
1 - 30 days $25,400 6%
1 - 30 days $25,400 6%
31 - 60 days $16,300 20%
31 - 60 days $16,300 20%
61 + days $ 3,300 70%
61 + days $ 3,300 70%
$85,300
$85,300
B. What journal entry would be made in the subsequent year, 20X8,
A. Prepare the 12/31/X7 adjusting entry for uncollectible accounts if Jordan writes-off accounts receivable amounting to $7,500?
receivable under the allowance method assuming Jordan has a What is the net effect of this entry on the company's financial
$1,402 debit balance in their Allowance for Uncollectible Accounts statements? Why isn't this write-off recorded as an expense?
Receivable account before any adjustment. Why is the amount of
uncollectible accounts (bad debt) expense different than the C. What is the direct write-off method of accounting for uncollectible
estimate of uncollectible accounts? accounts receivable and why is it an unacceptable accounting
method for financial reporting purposes?
19 20

Problem 4-2 - Answer Problem 4-2 - Answer

Review of Accounting for Uncollectible Accounts Receivable
Estimate of
Days Past Due Amount Uncollectibility
B. What journal entry would be made in the subsequent year, 20X8,
if Jordan writes-off accounts receivable amounting to $7,500?
Current $40,300 3% = $ 1,209
1 - 30 days $25,400 6% = $ 1,524
31 - 60 days $16,300 20% = $ 3,260 Allowance for Uncollectible A/R 7,500
61 + days $ 3,300 70% = $ 2,310 Accounts Receivable 7,500
$85,300 $ 8,303
A. Adjusting entry at 12/31/X7: What is the net effect of this entry on the company's financial
Uncollectible Accounts Expense 9,705 statements? Why isn't this write-off recorded as an expense?
Allowance for Uncollectible A/R 9,705
Answer: There is no net effect on the company's financial statements as
Allowance for Uncollectible Accounts Receivable
a result of this entry. The reduction in assets is offset by the reduction in
XXX 12/31/X6 the contra-asset. All this entry did was clean up the company's books by
Write-offs XXX removing the "bad" accounts receivable. The reason this write-off is not
'X6 underestimation 1,402 recorded as an expense is that these bad debts were effectively part of the
9,705 Adjustment $8,303 estimate of uncollectibles in 20X7 and included in the expense
8,303 12/31/X7 recorded at that time. In fact, that 20X7 expense was actually
Why is the amount of uncollectible accounts (bad debt) expense overstated given that only $7,500 of those receivables ultimately proved
different (higher) than the estimate of uncollectible accounts? to be uncollectible. This overstatement will have to be compensated for
in the adjustment to record bad debt expense in 20X8 by understating the
Answer: It must be higher in order to compensate for the prior year's estimated expense.
$1,402 underestimation of expense.

21 22

Problem 4-2 - Answer

C. What is the direct write-off method of accounting for The allowance method of accounting for uncollectible accounts
uncollectible accounts receivable and why is it an unacceptable receivable relies on estimates of uncollectibility in determining and
accounting method for financial reporting purposes? recording a company's current bad debt expense.
Answer: The direct write-off method of accounting for uncollectible A/R
calls for bad debts to be expensed in the period written-off. This Most companies come up with this estimate based on a percentage
approach is unacceptable because it violates the matching principle, of ending accounts receivable. In fact, the receivables are usually
which requires bad debt expenses to be recorded in the same period as aged based on how long they've been outstanding with higher
the credit sales, which gave rise to the ultimately uncollectible
receivables. That's why the allowance method must be used and relies
percentages of estimated uncollectibility applied to older accounts.
on estimates of future uncollectibility.
An alternative approach that's sometimes used in making this
estimate is based on a percentage of sales revenues as opposed to
ending A/R. This method is especially helpful when preparing
interim monthly or quarterly financial statements.

23 24

4-4
 Example: Barlow, Inc.'s prior experience indicates that on Assume Barlow's balance in the allowance account at the beginning of the
average, about 2% of all the company's net credit sales end up year totaled $15,500 as a result of the prior year's recording of uncollectible
being uncollectible. The company's January net credit sales accounts receivable using the 2% of net credit sales estimate.
totaled $90,794. In this case, what would be the company's entry
to record Bad Debt Expense for the month of January? Also assume that actual accounts written off during the current year totaled
$26,404.
2% X $90,794 = $1,816, rounded.
Allowance for Uncollectible Accounts Receivable
Bad Debt Expense 1,816 15,500 Beg. Balance
Allowance for Uncollectible A/R 1,816 18,926 Bad Debt Expense
Accounts Written-Off 26,404
If total net credit sales for the year amounted to $946,306, then the 8,022 Ending Balance
total recorded bad debt expense for the year would be: 13,978 Adjustment
22,000 Ending Balance
2% X $946,306 = $18,926.
What if actual bad debts from this year's net credit sales exceeds Assume an aging produces a $22,000 estimate of uncollectible accounts
the 2% estimate? receivable.
In that case, the allowance for uncollectible accounts receivable will Adjustment entry:
get progressively smaller in amount over time and an adjustment will Bad Debt Expense 13,978
have to be made to correct the error in estimation. Allowance for Uncollectible A/R 13,978

25 26

Problem 4-3 Problem 4-3 - Answer

Percentage of Sales Method of Estimating Uncollectible Accounts Receivable

Percentage of Sales Method of Estimating Uncollectible Accounts Receivable
1/31/X6 adjusting entry to record January's bad debt expense:
Ames Manufacturing wants to prepare monthly financial statements Bad Debt Expense 29,250*
and chooses to estimate monthly bad debt expense using 6% of net Allowance for Uncollectible A/R 29,250
credit sales. Given the following information as of 1/31/X6, prepare the * .06 X $487,500 = $29,250
appropriate 1/31/X6 adjusting entry to record January's bad debt
expense: Answer: When using the percentage of sales method of estimating
uncollectible accounts receivable, the entry is based on the percentage
Dr (CR) calculation, as noted above, regardless of the existing balance in the
Accounts Receivable $125,432 allowance for uncollectible A/R.
Net Credit Sales Revenues ($487,500)
Bad Debt Expense 0 Question: When using this method of estimating and accounting for
Allowance for Uncollectible A/R ($8,762) uncollectible accounts receivable, what does it mean if the Allowance for
Uncollectible A/R gets progressively larger over time?
Questions: When using this method of estimating and accounting for Answer: A progressively increasing balance in the Allowance for
uncollectible accounts receivable, what does it mean if the Allowance for Uncollectible A/R could be the result of:
Uncollectible A/R gets progressively larger over time? What should be 1. Overestimation of bad debt expense over time.
done if such an increase is attributable to prior period overestimation of 2. Actual increasing uncollectible accounts as a result of increasing
bad debt expense? credit sales, liberalization of credit policies, poor collection efforts, or
a declining general economy, among other things.
27 28

Problem 4-3 - Answer

Question: What should be done if such an increase is attributable to

prior period overestimation of bad debt expense?
A company's criteria in accepting or rejecting credit
Answer: At the end of the year, an aging of accounts receivable should
customers will ultimately have a significant impact on
probably be performed to evaluate the ending balance in the allowance the amount of its bad debt expense.
for uncollectible accounts receivable with an adjustment made if over or
understated. Any over-recording of bad debt expense for the year will
result in an overstated allowance account which should be adjusted Another factor in the amount of a company's bad debt
down with a corresponding decrease in bad debt expense. expense will be the effectiveness of its collection efforts.

29 30

4-5
 1/14/X8 1/14/X8
For value received, Robert Jones agrees to pay to the order of For value received, Robert Jones agrees to pay to the order of
Barlow, Inc. -------------------------------------------------$4,000.00 Barlow, Inc. -------------------------------------------------$4,000.00
four thousand and no/100 dollars, on or before 5/14/X8, with interest four thousand and no/100 dollars, on or before 5/14/X8, with interest
from the date hereof at a simple annual rate of 18%, all due at from the date hereof at a simple annual rate of 18%, all due at
maturity. maturity.
Robert Jones Robert Jones
Signature of maker Signature of maker
Entry to covert an account receivable to a note.
Adjusting entry at 1/31/X8 to record earned interest for the month:
Note Receivable 4,000
Accounts Receivable 4,000 $4,000 X .18 X 17/365 = $34
Entry to record a sale made in receipt of a note. Interest Receivable 34
Interest Revenue 34
Note Receivable XXX
Sales Revenues XXX
Entry upon collection:
Cost of Goods Sold XXX
Inventory XXX Cash 34
Interest Receivable 34
Notes receivable arising from the sales of goods or services are
traditionally referred to as "trade" notes receivable.

31 32

If a company is desperate for cash, one option is the immediate and Factoring A/R and Discounting Notes Receivable
outright sale of receivables for cash.

Assume a friend of yours has a valid receivable from a company like Example: Barlow, Inc. factors, without recourse, $20,000 of
IBM for $1,000. Given the legal enforceability of the receivable and accounts receivable for $13,000 cash. Assume that Barlow's
IBM's ability to pay its debts, would you consider buying the receivable previously recorded allowance for uncollectible accounts
from your friend? receivable on the factored accounts totaled $2,000.
What price?
Entry to record factoring of A/R:
Say $900
Cash 13,000
$100 / $900 = 11% return on a 30-day investment Allowance for Uncollectible A/R 2,000
Annualized return = 11% X 12 months = 133% Loss on Factoring of A/R 5,000
Accounts Receivable 20,000
In other words, if I could do that same deal every month using the same
$900 my total return for the year would be $100 per month or $1,200 for
the year on an investment of $900.

$1,200 / $900 = 133% annualized return

33 34

Problem 4-4

Factoring A/R and Discounting Notes Receivable

Factoring and Discounting of Receivables

Example: Barlow has a $10,000 note receivable from a customer. Respond to each of the following:
Assuming Barlow discounts the note to its bank without recourse
A. Messick, Inc. factors $10,000 of accounts receivable due in 20 days
for $8,000:
to a financing company for $9,000 cash, without recourse. A $500
allowance for uncollectible accounts on the $10,000 of receivables
Cash 8,000
has been previously recorded and the following journal entry was
Loss on Discounting of N/R 2,000
Note Receivable 10,000 made to record the factoring:
Cash 9,000
Allowance for Uncollectible A/R 500
Loss on Factoring 500
Accounts Receivable 10,000
Determine Messick's cost of factoring these A/R in terms of an
annualized effective interest rate on the funds received.

35 36

4-6
 Problem 4-4 Problem 4-4 - Answer

Factoring and Discounting of Receivables Factoring and Discounting of Receivables

A. Cost of factoring A/R in terms of an annualized effective interest rate
B. Immediately following receipt of a $20,000, 10%, 60-day note on the funds received:
receivable on the sale of merchandise to a customer, Messick
Answer: Messick has already recognized $500 expense for bad debts on the
discounts the note to a local bank for $18,000, without recourse. $10,000 of A/R. Assuming that is an accurate amount, in other words, $500 is
This discounting was recorded with the following entry: truly uncollectible, then the cost of factoring is the $500 difference between the
$9,500 net realizable value of the A/R and the cash received upon factoring.
Cash 18,000 This cost could have been avoided if Messick had simply waited an
Loss on Discounting of N/R 2,000 additional 20 days. The cost of getting the $9,000 of immediate cash, stated
Note Receivable 20,000 as an interest percentage is determined by taking the cost of $500 and
dividing it by the amount of $9,000 cash received. The resulting 5.56% is a
Determine Messick's effective cost of discounting this note percentage cost over 20 days. This cost can be stated in annual terms by
receivable in terms of an annualized interest rate on the funds dividing the 5.56% by 20 days and then multiplying by 365 for a 101%
annual interest cost. In other words, the cost of this factoring of receivables
received. was effectively the same as if Messick had borrowed $9,000 for twenty days
at an annual interest rate of 101%.
C. Why would Messick do these deals when the effective interest $500
costs are so high? What, if any, financing options might be = 5.56% cost for 20 days
$9,000
available to Messick in lieu of these arrangements?
5.55%
= .278% cost per day
20 days
365 days X .277% = 101% annualized interest cost
37 38

Problem 4-4 - Answer Problem 4-4 - Answer

B. Effective cost of discounting the note receivable in terms of an C. Why would Messick do these deals when the effective interest costs are
annualized interest rate on the funds received: so high?
Answer: Messick is apparently desparate for cash or doesn't understand the
Answer: The sale of the note for $18,000 of immediate cash means Messick will
effective cost of these transactions.
forgo not only $2,000 of principal on the note but also 10% interest on $20,000
for 60 days. That interest amounts to $329 ($20,000 x .10 x 60/365). The total
cost of this discounting is $2,329 over a 60-day period. The effective cost What, if any, financing options might be available to Messick in lieu of
stated in terms of an annual interest rate comes to 78.7% as noted below: these arrangements?

$2,329 Answer: Selling accounts and notes receivable can usually be accomplished at a
= 12.94% cost for 60 days much lower cost if done with recourse. Recourse allows the buyer of the
$18,000
receivables or note to look to the seller for payment in the event of collection
12.94% problems. Another option might be to simply borrow money from a bank or
= .216% cost per day other lending institution. Even credit card debt at a rate of 18% would be a far
60 days
cheaper financing option than the sale of these two assets. If Messick is unable
365 days X .216% = 78.7% Annualized interest cost to qualify for an unsecured loan, then the providing of collateral in the form of
real estate or some other assets might be required. Even the A/R and note may be
In other words, the cost of the discounting of the note was effectively the same acceptable collateral for a loan.
as if Messick had borrowed $18,000 for 60 days at an annual interest rate of
almost 79%.

39 40

Example: Assume that on 12/15/X7, a U.S. company makes a credit sale of

Sales Denominated in a Foreign Currency merchandise costing $2,000 to a customer in Japan at a price of 480,000
Japanese yen when 1 yen is trading for $.008
Since accounting standards in the U.S require financial statement reporting in
U.S. dollars,
Accounts Receivable 3,840*
Most foreign sales are denominated, or made, in U.S. Sales Revenues 3,840
dollars. This means the price is set and then paid in * 480,000 yen X $.008 = $3,840

dollars and the accounting for sales revenues, A/R and Cost of Goods Sold 2,000
Inventory 2,000
the ultimate collection of cash would be the same as it is
Assume that at the end of the year, 12/31/X7, the yen has strengthened against
for any sale made in the United States. the dollar such that 1 yen is now worth $.009.
Current value of the A/R: 480,000 yen X $.009 = $4,320
Sometimes, however, these sales are denominated in a (Under GAAP, any asset held in a foreign currency must be adjusted and reflected
in the financial statements at its current dollar value based on the prevailing
foreign currency. When that happens, the accounting can exchange rate at the end of the period.)
become a bit more complicated. Adjusting Entry at 12/31/X7:
Accounts Receivable 480
Foreign Exchange Gain 480

41 42

4-7
Assume that on 1/15/X8 the company finally receives the 480,000 yen due on There's a significant financial risk involved when entering
account when the value of the yen has plunged to $.007. into transactions denominated in a foreign currency.
480,000 Yen X $.007 = $3,360
Ways to avoid that risk:
Entry at 1/15/X8:
Cash 3,360 1. Simply refuse to do business in anything other than U.S dollars.
Foreign Exchange Loss 960 That effectively shifts the risk of loss to the customer.
Accounts Receivable 4,320
Example: Assume the customer in Japan agreed to buy the
merchandise at the original $3,840 price payable in U.S.
dollars rather than yen.
Date of purchase: 480,000 yen at exchange rate of $.008
Date of payment: 548,571 yen at exchange rate of $.007
68,571 yen loss
2. Locking in the currency price at the date of sale through a
forward contract with a foreign currency broker. This is
commonly referred to as a derivative contract.

43 44

Problem 4-5 Problem 4-5 - Answer

Foreign Currency Transaction Foreign Currency Transaction
A. 1/12/X2: Barker makes a credit sale of merchandise costing $6,000
Barker Marketing sells lighting fixtures to customers around the world. to a customer in Italy at a price of 10,000 euros when one
A. Prepare the appropriate journal entries to record the following euro trades for $1.07.
transactions: Accounts Receivable 10,700*
Sales Revenues 10,700
1/12/X2: Barker makes a credit sale of merchandise costing $6,000
to a customer in Italy at a price of 10,000 euros when one Cost of Goods Sold 6,000
euro trades for $1.07. Inventory 6,000
* 10,000 euros X $1.07 = $10,700
2/10/X2: Barker then collects the 10,000 euros from its Italian
2/10/X2: Barker then collects the 10,000 euros from its Italian
customer. Assume the euro has strengthened such that
customer. Assume the euro has strengthened such that
one euro now trades for $1.10.
one euro now trades for $1.10.
B. What would the 2/10/X2 entry have been assuming an exchange rate Cash 11,000
$1.03 to the euro? Gain on Foreign Exchange 300
Accounts Receivable 10,700
C. Questions: Assuming the euro exchange rate to the dollar went from
$1.07 at the date of sale to $1.10 at the date of collection, did the B. What would the 2/10/X2 entry have been assuming an exchange rate
dollar get stronger or weaker against the euro and what was the $1.03 to the euro?
ultimate effect on Barker and his customer? Do you think U.S Cash 10,300
companies are glad to see a stronger dollar relative to foreign Loss on Foreign Exchange 400
currencies? Accounts Receivable 10,700

45 46

Problem 4-5 - Answer Problem 4-5 - Answer

C. Questions: Assuming the euro exchange rate to the dollar went Do you think U.S companies are glad to see a stronger dollar
from $1.07 at the date of sale to $1.10 at the date of collection, did relative to foreign currencies?
the dollar get stronger or weaker against the euro and what was the Answer: It depends. Companies that buy and sell goods and operate their business
ultimate effect on Barker and his customer? exclusively in the United States are unaffected by changing exchange rates.
Answer: This increasing exchange rate implies a stronger euro. At the time of Companies that buy goods or services from other countries would in theory like a
payment, one euro buys more dollars than it used to. A stronger euro means a stronger dollar if it allowed them to buy more for their dollar. However, that isn't
weaker dollar against the euro. automatically the case. Many foreign suppliers will effectively increase prices to
compensate for their weaker currency. This can be done by simply setting and
As the euro strengthens, all of Barker's assets denominated in euros, including maintaining prices in U.S. dollars, or, by actually increasing prices charged in their
A/R and cash held in euros, increase in value and any change in value on own currency.
foreign currency denominated assets are reported in the company's financial
In selling goods to foreign customers, a stronger dollar may result in lower sales
statements, in this case, as a foreign exchange gain.
volume if those customers can no longer afford to buy U.S. products given their
As far as the customer is concerned, if we assume their financial statements are weaker currency. As a result, companies may be forced to effectively cut prices in
prepared in euros for financial reporting in their own country's equity markets, order to maintain sales. This can be done by cutting selling prices stated in U.S.
the stronger euro has no effect on their outstanding payables denominated in dollars or by simply setting and maintaining prices in the foreign currency. Selling
euros. On their books, 10,000 euros were owed at the time of the merchandise a product at a price of 10,000 euros means a lower effective price if the value of the
purchase and 10,000 euros were subsequently paid. On the other hand, if the euro goes down.
Italian Company prepared financial statements in U.S. dollars, then a payable, The only sure result of a stronger dollar for a U.S company is that existing assets,
initially recorded at $10,700 (10,000 euros X $1.07) would be paid off with like receivables, denominated in a foreign currency decrease in value with a
euros worth $11,000 (10,000 euros X $1.10) and a $300 loss would be stronger dollar and existing liabilities denominated in a foreign currency are
recognized given the payoff of the obligation with more valuable euros. effectively reduced because they can be paid off with fewer dollars.

47 48

4-8
 Lesson 5
Problem 5-1

Review of Perpetual Inventory Accounting and Costing Methods

Respond to the following:

1. What does it mean to account for inventory perpetually and what

Lesson 5 are the benefits of such an approach?

2. What kinds of companies use specific identification in the costing

Cost of Goods Sold of their inventory and how does it work?
and Inventory 3. What is an inventory cost flow assumption and when is it
appropriate for a company to use such an assumption rather than
specific identification?

1 2

Problem 5-1 - Answer Problem 5-1 - Answer

Review of Perpetual Inventory Accounting and Costing Methods
1. What does it mean to account for inventory perpetually and what are 2. What kinds of companies use specific identification in the costing of
the benefits of such an approach? their inventory and how does it work?
Answer: Accounting for inventory perpetually means that the company's inventory Answer: Specific identification is an inventory costing method used by
general ledger account and corresponding subsidiary ledgers maintained for each companies that have distinctive inventory where each item is different in
type of inventory item, are immediately updated for every inventory transaction to nature or cost from every other item in stock. For example, a used car
keep a running balance of not only the number of units on dealership uses specific identification to cost its inventory because every
hand but their associated cost. car in stock is different from the others and has its own specific cost.
The primary benefit of perpetual accounting is more effective inventory Fine art dealers also use specific identification because of the unique
management. Excess inventory can be expensive. It takes up valuable space, nature and cost of each item of inventory.
increases handling costs, requires financing and increases the risk of loss from
obsolescence and theft. On the other hand, insufficient inventory can result in Actual implementation of specific identification requires that the
dissatisfied customers and declining sales volume. Effective inventory management
and control is crucial to a company's success, and having immediately available
cost of each inventory item purchased be recorded and included in
information on inventory quantities and costs is a valuable management tool. inventory until its sale, at which time that specific cost is removed from
inventory and accounted for as the cost of goods sold.
Another benefit of perpetual inventory accounting is that it allows
companies to determine the amount of inventory loss incurred due to waste, theft or
other loss. This is commonly referred to as inventory shrinkage, and the only way it
can be quantified is through periodic comparison of a company's perpetual
inventory records to an actual physical count. In fact, a periodic physical inventory
is required at least once a year, even when using a perpetual inventory system, in
order to verify, and, if necessary, adjust a company's inventory records to reflect
actual quantities on hand.

3 4

Problem 5-1 - Answer Problem 5-2

Review of Perpetual Inventory Accounting and Cost Flows

3. What is an inventory cost flow assumption and when is it appropriate
for a company to use such an assumption rather than specific Harris Appliances has the following inventory balance of EZ Clean washing
identification? machines as of 1/1/X4:
8 units @ $192/unit (purchased 10/21/X3)
Answer: Companies that sell products that are similar in nature and cost 20 units @ $194/unit (purchased 12/15/X3)
will often account for their inventory and cost of goods sold using an 28 units on hand at 1/1/X4
inventory cost flow assumption, such as FIFO (first-in, first-out), LIFO
(last-in, first-out) or some weighted average. In these cases, a cost is A. Prepare journal entries to record the transactions noted below assuming
assigned to the units sold that may not be that specific unit's cost. This is Harris uses a perpetual FIFO inventory accounting method:
justified on the basis that the costs are not significantly different, and, in 1/5 Harris purchases 50 EZ Clean machines at a price of $200/unit on
some cases, keeping a record of the specific cost of each individual item account, terms of 2/10, n/30.
of inventory may be difficult, if not impossible. For example, a jelly bean 1/14 Harris pays for the entire 1/5 EZ Clean purchase, net of the discount.
retailer will find it pretty much impossible to accountant for inventory 1/20 Harris sells and ships 40 EZ Clean machines to Jim's Laundry
and cost of goods sold using specific identification. How do you keep Services for $400/unit on account, terms of 2/10, n/30, FOB shipping
track of the cost of each individual jelly bean? Instead, either the cost of point.
the first units purchased, the last units purchased or an average cost of 1/22 Jim's Laundry returns 2 of the EZ Clean machines for full credit on
the units purchased and available for sale will be used for the cost of account. The machines are unused and can be resold at full price.
goods sold. 1/31 Harris receives payment in full, net of the discount on the 1/20 sale to
Jim's.
B. Determine Harris' gross margin, gross margin percentage and
percentage markup on the sale to Jim's Laundry Services.

5 6

5-1
 Problem 5-2 Problem 5-2 - Answer

C. If Harris had incurred freight costs in the purchase and receipt of EZ Review of Perpetual Inventory Accounting and Cost Flows
Clean washing machines and delivery costs in the subsequent sale to
Jim's, how would such costs have been accounted for and what effect
A.
1/5 Harris purchases 50 EZ Clean machines at a price of $200/unit on
would they have had on Harris' gross margin?
account, terms of 2/10, n/30.
D. Determine the gross margin on the sale to Jim's if the (1) perpetual Inventory 10,000
LIFO method, and (2) moving-weighted average (MWA) methods had Accounts Payable 10,000
been used? Which method (FIFO, LIFO, MWA) would have produced
the highest gross margin? Which method (FIFO, LIFO, MWA) would
have produced the highest gross margin if there had been decreasing 1/14 Harris pays for the entire 1/5 EZ Clean purchase, net of the discount.
inventory costs over time (deflation) instead of inflation? Which method
would have produced the highest gross margin if all inventory had been Accounts Payable 10,000
sold during the period? Cash 9,800
Inventory 200
E. Which inventory cost flow assumption is required for financial
reporting purposes? Which inventory cost flow assumption is required
for income tax purposes? Which assumption would be best for a private
company that typically faces increasing inventory costs and is interested
in minimizing its cash outflows? Would the use of LIFO in a time of
rising inventory costs tend to over or understate the company's assets
relative to current costs?

7 8

Problem 5-2 - Answer Problem 5-2 - Answer

A. (Continued) A. (Continued)
1/20 Harris sells and ships 40 EZ Clean machines to Jim's Laundry 1/22 Jim's Laundry returns 2 of the EZ Clean machines for full credit on
Services for $400/unit on account, terms of 2/10, n/30, FOB shipping account. The machines are unused and can be resold at full price.
point.
Sales Returns and Allowances 800
Accounts Receivable 16,000 Accounts Receivable 800
Sales Revenues 16,000 Inventory (2 units @196) 392
Cost of Goods Sold 7,768* Cost of Goods Sold 392
Inventory 7,768
* Inventory available for sale:
1/31 Harris receives payment in full, net of the discount on the 1/20 sale to
8 units @ $192/unit (purchased 10/21/X3) Jim's.
20 units @ $194/unit (purchased 12/15/X3)
Cash ($15,200 x 98%) 14,896
50 units @ $196/unit (purchased 1/5/X4)
Sales Discounts ($15,200 x 2%) 304
Accounts Receivable 15,200
Cost of Goods Sold (FIFO):
8 units @ $192/unit = $ 1,536
20 units @ $194/unit = 3,880
12 units @ $196/unit = 2,352
40 $ 7,768

9 10

Problem 5-2 - Answer Problem 5-2 - Answer

B.
Sales Revenues $ 16,000 C. If Harris had incurred freight costs in the purchase and receipt of EZ
Clean washing machines and delivery costs in the subsequent sale to
Less: Sales Returns (800) Jim's, how would such costs have been accounted for and what effect
Sales Discounts (304) would they have had on Harris' gross margin?
Net Sales Revenues 14,896
Less: Cost of Goods Sold (7,376) Answer: Any costs incurred in the acquisition of an asset, such as
Gross Margin $ 7,520 inventory, and any costs associated with getting that asset ready for its
original intended use (ready to sell) are to be capitalized as part of the
asset's original historical cost. As a result, any freight costs incurred in
Gross margin percentage: Percentage markup: receiving the inventory should be included as part of the inventory's cost
and debited to the inventory account. This would ultimately reduce
Gross Margin Gross Margin Harris' gross margin in that cost of goods sold would be higher upon the
Net Sales Revenues Cost of Goods Sold sale of that inventory.

$ 7,520 $ 7,520 Costs incurred in the delivery of inventory sold to a customer are not
= 50% = 102% costs incurred in the acquisition of the inventory. Such delivery costs are
$ 14,896 $ 7,376
actually selling costs and are reported as operating expenses below gross
margin on a multi-step formatted income statement.

11 12

5-2
 Problem 5-2 - Answer Problem 5-2 - Answer

D. (Continued)
D. Determine the gross margin on the sale to Jim's if the (1) perpetual
LIFO method, and (2) moving-weighted average (MWA) methods had MWA: Sales Revenues $ 16,000
been used? Which method (FIFO, LIFO, MWA) would have produced
the highest gross margin? Less: Sales Returns (800)
Sales Discounts (304)
LIFO: Sales Revenues $ 16,000 Net Sales Revenues 14,896
Less: Sales Returns (800) Less: Cost of Goods Sold (7,413)
Sales Discounts (304) Gross Margin $ 7,483
Net Sales Revenues 14,896
Inventory available/sold:
Less: Cost of Goods Sold (7,448)
Gross Margin $ 7,448 8 units @ $192/unit = $ 1,536
20 units @ $194/unit = 3,880
Inventory available/sold: 50 units @ $196/unit = 9,800
8 units @ $192/unit (purchased 10/21/X3) 78 $15,216
20 units @ $194/unit (purchased 12/15/X3)
50 units @ $196/unit (purchased 1/5/X4) MWA: $15,216 78 = $195.08/unit

Cost of Goods Sold (LIFO): Cost of Goods Sold (MWA):

38 units @ $196/unit = $ 7,448 38 units @ $195.08/unit = $ 7,413 (rounded)

13 14

Problem 5-2 - Answer Problem 5-2 - Answer

D. Which method (FIFO, LIFO, MWA) produced the highest gross E. Which inventory cost flow assumption is required for financial
margin? reporting purposes?
Answer: Any of the inventory cost flow assumptions can be used
Answer: FIFO: $ 7,520 highest for financial reporting purposes, regardless of the actual physical
LIFO: $ 7,448 flow of goods, as long as the method selected is used consistently
MWA: $ 7,483 from year-to-year.
Which method (FIFO, LIFO, MWA) would have produced the highest
Which inventory cost flow assumption is required for income tax
gross margin if there had been decreasing inventory costs over time
purposes?
(deflation) instead of inflation?
Answer: Current tax law requires that the method used for
Answer: LIFO, the opposite effect. financial reporting must also be used for income tax purposes.

Which method would have produced the highest gross margin if all Which assumption would be best for a private company that typically
inventory was sold during the period? faces increasing inventory costs and is interested in minimizing its cash
outflows?
Answer: No difference. Answer: LIFO

Would the use of LIFO in a time of rising inventory costs tend to over
or understate the company's assets relative to current costs?
Answer: Understate ending inventory

15 16

Mary's Hobby Shop

On 12/31/X5, Mary's inventory balance is $40,000 based on an actual
physical count of inventory on hand at the end of the year 'X5.
Prepare the journal entries for Mary's summarized inventory
Periodic Method transactions for the year 20X6, assuming the business uses a periodic
instead of a perpetual inventory accounting system.
of Purchased a total of $200,000 of inventory on account with
Accounting for Inventory terms of 2/10, n/30:
Purchases 200,000
Accounts Payable 200,000

Paid a total of $5,000 of freight costs to have the purchased

inventory delivered to her store:
Freight-In 5,000
Cash 5,000

17 18

5-3
 Returned $20,000 of previously purchased inventory to Merchandise sold to customers at a price $10,000 is returned
suppliers receiving full credit on account: to Mary for full credit on account:
Accounts Payable 20,000 Sales Returns and Allowances 10,000
Purchase Returns 20,000 Accounts Receivable 10,000
Paid off the $180,000 balance of accounts payable, net of the Inventory XXX
discount, with a $176,400 cash payment. Cost of Goods Sold XXX
(98% X $180,000 = $176,400)
Accounts Payable 180,000
Cash 176,400
Purchase Discounts* 3,600
* (2% x $180,000)
Total sales for the year amounted to $320,000, all made on
account.
Accounts Receivable 320,000
Sales Revenues 320,000

Cost of Goods Sold XXX

Inventory XXX

19 20

Inventory Inventory
1/1/X6 40,000 1/1/X6 40,000
Purchases 200,000 Purchases 200,000
Freight-in 5,000 Freight-in 5,000
20,000 Purchase returns 20,000 Purchase returns
3,600 Purchase discounts 3,600 Purchase discounts
Cost of goods available for sale 221,400
Purchases 178,400 Cost of goods sold
1/1/X6 0 12/31/X6 43,000
200,000 200,000 Closing
12/31/X6 0
Assume that at the end of the year 20X6, a physical
Freight-In inventory is performed and produces a $43,000 total.
1/1/X6 0
5,000 5,000 Closing Cost of Goods Sold
12/31/X6 0 1/1/X6 0
178,400
Purchase Returns 12/31/X6 178,400
0 1/1/X6
Closing 20,000 20,000
The key to the periodic method is the year-end physical
0 12/31/X6
inventory.
Purchase Discounts
0 1/1/X6
Closing 3,600 3,600
0 12/31/X6

21 22

Mary's Hobby Shop

12/31/X6 Physical Inventory:
Inventory Description # of Units
Porsche Model Car 17
Ferrari Model Car 25
Mustang Model Car 22
Should the cost of items sold and the cost of Ferrari Model Car:
any inventory still on hand be determined Beginning inventory: 20 units @ $5.00/ea. = $ 100.00
20X6 Invoices:
based on specific identification, or an Date
3/5
# Units
30
Cost/Unit
$6.00/ea. = $180.00
inventory cost flow assumption? 9/13 30 $7.00/ea. = $210.00
Ending Inventory:
FIFO assumption: 25 units @ $7.00 = $175.00
LIFO assumption: 20 units @ $5.00 = $100.00
5 units @ $6.00 = $ 30.00
$130.00
W/A assumption: $490 80 units = $6.125/unit
25 units @ $6.125 = $153.13 rounded

23 24

5-4
 Problem 5-3 Problem 5-3

Periodic Inventory Accounting B. Calculate Erickson's cost of goods sold for the month of January under
Erickson, Inc., a wholesaler of battery chargers has beginning inventory on periodic FIFO and LIFO inventory cost flow assumptions, assuming a
1/1/X8, which includes: total of 350 units of ending inventory based on a physical count at the
100 units @ $25/unit = $ 2,500 end of the month.
200 units @ $26/unit = 5,200
$ 7, 700 C. Explain how a company's cost of inventory theft or waste is determined
and accounted for under both the perpetual and periodic inventory
A. Prepare Erickson's journal entries for the transactions provided below
accounting methods.
using the periodic method of inventory accounting.
1/10: Purchased 1,200 units of inventory at a cost of $25/unit plus a
$2/unit freight charge, all on account with terms of 2/10, n/30.
1/15: Returned 10 of the 1,200 units purchased for full credit on
account at $27/unit.
1/19: Paid the net account payable due on the 1/10 purchase, net of the
discount.
1/21: Made a $57,000 sale to a customer on account.
1/29: Purchased and paid cash for 300 units of inventory, at $26/unit
with free shipping.

25 26

Problem 5-3 - Answer Problem 5-3 - Answer

Periodic Inventory Accounting
A. B.
1/10: Purchased 1,200 units of inventory at a cost of $25/unit plus a $2/unit freight Cost of Goods Sold (Periodic FIFO): $37,864
charge, all on account with terms of 2/10, n/30.
Purchases (1,200 @ $25/ea.) 30,000 Inventory
Freight-In (1,200 @ $2/ea.) 2,400
Accounts Payable 32,400 Beginning balance 7,700
Purchases 37,800
1/15: Returned 10 of the 1,200 units purchased for full credit on account at $27/unit. Freight-in 2,400
Accounts Payable (10 @ $27/ea.) 270 270 Purchase returns
Purchase Returns 270 643 Purchase discounts
1/19: Paid the net account payable due on the 1/10 purchase, net of the discount. Goods Available 46,987
Accounts Payable 32,130 ? Cost of goods sold
Cash ($32,130 x 98%) 31,487 Ending balance 9,123
Purchase Discounts 643
1/21: Made a $57,000 sale to a customer on account. Cost applied to the 350 units of ending inventory:
Accounts Receivable 57,000 300 units @ $26/unit = $ 7,800
Sales Revenues 57,000
50 units @ $26.46/unit* = $ 1,323
1/29: Purchased and paid cash for 300 units of inventory, at $26/unit with free $ 9,123
350
shipping.
Purchases (300 @ $26/ea.) 7,800
* ($25 + $2) X .98 = $26.46
Cash 7,800

27 28

Problem 5-3 - Answer Problem 5-3 - Answer

C. Explain how a company's cost of inventory theft or waste is

Cost of Goods Sold (Periodic LIFO): $37,964 determined and accounted for under both the perpetual and periodic
inventory accounting methods.
Inventory
Beginning balance 7,700 Answer: Inventory shrinkage can be easily quantified when accounting
Purchases 37,800
for inventory perpetually. This is done through a simple comparison of
the perpetual records and the physical inventory. Although discrepancies
Freight-in 2,400
are sometimes the result of accounting errors rather than theft or waste,
270 Purchase returns
any adjustment required to lower the perpetual inventory records is
643 Purchase discounts accounted for as an expense commonly referred to as inventory
Goods Available 46,987 shrinkage. This would include the cost of any theft or waste.
? Cost of goods sold
Ending balance 9,023 Under the periodic method, inventory shrinkage can't be determined.
Without perpetual records, no comparison of what should be on hand
Cost applied to the 350 units of ending inventory: and what's actually on hand is possible. However, any costs of inventory
100 units @ $25/unit = $ 2,500 theft and waste are accounted for as an expense under the periodic
200 units @ $26/unit = $ 5,200 method through cost of goods sold. Because cost of goods sold is based
on the difference between the cost of goods available for sale and the
50 units @ $26.46/unit* = $ 1,323 ending physical inventory balance, any cost of inventory shrinkage is
350 $ 9,023 automatically included in this amount. It just can't be separately
* ($25 + $2) X .98 = $26.46 distinguished.

29 30

5-5
 Problem 5-4
Gross Margin Method of Estimation
Inventory Estimation
The essence of the method is to estimate a company's ending Given the following information for Jonas, Inc for the quarter ended 3/31/X8:
inventory by first estimating cost of goods sold based on a
gross margin percentage. Purchases $ 44,267
Purchase discounts $ 2,345
Freight-out $ 2,486
Net sales revenues $ XXX Beginning inventory $ 8,648
Less: Cost of goods sold XXX Net sales revenues $ 83,455
Gross margin $ XXX % Estimate Purchase returns $ 1,512
Ending inventory (estimated): Freight-in $ 3,990

Actual cost of goods available for sale: A. Estimate Jonas' ending inventory and cost of goods sold for the quarter
Beginning inventory $ XXX assuming Jonas historically prices their products to produce a 60%
Add: Purchases XXX gross margin.
Freight-in XXX
Less: Purchase returns (XXX) B. Given the assumptions above, what is Jonas' average markup on cost?
Purchase discounts (XXX)
XXX
Less: Cost of goods sold (estimated) (XXX)
Ending inventory (estimated) $ XXX

31 32

Problem 5-4 - Answer Problem 5-4 - Answer

Inventory Estimation Inventory Estimation
A. Estimate Jonas' ending inventory and cost of goods sold for the quarter B. Given the assumptions above, what is Jonas' average markup on cost?
assuming Jonas historically prices their products to produce a 60%
gross margin. Markup on cost:

Cost of goods sold estimate: $33,382 Gross Margin (markup) $50,073

= = 1.5 or 150% markup
Net sales revenues $83,455 100% Cost of Goods Sold $33,382
Less: Cost of goods sold 33,382 40% Given that this problem originally indicated that Jonas historically set
Gross margin $50,073 60% sales prices to produce a 60% gross margin, then what we're really saying
Ending inventory estimate: $19,666 is that a 150% markup on cost produces a 60% gross margin.
Inventory
Beginning balance 8,648
Purchases 44,267
Freight-In 3,990
1,512 Purchase returns
2,345 Purchase discounts
Goods Available 53,048
33,382 Cost of goods sold
Ending balance 19,666

33 34

Inventory
1/1/X5 64,000
Purchases 320,000
Freight-in 10,000
12,000 Purchase returns
3,000 Purchase discounts

Padding or overstatement of inventory Goods Available 379,000

283,000 Cost of Goods Sold
12/31/X5 96,000
is an easy way to make a company's Net Income
profits look better than they really are. Inventory
1/1/X6 96,000
Purchases 350,000
Freight-in 12,000
15,000 Purchase returns
5,000 Purchase discounts
Goods Available 438,000
366,000 Cost of Goods Sold
12/31/X6 72,000

Net Income

35 36

5-6
 Sometimes mistakes are made unintentionally
when accounting for inventory.
Example: On 12/31/X5, $5,000 of inventory purchased from a supplier is
received and properly counted and included in the company's ending physical Example: Inventory costing $2,000 and selling for $3,000 is shipped FOB
inventory totaling $76,000. However, the purchase isn't recorded until 1/1/X6. destination and is in transit to a customer on 12/31/X5. The sale is recorded on
Inventory 12/31 and the goods excluded from the year-end physical inventory.
1/1/X5 64,000
Purchases 320,000
20X5 20X6
Freight-in 10,000 Sales Revenues $3,000 $3,000
12,000 Purchase returns overstatement understatement
3.000 Purchase discounts
Goods Available 379,000 Cost of Goods Sold $2,000 $2,000
303,000 Cost of Goods Sold overstatement understatement
12/31/X5 76,000
20X5: $5,000 overstatement of net income. Net Income $1,000 $1,000
overstatement understatement
Inventory
1/1/X6 76,000
Purchases 350,000
Freight-in 12,000
15,000 Purchase returns
5.000 Purchase discounts
Goods Available 418,000
346,000 Cost of Goods Sold
12/31/X6 72,000
20X6: $5,000 understatement of net income.
37 38

Problem 5-5 Problem 5-5 - Answer

Effect of Inventory Errors Effect of Inventory Errors

Calculate the amount of Richin, Inc.'s net income over or understatement in Effect of errors in 20X7 (under or overstated ):
'X7 and 'X8 given the following: Sales Cost of Net Ending
Revenues Goods Sold Income Inventory
a. 1,235 1,235 1,235
a. Inventory on hand at 12/31/X7 was mistakenly excluded from the year- b. 3,532 3,532
end physical inventory. The inventory cost was $1,235. c. 6,000 6,000 6,000
d. 5,245 5,245 5,245
b. Goods costing $3,532 were received from a supplier on 1/1/X8 (FOB 5,245 5,245
destination) but recorded as a purchase in 20X7. The goods were e. 5,486 5,486
excluded from the 12/31/X7 physical inventory. 3,222 3,222 3,222
3,497 (Net income overstated)
c. Consigned goods from a supplier were included in Richin's 12/31/X7 Effect of errors in 20X8 (under or overstated ):
physical inventory at a cost of $6,000. Sales Cost of Net Beginning
Revenues Goods Sold Income Inventory
d. Goods in transit from a supplier on 12/31/X7 were excluded from a. 1,235 1,235 1,235
purchases and the ending 12/31/X7 physical inventory. The goods cost b. 3,532 3,532
$5,245 and were shipped FOB shipping point. c. 6,000 6,000 6,000
d. 5,245 5,245 5,245
e. Goods costing $3,222 in transit to a customer at 12/31/X7, FOB 5,245 5,245
destination, were recorded as a sales at their $5,486 sales price in 'X7 e. 5,486 5,486
and excluded from the 12/31/X7 physical inventory. 3,222 3,222 3,222
3,497 (Net income understated)

39 40

In addition to a correct inventory count, an accurate

The performance and accuracy of a company's physical physical inventory requires the application of an
inventory is the sole responsibility of management. appropriate cost to each item of inventory counted.

The external auditor's role is to independently review and That cost is based on specific identification, or, a LIFO,
observe the process and then spot check enough of the FIFO or weighted average cost flow assumption, except
actual counts so that they can express an opinion as to the in those cases where the inventory is damaged, obsolete,
overall accuracy of the company's financial statements. or simply worth less than it's original historical cost. In
those cases, the inventory's lower current market value is
used.

41 42

5-7
 Lower of Cost or Market or "LCM" Rule Assume a retailer of high tech consumer products has an inventory
item on hand that cost $200, but can now be purchased for $180 due
Requires the use of historical cost in accounting for inventory unless to increased competition among suppliers. Also assume the retailer
its market value has dropped below that cost. can sell the product for $300, paying a 10% sales commission and
normally makes about a 20% profit margin on the sale of such a
What are market values and how are they determined? product after all other costs are considered.
Ceiling Not higher than the item's current
LCM Rule: NRV $270 ($300 - $30)
net realizable value. (The price the
inventory could be sold for today,
in its current condition, less any
Cost Market Value Replacement Cost $180
selling costs.).
$200 $210
Market Value = Replacement Cost: The cost that
would be paid today to buy that NRV - Profit $210 ($270 - $60)
identical item.
This product had a declining replacement cost but hadn't lost its
Floor Not lower than its net realizable resale value in the marketplace. In this case, no write-down is
value less a normal profit margin. necessary given the higher expected future benefit.

43 44

Consider the lower of cost or market value to be used for an Assume used inventory is on hand at the end of the year that can be
inventory item that originally sold to customers for $150, but is now sold for $450. Its original cost was $500 and inventory in a similar
technically obsolete and is currently offered at a discounted price of "used" condition can be bought from suppliers at a cost of $350.
just $20. The item was purchased at a cost of $90 and replacement Assume a 10% sales commission and a normal profit margin of 16%
units, if they can be found, cost $5 or less. Assume a 10% sales on this product.
commission and a normal profit margin of 20% on this product. NRV $405 ($450 - $45)

NRV $18 ($20 - $2)

Cost Market Value Replacement Cost $350
$500 $350
Cost Market Value Replacement Cost $5
$90 $14 NRV - Profit $333 ($405 - $72)

NRV - Profit $14 ($18 - $4) This used inventory is written down because it's worth less than its
original cost. When writing inventory down it's valued at its
In this case the obsolete inventory is written down to what it can be replacement cost, but never above its resale value, net of selling costs,
sold for, net of selling costs and a normal profit margin. and never below that net realizable value less a normal profit
margin.

45 46

Inventory Items Inventory Items

1 2 3 1 2 3
Cost per unit $200 $90 $500 Cost per unit $200 $90 $500
Market value per unit $210 $14 $350 Market value per unit $210 $14 $350
Replacement Cost $180 $5 $350 Replacement Cost $180 $5 $350
NRV $270 $18 $405 NRV $270 $18 $405
NRV - Profit $210 $14 $333 NRV - Profit $210 $14 $333
LCM per unit $200 $14 $350 LCM per unit $200 $14 $350
# of units 100 10 20 Totals
# of units 100 10 20 Totals
Inventory at cost $20,000 $900 $10,000 $30,900 Inventory at cost $20,000 $900 $10,000 $30,900
Inventory at LCM $20,000 $140 $7,000 $27,140 Inventory at LCM $20,000 $140 $7,000 $27,140
Write-down (item-by-item) 0 $760 $3,000 $3,760 Write-down (item-by-item) 0 $760 $3,000 $3,760

Total inventory at market: $ xxxx Total inventory at market: $27,800

Replacement cost $18,000 $50 $7,000 $ xxxx Replacement cost $18,000 $50 $7,000 $25,050
NRV $27,000 $180 $8,100 $ xxxx NRV $27,000 $180 $8,100 $35,280
NRV - Profit $21,000 $140 $6,660 $ xxxx NRV - Profit $21,000 $140 $6,660 $27,800

Inventory at LCM (total inventory) $ xxxx Inventory at LCM (total inventory) $27,800
Write-down (total inventory) $3,100 Write-down (total inventory) $3,100

Adjusting Entry: Loss on Inventory Write-Down 3,760 Adjusting Entry: Loss on Inventory Write-Down 3,760
(Item by item basis) Inventory 3,760 (Item by item basis) Inventory 3,760

Adjusting Entry: Loss on Inventory Write-Down 3,100 Adjusting Entry: Loss on Inventory Write-Down 3,100
(Total inventory basis) Inventory 3,100 (Total inventory basis) Inventory 3,100

47 48

5-8
 Problem 5-6 Problem 5-6 - Answer
Inventory Write-Down for Lower of Cost or Market Inventory Write-Down for Lower of Cost or Market
Inventory Items
Given the following information for ZZZ Company at 12/31/X5: A B C D
Cost per unit $200 $100 $300 $80
Inventory Items A B C D
Market value per unit $225 $100 $175 $70
# of units 200 150 550 300 Replacement Cost $225 $90 $250 $70
Cost per unit (FIFO) $200 $100 $300 $80 NRV $320 $160 $175 $110
NRV - Profit $200 $100 $125 $60
Replacement cost $225 $90 $250 $70
LCM per unit $200 $100 $175 $70
Selling price $400 $200 $275 $140
# of units 200 150 550 300 Totals
Selling costs $80 $40 $100 $30
Inventory at cost $40,000 $15,000 $165,000 $24,000 $244,000
Normal profit margin $120 $60 $50 $50 Inventory at LCM $40,000 $15,000 $96,250 $21,000 $172,250
Write-down (item-by-item) 0 0 $68,750 $3,000 $71,750
Prepare the adjusting journal entries to write-down inventory to lower of cost
Total inventory at market: $217,000
or market: Replacement cost $45,000 $13,500 $137,500 $21,000 $217,000
A. Using the item-by-item approach. NRV $64,000 $24,000 $96,250 $33,000 $217,250
NRV - Profit $40,000 $15,000 $68,750 $12,000 $141,750
B. Using the total inventory approach.
Total inventory at LCM $217,000
Questions: Write-down (total inventory) $27,000
1. Which inventory item was the primary cause of the inventory write-down
Loss on Inventory Write-Down 71,750
and why? What are some of the possible causes for its declining value? Item by item:
Inventory 71,750
2. Why do you think an inventory item's market value is not allowed to go
Loss on Inventory Write-Down 27,000
below its net realizable value less a normal profit margin, even if its Total inventory:
Inventory 27,000
replacement cost is lower?

49 50

Problem 5-6 - Answer

Questions:
1. Which inventory item was the primary cause of the inventory write-
down and why? What are some of the possible causes for its declining
value?
Answer: Almost all of the write-down was attributable to item C. With a
net realizable value of only $175 per unit, this item is clearly worth a lot
less than its original $300 per unit cost.
Because the item's replacement cost is still relatively high, the lower net
resale value, after selling costs, is most likely due to falling customer
demand due to changing tastes rather than any physical damage to the
inventory itself.
2. Why do you think an inventory item's market value is not allowed to go
below its net realizable value less a normal profit margin, even if its
replacement cost is lower?
Answer: This floor on the market value of inventory prevents companies
from grossly overstating losses in one period in order to realize substantial
gains in the next. In some cases, company's experiencing a difficult year
will seek to maximize asset write-offs in that year. The thinking is that if
things are going to look bad, we might as well make them look really bad,
especially if those write-offs can make it easier to show higher profits upon
the sale of those assets next year.

51

5-9
 Lesson 6

Employee Compensation

Salary and wages

Health insurance
Lesson 6
Accounting for Employee Paid vacation and sick days
Compensation, Taxes,
Bonuses
Contingencies, and Other Items
Stock options
Pensions
Other postretirement benefits.

1 2

Problem 6-1 Problem 6-1 - Answer

Review of Payroll Accounting Review of Payroll Accounting
Given the following totals for Jorgenson, Inc.'s December, 20X4 payroll: Wage Expense 10,000
Employee FICA Withholdings Payable 600
Employee Federal State Employee FIT Withholdings Payable 2,000
Gross Net
Wages
FICA Income Tax Income Tax
Wages
Employee SIT Withholdings Payable 900
Withholdings Withholding Withholding Wages Payable 6,500
$10,000 $600 $2,000 $900 $6,500
Employer Payroll Tax Expense 1,100
Employer FICA Payable 600
Federal State Employer FUI Payable 300
Unemployment Unemployment Employer SUI Payable 200
Insurance Insurance
Remember: Employers have two types of payroll related expenses. The first is
$300 $200 salary or wage expense equal to the gross amount of employee salaries or wages
regardless of the nature and amount of withholdings to be paid on behalf of the
employee. The second expense is the employer's payroll tax expense in the
Prepare the December 31st year-end adjusting entry(ies) assuming actual amount of employer FICA and unemployment taxes (federal and state). This
payment isn't made until 1/15/X5. expense is effectively a tax on employers for the privilege of having employees.

The payables are subsequently debited upon payment to the employee and the
various federal and state taxing authorities.

3 4

Health Insurance Paid Vacation, Sick Days or Family Leave

Companies paying health insurance premiums on behalf of employees (Compensated Absences)
account for those costs as an expense in the period incurred under the Example: Assume a company provides employees with one paid sick
terms of the policy. day for every full month that's worked. When should the cost of that
paid sick day be accounted for as an expense?
Employee Health Insurance Expense XXX
Cash or Premiums Payable XXX
Under the matching principle, the cost of compensated absences for
In some cases, employees are offered a choice of insurance plans and sick days, vacations and family leave are expensed when earned by
are required to make a small contribution to the cost of those plans the employee.
themselves, above and beyond the employers' contribution.
At the end of each month:
Wage Expense XXX Salary or Wage Expense XXX
Employee FICA Withholdings Payable XXX Sick Days Payable XXX
Employee FIT Withholdings Payable XXX
Employee SIT Withholdings Payable XXX
Health Insurance Withholdings Payable XXX
Wages Payable XXX

5 6

6-1
 When employees subsequently take their sick days, payment is made Bonuses
through the company's regular payroll. (Amounts over and above their base salary or wage, if the
employee or the company reaches certain specified goals.)
Salary or Wage Expense XXX
Sick Days Payable XXX Bonuses can be a great way to motivate employees to accomplish a
Employee FICA Withholdings Payable XXX
Employee FIT Withholdings Payable XXX
company's goals and objectives. However, they can also increase the
Employee SIT Withholdings Payable XXX incentives for fraudulent financial reporting. In fact, the existence of
Wages Payable XXX employee bonus plans must be considered when an auditor evaluates
the risks of fraud in a company's financial statements.
Its possible that some employees will never take their sick days or
when they do, their pay rate may have changed. As a result, the net The accounting for bonuses requires the recording of an expense in
balance of sick days payable reported as a liability on a company's the period the bonuses are earned by employees regardless of when
balance sheet, is an estimated future obligation that may require some they're paid.
periodic adjustment if the amount becomes inadequate or overstated
with the passage of time. Employee Bonus Expense XXX
Employee FICA Withholdings Payable XXX
Employee FIT Withholdings Payable XXX
Employee SIT Withholdings Payable XXX
Bonus Payable XXX

7 8

Stock Options
(Rights to purchase shares of stock in a company Actually determining what an option is worth at the date of grant, its
at a set price over a period of time.) fair market value, can be highly subjective, but mathematical models
can be used to come up with amounts that are acceptable for
When stock options are granted, employees are usually then required accounting purposes.
to work for a period of time before the options actually "vest" or
become exercisable. This is referred to as the service period, and Entry to record the granting of stock options:
under the matching principle, the value of options granted should be
recorded as an expense over that period of time. Compensation or Stock Option Expense XXX
Paid-in Capital, Stock Options XXX
How should the value of options be determined, or in other words,
what is the amount of expense to be recorded? When employees subsequently exercise options:

Example: If options to buy 1,000 shares of stock for five years at a Cash XXX
Paid-in Capital, Stock Options XXX
price of $10 a share are granted to an employee when the market price Common Stock XXX
of the stock is $10, then do the options have any real value?

The right to buy shares at a set $10 price over the next five years has
real value, given that stock values may rise over time.

9 10

Pension Plans Defined benefit plans: Create an obligation for a company to provide certain
(Provide retirement benefits for employees) specified benefits to employees in retirement. The determination and recording of
that obligation requires complicated actuarial calculations that take into effect not
Two categories: only the benefits promised, but also estimates of employee turnover, future salary
increases, employee life spans, and other factors.
1. Defined contribution plans
2. Defined benefit plans Defined benefit plans also require company contributions into an independently
managed fund, however, in this case the balance of those funds including any
Defined contribution plans: Call for a company to make specified contributions
investment earnings are reflected on the company's balance sheet as an offset
into an independent fund on behalf of each participating employee. The fund assets
against the company's recorded pension obligation. To the extent the obligation is
are typically invested in stocks and bonds and are then available for distribution to
under funded the net amount is reflected as a long-term liability. In the event of
employees upon retirement in amounts equal to the contributions made plus any
investment earnings. over funding the net amount is reflected as a long-term asset.

On the income statement, the amount of pension expense recorded each year under
Annual entry:
a defined benefit plan is equal to the net amount of:
Pension Expense XXX (1) the increase in the company's, pension obligation arising from the
Cash XXX employees' current year's service, plus

Because the fund assets are maintained and managed by a separate legal entity (2) imputed interest expense on the pension obligation, less
assuming full responsibility for future payments to retirees, the fund balance is not (3) any earnings on, the pension fund assets.
reflected as a company asset and no obligation to make future retirement payments
to employees is recorded.

11 12

6-2
 Problem 6-2

Other Postretirement Benefits Employee Benefits

(Continuing health and life insurance) Briefly summarize, in your own words, the accounting requirements for:
The accounting is similar to that used for defined benefit pension
plans requiring companies to currently recognize the expense and A. Health insurance
long-term liability associated with the benefits earned by employees
in the current period. B. Compensated absences (paid vacation and sick days)

C. Stock options

D. Defined contribution pension plan

E. Defined benefit pension plan

F. Postretirement benefits other than pensions

(life and health insurance)

13 14

Problem 6-2 - Answer Problem 6-2 - Answer

Employee Benefits
Briefly summarize, in your own words, the accounting requirements for: B. Compensated absences (paid vacation and sick days)
A. Health insurance Answer: Compensated absences are recorded as a liability and an
expense at the employee's current salary or wage rate as the employee
Answer: Health insurance paid by a company on behalf of employees earns those benefits.
is recognized as an expense when incurred, regardless of the timing of
payment. Salaries or Wage Expense XXX
Vacation Days Payable XXX
Any contributions to the cost of health insurance paid by employees is
typically withheld from the employees' gross salary and wage and paid When employees subsequently take their vacation or sick days,
on their behalf directly to the health insurance provider. payment is made through the company's regular payroll and the
previously recorded liability is debited for the cost of vacation or sick
days taken.

Wage Expense XXX

Vacation Days Payable XXX
Employee FICA Payable XXX
Employee FIT Payable XXX
Employee SIT Payable XXX
Wages Payable XXX

15 16

Problem 6-2 - Answer Problem 6-2 - Answer

C. Stock options D. Defined contribution pension plan

Answer: The fair market value of stock options at the time granted to Answer: Under a defined contribution plan, a company contributes a
employees is accounted for as an expense over the period in which designated amount to a fund separately owned and operated on behalf
employment is required before the options become exercisable. The of employees. The company does not guarantee returns on the invested
fair market value is typically calculated using a complex mathematical funds and therefore does not guarantee the amount that will ultimately
model based on a number of factors including the option price and the be available from the fund to its retiring employees. The company's
current market price of the stock. accounting is limited to the recording of an expense when
contributions are required under the plan. In this case, the only time a
Entry to record option expense in the current period: liability is recorded is if the annual contribution isn't made at the time
it's required.
Compensation or Stock Option Expense XXX
Paid-in Capital, Stock Options XXX Pension Expense XXX
Cash or Pension Payable XXX
When employees subsequently exercise options:
Cash XXX
Paid-in Capital, Stock Options XXX
Common Stock XXX

17 18

6-3
 Problem 6-2 - Answer Problem 6-2 - Answer

E. Defined benefit pension plan F. Postretirement benefits other than pensions

(life and health insurance)
Answer: Under a defined pension plan, a company agrees to pay
certain specified benefits to retiring employees based on a number of Answer: The method used to account for employer promises to cover
factors including the employee's number of years of employment and retiree's health and life insurance costs is similar to that used for
compensation level at or near the time of retirement. The amount of defined benefit pension plans. Estimated future obligations are
this future obligation is actuarilly determined each year and recorded recorded as long-term liabilities net of any funds set up to pay those
as a long-term liability on the company's balance sheet net of any fund costs, and an annual expense is recorded to the extent of any current
balance set up to pay this future obligation. In the event the funds year increase in that obligation plus imputed interest and less any fund
exceed the obligation the net amount is recorded as a long-term asset. investment earnings.
An annual expense is also recorded under defined benefit plans equal
to the increase in the pension obligation as a result of the current
year's employment, plus imputed interest on the pension obligation for
the year, less any current earnings on the invested funds.

19 20

Problem 6-3 Problem 6-3 - Answer

Review of Sales and Property Taxes Review of Sales and Property Taxes
Respond to the following For Landon, Inc., a clothing retailer. A. 11/1/X1 Entry to record cash sales and collection of sales tax:

A. Prepare journal entries to record the following: Cash 10,400

Sales Revenues 10,000
Sales Taxes Payable 400
11/1/X1: Made cash sales totaling $10,000 collecting an additional
4% state sales tax ($400) at the time of sale.
Assuming perpetual inventory accounting, an additional entry would
11/1/X1: Paid $2,400 of property taxes for the six month period from be required to record cost of goods sold. In this case no amount was
11/1/X1 to 4/30/X2. provided.

B. What journal entry would be made to record any subsequent Cost of Goods Sold XXX
payment of collected sales taxes to the state? Why is no sales Inventory XXX
tax revenue or expense recorded on the company's books?

C. Prepare the adjusting entry required at the company's 11/1/X1: Entry to record payment of property taxes:
12/31/X1 year-end to properly account for the property taxes Prepaid Property Tax Expense 2,400
prepaid on 11/1. Cash 2,400

21 22

Problem 6-3 - Answer Problem 6-3 - Answer

B. What journal entry would be made to record any subsequent C. Prepare the adjusting entry required at the company's 12/31/X1
payment of collected sales taxes to the state? year-end to properly account for the property taxes prepaid on 11/1.
Sales Taxes Payable XXX Property Tax Expense 800*
Cash XXX Prepaid Property Tax Expense 800

Why is no sales tax revenue or expense recorded on the company's * Property tax expense for the two months from 11/1 to 12/31:
books? ($2,400 6 mo. = $400/mo., then 2 mo. $400 = $800)
Answer: Sales taxes are an expense of the customer and revenue of the
state. The role of the company is simply to act as an agent of the state
in collecting the tax from customers and then remitting it to the
government. From the company's perspective no revenues are earned
and no expenses incurred when collecting and paying these taxes.
Upon collection of the tax the company incurs an obligation to the state
and then subsequently pays that obligation. There's nothing more to it.

23 24

6-4
 Assume a corporation has net income for financial reporting purposes
Corporate Income Taxes of $10 million and at that income level the combined federal and state
income tax rate is 30%. Let's also assume that for tax purposes an
additional $1 million dollar expense is allowed for accelerated
depreciation of equipment, producing taxable income of $9 million.
Financial Income Tax
Reporting Reporting
Net Income $10,000,000 $ 9,000,000
In accounting, it's important to note that the laws governing Tax Rate 30% 30%
the determination of taxable income often differ from $ 3,000,000 $ 2,700,000
accounting standards used for financial reporting purposes. (Expense) (Payable)
This can create differences in the amount of income before
Income Tax Expense 3,000,000
income taxes and income tax expense reported on a Income Taxes Payable 2,700,000
company's income statement and the amount of taxable Deferred Income Tax Liability 300,000
income and actual taxes payable to the government. In the later years of the equipment's useful life:
Income Tax Expense "Lower"
Deferred Income Tax XXX
Income Taxes Payable "Higher"

25 26

Problem 6-4
Deferred Income Taxes

A. Describe deferred income taxes in your own words.

On occasion, a company's deferred income tax account may
B. In essence, the difference between income tax expense and
actually end the year with a net debit balance. When that
income taxes payable that gives rise to deferred income taxes
happens, it's the result of tax laws that created higher is the result of timing differences that reverse themselves over
cumulative taxes payable to date than reported income tax time. In that case, why not just report income taxes as an
expense. That difference will ultimately reverse itself expense in the amount that's currently payable eliminating
resulting in lower tax payments in the future. The right to the need for the deferred income tax account?
lower tax payments in the future is an asset to a company
and, as a result, any net debit balance is reported as a long-
term asset called a "deferred tax benefit."

27 28

Problem 6-4 - Answer

Deferred Income Taxes Contingent Assets and Liabilities
A. Describe deferred income taxes in your own words. Contingent assets and gains: Never recorded until they're fully realized,
Answer: Deferred income taxes are the difference between the amount of meaning that no future uncertainty remains and cash or some other property or
income tax expense reported in the company's income statement and the amount enforceable right has been received.
actually payable to the government. In the event the recorded income tax
expense is greater than the amount payable to the government, then the deferred Contingent liabilities and losses: May be recognized before final resolution
amount is a long-term liability representing taxes payable in the future. If the takes place depending on the perceived probability of the outcome.
taxes currently payable exceed the expense, the deferred taxes are a long-term
asset, in effect a benefit that will reduce the amount payable in the future. Probable losses, where the future event is likely to occur and the amount of the
loss can be reasonably estimated, should be recorded in the current period with
B. In essence, the difference between income tax expense and income a debit to an expense or loss and a credit to a liability, along with detailed
taxes payable that gives rise to deferred income taxes is the result disclosure in the notes to the financial statements.
of timing differences that reverse themselves over time. In that Future obligations that are reasonably possible but are not yet probable in their
case, why not just report income taxes as an expense in the outcome or subject to reasonable estimation must be disclosed in the notes to the
amount that's currently payable eliminating the need for the financial statements but are not recorded as liabilities and losses in the financial
deferred income tax account? statements.
Answer: That would violate the matching principle. Under the matching Claims that are unlikely to result in any future obligation do not need to be
principle, the amount of income tax expense recorded in the current year should recorded or disclosed anywhere in the financial statements.
be based on the company's reported net income.
Generally speaking, an auditor will request and rely on the written
representations of the company's legal counsel in evaluating the adequacy of
its accounting and disclosures relative to contingent legal liabilities.

29 30

6-5
 Product Warranties Warranty Obligations
xxx 1/1/X4 Balance
(Promises made by a company to repair or replace merchandise Estimated costs from:
sold to customers if the product malfunctions.) January actual costs xxx 750 January sales
Example: Assume Harris Appliances provides a free six-month warranty on any February actual costs xxx xxx February sales
EZ Clean washing machines sold. The warranty covers parts and labor to fix any March actual cost xxx xxx March sales
machine breakdown for up to six months following sale. Also assume that Harris April actual costs xxx xxx April sales
contracts out all product warranty work to a local repair shop and based on prior May actual costs xxx xxx May sales
experience Harris estimates that 10% of all EZ Clean machines sold will require June actual costs xxx xxx June sales
warranty service at an average contract cost of $75 per unit. xxx 6/30/X4 Balance
In the month of January, the company's net sales of EZ Clean machines amounted If we assume each month's sales are made on the last day of each month and actual
to 100 units. costs are incurred equally over the six-month warranty period, then the balance at
Estimated future warranty costs: 6/30 should be equal to the sum of:
One month of estimated costs from January sales $ XXX
100 units X 10% X $75/unit = $750
Two months of estimated costs from February sales XXX
Warranty Expense 750 Three months of estimated costs from March sales XXX
Warranty Obligations 750 Four months of estimated costs from April sales XXX
Five months of estimated costs from May sales XXX
As machines subsequently breakdown and require warranty work: Six months of estimated costs from June sales XXX
$ XXX
Warranty Obligations XXX This would be true if the estimates used by the company in projecting and recording
Cash XXX future costs were accurate.

31 32

Problem 6-5
Under current accounting standards, any errors in prior year estimates Accounting for Contingent Liabilities
should be compensated for in the current year. That means that if the
ending balance of warranty obligations is too high based on previous Describe the accounting and disclosure requirements given the
overestimations, then: following contingencies.

Adjusting entry at the end of the current period: A. A customer who slipped and fell on company property has
filed suit for $100,000 of damages. The company's legal
Warranty Obligations XXX counsel believes it's probable the company will have to pay
Warranty Expense XXX $25,000 to settle the claim.

An even better approach is to continually monitor the balance in the B. A disgruntled former employee has filed a wrongful
warranty obligation and simply adjust the estimates along the way to termination suit against the company. Given that the
maintain a balance that is reasonable given actual recent experience. employee was fired for illegal drug use on the job, the
company's legal counsel and management are confident no
liability will result from this claim.

C. A company has been sued for $1 million by the federal

government for an alleged violation of pollution emission
standards. The company's legal counsel believes there is a
50% chance the government will prevail.

33 34

Problem 6-5 - Answer Problem 6-6

Deferred Income Taxes Accounting for Warranty Obligations

A. Answer: In this case, a $25,000 liability and expense should be Jones TV Sales and Service sells used television sets and provides
recorded with a supplemental explanation provided in the notes to one-month of free repairs on all such sales. Jones' warranty
the financial statements. In reality, this situation is quite rare. obligation account has a $2,150 credit balance at 4/30/X1. Sales
Even if a company's legal position is considered weak, a company's of used TVs in the month of May totaled $34,000 and actual
legal counsel will rarely indicate a probable future loss on a warranty repair costs amounted to $1,500 ($1,000 labor and $500
pending case. To do so and record a liability in the financial parts), $1,000 of which was for sets sold in April. Jones
statements would severely weaken the company's case in court. estimates that warranty costs on sales of used sets runs at about
Most outstanding lawsuits are disclosed in the notes to the financial 5% of sales revenues.
statements without the recording of a specific future obligation, at
least until a final judgment or settlement has been reached. A. Prepare the journal entry to record Jones' warranty
expense for the month of May.
B. Answer: In situations where future losses are unlikely or remote no
financial statement disclosure is required. B. Determine the balance of Jones' warranty obligation
account at 5/31/X1.
C. Answer: In a case such as this, where a loss is possible, disclosure in
the notes to the financial statements is required but no liability and C. Do you think this warranty obligation account balance is
expense are recorded. over or understated? If so, what should be done to
correct the account?

35 36

6-6
 Problem 6-6 - Answer Problem 6-6 - Answer
Accounting for Warranty Obligations
A. Prepare the journal entry to record Jones' warranty expense for C. Do you think this warranty obligation account balance is over or
the month of May. understated? If so, what should be done to correct the account?
Warranty Expense ($34,000 x 5%) 1,700 Answer: The warranty obligation appears to be overstated. In fact,
Warranty Obligation 1,700 we know that the $2,150 balance at 4/30/X1 was overstated by $1,150
given that the warranty period is limited to 30 days and the actual
B. Determine the balance of Jones' warranty obligation account at warranty costs incurred in May to repair TV sets sold in April
5/31/X1. amounted to $1,000. That also means that the percentage currently
used to estimate warranty costs is probably excessive.
Warranty Obligations
2,150 4/30/X1 To correct the prior overstatement, an adjusting entry can be made
Repairs performed 1,500* 1,700 Warranty expense debiting the warranty obligation and crediting warranty expense for
$1,150. In addition the 5% estimate should probably be adjusted
2,350 5/31/X1 down for the current and all future months. Alternatively, some
* Entry to record costs of repair work performed: companies might forgo the adjusting entry and simply lower the %
estimate for future months with the expectation that in time the
Warranty Obligation 1,500 balance will decline to a more appropriate level. Frankly, the use of
Cash or Wages Payable 1,000 such an approach is acceptable as long as the amount of the
Cash or Inventory 500 overstatement is not significant at the end of any accounting period.

37 38

NRN Corporation
Income Statement
for the year ended December 31, 20X7
Extraordinary Item
(in thousands) (Occurs infrequently and is unusual)
20X7
Gains and losses that qualify as extraordinary typically result from:
Net sales revenues $105,000
Cost of goods sold 65,000
Gross margin 40,000 Casualties due to fire, flood, earthquakes or other natural
Operating expenses 24,000 disasters.
Operating income 16,000
Other revenues (expenses) (1,000) Expropriations of assets by a government.
Income before income taxes 15,000
Income tax expense 3,000 Specific prohibitions under newly enacted laws or regulations.
Income before extraordinary item 12,000
Extraordinary loss, net of tax (4,000) It's also important to note that in determining whether an event is
Net income $ 8,000
extraordinary or not, the place and circumstances in which a company
operates must be taken into account.
Earning per share (1,000,000 shares): $ 12
Income before extraordinary items $ 12
Extraordinary gain (loss), net of tax (4)
Net income $ 8

39 40

Gain or Loss from Discontinued Operations Change in Accounting Principle

(Gain or loss from the sale or disposal of some For example, a company may decide to convert from a FIFO to a LIFO inventory costing
clearly distinguishable segment of a company's business.) method because they believe LIFO will do a better job of representing the company's
operating results. In that case, the company is required to determine and separately
NRN Corporation disclose the cumulative effect such a change would have had on the company's prior years'
Income Statement net income if the new method had been retroactively applied.
for the year ended December 31, 20X7
NRN Corporation
(in thousands) 20X7
Income Statement
Net sales revenues $105,000
for the year ended December 31, 20X7
Cost of goods sold 65,000
Gross margin 40,000
(in thousands) 20X7

Operating expenses 24,000 Net sales revenues $105,000

Operating income 16,000 Cost of goods sold 65,000
Other revenues (expenses) (1,000) Gross margin 40,000
Income before income taxes 15,000 Operating expenses 24,000
Income tax expense 3,000 Operating income 16,000
Income from continuing operations 12,000 Other revenues (expenses) (1,000)
Discontinued operations: Income before income taxes 15,000
Income or (loss) on the discontinued segment's current operations, net of tax (1,000) Income tax expense 3,000
Gain or loss on the disposal of the segment, net of tax (3,000) Income before cumulative effect of a change in accounting principle 12,000
Net income $ 8,000 Cumulative effect of change in accounting principle, net of tax (1,000)
Net income $ 11,000
Earning per share (1,000,000 shares):
Income from continuing operations $ 12 Earning per share (1,000,000 shares):
Income or loss on the discontinued segment's current operations, net of tax (1) Income before the cumulative effect of change in accounting principle $ 12
Gain or loss on the disposal of the segment, net of tax (3) Cumulative effect of change in accounting principle, net of tax (1)
Net income $ 8 Net income $ 11

41 42

6-7
 Problem 6-7
Restructuring Charges Extraordinary and Other Irregular Items
A. Identify the proper income statement disclosure for the following items:
1. A loss is incurred on a plant destroyed during a coup in a foreign
NRN Corporation country. This is the first time such a change in government has taken
Income Statement place in the country, and nothing like this has happened in the
for the year ended December 31, 20X7 company's previous experience.
(in thousands) 2. A large loss results from an employee strike.
20X7
Net sales revenues $105,000 3. A change is made in the percentage used for estimating uncollectible
Cost of goods sold 65,000 accounts receivable.
Gross margin 40,000 4. A toy manufacturer incurs significant costs in dropping a product line
Operating expenses 24,000 from it board game division.
Operating income 16,000
Other revenues (expenses) (1,000) 5. A change is made from the straight-line to a units-of-production method
Income before income taxes 15,000 of depreciating equipment.
Income tax expense 3,000
Net income $ 12,000 B. Prepare the section of an income statement that discloses a company's
$5 million of income before extraordinary items and $1 million
Earning per share (1,000,000 shares) $ 12 extraordinary loss, given an income tax rate of 30% and one million
shares of stock outstanding.

43 44

Problem 6-7 - Answer Problem 6-7 - Answer

Deferred Income Taxes
4. Answer: The costs incurred in eliminating a product line within a
A. 1. Answer: This loss would qualify as an extraordinary loss given its division are restructuring charges reported in the income statement
unusual nature and infrequent occurrence. Extraordinary losses above income tax expense. If the entire game board division had
are reported separately, net of any related tax benefit, below the been sold or disposed of, then any gain or loss in that case would
company's income after income taxes. It's also reported separately have qualified for separate net of tax disclosure as a discontinued
on a per share basis in the earnings per share disclosure. operation, below income after income taxes and on a per share
basis.
2. Answer: This is not an extraordinary loss. Strikes are specifically 5. Answer: This is a change in accounting principle and the
disallowed as extraordinary items on the basis that they are a cumulative effect of that change on prior years' net income would
normal although somewhat infrequent event in the operation of a be shown, net of tax, below income after income taxes and on a
business. This loss would be noted above income tax expense in the separate per share basis.
category of other revenues and expenses or as a separately reported
item. B. (in thousands)
Income before extraordinary items $ 5,000
3. Answer: This is not a change in accounting principle, it's a change Extraordinary loss, net of tax (700)
in accounting estimate and any change in estimate is accounted for Net income $ 4,300
currently with no retroactive application. Bad debt expense is a Earning per share (1,000,000 shares):
normal recurring expense included in a company's income Income before extraordinary items $ 5.00
statement under "operating expenses." Extraordinary gain (loss), net of tax (.70)
Net income $ 4.30

45 46

6-8
 Lesson 7
A dollar today is worth more than a dollar tomorrow.
Which would you prefer, a $1,000 today or a $1,000 a
year from now?
$1,000 today!
Lesson 7 Take the money and invest it.
It's a sure thing.
The Time Value of Money Inflation can negatively affect the value of money
over time.

Money today is worth more than the same amount of

money tomorrow.

That's the time value of money!

1 2

A financial calculator is required for this course.

Hewlett-Packard, HP10bii
Texas Instruments, TI BA II Plus
How much is a $1,000 a year from now Any calculator that has these keys noted here,
actually worth in today's dollars?
N I PV PMT FV CFj

or
and is capable of calculating internal rates of return on
How much would you be willing to pay uneven cash flows and will probably get the job done.
today for the right to receive $1,000 a
year from now? In this lesson, all of the examples that we'll be working on
will refer to keystrokes used on the HP (10bii) calculator
and all of the solutions to homework problems will include
both the HP (10bii) and the TI (BA II Plus) keystrokes.

3 4

Set decimal places on the calculator's display: DISP 2

Clear memory: C ALL

1 N : Number of periods involved.

How much would you be willing to 0 PMT : Annuity payment (a series of two or more
payments made in equal amounts over equal
pay today for the right to receive intervals of time)
1,000 FV : Future value.
$1,000 a year from now? 12 I/YR : Interest rate per year

(The present value of a single cash flow or lump

sum of $1,000.)

5 6

7-1
 Set decimal places on the calculator's display: DISP 2
Clear memory: C ALL

1 N : Number of periods involved.

0 PMT : Annuity payment (a series of two or more
payments made in equal amounts over equal
Compounding means that the amount of interest intervals of time)
earned during each compounding period is based
on both the amount of the original investment and 1,000 FV : Future value.

any previously earned but unpaid interest to date. 12 I/YR : Interest rate per year

In effect, it means that interest is earned on interest. 1 P/YR : Reset to reflect annual compounding
PV : Present value.
In this case, we'll calculate the present value of the -892.86
$1,000 receivable in one year using 12 percent
An investment of $892.86 today grows to $1,000 at the end of a year at an
interest, compounding annually. interest rate 12% compounding annually.
$892.86 + (12% x $892.86 x 1 yr)
$892.86 + $107.14 = $1,000
That $1,000 total could also be characterized as the future value in a year of
an $892.86 single cash outflow today at a rate of 12% compounding annually.

7 8

Determine the future value of the same $892.86 for one year at an interest rate of
Clear memory: C ALL 12%, but instead of annual compounding, let's assume interest compounds quarterly.

1 N : Number of periods involved. Clear memory: C ALL

0 PMT : Annuity payment (a series of two or more 4 N : Number of compounding periods

payments made in equal amounts over equal
intervals of time) 0 PMT : Annuity payment
892.86 +/- PV : Present value.
892.86 +/- PV : Present value.
12 I/YR : Interest rate
12 I/YR : Interest rate per year
4 P/YR : Reset compounding periods per year.
1 P/YR : Reset to reflect annual compounding
FV : Future value
FV : Future value.
1,004.92
1,000.00 Verify compounding mathematically:
$892.86 + (12% x $892.86 x 3/12 yr.) = $ 919.65 1st Quarter
In summary, $892.86 of cash invested today at an interest rate of 12% $919.65 + (12% x $919.65 x 3/12 yr.) = $ 947.24 2nd Quarter
$947.24 + (12% x $947.24 x 3/12 yr.) = $ 975.65 3rd Quarter
compounding annually will grow to $1,000 at the end of a year. $975.65 + (12% x $975.65 x 3/12 yr.) = $1,004.92 4th Quarter
Total interest earned on this investment for the entire year:
$1,004.92 - $892.86 = $112.06
$112.06 $892.86 = 12.55% effective rate or APR*
* Annual Percentage Rate

9 10

What would the effective interest rate or APR have been in the previous How much would a person have to invest today in an account that earns 5%
example if the12% interest rate had compounded daily rather than quarterly? interest compounding monthly, if they wished to accumulate $50,000 at the
start of their daughter's college education in 4½ years.
Clear memory: C ALL
Clear memory: C ALL
365 N : Number of compounding periods (total).
0 PMT : Annuity payment 54 N : Number of compounding periods (total).
0 PMT : Annuity payment.
892.86 +/- PV : Present value.
50,000 FV : Future value.
12 I/YR : Interest rate.
365 P/YR : Reset compounding periods per year. 5 I/YR : Interest rate.

FV : Future value. 12 P/YR : Reset compounding periods per year.

PV : Present value.
1,006.68
Interest earned on this investment: -39,944.48
$113.82
($1,006.68 - $892.86)
$113.82
= 12.78% APR
$892.86

11 12

7-2
Determine the interest rate that would be required to double a $1,000 How long would it take to double our money if the best investment we could
investment in 5 years, assuming interest compounds annually. find produced a 10% return, compounding monthly?
Clear memory: C ALL Clear memory: C ALL

5 N : Number of compounding periods (total). N : Number of compounding periods (total).

0 PMT : Annuity payment. 83.52 12 = 6.97 years
2,000 FV : Future value. 0 PMT : Annuity payment.
I/YR : Interest rate. 14.87% 2,000 FV : Future value.
1 P/YR : Reset compounding periods per year. 10 I/YR : Interest rate.
1,000 +/- PV : Present value. 12 P/YR : Reset compounding periods per year.
1,000 +/- PV : Present value.

13 14

Problem 7-1 Problem 7-1 - Answer

Calculations Using Single Cash Flows Calculations Using Single Cash Flows
Respond to each of the following: A. Determine the present value of a single future cash flow of $10,000, due
in 20 years at 7% compounding semi-annually.
A. Determine the present value of a single future cash flow of $10,000, due
in 20 years at 7% compounding semi-annually. Answer: $2,525.72 (The negative sign is ignored in this case.)
B. If an investment account is opened with a deposit of $1,000, how much HP10bii:
will that account be worth in 30 years assuming an expected return on
investment of 12% compounding annually? C ALL : Clear memory.
C. What rate of return, compounding monthly, would have to be earned 40 N : Number of compounding periods
on a $100,000 investment in order to accumulate $1 million in 30 years?
0 PMT : Annuity payment.
D. How many years would it take to accumulate $1,000,000 on a $100,000
investment, assuming an 8% return compounding monthly? 10,000 FV : Future value.

E. Compute the future value of $100,000 in 30 years at 10% compounding 7 I/YR : Interest rate.
daily (ignore the effect of leap years). 2 P/YR : Reset compounding periods per year.
F. An investor is considering the purchase of a 5-year, $20,000 note Press PV : Present value.
receivable, which bears interest, all due at maturity, at a rate of 8%
compounding annually. If the investor were to buy the note at a time
when there are four years left to maturity, how much would the
investor pay to achieve a 12% rate of return, compounding quarterly?

15 16

Problem 7-1 - Answer Problem 7-1 - Answer

A. Determine the present value of a single future cash flow of $10,000, due A. Determine the present value of a single future cash flow of $10,000, due
in 20 years at 7% compounding semi-annually. in 20 years at 7% compounding semi-annually.
Answer: $2,525.72 (The negative sign is ignored in this case.) Answer: $2,525.72 (The negative sign is ignored in this case.)
TI BAII Plus: ** Note for users of other calculators: Some financial calculators are set to
one compounding period per year and don't allow modification of that
C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values. setting. That is easily overcome by always inputting the interest rate as
40 N : Number of compounding periods. the interest rate per compounding period, rather the annual interest rate
0 PMT : Annuity payment. Other calculators:
10,000 FV : Future value. (See manual) : Clear memory:
7 I/Y : Interest rate.
40 N : Number of compounding periods
2nd P/Y 2 ENTER C/CE : Reset compounding periods per year.
0 PMT : Annuity payment.
CPT PV : Present value.
10,000 FV : Future value.
3.5 I : Interest rate.
PV : Present value. (See manual for compute function.)

17 18

7-3
 Problem 7-1 - Answer Problem 7-1 - Answer

B. If an investment account is opened with a deposit of $1,000, how much B. If an investment account is opened with a deposit of $1,000, how much
will that account be worth in 30 years assuming an expected return on will that account be worth in 30 years assuming an expected return on
investment of 12% compounding annually? investment of 12% compounding annually?
Answer: $29,959.92 Answer: $29,959.92

HP10bii: TI BAII Plus:

C ALL : Clear memory: C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values
30 N : Number of compounding periods 30 N : Number of compounding periods
0 PMT : Annuity payment. 0 PMT : Annuity payment.
1,000 +/- PV : Present value. 1,000 +/- PV : Present value.
12 I/YR : Interest rate. 12 I/Y : Interest rate.
1 P/YR : Reset compounding periods per year. 2nd P/Y 1 ENTER C/CE : Reset compounding periods per year.
Press FV : Future value. CPT FV : Future value.

19 20

Problem 7-1 - Answer Problem 7-1 - Answer

C. What rate of return, compounding monthly, would have to be earned C. What rate of return, compounding monthly, would have to be earned
on a $100,000 investment in order to accumulate $1 million in 30 years? on a $100,000 investment in order to accumulate $1 million in 30 years?
Answer: 7.70% Answer: 7.70%
HP10bii: TI BAII Plus:
C ALL : Clear memory: C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values
360 N : Number of compounding periods. 360 N : Number of compounding periods.
0 PMT : Annuity payment. 0 PMT : Annuity payment.
1,000,000 FV : Future value. 1,000,000 FV : Future value.
100,000 +/- PV : Present value. 100,000 +/- PV : Present value.
12 P/YR : Reset compounding periods per year. 2nd P/Y 12 ENTER C/CE : Reset compounding periods per year.
Press I/YR : Interest rate.* CPT I/Y : Interest rate.

* For calculators set to one compounding period per year, then the solution
will appear as .64%, which is a monthly interest rate and must be
multiplied by 12 to get the 7.70% annual rate.

21 22

Problem 7-1 - Answer Problem 7-1 - Answer

D. How many years would it take to accumulate $1,000,000 on a $100,000 D. How many years would it take to accumulate $1,000,000 on a $100,000
investment, assuming an 8% return compounding monthly? investment, assuming an 8% return compounding monthly?
Answer: 28.88 years (346.54 mo. 12) Answer: 28.88 years (346.54 mo. 12)
HP10bii: TI BAII Plus:
C ALL : Clear memory: C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values
0 PMT : Annuity payment. 0 PMT : Annuity payment.
1,000,000 FV : Future value. 1,000,000 FV : Future value.
100,000 +/- PV : Present value 100,000 +/- PV : Present value
8 I/YR : Interest rate.* 8 I/Y : Interest rate.
12 P/YR : Reset compounding periods per year. 2nd P/Y 12 ENTER C/CE : Reset compounding periods per year.
Press N : Number of compounding periods. CPT N : Number of compounding periods.

* For calculators set to one compounding period per year, the interest rate to
be input is the monthly interest rate of .6667% (8% 12)

23 24

7-4
 Problem 7-1 - Answer Problem 7-1 - Answer

E. Compute the future value of $100,000 in 30 years at 10% compounding E. Compute the future value of $100,000 in 30 years at 10% compounding
daily (ignore the effect of leap years). daily (ignore the effect of leap years).
Answer: $2,007,728.58 Answer: $2,007,728.58
HP10bii: TI BAII Plus:
C ALL : Clear memory: C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values
10,950 N : Number of compounding periods. 10,950 N : Number of compounding periods
0 PMT : Annuity payment. 0 PMT : Annuity payment.
100,000 +/- PV : Present value. 100,000 +/- PV : Present value.
10 I/YR : Interest rate.* 10 I/Y : Interest rate.
365 P/YR : Reset compounding periods per year. 2nd P/Y 365 ENTER C/CE : Reset compounding periods per year.
Press FV : Future value. CPT FV : Future value.

* For calculators set to one compounding period per year, the interest rate to
be input is the daily rate of .0274% (10 365)

25 26

Problem 7-1 - Answer Problem 7-1 - Answer

F. An investor is considering the purchase of a 5-year, $20,000 note F. An investor is considering the purchase of a 5-year, $20,000 note
receivable, which bears interest, all due at maturity, at a rate of 8% receivable, which bears interest, all due at maturity, at a rate of 8%
compounding annually. If the investor were to buy the note at a time compounding annually. If the investor were to buy the note at a time
when there are four years left to maturity, how much would the when there are four years left to maturity, how much would the
investor pay to achieve a 12% rate of return, compounding quarterly? investor pay to achieve a 12% rate of return, compounding quarterly?
Answer: In this problem you first calculate the future value of the note Answer: In this problem you first calculate the future value of the note
receivable at maturity ($29,386.56) and then determine the receivable at maturity ($29,386.56) and then determine the
present value of that future amount. present value of that future amount.
$18,312.73 (Ignore the negative sign in this case.) $18,312.73 (Ignore the negative sign in this case.)
HP10bii: First HP10bii: Then
C ALL : Clear memory: C ALL : Clear memory:
5 N : Number of compounding periods. 16 N : Number of compounding periods.
0 PMT : Annuity payment. 0 PMT : Annuity payment.
20,000 +/- PV : Present value. 29,386.56 FV : Future value.
8 I/YR : Interest rate. 12 I/YR : Interest rate.
1 P/YR : Reset compounding periods per year. 4 P/YR : Reset compounding periods per year.
Press FV : Future value. Press PV : Present value.

27 28

Problem 7-1 - Answer Problem 7-1 - Answer

F. An investor is considering the purchase of a 5-year, $20,000 note F. An investor is considering the purchase of a 5-year, $20,000 note
receivable, which bears interest, all due at maturity, at a rate of 8% receivable, which bears interest, all due at maturity, at a rate of 8%
compounding annually. If the investor were to buy the note at a time compounding annually. If the investor were to buy the note at a time
when there are four years left to maturity, how much would the when there are four years left to maturity, how much would the
investor pay to achieve a 12% rate of return, compounding quarterly? investor pay to achieve a 12% rate of return, compounding quarterly?
Answer: In this problem you first calculate the future value of the note Answer: In this problem you first calculate the future value of the note
receivable at maturity ($29,386.56) and then determine the receivable at maturity ($29,386.56) and then determine the
present value of that future amount. present value of that future amount.
$18,312.73 (Ignore the negative sign in this case.) $18,312.73 (Ignore the negative sign in this case.)
TI BAII Plus: First TI BAII Plus: Then
C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values
5 N : Number of compounding periods. 16 N : Number of compounding periods.
0 PMT : Annuity payment. 0 PMT : Annuity payment.
20,000 +/- PV : Present value. 29,386.56 FV : Future value.
8 I/Y : Interest rate. 12 I/Y : Interest rate.
2nd P/Y 1 ENTER C/CE : Reset compounding periods per year. 2nd P/Y 4 ENTER C/CE : Reset compounding periods per year.
CPT FV : Future value. CPT PV : Present value.

29 30

7-5
 How much would you have for retirement in 30 years, if you invested
$100 at the end of each month at an interest rate of 7% compounding
monthly?
In other words, what's the future value of this $100 annuity?
HP 10bii calculator:
Clear memory: C ALL

360 N : Number of payments.

Annuity 100 +/- PMT : Annuity payment.

(A series of equal cash payments over equal intervals of time.) 0 PV : Present value.
7 I/YR : Interest rate.

12 P/YR : Set compounding periods per year.

FV : Future value.
121,997.10

31 32

How much would accumulate if you could afford $300 at the end of Calculate the future value of the $300 annuity assuming payments at
each month and could somehow find an investment that generated a the beginning rather than the end of each month for 30 years.
12% return, compounding monthly? Clear memory: C ALL

Clear memory: C ALL Reset the end of the period payment schedule to the beginning of
360 N : Number of payments. the period by: BEG/END

300 +/- PMT : Annuity payment. 360 N : Number of payments.

0 PV : Present value. 300 +/- PMT : Annuity payment.

12 I/YR : Interest rate. 0 PV : Present value.

12 P/YR : Set compounding periods per year. 12 I/YR : Interest rate.

FV : Future value. 12 P/YR : Set compounding periods per year.

FV : Future value.
1,048,489.24
1,058,974.13
$1,058,974.13 vs. $1,048,489.24
($10,484.89 additional interest)
This amount is equal to the amount of interest earned on a single
investment of $300 for 30 years at 12% compounding monthly.

33 34

Assume you wish to set up an investment account from which you'll be Assume your expecting your first child and want to invest an equal
able to withdraw $10,000 at the end of each year for the next 20 years. amount at the beginning of each month for 18 years to help cover the
Assuming the account will earn interest at a rate of 8% compounding anticipated costs of college. Assuming an 8% return on investment,
annually how much will have to be invested today to accommodate compounding monthly, how much must the monthly investment be to
those future withdrawals? have $50,000 at the end of that 18-year period?
Clear memory: C ALL Clear memory: C ALL

Reset to end of the period payments: BEG/END Reset to end of the period payments: BEG/END

20 N : Number of payments. 216 N : Number of payments.

10,000 PMT : Annuity payments. 50,000 FV : Future value.
0 FV : Future value. 0 PV : Present value.
8 I/YR : Interest rate. 8 I/YR : Interest rate.

1 P/YR : Set compounding periods per year. 12 P/YR : Set compounding periods per year.
PV : Present value. PMT : Annuity payment.
-98,181.47 -103.46

35 36

7-6
 How much longer will it take to accumulate the $50,000 given a Calculate the rate that would have to be achieved to meet the original
monthly payment of $75 a month? 18-year timetable given payments of $75 a month.
Clear memory: C ALL Clear memory: C ALL

Check display to verify beginning of the period payments are set. Check display to verify beginning of the period payments are set.
N : Number of payments. 216 N : Number of payments.
254.22 12 = 21.19 years 50,000 FV : Future value.

50,000 FV : Future value. 0 PV : Present value.

0 PV : Present value. I/YR : Interest rate.

8 I/YR : Interest rate. 10.83

12 P/YR : Set compounding periods per year. 12 P/YR : Set compounding periods per year.

75 +/- PMT : Annuity payment. 75 +/- PMT : Annuity payment.

37 38

Problem 7-2
Assume your considering the purchase of a $170,000 home with a
$20,000 cash down payment and a $150,000 mortgage loan. Calculations with Annuities
Respond to each of the following:
What's the monthly mortgage payment?
A. Determine the present value of an annuity of $1,000 at the end of each quarter
Assuming a traditional 30-year, fixed rate, fully amortizing mortgage, an for 5 years at 9% compounding quarterly.
equal monthly payment is established in an amount that pays off the entire B. Determine the future value of an annuity of $100 at the beginning of each
principal and interest due on the loan over the 30-year period. This fixed month for 10 years, at 7% compounding monthly.
monthly payment is an annuity that can be easily determined using a
C. If $200,000 is needed for retirement in 10 years, how much must be invested at
financial calculator. the beginning of each year, at an interest rate of 10% compounding annually, to
Clear memory: C ALL reach that goal?
D. Determine the amount of the equal monthly mortgage payment on a $100,000,
Reset to end of the period payments: BEG/END
30-year, fully amortizing mortgage, bearing interest at a fixed 7% rate,
compounding monthly. (Mortgage payments are made at the end of each month.)
360 N : Number of payments.
Then make the journal entries to record the first two monthly payments.
0 FV : Future value.
E. Determine the fixed interest rate that will produce a monthly mortgage payment
150,000 PV : Present value. of $750 on a $120,000, 30 year, fully amortizing mortgage.
7 I/YR : Interest rate. F. The parents of a newborn daughter anticipate they'll need $10,000 at the
beginning of each year for four years to pay her annual college tuition beginning
12 P/YR : Set compounding periods per year. on her 18th birthday. How much must be invested at the beginning of each year
PMT : Annuity payment. for 18 years (beginning on her date of birth) to accumulate the funds necessary
to make those annual payments assuming a 7% return on investment,
-997.95 compounding annually?

39 40

Problem 7-2 - Answer Problem 7-2 - Answer

Calculations with Annuities Calculations with Annuities
A. Determine the present value of an annuity of $1,000 at the end of each quarter A. Determine the present value of an annuity of $1,000 at the end of each quarter
for 5 years at 9% compounding quarterly. for 5 years at 9% compounding quarterly.
Answer: $15,963.71 (ignore the negative sign) Answer: $15,963.71 (ignore the negative sign)
HP10bii: TI BAII Plus:
Check display to make sure end of the period payments are set. Check display to make sure end of the period payments are set.
("Begin" does not appear.) ("BGN" does not appear.)
If this needs to be changed then enter: BEG/END If this needs to be changed then enter: 2nd BGN 2nd SET C/CE

C ALL : Clear memory C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values.
20 N : Number of payments. 20 N : Number of payments.
1,000 PMT : Annuity payment. 1,000 PMT : Annuity payment.
0 FV : Future value. 0 FV : Future value.
9 I/YR : Interest rate. 9 I/Y : Interest rate.
4 P/YR : Set compounding periods per year. 2nd P/Y 4 ENTER C/CE : Set compounding periods per year.
Press PV : Present value. CPT PV : Present value.

41 42

7-7
 Problem 7-2 - Answer Problem 7-2 - Answer

B. Determine the future value of an annuity of $100 at the beginning of each B. Determine the future value of an annuity of $100 at the beginning of each
month for 10 years, at 7% compounding monthly. month for 10 years, at 7% compounding monthly.
Answer: $17,409.45 (ignore the negative sign) Answer: $17,409.45 (ignore the negative sign)
HP10bii: TI BAII Plus:
Check display to make sure beginning of the period payments are set. Check display to make sure beginning of the period payments are set.
("Begin" appears.) ("BGN" appears.)
If this needs to be changed then enter: BEG/END If this needs to be changed then enter: 2nd BGN 2nd SET C/CE

C ALL : Clear memory C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values.
120 N : Number of payments. 120 N : Number of payments.
100 PMT : Annuity payment. 100 PMT : Annuity payment.
0 PV : Present value. 0 PV : Present value.
7 I/YR : Interest rate. 7 I/Y : Interest rate.
12 P/YR : Set compounding periods per year. 2nd P/Y 12 ENTER C/CE : Set compounding periods per year.
Press FV : Future value. CPT FV : Future value.

43 44

Problem 7-2 - Answer Problem 7-2 - Answer

C. If $200,000 is needed for retirement in 10 years, how much must be invested at C. If $200,000 is needed for retirement in 10 years, how much must be invested at
the beginning of each year, at an interest rate of 10% compounding annually, to the beginning of each year, at an interest rate of 10% compounding annually, to
reach that goal? reach that goal?
Answer: -$11,408.25 Answer: -$11,408.25
HP10bii: TI BAII Plus:
Check display to make sure beginning of the period payments are set. Check display to make sure beginning of the period payments are set.
("Begin" appears.) ("BGN" appears.)
If this needs to be changed then enter: BEG/END If this needs to be changed then enter: 2nd BGN 2nd SET C/CE

C ALL : Clear memory C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values.
10 N : Number of payments. 10 N : Number of payments.
0 PV : Present value. 0 PV : Present value.
200,000 FV : Future value. 200,000 FV : Future value.
10 I/YR : Interest rate. 10 I/Y : Interest rate.
1 P/YR : Set compounding periods per year. 2nd P/Y 1 ENTER C/CE : Set compounding periods per year.
Press PMT : Annuity payment. CPT PMT : Annuity payment.

45 46

Problem 7-2 - Answer Problem 7-2 - Answer

D. Determine the amount of the equal monthly mortgage payment on a $100,000, D. Determine the amount of the equal monthly mortgage payment on a $100,000,
30-year, fully amortizing mortgage, bearing interest at a fixed 7% rate, 30-year, fully amortizing mortgage, bearing interest at a fixed 7% rate,
compounding monthly. (Mortgage payments are made at the end of each month.) compounding monthly. (Mortgage payments are made at the end of each month.)
Then make the journal entries to record the first two monthly payments. Then make the journal entries to record the first two monthly payments.
Answer: -$665.30 Answer: -$665.30
HP10bii: TI BAII Plus:
Check display to make sure end of the period payments are set. Check display to make sure end of the period payments are set.
("Begin" does not appear.) ("BGN" does not appear.)
If this needs to be changed then enter: BEG/END If this needs to be changed then enter: 2nd BGN 2nd SET C/CE

C ALL : Clear memory C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values.
360 N : Number of payments. 360 N : Number of payments.
100,000 PV : Present value. 100,000 PV : Present value.
0 FV : Future value. 0 FV : Future value.
7 I/YR : Interest rate. 7 I/Y : Interest rate.
12 P/YR : Set compounding periods per year. 2nd P/Y 12 ENTER C/CE : Set compounding periods per year.
Press PMT : Annuity payment. CPT PMT : Annuity payment.

47 48

7-8
 Problem 7-2 - Answer Problem 7-2 - Answer

E. Determine the fixed interest rate that will produce a monthly mortgage payment E. Determine the fixed interest rate that will produce a monthly mortgage payment
of $750 on a $120,000, 30 year, fully amortizing mortgage. of $750 on a $120,000, 30 year, fully amortizing mortgage.
Answer: 6.39% Answer: 6.39%
HP10bii: TI BAII Plus:
Check display to make sure end of the period payments are set. Check display to make sure end of the period payments are set.
("Begin" does not appear.) ("BGN" does not appear.)
If this needs to be changed then enter: BEG/END If this needs to be changed then enter: 2nd BGN 2nd SET C/CE

C ALL : Clear memory C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values.
360 N : Number of payments. 360 N : Number of payments.
750 +/- PMT : Annuity payment. 750 +/- PMT : Annuity payment.
0 FV : Future value. 0 FV : Future value.
120,000 PV : Present value. 120,000 PV : Present value
12 P/YR : Set compounding periods per year. 2nd P/Y 12 ENTER C/CE : Set compounding periods per year.
Press I/YR : Interest rate. CPT I/Y : Interest rate.

49 50

Problem 7-2 - Answer Problem 7-2 - Answer

F. The parents of a newborn daughter anticipate they'll need $10,000 at the

HP10bii:
beginning of each year for four years to pay her annual college tuition beginning Check display to make sure beginning of the period payments are set.
on her 18th birthday. How much must be invested at the beginning of each year ("Begin" appears.)
for 18 years (beginning on her date of birth) to accumulate the funds necessary
to make those annual payments assuming a 7% return on investment, If this needs to be changed then enter: BEG/END
compounding annually?
First
Answer: -$996.27 (ignore the negative sign)
C ALL : Clear memory
(This solution requires a two-part process. First, the present value of a
$10,000 annual annuity with payments made at the beginning of each year 4 N : Number of payments.
must be determined at a 7% rate compounding annually. Then that present
value will be used as the future value amount in determining the annual 10,000 PMT : Annuity payment.
investment required at the beginning of each year for 18 years at the same 0 FV : Future value.
7% rate)
7 I/YR : Interest rate.

See pages that follow for calculation: 1 P/YR : Set compounding periods per year.
Press PV : Present value.

-36,243.16

51 52

Problem 7-2 - Answer Problem 7-2 - Answer

HP10bii: TI BAII Plus:

Then Check display to make sure beginning of the period payments are set.
("BGN" appears.)
C ALL : Clear memory
If this needs to be changed then enter: 2nd BGN 2nd SET C/CE
18 N : Number of payments.
First
36,243.16 FV : Future value.
C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values.
0 PV : Present value.
7 I/YR : Interest rate. 4 N : Number of payments.

1 P/YR : Set compounding periods per year. 10,000 PMT : Annuity payment.

Press PMT : Annuity payment. 0 FV : Future value.

7 I/Y : Interest rate.
-996.27 2nd P/Y 1 ENTER C/CE : Set compounding periods per year.
CPT PV : Present value.

-36,243.16

53 54

7-9
 Problem 7-2 - Answer
The present or future value of multiple cash flows is simply the
TI BAII Plus: sum of the present or future values of all cash flows involved.
Then Determine the future value of an investment at the end of three years that includes contributions
of $1,000 today, $2,000 a year from now, and $3,000 a year after that, assuming the investment
C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values. earns a 10% return compounding annually.
FV = ?
18 N : Number of payments.
-$1,000 FV = $1,331
36,243.16 FV : Future value. -$2,000 FV = $2,420
-$3,000 FV = $3,300
0 PV : Present value. $7,051

7 I/Y : Interest rate. FV = ?

2nd P/Y 1 ENTER C/CE : Set compounding periods per year. -$1,000 -$1,000
-$1,000
-$1,000
-$1,000
FV = $3,641
FV = $2,310
CPT PMT : Annuity payment. -$1,000 FV = $1,100
$1,000 $2,000 $3,000 $7,051
-996.27 FV = ?
-$1,000 FV = $1,331
-$2,000 -$2,000 FV = $4,620
-$1,000 FV = $1,100
$1,000 $2,000 $3,000 $7,051
The future value of uneven cash flows is simply the sum of the future values of each single cash
flow or any combination of single or annuity cash flows involved. That's also true when applied
to present values.

55 56

Determine how much would have to be invested in an account today, if, at the Determine how much would have to be invested in an account today, if, at the
beginning of the 5th year following investment, you wished to withdraw $1,000 a beginning of the 5th year following investment, you wished to withdraw $1,000 a
month for 12 months plus the lump-sum amount of $10,000 at the end of that 12th month for 12 months plus the lump-sum amount of $10,000 at the end of that 12th
month. Assume an 8% return on investment, compounding monthly. month. Assume an 8% return on investment, compounding monthly.

PV = ? 1 2 3 4 5 60 61 62 70 71 72 Months PV = ? 1 2 3 4 5 60 61 62 70 71 72 Months

PV = -671.21 1,000 1,000 1,000 1,000 1,000 10,000 PV = -7,767.53 1,000 1,000 1,000 1,000 1,000 10,000
PV = -666.76 PV = -6,197.70
PV = -662.35 PV = 11,572.42
. -13,965.23
.
.
-13,965.23

57 58

Problem 7-3 Problem 7-3

PV and FV Calculations with Uneven Cash Flows PV and FV Calculations with Uneven Cash Flows
Respond to each of the following: C. If you open an investment account and expect to earn 12% compounding
monthly, how much will you have for retirement in 30 years if you invest
A. If withdrawals of $10,000, $12,000 and $15,000 are needed from an the following amounts at the beginning of each month?
investment account at the end of each year for the next three years,
respectively, how much must be invested today assuming a 10% return on $ 250/mo. for the first 5 years
investment, compounding annually. (Make this calculation two ways. Use $ 500/mo. for the next 10 years
an annuity in at least in one of your computations.) $1,000/mo. for the final 15 years

B. The parents of a newborn daughter anticipate they'll need the following

amounts to fund their daughters' future college education and wedding:
$15,000 at 18th birthday
$16,000 at 19th birthday
$17,000 at 20th birthday
$18,000 at 21st birthday
$25,000 at 26th birthday
How much will have to be invested at the beginning of each year for 18
years (starting at the date of birth) to accumulate the funds necessary to
meet these anticipated future obligations? (Assume a 7% return on
investment, compounding annually.)

59 60

7-10
 Problem 7-3 - Answer Problem 7-3 - Answer
PV and FV Calculations with Uneven Cash Flows B. The parents of a newborn daughter anticipate they'll need the following amounts
to fund their daughters' future college education and wedding:
Respond to each of the following: $15,000 at 18th birthday
A. If withdrawals of $10,000, $12,000 and $15,000 are needed from an $16,000 at 19th birthday
$17,000 at 20th birthday
investment account at the end of each year for the next three years, $18,000 at 21st birthday
respectively, how much must be invested today assuming a 10% return on $25,000 at 26th birthday
investment, compounding annually. (Make this calculation two ways. Use How much will have to be invested at the beginning of each year for 18 years
an annuity in at least in one of your computations.) (starting at the date of birth) to accumulate the funds necessary to meet these
Answer: -$30,277.98 (ignore the negative sign) anticipated future obligations? (Assume a 7% return on investment,
compounding annually.)
PV = ? Answer: $2,035.39 at the beginning of each year for 18 years, with interest
PV = $ 9,090.90 $10,000 at 7% compounding annually produces a FV of $74,095.32 at the
PV = $ 9,917.36 $12,000 end of the 18th year.
PV = $11,269.72 $15,000
$30,277.98 0 1 2 16 17 18 19 20 21 22 23 24 25 26 years

? ? ? ? ? 15,000 16,000 17,000 18,000 25,000

PV = ?
PV = -15,000.00
PV = -14,953.27
PV = $24,868.52 $10,000 $10,000 $10,000
PV = -14,848.46
PV = $ 1,652.89 $ 2,000 PV = -14,693.36
PV = $ 3,756.57 $ 5,000 PV = -14,550.23
$30,277.98 $10,000 $12,000 $15,000 -74,045.32

61 62

Problem 7-3 - Answer

C. If you open an investment account and expect to earn 12% compounding

monthly, how much will you have for retirement in 30 years if you invest
the following amounts at the beginning of each month?
$ 250/mo. for the first 5 years
$ 500/mo. for the next 10 years
$1,000/mo. for the final 15 years

Answer: $1,609,175.21
FV of -$250 annuity at the beginning of 360 months = $882,478.44
FV of -$250 annuity at the beginning of 300 months = $474,408.77
FV of -$500 annuity at the beginning of 180 months = $252,288.00
$1,609,175.21

63

7-11
 Lesson 8

Property, Plant and Equipment

Lesson 8
Intangible Assets
Long-Term Assets
Natural Resources

1 2

Problem 8-1

Property, Plant and Equipment Review of Accounting for Property, Plant and Equipment
(Fixed Assets) On 4/1/X1, Elder Company purchased a used truck for $30,000 paying
$10,000 cash down and signing a note to pay the difference with interest
over time. In addition, Elder paid a 6% sales tax on the total purchase
Land price, overhauled the engine for $1,200 and paid $2,000 for a paint job
deemed necessary before putting the truck in service. Elder also prepaid
Land improvements $2,400 of insurance premiums for one year's coverage on the truck.
Buildings
A. What does it mean to "capitalize" an expenditure and what are
Equipment the criteria for capitalization of costs incurred in the acquisition of
property, plant and equipment? Prepare the 4/1/X1 journal entry
Machinery or entries required for the purchase of the truck and all associated
expenditures including insurance.
Vehicles
Office equipment B. Prepare the 12/31/X1 adjusting entry for the truck's 'X1
depreciation using the straight-line method and estimations of a
Furniture $5,000 salvage value at the end of a 5-year useful life. What kind
of account is "Accumulated Depreciation" and where does it
Etc. appear on a company's financial statements?

3 4

Problem 8-1 Problem 8-1 - Answer

Review of Accounting for Property, Plant and Equipment
C. Prepare the journal entry in 'X2 to record a $500 cash purchase
of new tires for the truck. When does an expenditure qualify as A. What does it mean to "capitalize" an expenditure and what are the criteria
an "improvement" that's to be capitalized as part of the cost of for capitalization of costs incurred in the acquisition of property, plant and
the truck? equipment?
Capitalization of an expenditure means to account for an expenditure as an asset
D. Prepare the 12/31/X2 adjusting entry for the truck's 'X2 or part of the cost of an asset rather than as an expense. In the case of property,
depreciation. plant and equipment, any cost incurred in acquiring or getting an asset ready for
its original intended use is capitalized as part of the cost of the asset.
E. Determine the book value of the truck at 12/31/X2.
Prepare the 4/1/X1 journal entry or entries required for the purchase of the
F. Prepare the journal entry to record the sale of the truck at truck and all associated expenditures including insurance.
12/31/X2 for $28,000 cash. What would the entry be assuming the
truck sold for $20,000 cash? What would the entry be assuming Truck 35,000* *Capitalized cost of the truck:
the truck was simply used up and disposed of at 12/31/X2? Where Cash 15,000 Purchase price $ 30,000
would a gain or loss on the sale of an asset appear in the Note Payable 20,000 Sales tax (6% X $30,000) 1,800
company's income statement? Engine overhaul 1,200
Prepaid Insurance 2,400 Paint job 2,000
G. Recalculate the truck's 12/31/X1 depreciation using the units of Cash 2,400 $ 35,000
production method under the following assumptions: 100,000
(The prepaid insurance is accounted for as a separate asset because it's the cost of
miles of anticipated usage, $5,000 estimated salvage value, and
future insurance coverage and not a cost incurred in acquiring the truck or getting
10,000 miles of actual usage from 4/1/X1 to 12/31/X1. it ready for its original intended use.)

5 6

8-1
 Problem 8-1 - Answer Problem 8-1 - Answer

B. Prepare the 12/31/X1 adjusting entry for the truck's 'X1 C. Prepare the journal entry in 'X2 to record a $500 cash purchase
depreciation using the straight-line method and estimations of a of new tires for the truck.
$5,000 salvage value at the end of a 5-year useful life.
Repairs & Maintenance Expense 500
Depreciation Expense 4,500* Cash 500
Accumulated Depreciation 4,500
When does an expenditure qualify as an "improvement" that's to
* $35,000 - $5,000 9 be capitalized as part of the cost of the truck?
= $6,000/year X of a year = $4,500
5 years 12
Answer: Expenditures are capitalized improvements when they either
What kind of account is "Accumulated Depreciation" and where extend the originally estimated useful life of the asset or increase the
does it appear on a company's financial statements? asset's productivity. In this case, the purchase of new tires is not
capitalized because tire replacement is part of the normal recurring
Answer: Accumulated depreciation is a contra-asset account that maintenance of a vehicle and does not meet the criteria for
appears in a company's balance sheet as an offset to the capitalized capitalization. If, however, something like a refrigeration system were
cost of the asset being depreciated. added to the truck, that cost would be capitalized given the change in
the truck's function and productivity. When such improvements are
made, depreciation from that point on must be recalculated given the
asset's new capitalized cost.

7 8

Problem 8-1 - Answer Problem 8-1 - Answer

D. Prepare the 12/31/X2 adjusting entry for the truck's 'X2 F. Prepare the journal entry to record the sale of the truck at 12/31/X2 for
$28,000 cash.
depreciation.
Cash 28,000
Depreciation Expense 6,000 Accumulated Depreciation 10,500
Accumulated Depreciation 6,000 Truck 35,000
Gain on Sale 3,500
(This reflects a full year's depreciation on the truck) What would the entry be assuming the truck sold for $20,000 cash?
Cash 20,000
E. Determine the book value of the truck at 12/31/X2. Accumulated Depreciation 10,500
Loss on Sale 4,500
Truck (capitalized cost) $35,000 Truck 35,000
Less: Accumulated depreciation ( 10,500) What would the entry be assuming the truck was simply used up and disposed
Book value $24,500 of at 12/31/X2?
Accumulated Depreciation 10,500
Accumulated Depreciation Loss on Disposal 24,500
4,500 'X1 entry
Truck 35,000
6,000 'X2 entry Where would a gain or loss on the sale of an asset appear in the company's
income statement?
10,500 12/31/X2
Answer: Gains and losses on the sale of long-term assets are included in "other
revenues and expenses" on a multi-step formatted income statement. Such sales
are not part of a company's normal operating activities.

9 10

Problem 8-1 - Answer

It's not uncommon for companies to acquire
G. Recalculate the truck's 12/31/X1 depreciation using the units of more than one asset in a single purchase.
production method under the following assumptions: 100,000
miles of anticipated usage, $5,000 estimated salvage value, and
10,000 miles of actual usage from 4/1/X1 to 12/31/X1.
Basket Purchases of Assets
The allocation of cost among the various assets purchased is
$35,000 - $5,000 typically done based on the relative current values of the assets
= $.30/mile X 10,000 miles = $3,000 involved based on recent appraisals.
100,000 miles
Example: Assume that a building and the land its located on are
purchased for $1,000,000 cash.
Land ?
Building ?
Cash 1,000,000
Assume a recent appraisal valued the land and building separately at
$200,000 and $600,000, respectively.
Appraised Value % of Total
Land $200,000 25%
Building $600,000 75%
Total $800,000 100%

11 12

8-2
 Problem 8-2 Problem 8-2 - Answer
Basket Purchase of Assets Basket Purchase of Assets
In a recent liquidation sale, Horace, Inc. paid $10,000 cash for all of the Journal entry to record the purchase:
assets listed below at their pre-liquidation prices.
Office Furniture 3,000
Office Equipment 6,000
Pre-Liquidation Prices Supplies 1,000
Office furniture $15,000 Cash 10,000
Office equipment $30,000
Supplies $ 5,000
Pre-Liquidation % of Purchase Allocated
Prepare the journal entry to record this purchase. Prices Total Price Price
$15,000 30% X $10,000 = $ 3,000
Why do you think management might wish to disproportionately allocate $30,000 60% X $10,000 = $ 6,000
more cost in a basket purchase to land or longer-lived assets than to assets
with shorter useful lives? $ 5,000 10% X $10,000 = $ 1,000
$50,000 100% $10,000

13 14

Problem 8-2 - Answer

Question: Why do you think management might wish to disproportionately

Self-Constructed Assets
allocate more cost in a basket purchase to land or longer-lived assets than to When companies choose to make or manufacture a fixed asset for
assets with shorter useful lives? their own future use, then all of the costs incurred in the construction
Answer: Since management is often evaluated based on a company's or manufacturing process should be capitalized as part of the cost of
reported earnings, managers will sometimes push for accounting that asset.
treatments that improve a company's net income.
Materials.
In a basket purchase of assets, any costs allocated to depreciating
assets will ultimately be accounted for as depreciation expense and will Labor.
reduce the company's net income. If those costs can be allocated
instead to a non-depreciating asset like land, then those costs are never Additional overhead costs (utilities, rent, depreciation of equipment
expensed and reported net income will be higher. Likewise, if costs are and any other costs associated with the construction process).
allocated to assets with longer rather than shorter useful lives, the
amount of annual depreciation expense will be lower as costs are Interest on construction loans or interest that could have been saved
spread out over a longer useful life. This will improve a company's net if the company's own money used on construction had been applied
income in the early years but will ultimately be offset when to the payoff of other outstanding debts, should be capitalized as
depreciation expense is recorded in the later additional years of the part of the cost of the building.
longer-lived assets.

15 16

Problem 8-3 Problem 8-3 - Answer

Self-Constructed Assets Self-Constructed Assets
Respond to the following questions: Respond to the following questions:
1. How does the capitalization of interest on a self-constructed asset
1. How does the capitalization of interest on a self-constructed asset comply with the matching principle?
comply with the matching principle?
Answer: The matching principle requires the expensing of costs in
2. What justifies the capitalization of interest that could have been
the same period those costs help to produce a company's revenues.
saved if a company's own money, used in construction of an asset,
Frankly, assets under construction rarely contribute to the production
had been applied to the payoff of other outstanding debts? of a company's revenues until they're completed and put to use. As a
result, all costs of construction are properly deferred, and in this
3. Which of the following do you think is most likely to have case, capitalized and then allocated to expense over the asset's
capitalized interest as a result of self-constructed assets? productive or useful life. That's done through depreciation of the
Boat manufacturer asset's capitalized costs, which properly include interest costs
incurred on construction financing.
Public utility company
Clothing retailer

17 18

8-3
 Problem 8-3 - Answer Problem 8-3 - Answer

2. What justifies the capitalization of interest that could have been 3. Which of the following do you think is most likely to have capitalized
saved if a company's own money, used in construction of an asset, interest as a result of self-constructed assets?
had been applied to the payoff of other outstanding debts?
Boat manufacturer
Answer: Under the historical cost principle, all costs incurred in Public utility company
constructing an asset, even costs incurred in financing that Clothing retailer
construction, should be capitalized as part of the cost of the asset.
This includes not only direct costs of construction but also any
costs that could have otherwise been avoided if the construction Answer: Public utilities are often involved in the construction of their
had not taken place. Interest costs incurred on debts that could own power generating equipment and facilities and will usually
have been paid off if no construction had occurred qualify as part capitalize a considerable amount of their interest costs.
of the legitimate historical cost of a self-constructed asset.
Although a boat manufacturer is involved in construction or
manufacturing activities, those activities are directed to the building
of boats for sale to customers. A boat manufacturer would rarely be
involved in the construction of its own fixed assets. The same would
be true of any merchandiser such as a clothing retailer.

19 20

Assume Herd Enterprises wants to buy a building and is willing to pay

Operating Leases the seller's full $800,000 asking price, requiring $80,000 cash down
(Typically documented in rental contracts or lease agreements and the signing of a $720,000 30-year fully amortizing mortgage note
that specify that the lessee is taking temporary possession of the payable. Given a fixed interest rate of 8% compounding monthly, the
lessor's property in exchange for periodic payments of rent.) monthly payment of principal and interest on the note would amount
to $5,283.10.
As lease payments are made:
As lease payments are made: Building 800,000
Cash 80,000
Rent Expense XXX Mortgage Note Payable 720,000
Cash XXX
Also assume that Herd hopes to raise some additional equity financing
over the next few years and is concerned that that mortgage note
These operating leases provide what is often referred to as payable will make the company appear less attractive to investors. To
off-balance sheet financing because they allow a company avoid that, Herd offers to lease the property rather than buy it outright.
to, in effect, borrow and use a resource without having to The terms of his proposed lease include an initial up front payment of
record any related debt. $80,000 as a non-refundable deposit, with subsequent monthly rental
payments of $5,283.10 per month for 30-years. The lease would be
non-cancelable and property ownership would automatically transfer
to Herd at the end of the lease.

21 22

Generally accepted accounting principles require that Present value of the proposed lease's anticipated payments:
transactions be accounted for based on their actual economic Present Value
substance rather than the legal form of the transaction. Non-refundable deposit of $80,000 $ 80,000
Current accounting standards provide that if a lease is non-cancelable and Monthly rental payments of $5,283.10 for 30-years $ 720,000
meets any one of four criteria that are indicators of an effective purchase, $ 800,000
then the leased property must be capitalized and accounted for as if it had The interest rate to be used in determining the present value of those future
actually been purchased with long-term debt. payments is the rate that the lessee would have incurred to borrow the funds
necessary to buy the property with repayment terms similar to the payment
Capital Lease schedule called for under the lease. In this case that was 8%, the same rate
provided for under the original mortgage note financing.
Four Criteria:
1. The lease provides the lessee with full ownership of the property at the
Under current accounting standards the capitalized cost of the leased asset
end of the lease. is to be recorded at the combined PV of all anticipated payments under the
lease, including any expected payments under a bargain purchase option.
2. The lease provides the lessee with an option to buy the property at a
bargain price at the end of the lease such that a transfer of ownership is Leased Building 800,000
virtually assured. Cash 80,000
3. The lease term is equal to or greater than 75% of the estimated economic Lease Liability 720,000
useful life of the property.
The balance of any lease liability recorded under a capital lease should
4. The present value of all amounts due under the lease is equal to or greater always be equal to the present value of any anticipated future payments to
than 90% of the current fair market value of the property be made under the lease.

23 24

8-4
Subsequent to the recording of this capitalized lease, the leased property is
subject to depreciation just like any other property, plant, and equipment.
That's recorded through an adjusting entry at the end of each accounting
period:
Depreciation Expense XXX
Accumulated Depreciation XXX Leases are capitalized when they meet any one of the four criteria
With each payment made under the lease, a portion of that payment represents
that imply a purchase in economic substance. Leases that do not
the effective cost of borrowing, or the cost of interest, and the remainder is meet those criteria are accounted for as simple operating leases
payment on the outstanding principal amount of the lease liability. with rent expense recorded with each lease payment made.
However, because these operating leases often involve significant
At the end of the first month: long-term commitments, GAAP requires supplemental disclosure
Interest Expense 4,800.00 of any future amounts due in the notes to the financial statements.
Lease Liability 483.10
Cash 5,283.10
Interest Calculation: $720,000 X 8% X 1/12 = $4,800.00
At the end of the second month:
Interest Expense 4,796.78
Lease Liability 486.32
Cash 5,283.10
Interest Calculation: 719,516.90 ($720,000 - $483.10)
$719,516.90 X 8% X 1/12 = $4,796.78

25 26

Problem 8-4 Problem 8-4 - Answer

Lease Accounting Lease Accounting
Zee Corporation wants to lease computer equipment and is considering Two-year lease: (This lease is accounted for as an operating lease because it
alternative lease contracts for the same equipment. Both are non- does not meet any of the four criteria of a capital lease: (1) automatic transfer
cancelable and require payment of a $1,000 up-front transaction fee. of ownership, (2) a bargain purchase option, (3) a lease term equal to or greater
One calls for lease payments of $1,000 at the end of each month over a than 75% of the equipment's estimated economic life, or (4) a present value of
two-year term, while the other is a five-year lease requiring payments of the future lease payments equal to or greater than 90% of the equipment's
$700 a month. The estimated economic life of the asset is 5 years. There current fair market value.)
is no automatic transfer of ownership or bargain purchase option at the
end of either lease. The cost of purchasing the equipment in today's 12/1/X5:
market would be $37,000 with an 8% interest cost on any associated Equipment Rent Expense 1,000
debt financing. Cash 1,000

Assuming a 12/1/X5 starting date, prepare the required journal entries 12/31/X5:
under each lease at 12/1/X5, 12/31/X5 and 1/31/X6. (For any Equipment Rent Expense 1,000
capitalized lease equipment, depreciation is to be calculated using the Cash 1,000
straight-line method assuming a 5-year estimated useful life and a
$1,000 salvage value.) 1/31/X6:
Equipment Rent Expense 1,000
Question: Why might the company choose to rent for two years even Cash 1,000
though it requires higher cash payments on a monthly basis?

27 28

Problem 8-4 - Answer Problem 8-4 - Answer

Five-year lease: (This lease is accounted for as capital lease given that its non-cancelable 1/31/X6:
and the lease term of five years is greater than 75% of the equipment's estimated economic
useful life which is also 5 years. In addition, the present value of the $1,000 upfront fee and Interest Expense 227*
the future lease payments totals $35,523* and is greater than 90% of the equipment's Lease Liability 473
current fair market value of $37,000.) Cash 700
* Interest: $34,053 X 8% X 1/12 = $227 rounded
* PV of a $700 annuity at the end of each month for 5 years at a rate of 8% compounding
monthly ($34,523 rounded), plus the PV of the $1,000 up-front payment ($1,000). If Zee prepares monthly financial statements a monthly adjustment to record
12/1/X5: depreciation expense would be required:
Leased Equipment 35,523 Depreciation Expense 575
Lease Liability 34,523 Accumulated Depreciation 575
Cash 1,000
Question: Why might the company choose to rent for two years even
12/31/X5:
though it requires higher cash payments on a monthly basis?
Interest Expense 230*
Lease Liability 470 Advantages of the two-year lease include:
Cash 700 1. A shorter-term commitment, both financially and from a technology
* Interest: $34,523 X 8% X 1/12 = $230 rounded standpoint. When it comes to computers a short-term lease allows for
greater flexibility if improved technology comes along.
Depreciation Expense 575*
2. From an accounting standpoint an operating lease is simpler and avoids
Accumulated Depreciation 575
the recording of debt that can negatively affect a company's reported
* ($35,523 - $1,000 salvage value) 60 months = $575 rounded financial position.

29 30

8-5
 Accelerated Depreciation Methods Sum-of-the-Years'-Digits Method
Example: Jones Printing Company purchased and installed a new printing
press on 1/1/X3 at a total capitalized cost of $15,000. The press has a 5-year
Sum-of-the-years'-digits method estimated useful life with a projected salvage value of $3,000.
Declining-balance method Depreciable cost = $12,000 ($15,000 - $3,000)
Straight-line method: $12,000 5 years = $2,400/yr
(They're referred to as accelerated methods because they both Sum-of-the-years-digits method:
expedite the depreciation process allocating higher amounts to
Annual Depreciable Depreciation Depreciation Book Value
expense in the early years and smaller amounts in the later Period Cost Fraction Expense of Asset
years of an asset's useful life.) 1 $12,000 x 5/15* = $4,000 $11,000
2 $12,000 x 4/15 = $3,200 $ 7,800
3 $12,000 x 3/15 = $2,400 $ 5,400
4 $12,000 x 2/15 = $1,600 $ 3,800
5 $12,000 x 1/15 = $ 800 $ 3,000
* Sum of the year's digits given the asset's estimated 5-year useful life:
(1 + 2 + 3 + 4 + 5 = 15) or n(n + 1)/2 = 5(5 +1)/2 = 15

31 32

Let's assume this equipment was purchased on 4/1/X3 rather than 1/1/X3.
Declining-Balance Method
Years Partial Year Calculations Total Instead of a declining fraction applied to an asset's depreciable cost, this
'X3 9/12 x $4,000 = $3,000 $ 3,000 method applies a fixed fraction or rate of depreciation to an asset's declining
3/12 x $4,000 = $1,000 book value to get its accelerated effect.
'X4 = $ 3,400
9/12 x $3,200 $2,400 The fixed rate of depreciation used can vary depending upon the desired
3/12 x $3,200 = $ 800 acceleration relative to each asset's straight-line rate of depreciation.
'X5 $ 2,600
9/12 x $2,400 = $1,800
Straight-line rate of depreciation: The annual percentage of an asset's
3/12 x $2,400 = $ 600 depreciable cost that's allocated evenly to expense each year under the
'X6 $ 1,800
9/12 x $1,600 = $1,200 straight-line method of depreciation. This rate depends on each individual
3/12 x $1,600 = $ 400 asset's estimated useful life. For example, an asset with a:
'X7 $ 1,000
9/12 x $ 800 = $ 600
5-year life = 1/5th or 20% straight-line rate of depreciation
'X8 3/12 x $ 800 = $ 200 $ 200
10-year life = 1/10th or 10% straight-line rate of depreciation
Total $12,000
15-year life = 1/15th or 6.67% straight-line rate of depreciation
Under the declining-balance method, the highest rate of depreciation used is
200% or double the straight-line rate of depreciation. That means that for an
asset with a useful life of 5 years, the depreciation rate will be 40%, which
is 200% or double the 20% straight-line rate.

33 34

150% - declining - balance method:

Double (or 200%) - declining - balance method:
Annual Beginning Annual Rate of Depreciation Ending
Annual Beginning Annual Rate of Depreciation Ending Period Book Value Depreciation Expense Book Value
Period Book Value Depreciation Expense Book Value
1 $15,000 x 30%* = $4,500 $10,500
1 $15,000 x 40%* = $6,000 $ 9,000 2 $10,500 x 30% = $3,150 $ 7,350
2 $ 9,000 x 40% = $3,600 $ 5,400 3 $ 7,350 x 30% = $2,205 $ 5,145
3 $ 5,400 x 40% = $2,160 $ 3,240 4 $ 5,145 x 30% = $1,544 $ 3,601
5 $ 3,601 x = $ 601 $ 3,000
4 $ 3,240 x = $ 240 $ 3,000
* 150% of the 20% straight-line rate of depreciation given the asset's 5-year estimated useful life.
5 $ 3,000 x = $ 3,000
Using 150%-declining-balance numbers and assuming an asset purchase on 4/1/X3
* Double the straight-line rate of depreciation given the asset's 5-year rather than 1/1/X3.
estimated useful life.
Years Partial Year Calculations Total
'X3 9/12 x $4,500 = $3,375 $ 3,375
3/12 x $4,500 = $1,125
'X4 9/12 x $3,150 = $2,363 $ 3,488
3/12 x $3,150 = $ 787
'X5 $ 2,441
9/12 x $2,205 = $1,654
3/12 x $2,205 = $ 551
'X6 $ 1,709
9/12 x $1,544 = $1,158
3/12 x $1,544 = $ 386
'X7 $ 837
9/12 x $ 601 = $ 451
'X8 3/12 x $ 601 = $ 150 $ 150

35 36

8-6
Which of all these methods, including the straight-line A few final observations.
and units of production methods, would be best
for a company's financial reporting?
The amount of depreciation expense reported on a
Under GAAP all of these methods are acceptable. In fact, different
methods can be used for different assets of the same company and the company's income statement is a highly subjective
only requirement is that the method selected be consistently applied over number.
the asset's depreciable life.
Most publicly held companies use the straight-line method for all of their It can be easily manipulated.
depreciation of property, plant and equipment. Its easy to use and even
more importantly it has a leveling effect on a company's net income.
Most analysts today simply ignore depreciation
Accelerated methods provide the best results from an income tax expense in their investment analysis.
perspective.
Under current income tax laws in the United States, companies are
allowed to use different depreciation methods for tax and financial
reporting purposes. In fact, current tax laws actually require the use of
specified accelerated methods, with shorter designated lives and zero
salvage values for assets falling into certain categories.

37 38

Problem 8-5 Problem 8-5 - Answer

Accelerated Depreciation Methods Accelerated Depreciation Methods
On 10/1/X7, Hansen, Inc. purchased equipment having a total capitalized A. Sum-of-the-Years'-Digits Method:
cost of $25,000. Assuming the equipment has a 7-year estimated useful Annual Depreciable Depreciation Depreciation
life with an anticipated salvage value of $5,000, Period Cost Fraction Expense
1 $20,000 x 7/28* = $ 5,000
A. Determine the equipment's book value at 12/31/X8 under (1) the 2 $20,000 x 6/28 = $ 4,286
sum-of-the-years'-digits, (2) the double-declining-balance, and (3)
the 175%-declining-balance methods of depreciation. (Round all * Sum of the year's digits given the asset's estimated 7-year useful life:
7 + 6 + 5 + 4 + 3 + 2 + 1 = 28, or n(n + 1)/2 = 7(7 + 1)/2 = 28
calculations to the nearest dollar.)

B. What is the equipment's book value at the end of its 7-year useful Years Partial Year Calculations Total
life under each of the methods used above?
'X7 3/12 x $5,000 = $1,250 $ 1,250
9/12 x $5,000 = $3,750
Question: Is there an ethical dilemma in a company's maintenance of a 'X8 $ 4,822
separate set of books (accounting records) for depreciation taken as a 3/12 x $4,286 = $1,072
deduction for income tax purposes? Accumulated depreciation $ 6,072

Book value at 12/31/X8: $25,000 - $6,072 = $18,928

39 40

Problem 8-5 - Answer Problem 8-5 - Answer

Double-Declining-Balance Method: 175%-Declining-Balance Method:

Annual Beginning Annual Rate of Depreciation Ending Annual Beginning Annual Rate of Depreciation Ending
Period Book Value Depreciation Expense Book Value Period Book Value Depreciation Expense Book Value
1 $25,000 x 28.6%* = $7,150 $ 17,850 1 $25,000 x 25%* = $6,250 $ 18,750
2 $17,850 x 28.6% = $5,105 2 $18,750 x 25% = $4,688
* Double the 1/7th or 14.3 % straight-line rate of depreciation given the asset's * 175% of the 1/7th or 14.3 % straight-line rate of depreciation given the asset's
7-year estimated useful life. 7-year estimated useful life.

Years Partial Year Calculations Total Years Partial Year Calculations Total
'X7 3/12 x $7,150 = $1,788 $ 1,788 'X7 3/12 x $6,250 = $1,563 $ 1,563
9/12 x $7,150 = $5,362 9/12 x $6,250 = $4,687
'X8 = $ 6,639 'X8 = $ 5,859
3/12 x $5,105 $1,276 3/12 x $4,688 $1,172
Accumulated depreciation $ 8,427 Accumulated depreciation $ 7,422

Book value at 12/31/X8: $25,000 - $8,427 = $16,573 Book value at 12/31/X8: $25,000 - $7,422 = $17,578

41 42

8-7
 Problem 8-5 - Answer Problem 8-6
Change in Depreciation Estimates
B. What is the equipment's book value at the end of its 7-year useful
life under each of the methods used above? On 1/1/X1, Scott Company purchased equipment at a cost of $50,000
and calculated depreciation for 20X1 and 20X2 using the double-
Answer: Under each of the methods the book value at the end declining-balance method based on a 5-year estimated useful life and
of the 7-year useful life would be equal to the salvage value of $10,000 salvage value. Beginning in 20X3 the company revised its
$5,000. (Any discrepancies due to rounding would be adjusted estimates for the equipment to a 12-year useful life (10 years remaining
for in the last year of recorded depreciation) from 1/1/X3) and $2,000 salvage value. Given these changing estimates,
calculate the equipment's 20X3 depreciation expense.
Question: Is there an ethical dilemma in a company's
maintenance of a separate set of books (accounting records) for
depreciation taken as a deduction for income tax purposes?
Answer: Current tax law in the U.S. allows different
depreciation methods to be used for financial statement
reporting and income tax purposes. As a result it is ethical and
common for companies to keep two sets of records for
depreciation of property, plant and equipment.

43 44

Problem 8-6 - Answer

Accounting for Changing Values
Answer: $3,600
of Long-Term Assets
Annual Beginning Annual Rate of Depreciation Ending
Period Book Value Depreciation Expense Book Value
20X1 $50,000 x 40%* = $20,000 $30,000 The recording of any increase or appreciation in
20X2 $30,000 x 40% = $12,000 $18,000 the value of long-term assets is deferred until the
* Double the 1/5th or 20 % straight-line rate of depreciation given the asset's property is sold and the gain is realized.
5-year estimated useful life.
Any loss associated with impaired assets is to be
Assuming a 1/1/X3 change in estimate that provides for a remaining recorded immediately.
10-year useful life, the rate of depreciation for those 10 years is 20%
(double the 1/10th or 10% straight-line rate of depreciation given a the
10-year remaining useful life). (International standards aren't nearly as conservative in this
area. Although they do require write-downs on impairment,
Annual Beginning Annual Rate of Depreciation Ending they also allow for the recording of increased values when a
Period Book Value Depreciation Expense Book Value gain can be established with reasonable assurance.)
20X3 $18,000 x 20% = $3,600 $14,400

45 46

Impairment Example: Assume a recently purchased hotel will not be nearly as profitable
as originally thought due to the cancellation of plans for the development of a
Under U.S. GAAP, an asset is impaired when the sum of its expected nearby amusement park.
future cash flows no longer covers the asset's current book value. Given the hotel's capitalized cost of $10,000,000, accumulated depreciation to
date totaling $200,000, current fair market value of $7,500,000 and the sum
Accounting for impairment of a long-term asset is a two-step process: of projected net future cash flows of $8,000,000 anticipated over a 10-year
holding period, prepare the journal entry that's necessary to record the
1. Impairment must be established by comparing an asset's current book hotel's impairment.
value with the sum of the expected net future cash flows without 1. Establish whether the standard for recording impairment has been met.
consideration for the time value of money.
Sum of Expected Net
Book Value vs. Future Cash Flows
2. Then the asset is written-down to its fair market value and the loss is
recorded. (The fair market value of an asset is the price the asset $9,800,000 $8,000,000
would bring if sold in the current market place or, if that's not ($10,000,000 - $200,000)
determinable, it's the present value of the expected net future cash Impairment!
flows of the asset.)
2. Record the write-down of the asset to its fair value. ($7,500,000)
Once a loss due to impairment has been recorded, no subsequent Book value $9,800,000
increase in value or recovery of that loss is recorded until the asset's Less: Current value (7,500,000)
ultimate sale. Loss $2,300,000

47 48

8-8
 Problem 8-7
Journal entry to record this write-down:
Accounting for Asset Impairment
Loss on Impairment 2,300,000
Accumulated Depreciation 200,000 Zircon Industries has decided to permanently cut back on the production
Hotel 2,500,000 of one of its products. As a result, the value of certain machinery and
equipment used exclusively in the manufacture of that product has been
greatly diminished.
Hotel
10,000,000 Given the following information for this machinery and equipment:
2,500,000
7,500,000
Capitalized cost $150,000
Sum of the expected net future cash flows $ 40,000
Accumulated depreciation $ 90,000
Accumulated Depreciation Present value of the expected net future cash flows $ 25,000
200,000
200,000 A. Prepare the journal entry required to record asset impairment.
0
B. Prepare the entry if the sum of the expected net future cash flows
was $70,000 with a $40,000 present value.

49 50

Problem 8-7 - Answer

Accounting for Asset Impairment
A.
Loss on Impairment 35,000
Accumulated Depreciation
Machinery and Equipment
90,000
125,000
Long-Term Intangible Assets
and
B. No entry would be made in this case. There is no impairment if the
sum of the expected net future cash flows ($70,000) is in excess of the
Natural Resources
book value of the asset ($60,000). That's true even if the fair value of
the asset or the present value of the expected net future cash flows is
less than the asset's book value. This requirement imposes a higher
standard of assurance that an impairment has taken place before its
actually recorded.

51 52

Problem 8-8 Problem 8-8

Accounting for Intangibles and Natural Resources
A. Identify some of the more common intangible assets that might be D. Define "goodwill." When is it recorded as an asset? Record the
classified with a company's long-term assets. $1,000,000 cash purchase of a business with assets having a combined
fair market value of $500,000 (book value on the seller's books of
B. Briefly describe the accounting for: $350,000) and liabilities to be assumed by the buyer in the amount of
$50,000. How should the recorded asset "Goodwill" be subsequently
(1) Research and development, advertising and other costs incurred in accounted for?
the development or improvement of an intangible asset.
E. Are capitalized costs incurred in the acquisition and improvement of
(2) Costs incurred in the purchase of an intangible asset from an natural resources ever recorded as an expense and if so, how?
unrelated third-party.

(3) The allocation of an intangible asset's capitalized cost to expense

over time.

(4) Impairment of an intangible asset.

(5) Gains or losses on the sale of an intangible asset.

C. Should $20,000 in legal fees paid in actually applying for a patent and
$100,000 in legal fees paid in the prosecution of a patent infringement
case be capitalized or expensed when incurred?

53 54

8-9
 Problem 8-8 - Answer Problem 8-8 - Answer
Accounting for Intangibles and Natural Resources
(3) The allocation of an intangible asset's capitalized cost to expense
A. Identify some of the more common intangible assets that might be over time.
classified with a company's long-term assets. Answer: Except in the case of goodwill, the capitalized costs of
intangible assets are allocated or "amortized" to expense on a
Answer: Copyrights, Trademarks, Patents, Franchise Rights, License straight-line basis over the lesser of the legal or estimated useful life
Rights, Goodwill of the asset. Goodwill is never amortized.
B. Briefly describe the accounting for: The adjusting entry to record the periodic amortization of an
intangible asset includes:
(1) Research and development, advertising and other costs incurred in
the development or improvement of an intangible asset. Amortization Expense XXX
Accumulated Amortization* XXX
Answer: All costs incurred in the development or improvement of
intangible assets, including R&D (research and development) and * The intangible asset account is often credited directly.
advertising costs are expensed when incurred. This accounting
(4) Impairment of an intangible asset.
reflects the fact that it's impossible to know for sure whether such
costs will ultimately benefit a company's future operating Answer: An intangible asset, like other long-term assets, becomes
performance. As a result, the capitalization of such costs as assets is impaired when the sum of its expected net future cash flows falls
inappropriate. below its book value. When that happens a loss is recorded as the
asset is written-down to its fair value or the present value of its
(2) Costs incurred in the purchase of an intangible asset from an expected net future cash flows. Such losses are typically reflected
unrelated third-party. with "other revenues and expenses" on a company's income
Answer: All costs incurred in the purchase of an intangible asset are statement. Any gains due to increasing asset values are deferred until
capitalized, or, in other words, they're accounted for as an asset. the asset is actually sold.

55 56

Problem 8-8 - Answer Problem 8-8 - Answer

D. Define "goodwill." When is it recorded as an asset? Record the $1,000,000 cash
(5) Gains or losses on the sale of an intangible asset. purchase of a business with assets having a combined fair market value of $500,000
Answer: Upon sale of an intangible asset, a gain or loss is recorded (book value on the seller's books of $350,000) and liabilities to be assumed by the
equal to the difference between the sales price and the asset's book buyer in the amount of $50,000. How should the recorded asset "Goodwill" be
value. Any such gain or loss is usually reported with a company's subsequently accounted for?
"other revenues and expenses" on its income statement. Answer: From an accounting standpoint, goodwill refers to the excess of a company's
overall fair market value above the fair market value of its total assets less liabilities. This
C. Should $20,000 in legal fees paid in actually applying for a patent and excess value may be attributable to favorable customer relations or other factors that allow
$100,000 in legal fees paid in the prosecution of a patent infringement the company to generate above-average profits on its assets. Under GAAP, the only time
case be capitalized or expensed when incurred? this excess value is recorded as an asset itself, is when its purchased, or, in other words,
when one company buys another and pays a price in excess of the fair market value of the
Answer: If the patent application is approved, all legal costs and fees assets purchased less any liabilities assumed.
incurred in the process are capitalized as an intangible asset ("patent").
This is not a cost of patent development, it's a cost incurred to finalize a Assets* 500,000
Goodwill 550,000
legal right arising from completed development. Legal costs incurred in a Liabilities* 50,000
successful prosecution affirming patent rights are also capitalized; Cash 1,000,000
however, in the event of an unsuccessful prosecution, any associated legal * In actual practice, each asset purchased would be separately identified and recorded at
costs should be expensed and the value of the patent may become impaired its relative fair market value and, each liability would be separately identified and recorded.
requiring a write-down of any previously capitalized costs.
Important Note: Up until 1/1/02, any goodwill recorded in the purchase of a business was
subject to amortization over a period not to exceed 40 years. Now, no amortization is
recorded and the FASB requires an annual re-evaluation of the "fair market value" of the
business purchased with a loss recorded in the event the value of goodwill has decreased or
become impaired. Subsequent gains in the value of goodwill are never recorded.

57 58

Problem 8-8 - Answer

E. Are capitalized costs incurred in the acquisition and improvement of

natural resources ever recorded as an expense and if so, how?
Answer: The capitalized costs of natural resources are accounted for as
"depletion expense" over the asset's productive life using the units of
production method. The entry to record this depletion is:
Depletion Expense XXX
Accumulated Depletion* XXX
* The natural resource asset account is often credited directly.

59

8-10
 Lesson 9
Bond Basics
Bonds are, in essence, notes payable issued by companies borrowing money
from the general public rather than from some bank or other financial institution.
Most bonds are issued by publicly-held companies and typically involve large
amounts of money borrowed on a long-term basis.
The actual issuance or sale of bonds to investors is usually done through
investment banking companies and is facilitated by dividing up the total face or

Lesson 9 par value of the bonds, or, in other words, the total principal amount payable
under the bonds, into smaller bond certificates with denominations that are
typically set at $1,000 each.
$100,000,000 = 100,000 X $1,000 bonds
Bond Financing Once issued, investors will sometimes sell their bonds to other investors in a
secondary market.
Registered bonds require any change in ownership to be registered with the
issuer before payments are made to the new investor.
Coupon or "bearer" bonds require no such registration and payments are simply
made to those who have physical possession of the bonds.
The detailed terms and conditions of a bond are documented in a written
agreement referred to as a bond indenture that's held and enforced by a
designated trustee acting on behalf of all bondholders.

1 2

Problem 9-1
Term bonds refer to bonds that provide for payment of the entire principal or face
value of the bonds at a specified date. Bonds Issued at Face Value

Serial bonds provide for principal payments in installments over time. On 11/1/X3, Stagg Corporation issued $10,000,000 of 5-year term bonds
Secured bonds pledge specific assets as collateral in the event of an issuer's default.
at face value. Assuming a 7% stated interest rate, payable semiannually,
prepare journal entries to record the following:
Debentures are unsecured bonds.
a. Issuance of bonds on 11/1/X3.
Senior or subordinated bonds specify certain priorities of claims that bondholders
may have against the assets of the issuer relative to the claims of other creditors. b. 20X3 interest expense given a calendar year-end.
Callable bonds allow an issuer to make payoffs at agreed amounts prior to maturity.
c. Payment of interest on 5/1/X4.
Convertible bonds allow bondholders to convert their bonds to stock after a
specified period of time. d. Payment of interest on 11/1/X4.
Junk bonds are bonds issued by companies with low credit ratings. e. Final payment of interest and principal on 11/1/X8
(High-yield bonds)
The interest rate payable on a bond or its stated rate is affected by more than just a
company's credit rating. Generally speaking, shorter-term, convertible, secured
bonds, issued by triple-A rated companies will pay lower rates of interest, than
longer term unsecured bonds.

3 4

Problem 9-1 - Answer Problem 9-1 - Answer

Bonds Issued at Face Value

a. Issuance of bonds on 11/1/X3. d. Payment of interest on 11/1/X4.

Cash 10,000,000 Interest Expense 350,000
Bonds Payable 10,000,000 Cash 350,000

b. 20X3 interest expense given a calendar year-end. e. Final payment of interest and principal on 11/1/X8
Interest Expense* 116,667 Interest Expense 350,000
Interest Payable 116,667 Bonds Payable 10,000,000
* $10,000,000 x 7% x 2/12 months = $116,667 Cash 10,350,000

c. Payment of interest on 5/1/X4.

Interest Payable 116,667
Interest Expense 233,333
Cash* 350,000
* $10,000,000 x 7% x 6/12 months = $350,000

5 6

9-1
 Bonds are often issued at a premium or a discount. Today Year 1 Year 2 Year 3

This happens when a bond's stated rate of interest differs from the - $1,000,000 $60,000 $60,000 $60,000
market rate demanded by investors at the time the bonds are issued. (investors' return = 6%) $1,000,000

Example: On 12/15/X4, Jordan, Inc. finalizes its bond indenture and

prints certificates for a planned 12/31 issuance of $1,000,000 of 3-year
term bonds bearing interest at a stated rate of 6% payable annually. This
6% rate is based on market rates at the time the indenture is finalized

On the date issuance 16 days later, market interest rates have increased
and investors are now demanding a 7% return on any investment in the
bonds.

Jordan now has $1,000,000 of bonds with no interested investors.

In most cases, companies solve this problem by offering the bonds at a

discount, or, in this case, Jordan would simply offer the bonds at a price
below the $1,000,000 face value to provide investors with an effective
7% return on their investment.

7 8

Today Year 1 Year 2 Year 3 Today Year 1 Year 2 Year 3

- $980,000 $60,000 $60,000 $60,000 PV of Annuity @ 7% = $157,459 $60,000 $60,000 $60,000

PV of SCF @ 7% = $816,298
(investors' return = higher than 6%) $1,000,000 $973,757
$1,000,000

Current Market Value or Price of the Bonds

(97.4 rounded or 97.4% of the $1 million face value of the bonds) (97.4 rounded or 97.4% of the $1 million face value of the bonds)
The issuance of the bonds at a discount, or an amount less than the face value The issuance of the bonds at a discount, or an amount less than the face value
of the bonds, is a way to increase an investors' return over and above the of the bonds, is a way to increase an investors' return over and above the
stated 6% rate. stated 6% rate.
How much of a discount is required to produce a 7% rate of return? How much of a discount is required to produce a 7% rate of return?
How much would someone have to invest today earning an annual rate of 7% How much would someone have to invest today earning an annual rate of 7%
to generate the cash flows promised under the 6% bond? What is the present to generate the cash flows promised under the 6% bond? What is the present
value of those future cash flows at an interest rate of 7% compounding value of those future cash flows at an interest rate of 7% compounding
annually? annually?

9 10

Jordan's accounting for the issuance of these bonds if we assume the Combined entry at 12/31/X5:
bonds are issued at $973,757 on 12/31/X4:
Interest Expense 68,163
Cash 973,757 Discount on Bonds 8,163
Discount on Bonds 26,243 Cash 60,000
Bonds Payable 1,000,000

Amortization of discount at the end of each period: $68,748 $973,757 = .071

Interest Expense 8,748 (Cost of borrowing was about 7%.)
Discount on Bonds 8,748
True interest cost at an effective 7% rate:
Straight-line approach: $26,243 3 years = $8,748/yr. $973,757 x 7% x 1 year = $68,163
(This straight-line method is acceptable only if the $8,748 amount doesn't
differ significantly with results that would otherwise be obtained under a more
accurate effective-interest method, which takes into account the time value of The process of effective interest amortization begins with the calculation
money.) and recording of total interest expense for the period based on the effective
interest rate times the actual amount borrowed, and then the difference
Payment of interest on 12/31/X5: between that amount and the amount of interest actually paid is the amount
Interest Expense 60,000 of discount amortization recorded for the period.
Cash 60,000

Stated interest: 6% x $1,000,000 x 1 year = $60,000

11 12

9-2
Effective Interest Method of Bond Discount Amortization Effective Interest Method of Bond Discount Amortization
Balance Effective Total Balance Effective Total
Annual Bonds of Bond Net Interest Interest Interest Discount Annual Bonds of Bond Net Interest Interest Interest Discount
Period Payable Discount Amount Rate Expense Paid Amort. Period Payable Discount Amount Rate Expense Paid Amort.
1 1,000,000 - 26,243 = 973,757 x 7% = 68,163 - 60,000 = 8,163 1 1,000,000 - 26,243 = 973,757 x 7% = 68,163 - 60,000 = 8,163
2 1,000,000 - 18,080 = 981,920 x 7% = 68,734 - 60,000 = 8,734 2 1,000,000 - 18,080 = 981,920 x 7% = 68,734 - 60,000 = 8,734
3 1,000,000 - 9,346 = 990,654 x 7% = 69,346 - 60,000 = 9,346 3 1,000,000 - 9,346 = 990,654 x 7% = 69,346 - 60,000 = 9,346
Jordan, Inc.
Balance Sheet Entry at 12/31/X6:
1/1/X6
Interest Expense 68,734
Long-term liabilities:
Discount on Bonds 8,734
Bonds payable, less $18,080 discount balance $981,920
Cash 60,000
Bond carrying value at 1/1/X6:
Amount originally borrowed $973,757
Entry at 12/31/X7:
Add: First year's discount amortization 8,163
$981,920 Interest Expense 69,346
GAAP: Long-term liabilities should always be reported at the present value of the future cash Discount on Bonds 9,346
flows payable. Cash 60,000
PV of the $60,000 annuity for two years $108,481
PV of the $1,000,000 single cash flow Bonds Payable 1,000,000
at end of 2nd year 873,439
Cash 1,000,000
$981,920

13 14

Problem 9-2 Problem 9-2 - Answer

Accounting for Bonds Issued at a Discount Accounting for Bonds Issued at a Discount
On 10/1/X4, Owens Corporation issued $10,000,000 of bonds at a price of a. Issuance of bonds on 10/1/X4.
98. Assuming the bonds have a four-year term and bear interest at a stated Cash 9,800,000
rate of 6% payable semi-annually, prepare journal entries to record the: Discount on Bonds 200,000
Bonds Payable 10,000,000
a. Issuance of bonds on 10/1/X4.
b. 12/31/X4 adjustment for 20X4 interest expense. (Use the b. 12/31/X4 adjustment for 20X4 interest expense. (Use the
straight-line method of bond discount amortization.) straight-line method of bond discount amortization.)
Interest Expense 162,500
c. Payment of interest on 4/1/X5 Discount on Bonds** 12,500
d. Payment of interest on 10/1/X5. Interest Payable* 150,000
* $10,000,000 x 6% x 3/12 months = $150,000
e. 12/31/X5 adjustment for 20X5 interest expense.
** $200,000 48 months = $4,167/mo. x 3 = $12,500
Questions: c. Payment of interest on 4/1/X5.
1. What is the carrying value of the bonds payable on Owens' 12/31/X4 Interest Payable 150,000
and 12/31/X5 balance sheets and why does it increase over time? Interest Expense 162,500
Discount on Bonds** 12,500
2. Is the effective interest rate on these bonds higher or lower than the Cash* 300,000
stated 6% rate? What was Owens' total interest expense in 20X5 and
* $10,000,000 x 6% x 6/12 months = $300,000
how does it compare with the stated interest actually paid?
** $4,167/mo. x 3 = $12,500

15 16

Problem 9-2 - Answer Problem 9-2 - Answer

d. Payment of interest on 10/1/X5. Questions:

Interest Expense 325,000 1. What is the carrying value of the bonds payable on Owens' 12/31/X4
Discount on Bonds** 25,000 and 12/31/X5 balance sheets and why does it increase over time?
Cash* 300,000
* $10,000,000 x 6% x 6/12 months = $300,000 12/31/X4 12/31/X5
** $4,167/mo. x 6 = $25,000
Bonds payable $10,000,000 $10,000,000
e. 12/31/X5 adjustment for 20X5 interest expense. Less: Discount on bonds (187,500) (137,500)
Interest Expense 162,500 $ 9,812,500 $ 9,862,500
Discount on Bonds** 12,500
Interest Payable* 150,000 Discount on Bonds
* $10,000,000 x 6% x 3/12 months = $150,000 10/1/X4 200,000
** $4,167/mo. x 3 = $12,500 12,500 'X4 Adjustment
12/31/X4 187,500
12,500 4/1/X5
25,000 10/1/X5
12,500 12/31/X5
12/31/X5 137,500

17 18

9-3
 Problem 9-2 - Answer Problem 9-2 - Answer
Questions:
2. Is the effective interest rate on these bonds higher or lower than the
stated 6% rate?
Since the carrying value is equal to the face value of the bonds
less the balance of any bond discount, the amortization and HIGHER
reduction of that discount over time will automatically increase
the bonds' carrying value. In fact, when the bonds finally What was Owens' total interest expense in 20X5 and
mature and the discount is fully amortized, the carrying value how does it compare with the stated interest actually paid?
will equal the full face value of the bonds or the amount due at
maturity. 20X5: Total interest expense recorded -
at 4/1/X5 $162,500
This carrying value can also be determined by adding the at 10/1/X5 325,000
amount of any unpaid interest expense to the amount originally
at 12/31/X5 162,500
borrowed under the bonds. In other words, the bonds' carrying
value is also equal to the amount of discount amortization to date $650,000
plus the amount of cash received upon original issuance and Total stated interest paid $600,000
since the total amount of amortized discount increases over time
the carrying value automatically increases as well. The actual (effective) interest cost is higher than the stated
interest paid due to the $50,000 discount amortization.

19 20

Problem 9-3 Problem 9-3 - Answer

Accounting for Bonds Issued at a Discount Accounting for Bonds Issued at a Discount
For the same Owens Corporation bonds noted in the preceding problem, a. Issuance of bonds on 10/1/X4.
Face value: $10,000,000 Cash 9,656,303*
Term: 4 years Discount on Bonds 343,697
Bonds Payable 10,000,000
Stated interest rate: 6% payable semi-annually
* Pricing of bonds to yield 7% compounding semi-annually:
Prepare journal entries for the following assuming issuance at a price to yield PV of a $300,000 annuity at the end of
an effective interest rate of 7% compounding semi-annually: every 6-months for 4 years $ 2,062,187
a. Issuance of bonds on 10/1/X4. PV of a $10,000,000 single cash flow
at the end of the 4th year $ 7,594,116
b. The 12/31/X4 adjustment for 20X4 interest expense. (Use the $ 9,656,303
effective interest method of bond discount amortization)
c. Payment of interest on 4/1/X5.
d. Payment of interest on 10/1/X5.
e. The 12/31/X5 adjustment for 20X5 interest expense.
Questions: Why are bonds sometimes issued at a discount rather than their
face or par value?

21 22

Problem 9-3 - Answer Problem 9-3 - Answer

Calculations: Calculations:
PV of a $300,000 annuity at the end of every 6-months for 4 years at PV of a $300,000 annuity at the end of every 6-months for 4 years at
a rate of 7% compounding semi-annually. a rate of 7% compounding semi-annually.
HP10bii: TI BAII Plus:
C ALL : Clear memory. C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values.
8 N : Number of compounding periods 8 N : Number of compounding periods.
-300,000 PMT : Annuity payment. -300,000 PMT : Annuity payment.
0 FV : Future value. 0 FV : Future value.
7 I/YR : Interest rate. 7 I/Y : Interest rate.
2 P/YR : Reset compounding periods per year. 2nd P/Y 2 ENTER C/CE : Reset compounding periods per year.
PV : Present value. CPT PV : Present value.

2,062,187 2,062,187

23 24

9-4
 Problem 9-3 - Answer Problem 9-3 - Answer

Calculations: Calculations:
PV of a $10,000,000 single cash flow at the end of the 4th year at 7% PV of a $10,000,000 single cash flow at the end of the 4th year at 7%
compounding semi-annually. compounding semi-annually.
HP10bii: TI BAII Plus:
C ALL : Clear memory. C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values.
8 N : Number of compounding periods 8 N : Number of compounding periods.
0 PMT : Annuity payment. 0 PMT : Annuity payment.
-10,000,000 FV : Future value. -10,000,000 FV : Future value.
7 I/YR : Interest rate. 7 I/Y : Interest rate.
2 P/YR : Reset compounding periods per year. 2nd P/Y 2 ENTER C/CE : Reset compounding periods per year.
PV : Present value. CPT PV : Present value.

7,594,116 7,594,116

25 26

Problem 9-3 - Answer Problem 9-3 - Answer

b. The 12/31/X4 adjustment for 20X4 interest expense. (Use the
effective interest method of bond discount amortization) d. Payment of interest on 10/1/X5.
Interest Expense 168,986 Interest Expense 339,300
Discount on Bonds** 18,986 Discount on Bonds** 39,300
Interest Payable* 150,000 Cash* 300,000
* $10,000,000 x 6% x 3/12 months = $150,000 * $10,000,000 x 6% x 6/12 months = $300,000
** Effective Interest Amortization: ** Effective Interest Amortization:
Balance Total
of Bond Interest Balance Total
6-Month Bonds Carrying Effect. Stated Discount
Discount Expense 6-Month Bonds of Bond Net Effect. Interest Stated Discount
Period Payable Value Rate Interest Amort.
Period Payable Discount Amount Rate Expense Interest Amort.
1 1,000,000 - 343,697 = 9,656,303 x 3.5% = 337,971 - 300,000 = 37,971
1 10,000,000 - 343,697 = 9,656,303 x 3.5% = 337,971 - 300,000 = 37,971
Discount amortization for the three months of October - December of 'X4: 2 10,000,000 - 305,726 = 9,694,274 x 3.5% = 339,300 - 300,000 = 39,300
$37,971 x 3/6 months. = $18,986
c. Payment of interest on 4/1/X5.
Interest Payable 150,000
Interest Expense 168,985
Discount on Bonds** 18,985
Cash* 300,000
* $10,000,000 x 6% x 6/12 months = $300,000
** $37,971 x 3/6 mos. = $18,985

27 28

Problem 9-3 - Answer Problem 9-3 - Answer

e. The 12/31/X5 adjustment for 20X5 interest expense. Questions: Why are bonds sometimes issued at a discount rather than their
face or par value?
Interest Expense 170,338
Discount on Bonds** 20,338 Answer: If market interest rates increase above a bond's stated
Interest Payable* 150,000 rate prior to the bond's actual issuance, investors will not buy the
* $10,000,000 x 6% x 3/12 months = $150,000 bonds unless they're offered at a discount sufficient to yield the
** Effective Interest Amortization: current market rate of interest. If market rates are equal to the
stated interest, then the bonds will be issued at their face or par
Balance Total
6-Month Bonds of Bond Net Effect. Interest Stated Discount
value.
Period Payable Discount Amount Rate Expense Interest Amort.
1 10,000,000 - 343,697 = 9,656,303 x 3.5% = 337,971 - 300,000 = 37,971
2 10,000,000 - 305,726 = 9,694,274 x 3.5% = 339,300 - 300,000 = 39,300
3 10,000,000 - 266,426 = 9,733,574 x 3.5% = 340,675 - 300,000 = 40,675

Amortization for first 3 months of the 3rd semi-annual period:

$40,675 x 3/6 months. = $20,338

29 30

9-5
If market interest rates decrease prior to funding, the bonds will be issued at a premium. Effective Interest Method of Bond Premium Amortization
This means the price of the bonds, or in other words, the amount of cash received from
investors upon issuance, will be greater than the face or maturity value of the bonds. Balance Effective Total
Bonds of Bond Carrying Interest Interest Interest Premium
Assume Jordan, Inc. finalizes its documentation for the issuance of 3-year term bonds Period Payable Premium Value Rate Expense Paid Amort.
with a total face value of $1,000,000, bearing interest at a stated rate of 6%, payable
annually. If market interest rates decrease to 5% prior to actual issuance, Jordan will 1 1,000,000 + 27,233 = 1,027,233 x 5% = 51,362 - 60,000 = 8,638
want to adjust the bonds' interest rate down before the bonds are issued. In actual 2 1,000,000 + 18,595 = 1,018,595 x 5% = 50,930 - 60,000 = 9,070
practice, rather than change the stated interest rate of the bonds, issuance at a price 3 1,000,000 + 9,525 = 1,009,525 x 5% = 50,475 - 60,000 = 9,525
above the face value of the bonds will create the same economic effect.
Entry to record interest expense for the year ended 12/31/X5:
PV of the bonds future cash flows at an interest rate of 5% compounding annually:
Interest Expense 51,362
Present Value at 5%
- Annuity of $60,000 or 6% stated interest Premium on Bonds 8,638
payable at the end of each year for three years $163,395 Cash 60,000
- $1,000,000 single cash flow at the end
of three years 863,838 Jordan, Inc.
$1,027,233 Balance Sheet
1/1/X5
Long-term liabilities:
Accounting for the issuance of these bonds at a price of $1,027,233 on 1/1/X5:
Bonds payable, including $18,595 premium balance $1,018,595
Cash 1,027,233
Premium on Bonds 27,233 In essence, any premium balance is an unearned offset against future interest
Bonds Payable 1,000,000 costs, which is substantially the same as unearned revenue.

31 32

Problem 9-4
Effective Interest Method of Bond Premium Amortization Determining a Bond's Price at Issuance
Balance Effective Total
Bonds of Bond Carrying Interest Interest Interest Premium On May 1, 20X5, Harrison Corp. issued 2-year term bonds with a total face
Period Payable Premium Value Rate Expense Paid Amort. value of $10,000,000 bearing interest at 8%, compounding semiannually.
1 1,000,000 + 27,233 = 1,027,233 x 5% = 51,362 - 60,000 = 8,638 The bond indenture provides for interest payments to be made on 11/1 and
2 1,000,000 + 18,595 = 1,018,595 x 5% = 50,930 - 60,000 = 9,070 5/1 of each year through maturity on May 1, 20X7.
3 1,000,000 + 9,525 = 1,009,525 x 5% = 50,475 - 60,000 = 9,525
Calculate the issuing price of the bonds if they are priced to generate an
Entry to record interest expense for the year ended 12/31/X6: effective interest rate to investors of:
Interest Expense 50,930
Premium on Bonds 9,070 A. 7.5% compounding semiannually
Cash 60,000
B. 8.0% compounding semiannually
Entries at 12/31/X6:
Interest Expense 50,475 C. 8.5% compounding semiannually
Premium on Bonds 9,525
Cash 60,000

Bonds Payable 1,000,000

Cash 1,000,000

33 34

Problem 9-4 - Answer Problem 9-4 - Answer

Determining a Bond's Price at Issuance Determining a Bond's Price at Issuance
A. Price of bonds to yield 7.5% effective interest rate compounding A. Price of bonds to yield 7.5% effective interest rate compounding
semiannually = $10,091,285 semiannually = $10,091,285
The sum of: The sum of:
PV of a $400,000 annuity at the end of every 6-months for 2 years at PV of a $400,000 annuity at the end of every 6-months for 2 years at
a rate of 7.5% compounding semi-annually. a rate of 7.5% compounding semi-annually.
HP10bii: TI BAII Plus:
C ALL : Clear memory. C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values
4 N : Number of compounding periods 4 N : Number of compounding periods
-400,000 PMT : Annuity payment. -400,000 PMT : Annuity payment.
0 FV : Future value. 0 FV : Future value.
7.5 I/YR : Interest rate. 7.5 I/Y : Interest rate.
2 P/YR : Reset compounding periods per year. 2nd P/Y 2 ENTER C/CE : Reset compounding periods per year.
Press PV : Present value. CPT PV : Present value.

1,460,554 1,460,554

35 36

9-6
 Problem 9-4 - Answer Problem 9-4 - Answer

PV of a $10,000,000 single cash flow at the end of 2 years at 7.5%, PV of a $10,000,000 single cash flow at the end of 2 years at 7.5%,
compounding semiannually = $8,630,731 (rounded) compounding semiannually = $8,630,731 (rounded)
HP10bii: TI BAII Plus:
C ALL : Clear memory. C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values.
4 N : Number of compounding periods 4 N : Number of compounding periods.
0 PMT : Annuity payment. 0 PMT : Annuity payment.
-10,000,000 FV : Future value. -10,000,000 FV : Future value.
7.5 I/YR : Interest rate. 7.5 I/Y : Interest rate.
2 P/YR : Reset compounding periods per year. 2nd P/Y 2 ENTER C/CE : Reset compounding periods per year.
Press PV : Present value. CPT PV : Present value.

8,630,731 8,630,731

37 38

Problem 9-4 - Answer Problem 9-4 - Answer

Determining a Bond's Price at Issuance Determining a Bond's Price at Issuance
B. Price of bonds to yield 8.0 % effective interest rate B. Price of bonds to yield 8.0 % effective interest rate
compounding semiannually = $10,000,000. compounding semiannually = $10,000,000.
The sum of: The sum of:
PV of an annuity of $400,000 at the end of 4 6-month periods at a PV of an annuity of $400,000 at the end of 4 6-month periods at a
rate of 8.0% compounding semiannually = $1,451,958 (rounded) rate of 8.0% compounding semiannually = $1,451,958 (rounded)
HP10bii: TI BAII Plus:
C ALL : Clear memory. C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values
4 N : Number of compounding periods 4 N : Number of compounding periods
-400,000 PMT : Annuity payment. -400,000 PMT : Annuity payment.
0 FV : Future value. 0 FV : Future value.
8 I/YR : Interest rate. 8 I/Y : Interest rate.
2 P/YR : Reset compounding periods per year. 2nd P/Y 2 ENTER C/CE : Reset compounding periods per year.
Press PV : Present value. CPT PV : Present value.

1,451,958 1,451,958
39 40

Problem 9-4 - Answer Problem 9-4 - Answer

PV of a $10,000,000 single cash flow at the end of 2 years at 8.0%, PV of a $10,000,000 single cash flow at the end of 2 years at 8.0%,
compounding semiannually = $8,548,042 (rounded) compounding semiannually = $8,548,042 (rounded)
HP10bii: TI BAII Plus:
C ALL : Clear memory. C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values.
4 N : Number of compounding periods 4 N : Number of compounding periods.
0 PMT : Annuity payment. 0 PMT : Annuity payment.
-10,000,000 FV : Future value. -10,000,000 FV : Future value.
8 I/YR : Interest rate. 8 I/Y : Interest rate.
2 P/YR : Reset compounding periods per year. 2nd P/Y 2 ENTER C/CE : Reset compounding periods per year.
Press PV : Present value. CPT PV : Present value.

8,548,042 8,548,042

41 42

9-7
 Problem 9-4 - Answer Problem 9-4 - Answer
Determining a Bond's Price at Issuance Determining a Bond's Price at Issuance
C. Price of bonds to yield 8.5% effective interest rate C. Price of bonds to yield 8.5% effective interest rate
compounding semiannually = $9,909,785 compounding semiannually = $9,909,785
The sum of: The sum of:
PV of an annuity of $400,000 at the end of 4 6-month periods at a rate PV of an annuity of $400,000 at the end of 4 6-month periods at a rate
of 8.5% compounding semiannually = $1,443,444 (rounded) of 8.5% compounding semiannually = $1,443,444 (rounded)
HP10bii: TI BAII Plus:
C ALL : Clear memory. C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values
4 N : Number of compounding periods 4 N : Number of compounding periods
-400,000 PMT : Annuity payment. -400,000 PMT : Annuity payment.
0 FV : Future value. 0 FV : Future value.
8.5 I/YR : Interest rate. 8.5 I/Y : Interest rate.
2 P/YR : Reset compounding periods per year. 2nd P/Y 2 ENTER C/CE : Reset compounding periods per year.
Press PV : Present value. CPT PV : Present value.

1,443,444 1,443,444

43 44

Problem 9-4 - Answer Problem 9-4 - Answer

PV of a $10,000,000 single cash flow at the end of 2 years at 8.5%, PV of a $10,000,000 single cash flow at the end of 2 years at 8.5%,
compounding semiannually = $8,466,341 (rounded) compounding semiannually = $8,466,341 (rounded)
HP10bii: TI BAII Plus:
C ALL : Clear memory. C/CE 2nd CLR TVM : Clear all Time-Value-of-Money values.
4 N : Number of compounding periods 4 N : Number of compounding periods.
0 PMT : Annuity payment. 0 PMT : Annuity payment.
-10,000,000 FV : Future value. -10,000,000 FV : Future value.
8.5 I/YR : Interest rate. 8.5 I/Y : Interest rate.
2 P/YR : Reset compounding periods per year. 2nd P/Y 2 ENTER C/CE : Reset compounding periods per year.
Press PV : Present value. CPT PV : Present value.

8,466,341 8,466,341

45 46

Problem 9-5 Problem 9-5 - Answer

Accounting for Bonds Issued at a Premium Accounting for Bonds Issued at a Premium
For the Harrison Corp. bonds described in the previous problem, a. Issuance of bonds on 5/1/X5.
"On May 1, 20X5, Harrison Corp. issued 2-year term bonds with a total face Cash 10,091,285
value of $10,000,000 bearing interest at 8%. The bond indenture provides for Premium on Bonds 91,285
interest payments to be made on 11/1 and 5/1 of each year through maturity Bonds Payable 10,000,000
on May 1, 20X7."
Assume the bonds are issued at a price of $10,091,285 to yield an effective b. Payment of interest on 11/1/X5.
interest rate of 7.5% compounding semi-annually and prepare the required Interest Expense 378,423
journal entries for: Premium on Bonds 21,577
Cash* 400,000
a. Issuance of the bonds on 5/1/X5.
* $10,000,000 x 8% x 6/12 months = $400,000
b. Payment of interest on 11/1/X5. (Use the effective interest ** Effective Interest Amortization:
method of bond premium amortization)
Balance Total
c. The 12/31/X5 adjustment for 20X5 interest expense. 6-Month Bonds of Bond Carrying Effect. Interest Stated Premium
Period Payable Premium Value Rate Expense Interest Amort.
Determine the carrying value of bonds payable on Harrison's 12/31/X5 1 10,000,000 - 91,285 = 10,091,285 x 3.75% = 378,423 - 400,000 = 21,577
balance sheet.
Prepare the journal entries to be made with Harrison's final payment of
interest and the payment of principal on 5/1/X7.

47 48

9-8
 Problem 9-5 - Answer Problem 9-5 - Answer

c. The 12/31/X5 adjustment for 20X5 interest expense. Determine the carrying value of bonds payable on Harrison's
Interest Expense 125,871 12/31/X5 balance sheet.
Premium on Bonds** 7,462 12/31/X4
Interest Payable* 133,333
Bonds payable $10,000,000
* $10,000,000 x 8% x 2/12 months = $133,333
Less: Premium on bonds 62,246
** Effective Interest Amortization:
$10,062,246
Balance Total
6-Month Bonds of Bond Carrying Effect.
Stated Interest Premium
Period Payable Premium Value Rate
Interest Expense Amort. Premium on Bonds
1 10,000,000 - 91,285 = 10,091,285 3.75% = 378,423 - 400,000 =
x 21,577 91,285 5/1/X5
2 10,000,000 - 69,708 = 10,069,708 x 3.75% = 377,614 - 400,000 = 22,386 11/1/X5 21,577
12/31/X5 7,462
Premium amortization for two months (Nov. - Dec.):
62,246 12/31/X5
$22,386 x 2/6 months. = $7,462

49 50

Problem 9-5 - Answer

Prepare the journal entries to be made with Harrison's final payment of interest and the The payoff and early retirement of bonds is generally
payment of principal on 5/1/X7.
Payment of interest:
prohibited, except in the case of callable bonds.
Interest Payable* 133,333
Interest Expense*** 250,603 Successful issuance of callable bonds usually requires payment of a higher rate
Premium on Bonds** 16,064 of interest and a call or redemption price that's greater than the face value of the
Cash 400,000 bonds due at maturity. As a result, callable bonds are rarely issued unless a
* Reflects the payment of 2 months of stated interest payable for November and December of company truly believes future refinancing will be available at a lower rate of
20X6 that would have been previously recorded at 12/31/X6. interest.
** Amortization schedule: Balance Total
6-Month Bonds of Bond Carrying Effect. Interest Stated Premium
Period Payable Premium Value Rate Expense Interest Amort. Example: Jordan, Inc issues at face value, $10,000,000 of 8% interest bearing,
1 10,000,000 - 91,285 = 10,091,285 x 3.75% = 378,423 - 400,000 = 21,577 5-year term bonds, callable at a price of 103 or $10,300,000. Two years after
2 10,000,000 - 69,708 = 10,069,708 x 3.75% = 377,614 - 400,000 = 22,386 issuance, interest rates fall from 8% to 5% and Jordan decides to refinance or
3 10,000,000 - 47,321 = 10,047,321 x 3.75% = 376,775 - 400,000 = 23,225 payoff the old bonds by issuing $10,000,000 of new bonds at the current 5%
4 10,000,000 - 24,096 = 10,024,096 x 3.75% = 375,904 - 400,000 = 24,096
rate.
Premium amortization for 4 months (Jan. - April): $24,096 x 4/6 months. = $16,064
*** Interest expense: 4 months of stated interest at 8% $266,667 Journal entry to record the bond retirement:
Less: Premium amortization. (16,064)
$250,603 Bonds Payable 10,000,000
Payment of principal:
Loss on Bond Retirement 300,000
Bonds Payable 10,000,000 Cash 10,300,000
Cash 10,000,000

51 52

Problem 9-6
Assume that Jordan's 8% bonds were originally issued on April 1, 20X4 at a Early Retirement of Bonds
$100,000 discount. Assuming interest is payable annually and the discount is
amortized on a straight-line basis, what entries would be required upon early
On 12/31/X5, Cook Corporation purchased and retired $1,000,000 of its
retirement of the bonds on 7/1/X6?
previously issued bonds for $970,000 cash, including $10,000 of interest
Update the bond interest expense through the date of retirement: payable at the time of retirement. Assuming Cook's premium on bonds
Interest Expense 205,000 account has a remaining balance of $20,000, prepare Cook's journal entry to
Discount on Bonds** 5,000 record the purchase of the bonds.
Interest Payable* 200,000
* $10,000,000 x 8% x 3/12 months = $200,000
Questions:
** $100,000 x 3/60 mos. = $5,000
- Why would the current purchase price of the bonds be lower
Payoff of the bonds: than their face value when the bonds were originally issued
at a premium?
Interest Payable 200,000
Bonds Payable 10,000,000 - How does this early retirement of bonds improve Cook's
Loss on Bond Retirement 355,000 financial position?
Discount on Bonds** 55,000
Cash* 10,500,000
* $10,300,000 + $200,000 = $10,500,000
** $100,000 - (100,000 x 27/60 mos.) = $55,000

53 54

9-9
 Problem 9-6 - Answer Problem 9-6 - Answer
Early Retirement of Bonds
Questions:
Entry to record the purchase of bonds:
- How does this early retirement of bonds improve Cook's financial
Interest Payable * 10,000 position?
Bonds Payable 1,000,000
Premium on Bonds 20,000 Answer: Payoffs of debt lower a company's debt ratio or the
Gain on Bond Retirement 60,000
amount of total debt to total assets. Generally speaking
Cash 970,000
companies that have lower levels of debt relative to their total
* Assumes the expense was previously recorded
assets have greater financial flexibility in the future. In addition,
Questions: lower debts can improve a company's profits if the interest costs
- Why would the current purchase price of the bonds be lower than their saved through debt reduction are greater than the earnings that
face value when the bonds were originally issued at a premium? could have alternatively been achieved through investment of the
Answer: Bond prices are a reflection of market values and a bonds' market value surplus cash.
fluctuates over time with changes in the effective interest rates demanded by investors.
Those effective rates are influenced by a number of things including the overall state
of the economy and a company's changing prospects and perceived risk.
In this case the declining market value of Cook's bonds over time means effective
interest rates demanded by investors have increased since the bonds original issuance.
In fact, the effective rate at the date of purchase has apparently increased above the
bond's stated interest rate if the bonds are now worth less than their face value. That
could be the result of higher interest rates in the overall economy or greater perceived
risk in Cook Corporation.

55 56

9-10
 Lesson 10
Problem 10-1
Review Questions

Respond to the following:

A. What are the two ways owners provide capital to a business?

B. What is the most significant advantage of equity vs. debt

financing? What is the most significant disadvantage?
Lesson 10 C. What is a corporation and what are the key advantages and
disadvantages of the corporate form to that of a proprietorship
Equity Financing or partnership?

D. What is common stock and what's the significance of its par or

stated value? How is the market value of stock determined?

E. What is preferred stock and what's the significance of its par

value?

1 2

Problem 10-1 - Answer Problem 10-1 - Answer

Review Questions
B. What is the most significant advantage of equity vs. debt financing?
Respond to the following:
The key advantage of equity financing is that it never has to be repaid.
A. What are the two ways owners provide capital to a business? Debt financing requires repayment of borrowed assets at specified future
1. By contributing resources to the business in exchange for ownership dates regardless of the company's ability to pay. That's not the case with
rights. In a corporation, ownership rights are evidenced through capital contributions and retained earnings. In fact, the only time a
shares of stock and the amount contributed is referred to as contributed company is obligated to pay its owners is upon official declaration of
capital or capital stock. dividends by a corporation's board of directors, or upon termination and
liquidation of the business. In the event of business liquidation, all
2. By allowing assets created through the company's profitable operations company assets are distributed to owners following the payoff of any
to be retained in the business. This is referred to as retained earnings. creditor claims.

What is the most significant disadvantage?

From the perspective of a company's original founders, the major
disadvantage of financing provided by outside investors is the sharing of
ownership rights; most significantly, the right to share in profits and the
right to vote in company affairs. If a business is successful, the sharing
of profits may very well exceed the interest costs that otherwise would
have been incurred if debt financing had been used. In other words,
equity financing can ultimately be a more expensive source of capital.

3 4

Problem 10-1 - Answer Problem 10-1 - Answer

C. What is a corporation and what are the key advantages and

disadvantages of the corporate form to that of a proprietorship
or partnership? The corporate form also facilitates the transfer of ownership interests and
allows a company to continue its operations in spite of any owner's
A corporation is a separate legal entity authorized and governed by the withdrawal, death or incapacity. In a corporation, stockholders are free
laws and requirements of the state in which it's incorporated. That to sell their ownership rights or shares of stock without corporate
means a corporation can buy, own and sell property in its own name and approval. That's not the case in a partnership. Any transfer of
can enter into contracts on its own behalf. It may also sue and be sued. partnership rights typically requires partner approval and if a partner
Because a corporation operates as a separate entity distinct from its withdraws, dies or is otherwise unable to function, the partnership
owners, no owner has a right to act on behalf of the corporation unless automatically dissolves.
he or she is duly appointed and authorized as it's legal agent.
Because of the benefits of limited legal liability and easy transfer of
The most significant benefit of the corporate form is limited legal liability. ownership, the corporate form is the clear choice for any business that
That means the personal assets of its owners or stockholders are shielded must raise a significant amount of capital from a large number of
from any claims against the business. In other words, the most a investors. Most equity investors prefer dealing in corporate stocks to
corporate stockholder can lose is the amount of their invested capital. partnership interests.
Other personal assets, like a home, are not at risk. That's not the case, The downside of a corporation is the additional legal red tape required in
however, with a proprietorship or partnership. In fact, in a general its formation and other government regulation and restrictions. In
partnership, all partners are personally liable for any claims against the addition, corporations may be subject to additional taxation given their
business and the acts of any other partner if it appears that partner's separate legal status.
operating within the scope of the business.
(Continued...)

5 6

10-1
 Problem 10-1 - Answer Problem 10-1 - Answer

D. What is common stock and what's the significance of its par or

stated value? How is the market value of stock determined?
Common stock is a certificate that represents general ownership in a cases, par values are set at one penny per share or less, and frankly,
corporation. All corporations issue common stock providing owners with creditors have other better ways to protect their interests. By the way, the
four basic rights: the right to vote in certain corporate matters including securities laws of many states now allow corporations to issue no par
the election of the board of directors; the right to share equally on a per stock.
share basis in any declared dividends; the pre-emptive first right of
refusal to buy an equal proportion of any newly issued shares; and the The market value of common stock is simply the amount agreed upon by a
right to share equally on a per share basis in any distributions in the willing buyer and seller of the stock. If a company tries to issue stock at
event of business termination. a price no one is willing to pay, then clearly the stock has a lower market
value. Because economic conditions and investor attitudes can change
The par value of common stock is usually a nominal amount established from one minute to the next, a stock's market value can likewise change at
by a company's founders in accordance with the laws of the incorporating any time.
state. Some states allow the use of a stated value in lieu of par, but in
either case the amount has nothing to do with the issuance price of the
stock or its subsequent market or trading value. Its only purpose is the
establishment of the company's legal capital, which is designed to protect
the interests of creditors by limiting any return of previously contributed
capital to shareholders. The fact is, however, that par or stated values
are typically set so low, that no real creditor protection exists. In many
(Continued...)

7 8

Problem 10-1 - Answer Problem 10-2

E. What is preferred stock and what's the significance of its par Issuance of Common and Preferred Stock
value? Prepare journal entries to record the following for Parker Corp.:
In addition to common stock, companies may also issue preferred stock, 10/1/X3: The company was formed with 100,000 shares of $.01 par value
which typically has no voting rights but provides preferential rights to common stock and 10,000 shares of 10% $20 par value preferred
limited amounts of dividends and distributions in the event of liquidation. stock authorized by the state for future issuance.
In other words, in the event a company declares dividends or makes a
final distribution of assets upon its termination and liquidation, the 10/2/X3: The company issued 25,000 shares of its common stock for $10 a
preferred shareholders get a specified amount before any distributions share.
are made to common stockholders. In addition, it's not unusual for 10/30/X3: The company issued 100 shares of its preferred stock to a CPA for
preferred stock to be issued with other rights including the right to $3,000 worth of consulting services.
convert preferred shares to common at a specified rate. If the market 11/11/X3: The company issued 3,600 shares of common stock to Maverick
value of a company's common stock increases significantly, this option Truck Sales for the purchase of a delivery truck.
can create big gains for preferred shareholders. (The current fair market value of the common stock is $10/share.)
Although par values on common stock have no real significance, the par Prepare the stockholders' (owners') equity section of Parker's balance
value of preferred stock is critical in that it serves as the basis for sheet after having made the above entries.
determining both the stock's dividend preference and rights to any
liquidating distribution. Annual dividend preferences are typically Prepare the journal entries for the 10/2 and 11/11 transactions assuming
calculated as a percentage of the stock's par value. the common stock authorized had:
(A) a $1 stated value per share as opposed to a $.01 par value.
(B) no par or stated value.
9 10

Problem 10-2 - Answer Problem 10-2 - Answer

Issuance of Common and Preferred Stock
Prepare the owners' equity section of Parker's balance sheet after having
10/1/X3: No entry made upon stock authorization. No assets have actually made the above entries.
been received.
10/2/X3: Cash 250,000
Common Stock, $.01 Par Value 250 Stockholders' Equity:
Paid-In Capital in Excess of Par, Capital contributions-
Common Stock 249,750 Preferred stock, $20 par value,
10/30/X3: Consulting Expense 3,000 (100 shares issued and outstanding) $ 2,000
Preferred Stock, $20 Par Value 2,000 Common stock, $.01 par value
Paid-In Capital in Excess of Par, (28,600 shares issued and outstanding) 286
Preferred Stock 1,000
Paid-in capital in excess of par, preferred stock 1,000
When stock is issued in exchange for goods or services rather than Paid-in capital in excess of par, common stock 285,714
cash, the cost of those goods or services should be recorded at the
289,000
current fair market value of the stock given up. However, if that fair
market value cannot be determined, then the market value of the goods Retained earnings xxx
or services received should be used. $ xxx,xxx
11/11/X3: Truck 36,000
Common Stock, $.01 Par Value 36
Paid-In Capital in Excess of Par,
Common Stock 35,964

11 12

10-2
 Problem 10-2 - Answer Problem 10-2 - Answer

Prepare the journal entries for the 10/2 and 11/11 transactions assuming Prepare the journal entries for the 10/2 and 11/11 transactions assuming
the common stock authorized had a $1 stated value per share as opposed the common stock authorized had no par or stated value.
to a $.01 par value.
10/2/X3: Cash 250,000
10/2/X3: Cash 250,000 Common Stock, no par value 250,000
Common Stock, $1 Stated Value 25,000
Paid-In Capital in Excess of
Stated Value, Common Stock 225,000
11/11/X3: Truck 36,000
Common Stock, no par value 36,000
11/11/X3: Truck 36,000
Common Stock, $1 Stated Value 3,600
Paid-In Capital in Excess of
Stated Value, Common Stock 32,400

13 14

Problem 10-3 Problem 10-3

Dividend Calculations and Entries Dividend Calculations and Entries
Johnson, Inc has the following stock outstanding throughout the years Johnson, Inc has the following stock outstanding throughout the years
20X3 and 'X4: 20X3 and 'X4:
Preferred stock (7%, $20 par value, 10,000 shares) $200,000 Preferred stock (7%, $20 par value, 10,000 shares) $200,000
Common stock ($1 par value, 50,000 shares) $ 50,000 Common stock ($1 par value, 50,000 shares) $ 50,000
Paid-in capital in excess of par, preferred stock $ 20,000 Paid-in capital in excess of par, preferred stock $ 20,000
Paid-in capital in excess of par, common stock $550,000 Paid-in capital in excess of par, common stock $550,000
Assume that in each year prior to 20X3, Johnson paid dividends in excess Assume that in each year prior to 20X3, Johnson paid dividends in excess
of the annual preferred stock dividend preference; however, no dividends of the annual preferred stock dividend preference; however, no dividends
were declared in 20X3. were declared in 20X3.

A. Assuming the preferred stock is cumulative: B. Assuming the preferred stock is non-cumulative:
i. Determine the amount of dividends in arrears at 12/31/X3. How are i. Determine the amount of dividends in arrears at 12/31/X3.
these dividends in arrears to be accounted for at that time?
ii. Determine the distribution of the 20X4 $50,000 dividend payable
ii. Record the following 20X4 events: between preferred and common stockholders.
2/5/X4: Declared a $50,000 dividend to stockholders of record at
3/5/X4, payable on 4/5/X4 C. Would an investor hoping to make big returns on investment opt to invest in
3/5/X4: Date of record. preferred or common stock, and why?
4/5/X4: Paid dividends declared on 2/5/X4.

15 16

Problem 10-3 - Answer Problem 10-3 - Answer

Dividend Calculations and Entries
A. i. Determine the amount of dividends in arrears at 12/31/X3. A. ii. Record the following 20X4 events:
$14,000 2/5/X4: Declared a $50,000 dividend to stockholders of
(7% x $20 par value/share x 10,000 shares) record at 3/5/X4, payable on 4/5/X4.
Dividends - Preferred Stock 28,000*
How are these dividends in arrears to be accounted for at that Dividends - Common Stock 22,000
time? Dividends Payable 50,000
The preferential rights to dividends under preferred stock, * Dividends in arrears of $14,000 plus the current year dividend
whether they are rights to dividends in the current year or preference of $14,000.
carryover rights to dividends in arrears, are rights to
dividends that exist only if dividends are declared. Because 3/5/X4: Date of record.
companies are never obligated to declare and pay dividends, No entry made. At this date the holders of the company's stock are
a liability for dividends in arrears exists only when and to the noted. They will be the ultimate recipients of the dividend when
extent those dividends are subsequently declared. Disclosure payment is made on 4/5/X4.
of dividends in arrears is limited to the notes to the financial
statements until dividend declaration.
4/5/X4: Paid dividends declared on 2/5/X4.
Dividends Payable 50,000
Cash 50,000

17 18

10-3
 Problem 10-3 - Answer Problem 10-3 - Answer

B. Assuming the preferred stock is non-cumulative: C. Would an investor hoping to make big returns on investment opt to
invest in preferred or common stock, and why?
i. Determine the amount of dividends in arrears at 12/31/X3.
If the preferred stock is non-cumulative there are never dividends Common stock offers potentially large returns if a company
in arrears. There are no carryover rights on non-cumulative generates significant profits. Preferred shareholders are limited
preferred stock. in their access to dividends, whereas common shareholders have
unlimited potential subject to the company's earnings and
ii. Determine the distribution of the 20X4 $50,000 dividend payable dividend declarations. As a result, the fair market value of
between preferred and common stockholders. common stock tends to be much more volatile than preferred
stock values. Conservative investors desiring a steady fixed rate
Preferred Stock $14,000 of return with limited risk often choose to invest in preferred
Common Stock $36,000 stock issued by quality companies. Common stockholders may
$50,000 earn big returns but they also face the possibility of significant
losses if the company fails to perform up to expectations and
market values fall.

19 20

Before the 10% stock dividend:

Stock Dividend 100,000 Total Shares
20,000 20,000 20,000 20,000 20,000
Example: Assume Clark Corporation has 100,000 shares of $1 par Shares Shares Shares Shares Shares
value common stock outstanding. In this case, the declaration of a 10% (20%)
stock dividend means that every stockholder of the company will receive
an additional one share of stock for every 10 shares currently held. Following the dividend:
110,000 Total Shares
100,000 shares x 10% = 10,000 shares 22,000 22,000 22,000 22,000 22,000
Shares Shares Shares Shares Shares
(In the event a shareholder owns less than 10 shares or some number (20%)
more than any increment of ten, a fractional share warrant will usually be
issued. These warrants can then be bought and sold and ultimately No change in any shareholder's relative rights to share in
combined with other warrants to claim a full share from the company.) the company's future profits.
No change in voting influence.
Do stockholders actually get anything of value
when they receive a stock dividend? No change in relative rights to future distributions in the
event of business liquidation.

No company assets are distributed in a stock dividend.

21 22

Accounting for this 10% stock dividend Stock Split

Assume a $15 market value for the stock: (A company's replacement of existing shares of
stock with a higher number of new shares.)
Retained Earnings 150,000
Common Stock, $1 par value 10,000 Example: A 2-for-1 stock split means
Paid-in Capital in Excess of Par, Stockholder
Common Stock 140,000 1 1 1
New Share New Share Old Share
The same as if the company had actually paid a $150,000 cash dividend:
$.50 par $.50 par $1.00 par
Retained Earnings 150,000
Cash 150,000 A 3-for-2 stock split means Stockholder
With the shareholders immediately buying 10,000 newly issued shares 1 1 1 1 1
at the $15 market price per share. New Share New Share New Share Old Share Old Share
Cash 150,000 $.66 par $.66 par $.66 par $1.00 par $1.00 par
Common Stock, $1 par value 10,000
Paid-in Capital in Excess of Par, A 3-for-2 stock split has the same ultimate effect as a 50% stock dividend.
Common Stock 140,000
A 50% stock dividend means
Stockholder
A stock dividend is sometimes referred to as the capitalization of retained
1 1 1
earnings. There is no net affect on the company's overall financial position, Share Share Share
but the amount of retained earnings available for future dividend distributions
has been reduced. $1.00 par $1.00 par $1.00 par

23 24

10-4
 These kinds of stock splits or large stock dividends From an accounting standpoint, even though stock splits
are usually motivated by a company's desire to lower may enhance the value of a stockholder's investment
the stock's market price per share in hopes that this portfolio, there's no change in the issuing company's
will increase trading in the company's stock and lift financial position or the composition of its stockholders'
its overall value over time. equity. Disclosure of the new par value and increased
number of shares issued and outstanding is required, but
no journal entry is necessary to adjust the company's
account balances.

25 26

Large Stock Dividend Summarizing Points

No entry is made, except to record any resulting increase in the
company's total outstanding par value from the additionally Small Stock Dividend
issued shares. (less than 20 to 25%)

Retained Earnings XXX Retained earnings capitalized @ Market value of the

Common Stock, at par value XXX additionally issued shares

Large Stock Dividend

(more than 20 to 25%)

Retained earnings capitalized @ Par value of the

additionally issued shares
In a large dividend, no entry is recorded if the stock has
no par value.

27 28

Problem 10-4 Problem 10-4 - Answer

Accounting for Stock Dividends and Splits Accounting for Stock Dividends and Splits
The following reflects all stockholders' equity accounts for Layton, Inc. A. 3/1 Layton declared and issued a 5% stock dividend when the stock's market
value was $12 per share.
at the beginning of the year 20X7:
1/1/X7 Retained Earnings * 120,000
Common stock, $.10 par value $ 20,000 Common Stock, $.10 par value 1,000
Paid-in Capital in Excess of Par,
Paid-in capital in excess of par, common stock $1,980,000
Common Stock 119,000
Retained earnings $ 495,000
* 5% x 200,000 shares = 10,000 dividend shares
A. Prepare journal entries to record the following 20X7 transactions: 10,000 shares x $12/share = $120,000
3/1 Layton declared and issued a 5% stock dividend when the stock's market 6/12 Layton split its stock 2 for 1. Assume the newly issued stock was assigned
value was $12 per share. a $.05 par value and had a post-split market value of $7 per share.
6/12 Layton split its stock 2 for 1. Assume the newly issued stock was assigned No entry made.
a $.05 par value and had a post-split market value of $7 per share. (420,000 new shares issued, $.05 par value per share)
12/1 Layton declared and issued a 25% stock dividend when the stock's market
12/1 Layton declared and issued a 25% stock dividend when the stock's market
value was $10 per share.
value was $10 per share.
B. Prepare the stockholders' equity section of Layton's 12/31/X7 balance sheet Retained Earnings * 5,250
assuming no other dividends were paid in 20X7 and net income for the year Common Stock, $.05 par value 5,250
amounted to $20,000.
* 25% x 420,000 shares = 105,000 shares
C. Compare Layton's total stockholders' equity at the beginning and end of the 105,000 shares x $.05/share par value = $5,250
year and explain any difference.

29 30

10-5
 Problem 10-4 - Answer
In business today, it's not all that uncommon for companies to
B. Stockholders' Equity: 12/31/X7 actually go into a secondary market and actually buy back their
Contributed capital- own previously issued stock.
Common stock, $.05 par value,525,000 shares $ 26,250
Paid-in capital in excess of par, common stock 2,099,000
2,125,250
Treasury Stock
Retained earnings 389,750 Why would a company do this?
Total Stockholders' Equity $ 2,515,000 1. Good investment.
(The purchase and subsequent reissuance of stock at a higher
C. Stockholders' Equity: 1/1/X7 12/31/X7
Contributed capital-
price is a way to generate more capital contributions on
Common stock, $.10 and $.05 par previously issued shares.)
value, and 200,000 and
525,000 shares, respectively $ 20,000 $ 26,250 2. Send a message of confidence to other potential investors.
Paid-in capital in excess of par,
common stock 1,980,000 2,099,000 3. Lift a stock's market price.
2,000,000 2,125,250
Retained earnings 495,000 389,750 4. Get rid of certain unwanted shareholders.
Total Stockholders' Equity $2,495,000 $ 2,515,000 $20,000 Difference
The difference is attributable to the $20,000 of net income for the year. Stock
5. Help prevent unfriendly or hostile takeovers.
dividends and stock splits change the composition within stockholders' equity
but have no net effect on the total. 6. Obtain previously issued stock for use in employee bonus or
stock option plans.

31 32

Example: At 1/1/X7, Bing Corporation's capital contributions include: Bing Corporation

Balance Sheet
Common stock, $.01 par value, 200,000 shares $ 2,000 As of January 15, 20X7
Paid-in capital in excess of par, common stock 2,998,000 Owners' Equity:
$ 3,000,000 Capital contributions-
Common stock, $.01 par value, 200,000 shares
1/15/X7: Bing takes $500,000 of excess cash and buys 25,000 of its
own previously issued common shares at a market price of issued and 175,000 shares outstanding $ 2,000
$20 per share. Paid-in capital in excess of par, common stock 2,998,000
3,000,000
Treasury Stock 500,000 Retained earnings
Cash 500,000
Less: Treasury stock (500,000)
Legally a company can't own itself. As a result, this treasury stock has no Total owners' equity $
voting, dividend or other rights in the company. Without those rights, this
stock is not an asset.

What kind of account is this treasury stock account?

Contra-Equity Account

33 34

3/15/X7: Bing sells (reissues) 5,000 of the treasury shares at a market 7/1/X7: Bing reissues an additional 5,000 shares at a market price of
price of $22 a share. $17 a share.
Cash ($22 x 5,000 shares) 110,000 85,000
Cash ($17 x 5,000 shares)
Treasury Stock ($20 x 5,000) 100,000 Paid-In Capital - Treasury Stock 10,000
Paid-In Capital - Treasury Stock 10,000 Retained Earnings 5,000
Treasury Stock ($20 x 5,000) 100,000
Bing Corporation
Balance Sheet
As of March 15, 20X7
Owners' Equity:
Capital contributions-
Common stock, $.01 par value, 200,000 shares
issued and 180,000 shares outstanding $ 2,000
Paid-in capital in excess of par, common stock 2,998,000
Paid-in capital, treasury stock 10,000
3,010,000
Retained earnings

Less: Treasury stock (400,000)

Total owners' equity $

35 36

10-6
 9/1/X7: Bing reissues an additional 7,000 treasury shares when the
stock's market price has increased to $25 a share.
Paid-In Capital - Treasury Stock
Cash ($25 x 7,000 shares) 175,000
Paid-In Capital - Treasury Stock 35,000 10,000 3/15/X7
Treasury Stock ($20 x 7,000) 140,000 7/1/X7 10,000
35,000 9/1/X7
Bing Corporation 35,000
Balance Sheet
As of September 1, 20X7
Owners' Equity:
Capital contributions-
Common stock, $.01 par value, 200,000 shares
issued and 192,000 shares outstanding $ 2,000
Paid-in capital in excess of par, common stock 2,998,000
Paid-in capital, treasury stock 35,000
3,035,000
Retained earnings

Less: Treasury stock (160,000)

Total owners' equity $

37 38

9/1/X7: Bing reissues an additional 7,000 treasury shares when the

stock's market price has increased to $25 a share. Treasury Stock
Cash ($25 x 7,000 shares) 175,000 1/15/X7 500,000
Paid-In Capital - Treasury Stock 35,000 100,000 3/15/X7
Treasury Stock ($20 x 7,000) 140,000 100,000 7/1/X7
140,000 9/1/X7
Bing Corporation (8,000 x $20) 160,000
Balance Sheet
As of September 1, 20X7
Owners' Equity:
Capital contributions-
Common stock, $.01 par value, 200,000 shares
issued and 192,000 shares outstanding $ 2,000
Paid-in capital in excess of par, common stock 2,998,000
Paid-in capital, treasury stock 35,000
3,035,000
Retained earnings

Less: Treasury stock (160,000)

Total owners' equity $

39 40

Problem 10-5 Problem 10-5 - Answer

Treasury Stock Transactions Treasury Stock Transactions
As of 12/31/X1, Martin Electronic 's balance sheet includes the following: A. 1/15/X2: Reacquired 10,000 shares as treasury stock at a price of $8 per share.
Common stock, $.01 par value, 100,000 shares Treasury Stock 80,000
issued and outstanding $ 1,000 Cash 80,000
Paid-in capital in excess of par, common stock $ 999,000
Retained earnings $ 245,000 2/15/X2: Reissued 1,000 treasury shares at $7 a share.
Given this information: Cash 7,000
Retained Earnings 1,000
A. Prepare Martin's journal entries for the following 20X2 transactions: Treasury Stock ($8 x 1,000) 8,000

1/15/X2: Reacquired 10,000 shares as treasury stock at a price

of $8 per share. 6/10/X2: Reissued 4,000 treasury shares at $10 a share.
Cash 40,000
2/15/X2: Reissued 1,000 treasury shares at $7 a share.
Treasury Stock ($8 x 4,000) 32,000
6/10/X2: Reissued 4,000 treasury shares at $10 a share. Paid-In Capital - Treasury Stock 8,000
9/3/X2: Reissued 2,000 treasury shares at $7 a share.
9/3/X2: Reissued 2,000 treasury shares at $7 a share.
B. Prepare the stockholders' equity section of Martin's 12/31/X2 balance sheet Cash 14,000
assuming net income and dividends for the year amounted to $95,000 and Paid-In Capital - Treasury Stock 2,000
$20,000, respectively. Treasury Stock ($8 x 2,000) 16,000

41 42

10-7
 Problem 10-5 - Answer

B. Stockholders' Equity:
Contributed capital-
Common stock, $.01 par value, 100,000 shares
issued, 97,000 shares outstanding $ 1,000
Paid-in capital in excess of par, common stock
Paid-in capital, treasury stock
999,000
6,000
Retained Earnings:
Total contributed capital 1,006,000
Retained earnings 319,000
+ Net Income
Total contributed capital and
retained earnings 1,325,000
- Dividends (paid in cash or other assets)
Less: Treasury stock, 3,000 common shares at cost (24,000) - Stock Dividends
Total stockholders' equity $1,301,000
- Treasury Stock Losses (in some cases)
Retained Earnings
245,000 12/31/X1
2/15/X2 1,000
95,000 Net Income
Dividends 20,000
319,000 12/31/X2

43 44

Prior-Period Adjustment
A direct entry made to retained earnings to correct a prior-year
accounting error. In most states the balance in a corporation's retained
earnings account represents the maximum amount
A mathematical error. available to stockholders for distribution of dividends.
An improper application of an accounting principle.
An error due to incorrect information. Sometimes lenders will demand additional restrictions
on dividend distributions before agreeing to fund a loan.
Not an error in estimation. These restrictions are written into the loan documents
(Prior year errors in estimation are corrected through and become part of the debt covenants agreed to by the
compensating entries made in the current year.) company. Any such restrictions on the payment of
dividends must be disclosed in a company's notes to the
If a company discovers an understatement of prior-year depreciation financial statements.
due to a mathematical error, that understatement is corrected
through a prior-period adjustment:

Retained Earnings XXX

Accumulated Depreciation XXX

45 45

ABC Corporation
Balance Sheet
Stockholders' Equity:
As of December 31, 20X9
Capital contributions -
Preferred stock, 5% $20 par value, 20,000 shares issued and outstanding $400,000 Foreign currency translation adjustment: The result of changes
Common stock, $.01 par value, 100,000 shares issued, 90,000 shares outstanding 1,000 in currency exchange rates affecting the valuation of a company's
Paid-in capital in excess of par - preferred stock 20,000
Paid-in capital in excess of par - common stock 220,000 investment in foreign subsidiaries.
Paid-in capital - treasury stock 30,000
671,000
Retained earnings 241,250
Unrealized gains and losses on investment securities: Involves
Accumulated other comprehensive income: increases and decreases in the market value of certain stocks and
Cumulative foreign currency translation adjustments (24,000) bonds of other companies held as an investment.
Unrealized gain (loss) on investment securities (57,500)
830,750
Less: Treasury stock, 10,000 shares of common stock (30,000)
Total stockholders' equity $800,750

Statement of Retained Earnings

for the year ended December 31, 20X9
Retained earnings at beginning of the year $192,905
Add: Net income for the year 125,345
Less: Dividends, preferred stock (20,000)
Dividends, common stock (5,000)
Stock dividends, common stock (15,000)
Treasury stock loss (2,000)
Prior-period adjustment - correction of revenues (35,000)
Retained earnings at the end of the year $241,250

46 47

10-8
 Collins, Inc.
Statement of Stockholders' Equity
For the year ended December 31, 20X4
Comprehensive income for the year ended 12/31/X9:
Paid-in Paid-in
Net income $125,345 Capital Capital,
Common Excess Treasury Retained Treasury
Foreign currency translation adjustment (12,350) Stock of Par Stock Earnings Stock Total
Unrealized gain (loss) on investment (22,456) Balance at beginning of year $ 5,000 $495,000 $ 50,000 $150,000 ($40,000) $660,000
Net income for the year 70,000 70,000
Other items 0 Cash dividends paid at $.20 per share (20,000) (20,000)
Comprehensive income $ 90,539 Stock dividend (10%) (30,000) (30,000)
Treasury stock purchase (30,000) (30,000)
Sale of treasury stock 2,000 10,000 12,000
Balance at end of year $ 5,000 $495,000 $ 52,000 $170,000 ($ 60,000) $662,000

This is useful information to most investors and although not required, most
companies provide this statement of stockholders' equity with their other
general-purpose financial statements.

48 49

Problem 10-6 Problem 10-6 - Answer

Other Complications in Stockholders' Equity Other Complications in Stockholders' Equity
Given the following information for Otis, Inc. as of 12/31/X5, prepare the Stockholders' Equity:
Contributed capital -
stockholders' equity section of the company's 12/31/X5 balance sheet: Preferred stock, 8% $10 par value, 10,000 shares
issued and outstanding $100,000
Retained earnings at 1/1/X5 $126,355 Common stock, $1 par value, 50,000 shares issued,
45,000 shares outstanding 50,000
Net income for the year ended 12/31/X5 $ 72,344 Paid-in capital in excess of par - preferred stock 10,000
Common stock, $1 par value, 50,000 shares issued $ 50,000 Paid-in capital in excess of par - common stock 450,000
Paid-in capital - treasury stock 12,000
Preferred stock, 8% $10 par value, 10,000 shares 622,000
issued and outstanding $100,000 Retained earnings* 133,278
Treasury stock, 5,000 shares of common stock $ 20,000 Accumulated other comprehensive income:
Unrealized gain on investment securities 14,367
Prior-period adjustment - correction of previously Foreign currency translation adjustments 3,420
understated employee compensation expense $ 25,421 773,065
Less: Treasury stock, 5,000 shares of common stock (20,000)
Paid-in capital - treasury stock $ 12,000 Total stockholders' equity $753,065
Paid-in capital in excess of par - preferred stock $ 10,000
*Calculation of Retained Earnings at 12/31/X5:
Dividends, common stock $ 32,000
Unrealized gain on investment securities $ 14,367 Retained earnings at the beginning of the year $126,355
Add: Net income for the year 72,344
Paid-in capital in excess of par - common stock $450,000 Less: Dividends, preferred stock (8,000)
Foreign currency translation adjustments, increase $ 3,420 Dividends, common stock (32,000)
Prior-period adjustment - correction of previously
Dividends, preferred stock $ 8,000 understated employee compensation expense (25,421)
Retained earnings at the end of the year $133,278

50 51

A legal partnership can be formed based on a simple oral agreement.

No signed document is required. However, a lot of potential problems
can be avoided if partners will take the time to put together a written
agreement.

A good partnership agreement will typically address such things as:

Equity Financing in The rights and duties of the partners.
Partnerships and Proprietorships
The amount of any required capital contributions.
The profit and loss sharing arrangement.
Rights and procedures in asset distributions and withdrawals.
Provisions for the buyout of partnership interests.
Procedures to be used in resolving partnership disputes.

52 53

10-9
 Partnership Accounting If, the following reflects Lindy's first month's revenues and expenses,
Debit Credit
All of the business transactions of a partnership, including the buying and Sales Revenues 15,000
selling of inventory, accounting for the purchase and use of property, plant Food Expense 7,000
and equipment, recording of revenues and expenses and the like, are Supplies Expense 2,500
accounted for the same as if the business was operated as a corporation. Misc. Expense 500
The only differences are in the accounting for transactions affecting owners'
and partnership profits are to be allocated monthly on a 50/50 basis,
equity accounts appearing in the balance sheet and any payments of salaries
or wages to partners. Closing entry:
Sales Revenues 15,000
Example: Two friends, Linda Jones and Cindy Palmer, form a partnership to Food Expense 7,000
operate a catering business called Lindy's Catering. To start the business, Supplies Expense 2,500
Linda contributes $5,000 cash, and Cindy contributes an additional $1,000 Misc. Expense 500
plus a $4,000 used van. Linda Jones, Capital 2,500
Cindy Palmer, Capital 2,500
Journal entry:
Cash 6,000 Sometimes partners agree that certain partners are to receive compensation for
Van 4,000 time spent working in the business. Because partners are never employees, this
Linda Jones, Capital 5,000 kind of compensation is accounted for as a priority distribution of profits. Similar
Cindy Palmer, Capital 5,000 distributions are sometimes agreed to for partners providing larger capital
contributions than their relative partnership interest. In this case, the priority is
Contributed assets are to be recorded at a fair market value agreed upon by typically calculated like interest on a loan with the partner receiving first profits
all partners involved. equal to some percentage of their additionally contributed capital.

54 55

Any payments made to partners are traditionally recorded in a separate Lindy's Catering
withdrawal or drawings account maintained for each partner. Balance Sheet
Owners' Equity:
Assume Linda needs $1,000 of allocated partnership profit distributed Linda Jones, Capital 6,500
for her own personal use: Cindy Palmer, Capital 7,500
Linda Jones, Drawings 1,000 $14,000
Cash 1,000

At the end of each accounting period this drawings account is then Lindy's Catering
closed: Statement of Partners' Capital
Linda Jones Cindy Palmer Total
Linda Jones, Capital 1,000
Linda Jones, Drawings 1,000 Beginning balance $ 0 $ 0 $ 0
Add: Capital contributions 5,000 5,000 10,000
Net income 2,500 2,500 5,000
Linda Jones, Capital Less: Withdrawals (1,000) 0 (1,000)
5,000 Capital contributions Ending balance $6,500 $7,500 $14,000
2,500 Profit allocation
Withdrawals 1,000
6,500 Ending balance

56 57

Problem 10-7
Partnership Accounting
Marty Clements and George Barnes share profits and losses on a 60/40
basis as partners in a small retail store. At the beginning of May their
capital account balances were $22,000 and $26,000, respectively.

Given the following information for the month of May, determine the
Accounting for a proprietorship is exactly the partners' ending capital account balances assuming Barnes has a monthly
priority right to $3,000 of profits for time spent actually managing the
same as it is for a partnership except that store.
there's only one capital account maintained Store Revenues $50,000
for the business' sole owner. Store Expenses $35,000
Clements cash drawings $10,000
Barnes cash drawings $ 3,000

Questions: Does it make sense that Clements' drawings for the month
were higher than Barnes? If the partnership were to liquidate at the end
of May producing $100,000 of distributable cash to the owners after the
payoff of all liabilities, how much should go to each partner? If the
distributable cash in liquidation amounted to only $30,000, how much do
you think would go to each partner?

58 59

10-10
 Problem 10-7 - Answer Problem 10-7 - Answer
Partnership Accounting
If the partnership were to liquidate at the end of May producing $100,000
Statement of Partners' Capital
of distributable cash to the owners after the payoff of all liabilities, how
for the month of May much should go to each partner?
Clements Barnes Clements Barnes Total
Beginning balance $22,000 $26,000 Capital balances $19,200 $30,800 $50,000
Profit allocation - Add: Gain on liquidation (60/40) 30,000 20,000 50,000
Barnes priority 3,000 Adjusted capital balances $49,200 $50,800 $100,000
60/40 split 7,200 4,800
Drawings (10,000) (3,000) Distribution: $49,200 $50,800 $100,000
Ending balance $19,200 $30,800
If the distributable cash in liquidation amounted to only $30,000, how
Question: Does it make sense that Clements' drawings for the month were
much do you think would go to each partner?
higher than Barnes?
Clements Barnes Total
Answer: It does seem a bit odd that Clement's would draw out of the
Capital balances $19,200 $30,800 $50,000
business more than his monthly profit allocation while Barnes draws
Less: Loss on liquidation (60/40) (12,000) (8,000) (20,000)
out less. The extent and timing of allowed withdrawals is something
Adjusted capital balances $ 7,200 $22,800 $30,000
that should be addressed in the partnership agreement. Partner draws
are usually limited to profit allocations, but that obviously wasn't the
Distribution: $ 7,200 $22,800 $30,000
case for this partnership.

60 61

10-11
 Lesson 11

An investment in equity securities refers to an investment

in or the purchase of a company's common or preferred
stock. Stocks are called equity securities because they
provide holders with ownership rights or equity interests
in a company. When stocks are purchased, returns on

Lesson 11 investment come in the form of dividends and any gains

on the subsequent sale of the stock.

Investments in Equity
and Debt Securities An investment in debt securities refers to an investment
in or the purchase of corporate or government issued
bonds. They're referred to as debt securities because
upon issuance a liability, or debt, is recorded on the
books of the issuing company or governmental entity.
When bonds are purchased, the investor becomes an
owner of debt, or, in effect, a lender with rights to receive
future payments of principal and interest.

1 2

Some companies invest in the stocks and bonds of other

In some cases, companies invest in the securities of other companies, because that's the essence of their business.
companies to simply make better use of excess cash, or Investment companies and mutual funds exist solely to make
cash that's temporarily available due to seasonal investments in debt and equity securities of other companies.
operations. Mutual funds take in cash obtained from investors upon
issuance of their own stock and then invest those funds in the
For example, a company manufacturing sporting goods stocks and/or bonds of other companies. Investors in mutual
sold primarily in the summer months will probably funds benefit when the value of the stocks and bonds held by
experience an annual cash flow cycle that looks the fund increase in value, or dividends and interest are
something like this: earned.
Excess cash available
for short-term investment. Some companies also invest in the stock of other companies
for strategic reasons. If enough shares are purchased a
company can obtain significant influence or even outright
control over another company's operations. That's why some
company's wishing to enter into new industries, or seeking to
Mar. June Sept. Dec. Mar. secure necessary supplies or outlets for distribution, will
Short-term financing often acquire large percentages of the outstanding shares of
required to cover other companies.
cash shortfalls.

3 4

Accounting for Investments in Equity Securities Accounting for Investments in Equity Securities
Under current accounting standards, companies may use different Under current accounting standards, companies may use different
methods of accounting for investments in equity securities depending methods of accounting for investments in equity securities depending
on the intent behind the investment. That intent's reflected in the on the intent behind the investment. That intent's reflected in the
following classifications used to determine an investment's following classifications used to determine an investment's
appropriate accounting method: appropriate accounting method:

Trading Securities: Includes all shares of stock purchased as part of an Securities that provide a company with significant influence over
active trading program. That means these shares are frequently bought another company's operations: Significant influence is generally
and sold based on short-term price fluctuations. Companies investing in assumed when 20-50% of the outstanding common stock of another
trading securities are, in effect, playing the market in an attempt to company is owned. However, other criteria may also be considered when
maximize investment returns. making this determination. (These securities are also sometimes called
"equity method securities" because they're accounted for using an equity
Available-for-Sale Securities: Includes all shares of stock held with the method of accounting.)
intent to sell if future cash needs arise. No effort is made to take
advantage of temporary price fluctuations. The strategy here is to buy and Securities that provide a company with a controlling interest over
hold for a more extended period of time. (This classification specifically another company: This usually requires ownership of at least 51% of a
excludes any shares that may provide a company with significant company's outstanding common stock, although effective control can
influence or control over another company.) sometimes be achieved with a lower percentage.

5 6

11-1
 In most cases, companies invest in a portfolio of stocks.
Investment in Trading Securities General Ledger
Example: On November 15th, 20X7, Crown Investments Investment in Trading Securities
purchased 1,000 shares of IBM common stock at a price of $20 a 12/31/X6 0
share, plus brokerage fees of $400. The shares are classified by xxx xxx
Crown as trading securities given plans to sell the stock as soon xxx xxx
as the price increases and shares can be sold at a profit. 12/31/X7 122,000

Subsidiary Ledger
Journal entry to record purchase:
Investment in Trading Securities
Investment in Trading Securities 20,400 IBM ATT
Cash 20,400
12/31/X6 0 12/31/X6 0
11/15/X7 20,400 6/12/X7 35,200
All costs incurred in the purchase of an asset are included as part 12/31/X7 20,400 12/31/X7 35,200
of the asset's historical cost.
Intel Microsoft
12/31/X6 0 12/31/X6 0
5/11/X6 40,800 2/26/X7 25,600
12/31/X7 40,800 12/31/X7 25,600

7 8

Adjust Crown's investment in trading securities to its fair market

value given the following market values on 12/31/X7
At 12/31/X7: IBM ATT Intel MSoft Total
FMV $21,000 $40,500 $35,300 $31,200 $128,000
Historical cost $20,400 $35,200 $40,800 $25,600 $122,000
Increase (decrease) $ 600 $ 5,300 ($5,500) $ 5,600 $ 6,000

12/31/X7 adjusting entry to record the effect of this net increase in

For financial reporting purposes, any increase or value:
decrease in the fair market value of a company's Market Adjustment - Trading Securities 6,000
investment in trading securities is to be reported Unrealized Gain - Trading Securities 6,000
in the company's financial statements. Because these securities remain unsold at the end of the year, the
increased value is "unrealized," but it is recognized (recorded) and
included on the company's income statement under the category of
other revenues and expenses.
Crown Investments
Balance Sheet
12/31/X7
Current Assets:
Investments in trading securities $122,000
Add: Market adjustment $ 6,000
$128,000

9 10

Assume for just a moment that the fair market value of the Why use this Market Adjustment account? Why not just
investment had actually declined to $120,000 from its $122,000 debit and credit the Investment in Trading Securities
historical cost. account directly when adjusting it for changing values?

12/31/X7 adjusting entry:

Unrealized Loss - Trading Securities 2,000 This approach allows the investment general ledger control
Market Adjustment - Trading Securities 2,000 account and its related subsidiary ledger accounts to be
maintained at historical costs, and having those costs readily
available can facilitate our subsequent accounting when the
Crown Investments stock is actually sold and also helps in the preparation of a
Balance Sheet company's income tax return. For income taxes, no gains or
12/31/X7
Current Assets: losses are recorded until securities are sold, and the amount
Investments in trading securities $122,000 of the gain or loss is then based on the difference between
Less: Market adjustment (2,000) the selling price and the stock's original cost. Having the
$120,000 investment account serve as a record of that original cost can
be beneficial.

11 12

11-2
On 1/20/X8, Crown sells its IBM shares at a price of $23 a share Assume that no other trading securities are bought or sold during
less a $500 brokerage commission. the current year 20X8 except for the IBM shares we've just
accounted for. Also assume that the market value of Crown's
Journal entry: remaining trading securities based on exchange prices at
Cash ($23,000 - $500) 22,500 12/31/X8 are as follows:
Investments in Trading Securities 20,400 ATT Intel MSoft Total
Realized Gain on Sale of Trading Securities 2,100 FMV at 12/31/X7 $40,500 $35,300 $31,200 $107,000
FMV at 12/31/X8 $34,500 $41,500 $28,000 $104,000
Unrealized gain (loss) ($ 6,000) $ 6,200 ($ 3,200) ($ 3,000)
At 12/31/X7: IBM ATT Intel MSoft Total 12/31/X8 Adjusting entry:
FMV $21,000 $40,500 $35,300 $31,200 $128,000
Historical cost $20,400 $35,200 $40,800 $25,600 $122,000 Unrealized Loss - Trading Securities 3,600*
Increase (decrease) $ 600 $ 5,300 ($5,500) $ 5,600 $ 6,000 Market Adjustment - Trading Securities 3,600
* Include the correction of the $600 of over-recorded gain.

13 14

There's an even easier way to come up with this same adjustment…. that's
done by taking the balances in the company's investment and market
adjustment accounts before any adjusting entry, and then making the Summary of balance sheet approach to adjustment:
adjustment that's necessary to properly state those accounts in the
company's balance sheet. 1. Identify the ending balances in the investment in trading
Investment in Trading Securities securities and market adjustment accounts before the year-end
12/31/X7 122,000 adjustment.
20,400 Sold IBM shares
12/31/X8 101,600 2. Determine the appropriate ending balance for the market
Market Adjustment - Trading Securities
adjustment account (the amount of the difference between the
market value and historical cost of the company's investment
12/31/X7 6,000
in trading securities at the end of the year).
3,600 Adjusting entry
12/31/X8 2,400
3. An entry is then made to adjust the market adjustment account
ATT Intel MSoft Total to that balance with any increase or decrease recorded as an
FMV at 12/31/X8 $34,500 $41,500 $28,000 $104,000 unrealized gain or loss, respectively.
Historical cost $35,200 $40,800 $25,600 $101,600
Differences $ 5,300 ($5,500) $ 5,600 $ 2,400
12/31/X8 Adjusting entry:
Unrealized Loss - Trading Securities 3,600
Market Adjustment - Trading Securities 3,600

15 16

Problem #11-1
Classifications of Investments in Equity Securities
On occasion, a company making an investment in trading
securities will receive dividends on their investment.
When that happens:

Journal entry:
Cash XXX Note the four possible securities classifications requiring different
Dividend Revenues XXX methods of accounting for an investment in the stock of another
company and describe the criteria for classification.

17 18

11-3
 Problem 11-1 - Answer Problem #11-2
Classifications of Investments in Equity Securities Investment in Trading Securities
1. Trading Securities: Stock purchased with the intent to make a return on Prepare journal entries to record the following investment transactions
investment in the short-term. entered into by the Clark Company:
2. Available-for-Sale Securities: Stock purchased and held with the intent to 20X5: 2/15 Purchased 1,000 shares of General Motors ("GM") stock at a price of
sell if and when future cash needs arise. Although investors in available- $60 a share, plus a 1% brokerage commission. Clark has no significant
influence over GM affairs and classifies the stock as trading securities.
for-sale securities hope for increasing stock values over time, the timing
of sale is based on cash needs rather than on short-term market 8/10 Sold 200 GM shares for $70 a share, less a $100 brokerage fee.
fluctuations in price. (This classification excludes shares that provide a 9/30 Received a $400 cash dividend on the GM stock.
company with significant influence or control over the affairs of another 12/31 GM shares are trading on the NYSE at $55 a share. (Clark has no
company.) investment in trading securities other than the GM shares.)

3. Securities that provide significant influence in another company's 20X6: 3/11 Sold 200 GM shares for $58 a share, less a $100 brokerage fee.
operations (Equity Method Securities): Stock purchased and held with 9/30 Received a $200 cash dividend on the GM stock.
the intent to significantly influence the operations of the company 12/31 GM shares are selling on the NYSE at $75 a share. (Clark has no
invested in. Unless there is evidence to the contrary, ownership of at least investment in trading securities other than the GM shares.)
20% and not more than 50% of a company's outstanding common stock Prepare: 1. Clark's balance sheet presentation of the investment in trading
represents the ability to significantly influence a company. securities at 12/31/X6
4. Securities that provide a controlling interest over another company: Stock 2. Clark's income statement presentation of all revenues and
purchased and held to exercise effective control over another company expenses associated with the investment in trading securities
(usually more than 50% ownership). for the year ended 12/31/X6

19 20

Problem 11-2 - Answer Problem 11-2 - Answer

Investment in Trading Securities
12/31 GM shares are trading on the NYSE at $55 a share. (Clark has
20X5 Entries: no investment in trading securities other than the GM shares.)
2/15 Purchased 1,000 shares of General Motors ("GM") stock at a Unrealized Loss - Trading Securities 4,480
price of $60 a share, plus a 1% brokerage commission. Market Adjustment - Trading Securities 4,480

Investment in Trading Securities 60,600 FMV at 12/31/X5 (800 shares x $55) $44,000
Cash ($60,000 + $600) 60,600 Historical cost (800 shares x $60.60) $48,480
Decrease in value ($4,480)

8/10 Sold 200 GM shares for $70 a share, less a $100 brokerage fee. 20X5 Entries:
Cash ($14,000 - $100) 13,900 3/11 Sold 200 GM shares for $58 a share, less a $100 brokerage fee.
Investment in Trading Securities 12,120*
Realized Gain on Sale of Trading Securities 1,780 Cash ($11,600 - $100) 11,500
Realized Loss on Sale of Trading Securities 620
* $60,600 1,000 shares = $60.60 cost per share Investment in Trading Securities 12,120*
$60.60/share x 200 shares = $12,120
* $60.60/share x 200 shares = $12,120

9/30 Received a $400 cash dividend on the GM stock. 9/30 Received a $200 cash dividend on the GM stock.
Cash 400 Cash 200
Dividend Revenues 400 Dividend Revenues 200

21 22

Problem 11-2 - Answer Problem 11-2 - Answer

Clark Company
12/31 GM shares are trading on the NYSE at $75 a share. (Clark has Balance Sheet
no investment in trading securities other than the GM shares.) Current Assets:
12/31/X6

Market Adjustment - Trading Securities 13,120 Investments in trading securities $ 36,360

Unrealized Gain - Trading Securities 13,120 Add: Market adjustment $ 8,640
or $ 45,000
FMV at 12/31/X6 (600 shares x $75) $45,000 Current Assets:
Historical cost (600 shares x $60.60) $36,360 Investment in trading securities, at market $ 45,000
Market adjustment $ 8,640
Investment in Trading Securities
Market Adjustment - Trading Securities 2/15/X5 60,600
12,120 8/10/X5
4,480 Adjusting entry
12/31/X5 48,480
4,480 12/31/X5
12,120 3/11/X6
Adjusting entry 13,120
12/31/X6 36,360
12/31/X6 8,640
Market Adjustment - Trading Securities
4,480 Adjusting entry
4,480 12/31/X5
Adjusting entry 13,120
12/31/X6 8,640

23 24

11-4
 Problem 11-2 - Answer Problem #11-3
Investment in Trading Securities
Clark Company Given the following balances for Cross, Inc at 12/31/X3:
Income Statement
for the year ended 12/31/X6 DR CR
Investment in trading securities $ 84,000
Other revenues and expenses: Market adjustment - trading securities $ 4,000
Dividend revenues $ 200
Realized loss on sale of trading securities (620) Prepare the year-end adjustments to record any unrealized gains or
Unrealized gain - trading securities 13,120 losses on trading securities at 12/31/X4 and 'X5 given the following
$ 12,700 information:
Securities held at 12/31/X4
A B C Total
Historical cost $20,000 $30,000 $25,000 $75,000
FMV at 12/31/X4 $22,000 $26,000 $25,000 $73,000

Securities held at 12/31/X5

A C D Total
Historical cost $20,000 $25,000 $10,000 $55,000
FMV at 12/31/X5 $27,000 $26,000 $17,000 $70,000

25 26

Problem 11-3 - Answer Problem 11-3 - Answer

Investment in Trading Securities Investment in Trading Securities

Adjustment at 12/31/X4: Adjustment at 12/31/X5:

Unrealized Loss - Trading Securities 6,000 Market Adjustment - Trading Securities 17,000
Market Adjustment - Trading Securities 6,000 Unrealized Gain - Trading Securities 17,000

Market Adjustment - Trading Securities Market Adjustment - Trading Securities

12/31/X3 4,000 12/31/X3 4,000

6,000 Adjusting entry 6,000 Adjusting entry

2,000 12/31/X4 2,000 12/31/X4

Adjusting entry 17,000
12/31/X5 15,000
Securities held at 12/31/X4
A B C Total
Securities held at 12/31/X5
Historical cost $20,000 $30,000 $25,000 $75,000
A C D Total
FMV at 12/31/X4 $22,000 $26,000 $25,000 $73,000
Historical cost $20,000 $25,000 $10,000 $55,000
($2,000)
FMV at 12/31/X5 $27,000 $26,000 $17,000 $70,000
$15,000

27 28

Example: Assume that at the end of 20X6, NRN Corporation has:

Investment in Available-for-Sale Securities
DR CR
(Equity securities included in this category are stocks bought Investment in available-for-sale securities $100,000
and held with the intent to sell when future cash needs arise.) Market adjustment - available-for-sale securities $ 5,000

The accounting for an investment in available-for-sale securities is almost 12/31/X6:

exactly the same as it is for an investment in trading securities. In fact, the FMV of securities $105,000
only distinction is in the disclosure of unrealized gains or losses on changing Historical cost $100,000
stock values over time. Also assume that at the end of 20X7, the investment account has the same
$100,000 balance but the fair market value of the securities held has increased
Available-for-sale securities are recorded as an investment at the purchase to $113,000.
price paid plus any additional incidental costs of acquisition including Market Adjustment - Available-for-Sale Securities
brokerage or other fees.
12/31/X6 5,000
Any realized gains and losses on the subsequent sale of shares are included Adjusting entry 8,000
with other revenues and expenses on the company's income statement 12/31/X7 13,000
along with any dividend revenues.
Entry at Market Adjustment - Available-for-Sale Securities 8,000
A market adjustment account is used to adjust the historical cost of the 12/31/X7: Unrealized Gain/Loss - Available-for-Sale Securities 8,000
company's investment to its current fair market value at the end of each
accounting period. However, with available-for-sale securities, the Unrealized Gain/Loss - Available-for-Sale Securities
resulting unrealized gain or loss associated with that adjustment is not
reflected in the company's income statement and closed to retained 5,000 12/31/X6
earnings. Instead, it bypasses the income statement and is reflected 8,000 Adjusting entry
directly on a cumulative basis in the owners' equity section of the balance
13,000 12/31/X7
sheet as part of accumulated other comprehensive income.

29 30

11-5
 Problem #11-4
Crown Investments Accounting for Trading vs. Available-for-Sale Securities
Balance Sheet
12/31/X7 On 12/31/X1, Moore Company owned 1,000 shares of stock in General Electric
("GE") with an original cost of $30 and a fair market value of $28 per share.
Assets: Assuming the shares are classified as:
Investment in available-for-sale securities $ 100,000 A. Trading securities
Plus: Market adjustment 13,000 B. Available-for-sale securities
$ 113,000
1. Prepare entries to record Moore's 20X2 sale of 300 GE shares at a price of
$32/share along with the appropriate year-end adjustment given a market
Owners' Equity: price of $35/share at 12/31/X2. (Assume the company has no other
Accumulated other comprehensive income: investments in equity securities and entered into no other transactions
Unrealized gain on available-for-sale securities $ 13,000 involving GE stock during the year.)

2. Prepare Moore's 12/31/X2 balance sheet and income statement disclosures.

Question: Why might a company experiencing declining values on newly

purchased equity securities be inclined to classify them as available-for-sale
rather than trading securities regardless of their future plans? What kind of
problem might this present to the company's auditor?

31 32

Problem 11-4 - Answer Problem 11-4 - Answer

Accounting for Trading vs. Available-for-Sale Securities
2. Moore Company
A. Trading securities: Balance Sheet
1. Entry to record the sale of 300 GE shares at $32/share: 12/31/X2
Cash (300 x $32) 9,600
Investment in Trading Securities (300 x $30) 9,000* Current Assets:
Realized Gain on Sale of Trading Securities 600
Investment in trading securities, at market $ 24,500
* $30 x 300 shares = $9,000

12/31/X2 adjusting entry to reflect market value of investment:

Market Adjustment - Trading Securities 5,500 Moore Company
Unrealized Gain - Trading Securities 5,500 Income Statement
Market Adjustment - Trading Securities
for the year ended 12/31/X2
2,000 12/31/X1
Other revenues and expenses:
Adjusting entry 5,500
12/31/X2 3,500 Realized gain on sale of trading securities $ 600
Unrealized gain - trading securities 5,500
12/31/X2: GE $ 6,100
Historical cost (700 x $30) $21,000
FMV at 12/31/X2 (700 x $35) $24,500
Adjustment $ 3,500

33 34

Problem 11-4 - Answer Problem 11-4 - Answer

B. Available-for-sale securities:
2. Moore Company
1. Entry to record the sale of 300 GE shares at $32/share: Balance Sheet
Cash (300 x $32) 9,600 Assets: 12/31/X2
Investment in Available-for-Sale Securities 9,000*
Realized Gain on Sale of Available-for-Sale Securities 600 Investment in available-for-sale securities, at market $ 24,500
* $30 x 300 shares = $9,000 Stockholders' Equity:

12/31/X2 adjusting entry to reflect market value of investment: Accumulated other comprehensive income:
Unrealized gain on available for sale securities $ 3,500
Market Adjustment - Available-for-Sale Securities 5,500
Unrealized Gain/Loss - Available-for-Sale Securities 5,500 Unrealized Gain/Loss - Available-for-Sale Securities
12/31/X1 2,000
Market Adjustment - Available-for-Sale Securities
5,500 Adjusting entry
2,000 12/31/X1
3,500 12/31/X2
Adjusting entry 5,500
12/31/X2 3,500 Moore Company
Income Statement
12/31/X2: GE for the year ended 12/31/X2
Historical cost (700 x $30) $21,000
FMV at 12/31/X2 (700 x $35) $24,500 Other revenues and expenses:
Adjustment $ 3,500
Realized gain on sale of available-for-sale securities $ 600

35 36

11-6
 Problem 11-4 - Answer
Equity Method of Accounting
Question: Why might a company experiencing declining values on newly The required approach when a company acquires significant influence over
purchased equity securities be inclined to classify them as available-for-sale the affairs of another company. Significant influence is presumed when 20-
rather than trading securities regardless of their future plans? 50% of a company's outstanding common stock is owned, although
other criteria may be considered when making this determination.
Answer: Classification as available-for-sale securities would allow the
company to exclude any unrealized losses from its income statement and Under the equity method:
EPS calculations. The inclusion of those losses in reported net income
1. An investment in the securities of another company is initially recorded at
might negatively influence the public's perception of management its cost.
performance and cause a decline in the company's stock valuation.
2. That cost is then subsequently adjusted up for the investor's percentage
interest in the company's reported profits and down for its share of
What kind of problem might this present to the company's auditor? reported losses.
3. Any dividend receipts are accounted for as reductions in the investment's
Answer: Since accounting for unrealized gain and losses depends on adjusted cost.
management intent, auditors may be forced to rely on management's 4. No year-end adjustment is made for changing stock values unless a
word rather than any tangible evidence in expressing an opinion on the permanent decline occurs.
appropriateness of the company's financial reporting. An auditor might
5. Upon sale of shares, the difference between net proceeds received and the
look to a company's past trading history, current liquidity and future stocks' book value (adjusted cost) is recorded as a realized gain or loss.
cash flow projections to try and verify management's stated intent, but
ultimately a certain degree of trust will have to be involved. The key elements in this equity method approach are the adjustments made
the investment's cost for percentage interests in reported profits and losses,
along with reductions made for dividend receipts.

37 38

Example: Assume Bass Enterprises buys significant influence over

a supplier of merchandise with the 40% purchase of its outstanding
common stock for $200,000 cash.
Investment in Equity Method Securities 200,000
Cash 200,000
When a company buys more than 50% of another company's
The supplier's reported profits for the year totaled $30,000. stock or otherwise has effective control over its operations,
Investment in Equity Method Securities 12,000 then consolidated financial statements are prepared in which
Investment Revenues (40% x $30,000) 12,000 all of the assets, liabilities, revenues and expenses of the
subsidiary are combined on the financial statements of the
A $5,000 cash dividend is received on the investment. parent company.
Cash 5,000
Investment in Equity Method Securities 5,000

The entire investment is sold for $230,000 cash.

Cash 230,000
Investment in Equity Method Securities 207,000*
Gain on Sale of Investment 23,000
* $200,000 + $12,000 - $5,000 = $207,000

39 40

Problem #11-5 Problem 11-5 - Answer

Comparison of Methods of Accounting for Investments in Equity Securities Comparison of Methods of Accounting for Investments in Equity Securities

During the year 20X8, Jordan, Inc. purchased 20% of the common stock of A. Available-for-sale securities
Carson Corporation at a price of $112,000, net of all brokerage fees.
Purchased securities:
Assuming: Investment in Available-for-Sale Securities 112,000
Cash 112,000
1. Carson's reported net income for the year amounted to $60,000.
2. Jordan received $6,000 of cash dividends on its investment in the
Carson stock. Received dividends:
Cash 6,000
3. The Carson shares have a $120,000 market value at the end of the year. Dividend Revenues 6,000
4. Jordan had no other investments in securities during the year.

Prepare all of Jordan's investment-related entries for the year if the Year-end valuation adjustment:
Carson shares: Market Adjustment - Available-for-Sale Securities 8,000
Unrealized Gain/Loss - Available-for-Sale Securities 8,000
A. Are classified as available-for-sale securities.
B. Provide Jordan with significant influence over Carson's affairs.

41 42

11-7
 Problem 11-5 - Answer

B. Significant influence

Purchased securities:
Investment in Equity Method Securities 112,000
Cash 112,000

Debt Securities
Recognized share of Carson's reported net income:
(Bonds issued by other companies or governmental entities.)
Investment in Equity Method Securities 12,000
Investment Revenues (20% x $60,000) 12,000

Received dividends:
Cash 6,000
Investment in Equity Method Securities 6,000

Year-end valuation adjustment:

No entry

43 44

Accounting for an Investment in Bonds Accounting for an Investment in Bonds

Example: On September 30th, 20X6, Damron, Inc. purchased in a secondary market,
Depends on the company's intent reflected in three possible classifications. $100,000 of 8%, 3-year, term bonds with interest payable semi-annually on June 30th
and December 31st of each year through maturity on December 31st, 20X7. Upon
purchase, Damron paid a price of 97 (97% of the $100,000 face value), plus $2,000 of
Trading Securities: The company's intent is to actively buy and sell accrued interest.
bonds to maximize returns on investment. Bonds Bonds Bonds
Issued Purchased Mature
Available-for-Sale Securities: The company's intent is to buy and 1/1/X5 6/30 12/31/X5 6/30 9/30 12/31/X6 6/30 12/31/X7
hold the bonds until future cash needs
$4,000 $4,000 $4,000
arise. $4,000
($2,000)
$4,000
$4,000
($97,000) $100,000
Held-to-Maturity Securities: The company's intent is to hold the
bonds until the final principal payment Journal entry to record Investment in Trading Securities 97,000
is received. the purchase of the bonds: Interest Receivable 2,000
Cash 99,000

Bonds purchased at a discount produce a higher effective rate of return than the stated
interest rate provided for in the bonds. In fact, bonds are priced at a discount when
market interest rates exceed the bond's stated rate. When market rates are lower than
the stated interest rate then bonds are priced at a premium.
From an accounting standpoint, this $3,000 discount, or additional interest should be
recognized or amortized to revenue over the remaining 15-month term of the bonds.

45 46

12/31/X6 interest receipt: Assume that on 12/31/X6 the fair market value of the bonds, or in other words, the
price these bonds could be sold for in a secondary market, has increased from 97 to
Cash 4,000 101 or 101% of their $100,000 face value.
Interest Receivable 2,000
Interest Revenue 2,000 If Damron sold the bonds at this point in time:
Cash 101,000
12/31/X6 discount amortization: Investment in Trading Securities 97,600
Investment in Trading Securities 600 Realized Gain on the Sale of Trading Securities 3,400
Interest Revenue 600
This increase in the value of the bonds to $101,000 is a direct result of decreasing
effective interest rates demanded by investors.
Straight-line amortization: $3,000 15 months = $200/month
$200 x 3 months = $600 As market interest rates the value of existing bonds
Think of it this way; if bonds bearing 8% interest are attractive when market interest
Effective Interest Method: Assuming the $97,000 purchase price produced rates are at 8%, consider how much more attractive those bonds are when market
an effective interest rate of 10.62% compounding semiannually. interest rates are only 6%.
Bond Carrying On the other hand, if rates rise to 10%, no one wants 8% bonds unless they're priced
Face Unamort. Value of Effect. Effect. Stated Discount at a discount.
Period Value Discount Investment Rate Interest Interest Amort.
As market interest rates the value of existing bonds
3 mo. 100,000 - 3,000 = 97,000 x 10.62% x 3/12 = 2,575 - 2,000 = 575
6 mo. 100,000 - 2,425 = 97,575 x 10.62% x 6/12 = 5,181 - 4,000 = 1,181 In this case, where the $100,000 of bonds have increased in value from $97,000 in
6 mo. 100,000 - 1,244 = 98,756 x 10.62% x 6/12 = 5,244 - 4,000 = 1,244 September to $101,000 at the end of December, market interest rates must have
decreased making the 8% bonds more attractive to investors.

47 48

11-8
Assume these bonds increased in value but are not sold based on Damron's Damron, Inc
belief that short-term interest rates will continue to fall and the bonds will be Balance Sheet
worth even more in the near future. 12/31/X6
Given that these bonds are included in the classification of trading securities Assets:
on the company's balance sheet, an adjustment must be made to reflect these
bonds along with all of the other trading securities at their current fair market Investment in trading securities $ 97,600
value. Add: Market adjustment 3,400
If these bonds are the only trading securities held during the year, $101,000

Adjusting entry at 12/31/X6: Damron, Inc

Market Adjustment - Trading Securities 3,400
Income Statement
Unrealized Gain - Trading Securities 3,400 for the year ended 12/31/X6
Other revenues and expenses:
FMV of bonds $101,000
Historical cost $ 97,600 Interest revenues $ 2,600
Difference $ 3,400 Unrealized gain - trading securities 3,400
Market Adjustment - Trading Securities $ 6,000
12/31/X5 0
Adjusting entry 3,400
12/31/X6 3,400

49 50

Investment in Bonds Classified as Held-to-Maturity Securities

Available-for-Sale Securities The accounting for an investment in bonds classified as held-to-
maturity securities is exactly the same as it is for trading and
In this case, the accounting is exactly the same as it was for bonds available-for-sale securities except that no adjustment is made to
classified as trading securities, except for the disclosures required reflect the bonds at their current fair market value at the end of an
for unrealized gains or losses on changing bond values over time. accounting period. As a result, no unrealized gains or losses are
When accounting for bonds classified as available-for-sale ever recorded.
securities, the total net unrealized gain or loss on stocks and bonds
included in that classification is reported on a cumulative basis in Upon final collection of the principal:
the owners' equity section of the company's balance sheet. Cash XXX
Investment in Held-to-Maturity Securities XXX

51 52

Problem #11-6 Problem 11-6 - Answer

Accounting for an Investment in Bonds Accounting for an Investment in Bonds
3/1/X5: Bond purchase-
Investment in Held-to-Maturity Securities 49,000
Interest Receivable ($50,000 x 6% x 2/12) 500
Cash 49,500
On 3/1/X5, Otto, Inc. paid $49,000 (yielding 8.53% effective 6/30/X5: Interest receipt-
interest) plus accrued interest to acquire $50,000 of previously Cash ($50,000 x 6% x 6/12) 1,500
issued, 6% term bonds, maturing on December 31st of the current Interest Receivable 500
year. Assuming the bonds are held to maturity and semi-annual Interest Revenue 1,000
interest payments are received on June 30th and December 31st, Discount amortization*-
prepare all of Otto's bond-related entries for the year-ended 20X5. Investment in Held-to-Maturity Securities 400
Interest Revenue 400
Straight-line amortization: $1,000 discount 10 months = $100/month
$100 x 4 months = $400
Effective Interest Method:
Bond Carrying
Face Unamort. Value of Effect. Effect. Stated Discount
Period Value Discount Investment Rate Interest Interest Amort.
4 mo. 50,000 - 1,000 = 49,000 x 8.53% x 4/12 = 1,393 - 1,000 = 393
6 mo. 50,000 - 607 = 49,393 x 8.53% x 6/12 = 2,107 - 1,500 = 607
* This entry on 6/30 is not mandatory. A single entry made on 12/31/X5 for the full $1,000
discount would be an acceptable alternative under both methods.

53 54

11-9
 Problem 11-6 - Answer Problem #11-7
Accounting for an Investment in Bonds
12/31/X5: Interest receipt-
On May 1, 20X5, ATT issued bonds with a total face value of $100,000,000 bearing interest at
Cash 1,500 8%. The bond indenture provides for interest payments to be made on 11/1 and 5/1 of each
Interest Revenue 1,500 year through maturity, May 1, 20X9.
Prepare journal entries on the dates noted below from the standpoint of an investor acquiring
Discount amortization- $20,000 of the ATT bonds for $20,480 on the date of issuance yielding an effective interest
Cash 1,500 rate of 7.3%. (Assume the bonds are classified as available-for-sale securities.)
Interest Revenue 1,500 1. Bond issuance on 5/1/X5.
2. Collection of interest and effective interest amortization of the bond premium on 11/1/X5.
3. Adjusting entry(ies) required for the bond interest earned on 12/31/X5.
Straight-line amortization: $100 x 6 months = $600 4. Adjusting entry at 12/31/X5 assuming an existing $4,000 credit balance in the investor's
market adjustment account and the following information:
Effective Interest Method: Available-for-Sale Securities
Bond Carrying GM Stock GE Stock ATT Bonds Total
Face Unamort. Value of Effect. Effect. Stated Discount Historical cost $15,000 $19,000 $20,410 $54,410
Period Value Discount Investment Rate Interest Interest Amort. FMV at 12/31/X5 $13,000 $17,000 $22,000 $52,000
4 mo. 50,000 - 1,000 = 49,000 x 8.53% x 4/12 = 1,393 - 1,000 = 393 5. Collection of interest and amortization of the bond premium on 5/1/X6.
6 mo. 50,000 - 607 = 49,393 x 8.53% x 6/12 = 2,107 - 1,500 = 607 6. Sale of the bonds on 5/1/X6 at a price of 105.
7. Adjusting entry at 12/31/X6 given the following information:
Receipt of principal: Available-for-Sale Securities
GM Stock GE Stock Total
Cash 50,000
Investment in Held-to-Maturity Securities 50,000 Historical cost $15,000 $19,000 $34,000
FMV at 12/31/X6 $17,000 $20,000 $37,000

55 56

Problem #11-7 Problem 11-7 - Answer

Questions: Accounting for an Investment in Bonds

1. Bond issuance on 5/1/X5.
A. What is the balance in the investor's Unrealized Gain/Loss - Available-
for-Sale Securities account at 12/31/X6 and where does it appear on the Investment in Available-for-Sale Securities 20,480
Cash 20,480
company's financial statements?

B. If the ATT bonds had been classified with the investor's trading 2. Collection of interest and straight-line amortization of the bond premium on
11/1/X5.
securities, how would the accounting in this problem have been
different? Cash (20,000 x 8% x 6/12) 800
Interest Revenues 800
C. Why is no adjustment made for current year-end fair market values
Interest Revenues 52
when bonds are classified as held-to-maturity securities? Investment in Available-for-Sale Securities 52

Effective Interest Method:

Bond Carrying
Face Unamort. Value of Effect. Effect. Stated Premium
Period Value Premium Investment Rate Interest Interest Amort.
6 mo. 20,000 + 480 = 20,480 x 7.3% x 6/12 = 748 - 800 = 52

57 58

Problem 11-7 - Answer Problem 11-7 - Answer

3. Adjusting entry(ies) required for bond interest earned on 12/31/X5. 4. Adjusting entry at 12/31/X5 assuming a $4,000 credit balance in the investor's
market adjustment account and the following information:
Interest Receivable (20,000 x 8% x 2/12) 267
Interest Revenues 267
Available-for-Sale Securities
Interest Revenues 18
GM Stock GE Stock ATT Bonds Total
Investment in Available-for-Sale Securities 18
Historical cost $15,000 $19,000 $20,410 $54,410
FMV at 12/31/X5 $13,000 $17,000 $22,000 $52,000
Effective Interest Method:
Difference ($2,410)
Bond Carrying
Face Unamort. Value of Effect. Effect. Stated Premium
Period Value Premium Investment Rate Interest Interest Amort. Market Adjustment - Available-for-Sale Securities
6 mo. 20,000 + 480 = 20,480 x 7.3% x 6/12 = 748 - 800 = 52 4,000 12/31/X5
6 mo. 20,000 + 428 = 20,428 x 7.3% x 6/12 = 746 - 800 = 54
Adjusting entry 1,590
2,410 12/31/X5
Amortization for two months of 2nd 6-month period: $54 x 2/6 = $18
Adjusting entry:
Market Adjustment - Available-for-Sale Securities 1,590
Unrealized Gain/Loss - Available-for-Sale Securities 1,590

59 60

11-10
 Problem 11-7 - Answer Problem 11-7 - Answer

5. Collection of interest and amortization of the bond premium on 5/1/X6. 6. Sale of the bonds on 5/1/X6 at a price of 105.
Cash (20,000 x 8% x 6/12) 800 Cash 21,000
Interest Receivable 267 Investment in Available-for-Sale Securities 20,374
Interest Revenues 533 Realized Gain on the Sale of
Available-for-Sale Securities 626
Interest Revenues 36
Investment in Available-for-Sale Securities 36
ATT Bonds
Effective Interest Method: 5/1/X5 20,480
Bond Carrying 52 11/1/X5
Face Unamort. Value of Effect. Effect. Stated Discount 18 12/31/X5
Period Value Premium Investment Rate Interest Interest Amort.
12/31/X5 20,410
6 mo. 20,000 + 480 = 20,480 x 7.3% x 6/12 = 748 - 800 = 52
36 5/1/X6
6 mo. 20,000 + 428 = 20,428 x 7.3% x 6/12 = 746 - 800 = 54
5/1/X6 20,374
Amortization for last four months of 2nd 6-month period: $54 x 4/6 = $36

61 62

Problem 11-7 - Answer Problem 11-7 - Answer

Questions:
7. Adjusting entry at 12/31/X6 given the following information: A. What is the balance in the investor's Unrealized Gain/Loss - Available-
Available-for-Sale Securities
for-Sale Securities account at 12/31/X6 and where does it appear on the
company's financial statements?
GM Stock GE Stock Total
Historical cost $15,000 $19,000 $34,000 Answer: The unrealized gain or loss account is a balance sheet
FMV at 12/31/X6 $17,000 $20,000 $37,000 account that maintains a corresponding balance to the investment's
Difference $ 3,000 market adjustment account, except that it's opposite in terms of debits
and credits. Given this market adjustment account balance at 12/31/X6,
Market Adjustment - Available-for-Sale Securities
Market Adjustment - Available-for-Sale Securities
4,000 12/31/X5
4,000 12/31/X5
Adjusting entry 1,590
Adjusting entry 1,590
2,410 12/31/X5
2,410 12/31/X5
Adjusting entry 5,410
Adjusting entry 5,410
12/31/X6 3,000
12/31/X6 3,000
Adjusting entry: the unrealized gain/loss account balance has a credit balance
Market Adjustment - Available-for-Sale Securities 5,410 or cumulative gain to date of $3,000, appearing as part of the
Unrealized Gain/Loss - Available-for-Sale Securities 5,410 company's accumulated other comprehensive income in the
owners' equity section of its balance sheet.

63 64

Problem 11-7 - Answer Problem #11-8

Question
B. If the ATT bonds had been classified with the investor's trading
securities, how would the accounting in this problem have been
different?
Answer: Besides the use of different account titles, the bonds would
have been excluded from any adjustment of available-for-sale securities
to their FMV and included in any adjustment for the company's trading
securities. That means the change in the difference between the bonds'
adjusted historical cost and FMV would have been included in the If you thought interest rates were going to increase
company's income statement and ending retained earnings balance.
in the future, would you buy bonds today?
C. Why is no adjustment made for current year-end fair market values
when bonds are classified as held-to-maturity securities?
Answer: No adjustment is made because no gain or loss will ever be
incurred if the bonds are held to maturity. Ultimately the full book
value of the bonds will be collected at maturity.,

65 66

11-11
 Problem 11-8 - Answer
Question

If you thought interest rates were going to increase in the future,

would you buy bonds today?
Answer: It depends. If you plan to sell the bonds prior to maturity,
then the value of the bonds will decrease as interest rates rise and a loss
will be incurred upon sale. That loss will offset a portion of interest
earned and reduces the investment's overall return. If you plan to hold
the bonds to maturity, then no gain or loss will be incurred but you will
earn a lower interest rate over the term of the bonds than you would
have otherwise earned if you had waited for rates to rise before making
the investment. The problem with waiting, however, is that no interest is
earned prior to the bond purchase unless an alternative investment can
be made in the interim. If, however, an investor plans to hold a bond to
maturity and is satisfied in earning today's effective interest rate over
the term of the bonds, then an investment today probably makes sense.

67

11-12
 Lesson 14
The accurate determination of a company's product costs provides managers
with valuable information that can be used in a variety of ways to improve a
company's performance. It's especially useful in helping management control
its product costs.

For example, a simple comparison of a company's costs per unit of production

from one period to the next might highlight increasing costs that could be
easily avoided through more focused management effort.

Lesson 14 Although this simple monitoring of changing costs over time can be an
effective tool in helping managers control costs, an additional and probably
even more useful approach would involve the comparison of current costs with
Standard Costs and some budgeted amount reflecting management's goals and expectations.
Responsibility Accounting
When comparing actual costs over time, increases and decreases can be
identified and acted upon, but there's no assurance that any prior month's costs
represent a benchmark or standard of what management believes is the lowest
cost possible under the circumstances. All a comparison with prior costs does
is indicate whether those costs have gone up or down. That's important to
know, but its even more important to know how those costs compare to what
management thinks those costs really should be if the company was operating
at the highest level of performance possible.

1 2

Standard Costs In the establishment of a product's standard costs, should those

standards be set at levels that reflect ideal performance that will
Standard costs represent management's goals relative to a product's cost per
unit of production. In most cases, those costs are determined based on the
seldom if ever be achieved, or should they be set at more
combined input of all of a company's managers having some responsibility or reasonable levels?
control over product costs, including managers involved in product design, raw
material purchases, the hiring of production personnel and the general Most companies choose "tight but attainable" standards on the
operation of the production department. In addition, a company's general belief that such standards can actually have a greater
manager and controller will also usually be involved in the final determination motivating influence on employees.
of a product's standard cost. In effect, standard costs are a company's budgeted
costs per unit of production.
When actual performance is compared against attainable
Perry Shirt Manufacturing
standards, any resulting unfavorable variances highlight
Standard Cost Card - Basic Extra-Large Men's T-Shirt
opportunities for improvement. If unrealistically high
Standard Standard standards are set, then unfavorable variances become the norm
Quantity Price or Rate Cost/Unit
rather than the exception, and, as a result, such variances lose
Direct materials 1.5 yards x $1.40/yd.* = $2.10 their significance as a managerial tool.
(Grade A cotton fabric)
Direct labor .10 hour x $16/hr. = $1.60
Mfg. overhead .10 hour x $8/hr. = $ .80
Total $4.50
* Includes the purchase price plus any freight and other costs associated with the purchase
and receipt of the materials used.

3 4

A comparison of standard versus actual costs incurred in Perry Shirt

"Management by Exception" Manufacturing's production of its Basic Extra-Large Men's T-Shirt in the
month of October, 20X5. Actual Costs/October
Production # Units Cost Quantity Quantity Price or
Costs Produced per Unit Usage per Unit Rate
An approach that emphasizes the comparison of actual Direct materials
Direct labor
$240,000
$165,000
100,000
100,000
$2.40
$1.65
160,000 yds.
11,000 hours
1.6 yds.
.11 hr.
$1.50/yd.
$15.00/hr.
results to standards, budgets and other expected or Manufacturing Overhead $ 87,000 100,000 $ .87 11,000 hours .11 hr. $7.91/hr.
desired measures of performance to highlight deviations Total $492,000 $4.92
Standard Cost Card - Basic Extra-Large Men's T-Shirt
that call for management attention. Standard Standard
Quantity Price or Rate Cost/Unit
Direct materials 1.5 yards x $1.40/yd. = $2.10
Direct labor .10 hour x $16/hr. = $1.60
Mfg. overhead .10 hour x $8/hr. = $ .80
Total $4.50
Variance Analysis
Actual Standard Variance # Units
Cost/Unit - Cost/Unit = per Unit x Produced = Variance
Total $4.92 - $4.50 = $.42 (U) x 100,000 = $42,000 (U)
Breakdown:
Direct materials $2.40 - $2.10 = $.30 (U) x 100,000 = $30,000 (U)
Direct labor $1.65 - $1.60 = $.05 (U) x 100,000 = $ 5,000 (U)
Mfg. overhead $ .87 - $ .80 = $.07 (U) x 100,000 = $ 7,000 (U)
$42,000 (U)

5 6

14-1
 Actual Costs/October
Who is it in the company's management that's really responsible Production # Units Cost Quantity Quantity Price or
for this direct material variance? Costs Produced per Unit Usage per Unit Rate
Direct materials $240,000 100,000 $2.40 160,000 yds. 1.6 yds. $1.50/yd.
That depends. It depends on whether this variance is the result Direct labor $165,000 100,000 $1.65 11,000 hours .11 hr. $15.00/hr.
Manufacturing Overhead $ 87,000 100,000 $ .87 11,000 hours .11 hr. $7.91/hr.
of higher than expected material prices or the use of excess Total $492,000 $4.92
materials in the production process. If the variance is the
result of higher than expected prices, then the company's Standard Cost Card - Basic Extra-Large Men's T-Shirt
purchasing manager will probably be the one responsible for Standard Standard
addressing this variance and improving the company's future Quantity Price or Rate Cost/Unit
Direct materials 1.5 yards x $1.40/yd. = $2.10
performance. On the other hand, if the problem was due to Direct labor .10 hour x $16/hr. = $1.60
excess material usage, then the production manager is Mfg. overhead .10 hour x $8/hr. = $ .80
probably the one responsible for solving this problem. Total $4.50

Variance Analysis
What we really need to do here is figure out what portion, if Actual Standard Variance # Units
any, of this $30,000 variance is attributable to higher than Cost/Unit - Cost/Unit = per Unit x Produced = Variance
expected prices and what portion is due to excess material Total $4.92 - $4.50 = $.42 (U) x 100,000 = $42,000 (U)
Breakdown:
usage. Direct materials $2.40 - $2.10 = $.30 (U) x 100,000 = $30,000 (U)
Direct labor $1.65 - $1.60 = $.05 (U) x 100,000 = $ 5,000 (U)
Mfg. overhead $ .87 - $ .80 = $.07 (U) x 100,000 = $ 7,000 (U)
$42,000 (U)

7 8

Materials Price Variance

( Actual Price - Standard Price ) x Actual Quantity
( $1.50/yd. - $1.40/yd. )
$.10/yd. x 160,000 yds.
$16,000 Unfavorable
These variance accounts serve a useful managerial purpose, but for
financial reporting purposes, any balances in these variance accounts
Materials Quantity (Usage) Variance
at the end of the period must be closed out to either WIP, finished
( Actual Quantity - Standard Quantity ) x Standard Price goods and/or cost of goods sold, based on the relative amount of
( 160,000 yd. - 150,000 yd.* ) direct materials included in the ending balances of those accounts.
10,000 yd. x $1.40/yd.
In actual practice, the total amounts of these variances are usually
$14,000 Unfavorable
closed out to cost of goods sold based on the fact that most of a
* Based on the standard of 1.5 yards per shirt x 100,000 shirts produced. company's WIP inventory is completed and sold by the end of the
period. However, when that's not the case, an allocation of some
These variances are then separately accounted for through a journal entry made portion of these variance amounts should be made to WIP and
to record the transfer of direct materials from raw materials inventory to WIP: finished goods as well as cost of goods sold.
WIP Inventory ($1.40/yd. x 150,000 yds.) 210,000
Materials Price Variance ($ .10 x 160,000 yds.) 16,000
Materials Quantity Variance (10,000 yds. x $1.40) 14,000
Raw Materials Inventory ($1.50/yd. x 160,000 yds.) 240,000

9 10

Our ultimate goal here is to use this variance information to better control the Labor Rate Variance
company's product costs. That requires a company's management to identify and act ( Actual Rate - Standard Rate ) x Actual Hours
on the underlying causes behind those variances. ( $15/hr. - $16/hr. )
$1/hr. x 11,000 hrs.
For Perry Shirt Manufacturing, the company's unfavorable materials price variance
$11,000 Favorable
could be the result of higher than expected supplier prices, failure to take advantage of
available volume or purchase discounts, and/or as higher than expected freight costs.
Labor Efficiency (Quantity) Variance
Generally speaking, the company's purchasing manager would be the one responsible ( Actual Hours - Standard Hours ) x Standard Rate
for investigating and ferreting out the source of this unfavorable variance, and then ( 11,000 hrs. - 10,000 hrs. )
taking action, if possible, to improve the company's future performance. However, in 1,000 hrs. x $16/hr.
some cases, higher material prices and freight costs result from rush orders caused by $16,000 Unfavorable
poor production planning. In that case, the responsibility for this variance might
properly fall to the company's production manager. * .10 standard hours per shirt x 100,000 shirts produced.

Unfavorable material quantity variances typically reflect higher than expected Journal entry to record these labor costs:
material waste or spoilage in the production process incurred as a result of untrained WIP Inventory ($16/hr. x 10,000 hrs.) 160,000
workers, poor supervision, malfunctioning equipment and/or the use of inferior Labor Efficiency Variance 1,000 hrs. x $16 hrs. 16,000
materials. In most cases, the production manager is the one to address these problems; Labor Rate Variance $1 x 11,000 hrs. 11,000
however, responsibility for inferior materials might rest with a company's purchasing Cash or Wages Payable ($15/hr. x 11,000 hrs.) 165,000
department.
These variance accounts are, in effect, temporary accounts used to highlight variances
In some cases, a company's price and quantity standards may simply be unrealistic. In for management use, but at the end of the period they must be closed out to WIP,
those cases, more reasonable standards should be considered to produce variances that finished goods and/or cost of goods sold as appropriate to reflect those amounts at their
highlight real opportunities for improved performance. actual cost. In most cases, these accounts are simply closed out to cost of goods sold.

11 12

14-2
 Problem 14-1
In most cases, an unfavorable labor efficiency variance results when employees lack Material and Labor Variances
proper supervision, are poorly trained or lack adequate motivation. In addition,
equipment breakdowns, poor quality of materials and unreasonable standards can Given the following information for Carmack, Inc. for the month of June, 20X8:
contribute to unmet goals in terms of labor hours. Generally speaking, a company's
production manager assumes responsibility for addressing these variances as long they Actual costs incurred in the production of 400 units:
fall within his/her control. However, if inferior materials are the cause of production Direct materials purchased (1,000 lbs. at $7/lb.) $ 7,000
slowdowns, then the purchasing manager is probably the one to follow up on that Direct materials used 900 lbs.
problem. Direct labor incurred (550 hours at $20/hr.) $11,000
Standard costs per unit:
Labor rate variances often result when a company uses higher or lower skilled $15.00
Direct materials (2lbs. at $7.50/lb.)
employees for certain production jobs. In this case, Perry's favorable labor rate
Direct labor (1.4 hours. at $18/hr.) $25.20
variance may be the result of lower skilled and lower paid employees put to work in
tasks that typically require higher skilled employees. If that's true, then that may also
explain the cause behind the higher than expected labor hours worked during the Determine the company's:
period. Lower skilled workers will usually take more time to complete a task. If that's a. Materials price variance recorded at the time of purchase.
the case, then the labor rate and efficiency variances should probably be evaluated on a b. Material quantity variance.
combined basis to determine their net affect on the company's profits. c. Labor rate variance.
d. Labor efficiency variance.
In some cases, unfavorable labor rate variances are caused by higher than expected
overtime pay or the unplanned use of higher paid temporary employees. If that's the Prepare journal entries to record the company's purchase and use of materials as
result of poor production planning then a company's production manager will assume well as its labor costs so that all inventories are carried at standard and all
responsibility for future improvement. However, if production scheduling is variances are separately recorded.
complicated by inaccurate sales forecasts then improved projections from the
company's sales manager may be the solution to this problem.
Prepare closing entries for all of the recorded variances assuming they are all
closed to cost of goods sold at the end of the period.

13 14

Problem 14-1 - Answer Problem 14-1 - Answer

Material and Labor Variances Material and Labor Variances

a. Materials price variance recorded at the time of purchase: c. Labor rate variance:
( Actual Price - Standard Price ) x Actual Quantity ( Actual Rate - Standard Rate ) x Actual Hours
( $7.00/lb. - $7.50/lb. ) x 1,000 lbs. ( $20/hr. - $18/hr. ) x 550 hrs.
$ .50/lb. x 1,000 lbs. $2/hr. x 550 hrs.
$500 Favorable $1,100 Unfavorable

b. Material quantity variance: d. Labor efficiency variance:

( Actual Quantity - Standard Quantity ) x Standard Price ( Actual Hours - Standard Hours ) x Standard Rate
( 900 lbs. - 800 lbs.* ) x $7.50/lb. ( 550 hrs. - 560 hrs.* ) x $18/hr.
100 lbs. x $7.50/lb. 10 hrs. x $18/hr.
$750 Unfavorable $180 Favorable
* 2 lbs. per unit x 400 units produced. * 1.4 standard hours per unit x 400 units produced.

15 16

Problem 14-1 - Answer Problem 14-1 - Answer

Closing entries:
Journal entry to record the purchase of materials:
Raw Materials Inventory $7.50/lb. x 1,000 lbs. 7,500
Materials Price Variance 500
Materials Price Variance $.50 x 1,000 lbs. 500 Cost of Goods Sold 500
Cash or A/P $7.00/lb. x 1,000 lbs. 7,000
Cost of Goods Sold 750
Materials Quantity Variance 750
Journal entry to record the use of materials:
Cost of Goods Sold 1,100
WIP Inventory 800 lbs. x $7.50/lb. 6,000
Labor Rate Variance 1,100
Materials Quantity Variance 100 lbs. x $7.50/lb. 750
Raw Materials Inventory 900 lbs. x $7.50/lb. 6,750
Labor Efficiency Variance 180
Cost of Goods Sold 180
Journal entry to record labor costs:
Or combined closing entry:
WIP Inventory $18/hr. x 560 hrs.* 10,080
Labor Rate Variance $2/hour x 550 hrs. 1,100 Materials Price Variance 500
Labor Efficiency Variance 10 hrs. x $18/hr. 180 Labor Efficiency Variance 180
Cash or Wages Payable $20/hr. x 550 hrs. 11,000 Cost of Goods Sold 1,170
* 1.4 standard hours per unit x 400 units. Materials Quantity Variance 750
Labor Rate Variance 1,100

17 18

14-3
 Problem 14-2 Problem 14-2
Material and Labor Variances Material and Labor Variances
Given the following information for Harkin Company. Given the following information for Harkin Company.
Actual results: Actual results:
Number of direct material yards purchased 20,000 yards. Number of direct material yards purchased 20,000 yards.
Total cost of direct labor incurred $46,000 Total cost of direct labor incurred $46,000
Total cost of direct material yards purchased $84,000 Total cost of direct material yards purchased $84,000
Number of units produced 12,000 units Number of units produced 12,000 units
Number of direct material yards used 22,000 yards Number of direct material yards used 22,000 yards
Direct labor rate per hour $23.00 Direct labor rate per hour $23.00
Standard costs: Standard costs:
Price per yard of direct materials $4.00 Price per yard of direct materials $4.00
Number of direct material yards per unit 1.5 yards Number of direct material yards per unit 1.5 yards
Direct labor rate per hour $21.00 Direct labor rate per hour $21.00
Number of direct labor hours per unit 0.15 hours Number of direct labor hours per unit 0.15 hours

Determine the company's: Questions:

a. Materials price variance recorded at the time of purchase. Who would typically be responsible for a company's unfavorable materials
b. Material quantity variance. price variance and what might be some of the causes for that variance?
c. Labor rate variance.
d. Labor efficiency variance. Who would typically be responsible for a company's unfavorable materials
quantity variance and what might be some of the causes for that variance?

19 20

Problem 14-2 - Answer Problem 14-2 - Answer

Material and Labor Variances Material and Labor Variances

a. Materials price variance recorded at the time of purchase: c. Labor rate variance:
( Actual Price - Standard Price ) x Actual Quantity ( Actual Rate - Standard Rate ) x Actual Hours
( $4.20/yd - $4/yd. ) x 20,000 yds. ( $23/hr. - $21/hr. ) x 2,000 hrs.
$ .20/yd x 20,000 yds. $2/hr. x 2,000 hrs.
$4,000 Unfavorable $4,000 Unfavorable

b. Material quantity variance: d. Labor efficiency variance:

( Actual Quantity - Standard Quantity ) x Standard Price ( Actual Hours - Standard Hours ) x Standard Price
( 22,000 yds. - 18,000 yds.* ) x $4/yd. ( 2,000 hrs. - 1,800 hrs.* ) x $21/hr.
4,000 yds. x $4/yd. 10 hrs. x $21/hr.
$16,000 Unfavorable $4,200 Unfavorable
* 1.5 standard yards per unit x 12,000 units produced. * .15 standard hours x 12,000 units produced.

21 22

Problem 14-2 - Answer Problem 14-2 - Answer

Questions: Questions:
Who would typically be responsible for a company's unfavorable materials Who would typically be responsible for a company's unfavorable materials
price variance and what might be some of the causes for that variance? quantity variance and what might be some of the causes for that variance?
Answer: Generally speaking a company's purchasing manager is Answer: Generally speaking a company's production manager is
responsible for any unfavorable materials price variance. responsible for any unfavorable materials quantity variance.

Because material prices may depend on the supplier used, the number In most cases this variance indicates higher than expected material
of units purchased, payment terms, and the mode and timing of waste or spoilage resulting from inexperienced and untrained
delivery, some common causes of this variance might be: workers, poor planning and supervision, and/or mechanical
breakdowns in the production process.
1. Higher than expected supplier prices.
2. Failure to take advantage of volume or purchase discounts. In the event waste or spoilage is the result of poor quality materials,
3. Higher than expected freight costs. then the purchasing manager may be the one responsible for the
failure to meet expectations.
In some cases higher prices and delivery costs may be associated with
rush orders that are actually the result of poor production scheduling. In some cases, the company's standards may simply be unreasonable.
In that case the production manager would be the responsible party
rather than the purchasing manager.

Sometimes this variance is simply the result of unreasonable

standards.

23 24

14-4
 Perry Shirt Manufacturing
Actual Costs/October
Basic Extra-Large Men's T-Shirt
Production # Units Cost Quantity Quantity Price or
Manufacturing Overhead
Costs Produced per Unit Usage per Unit Rate Actual costs 87,000 80,000 Application to WIP
Direct materials $240,000 100,000 $2.40 160,000 yds. 1.6 yds. $1.50/yd.
($8/hr. 10,000 hrs. *)
Direct labor $165,000 100,000 $1.65 11,000 hours .11 hr. $15.00/hr.
Manufacturing Overhead $ 87,000 100,000 $ .87 11,000 hours .11 hr. $7.91/hr. * .10 hrs/unit 100,000 units
Total $492,000 $4.92 Under-applied overhead 7,000
Standard Cost Card - Basic Extra-Large Men's T-Shirt (Unfavorable variance)
Standard Standard 7,000 Closing entry
Quantity Price or Rate Cost/Unit 0
Direct materials 1.5 yards x $1.40/yd. = $2.10
Direct labor .10 hour x $16/hr. = $1.60
Mfg. overhead .10 hour x $8/hr. = $ .80
Closing entry:
Total $4.50
Variance Analysis Cost of Goods Sold 7,000
Actual Standard Variance # Units Manufacturing Overhead 7,000
Cost/Unit - Cost/Unit = per Unit x Produced = Variance
Total $4.92 - $4.50 = $.42 (U) x 100,000 = $42,000 (U)
Breakdown:
Direct materials $2.40 - $2.10 = $.30 (U) x 100,000 = $30,000 (U)
Direct labor $1.65 - $1.60 = $.05 (U) x 100,000 = $ 5,000 (U)
Mfg. overhead $ .87 - $ .80 = $.07 (U) x 100,000 = $ 7,000 (U)
$42,000 (U)

25 26

Standard = $8/hr. predetermined x .10 hrs/unit = $ .80/unit

Overhead Cost overhead rate

Which of the company's various overhead Total budgeted overhead costs for
costs exceeded management's budgeted goals? Predetermined the upcoming period
=
Overhead Rate Total budget for a measurable activity or
To answer that question, we're going to need a further cost that correlates with or drives overhead
breakdown of the $7,000 variance, which requires a costs over the same period of time
more detailed breakdown of both the company's In this case, we'll assume the company's $8 rate was determined at the
standard and actual manufacturing overhead costs. beginning of the year (20X5) based on management's budgeted costs and
direct labor hours for the upcoming year. We'll also assume the company
plans to produce 960,000 shirts during the course of the year, and based on
that amount, has budgeted manufacturing overhead costs at a total of
$768,000. In addition, the company's budgeted direct labor hours, based
on its .10 standard direct labor hours per unit, comes to 96,000 hours.
Given that information:
$768,000
$8/hr. =
96,000 hours

27 28

Detailed Manufacturing Overhead Budget Variable Manufacturing Overhead Variances

For the year, 20X5 October
Actual Standard/Budget
Total Total Costs* Hours Rate/hr. Rate/hr. Hours Costs
Variable costs:
Budget Budgeted Budgeted
Indirect materials $14,000 - 11,000 = $1.27 $1.00 x 10,000** = $10,000
per Hour Hours Costs
Factory utilities 21,000 - 11,000 = 1.91 2.00 x 10,000 = 20,000
Variable costs per hour: Repair/maintenance 15,000 - 11,000 = 1.36 .50 x 10,000 = 5,000
Indirect materials $1.00/hr. x 96,000 hrs. = $ 96,000 Total variable $50,000 $4.54 $3.50 $35,000
Factory utilities 2.00/hr. x 96,000 hrs. = 192,000 * Actual costs incurred in the company's production of 100,000 shirts.
Repairs and maintenance .50/hr. x 96,000 hrs. = 48,000 ** 100,000 shirts at a standard of .10 hours per shirt
Total variable $3.50/hr. $336,000
Total Variable Manufacturing Overhead Variance = $15,000 Unfavorable

Budget
Variable Manufacturing Overhead Spending Variance
per Month
( Actual Rate - Standard Rate ) x Actual Hours
Fixed costs per month: ( $4.54/hr. - $3.50/hr. )
Indirect labor $20,000/mo. x 12 months = $240,000 $1.04/hr. x 11,000 hrs.
Equipment depreciation 4,000/mo. x 12 months = 48,000 $11,440 Unfavorable
Building rent 12,000/mo. x 12 months = 144,000 ($11,500 if no rounding error)
Total fixed costs $36,000/mo. $432,000
Variable Manufacturing Overhead Efficiency (Quantity) Variance
Total costs $768,000
( Actual Hours - Standard Hours ) x Standard Rate
( 11,000 hrs. - 10,000 hrs. )
1,000 hrs. x $3.50/hr.
$3,500 Unfavorable

29 30

14-5
 Variable Manufacturing Overhead Variances Variable Manufacturing Overhead Variances
October October
Actual Standard/Budget Actual Standard/Budget
Costs* Hours Rate/hr. Rate/hr. Hours Costs Costs* Hours Rate/hr. Rate/hr. Hours Costs
Variable costs: Variable costs:
Indirect materials $14,000 - 11,000 = $1.27 $1.00 x 10,000** = $10,000 Indirect materials $14,000 - 11,000 = $1.27 $1.00 x 10,000** = $10,000
Factory utilities 21,000 - 11,000 = 1.91 2.00 x 10,000 = 20,000 Factory utilities 21,000 - 11,000 = 1.91 2.00 x 10,000 = 20,000
Repair/maintenance 15,000 - 11,000 = 1.36 .50 x 10,000 = 5,000 Repair/maintenance 15,000 - 11,000 = 1.36 .50 x 10,000 = 5,000
Total variable $50,000 $4.54 $3.50 $35,000 Total variable $50,000 $4.54 $3.50 $35,000
* Actual costs incurred in the company's production of 100,000 shirts. * Actual costs incurred in the company's production of 100,000 shirts.
** 100,000 shirts at a standard of .10 hours per shirt ** 100,000 shirts at a standard of .10 hours per shirt
Total Variable Manufacturing Overhead Variance = $15,000 Unfavorable Total Variable Manufacturing Overhead Variance = $15,000 Unfavorable

Indirect Materials Spending Variance Repairs and Maintenance Spending Variance

( Actual Rate - Standard Rate ) x Actual Hours ( Actual Rate - Standard Rate ) x Actual Hours
( $1.27/hr. - $1.00/hr. ) ( $1.36/hr. - $ .50/hr. )
$ .27/hr. x 11,000 hrs. $ .86/hr. x 11,000 hrs.
$2,970 Unfavorable $9,460 Unfavorable
($3,000 if no rounding error) ($9,500 if no rounding error)

Indirect Materials Efficiency Variance Repairs and Maintenance Efficiency Variance

( Actual Hours - Standard Hours ) x Standard Rate ( Actual Hours - Standard Hours ) x Standard Rate
( 11,000 hrs. - 10,000 hrs. ) ( 11,000 hrs. - 10,000 hrs. )
1,000 hrs. x $1.00/hr. 1,000 hrs. x $ .50/hr.
$1,000 Unfavorable $500 Unfavorable

31 32

Fixed Manufacturing Overhead Variances

October Summary of Total
Standard/ Costs Manufacturing Overhead Variances
Actual Budgeted Applied
Costs Costs to WIP
October
Fixed costs:
Indirect labor $20,000 $20,000
Equip. depreciation 5,000 4,000 Variable:
Building rent 12,000 12,000 Spending variance $11,500 (U)
Total fixed costs $37,000 $36,000 $45,000* Efficiency variance 3,500 (U)
Fixed:
Fixed Manufacturing Overhead Budget Variance = $1,000 Unfavorable
Fixed Manufacturing Overhead Volume Variance = $9,000 Favorable** Budget variance 1,000 (U)
Volume variance 9,000 (F)
* Fixed manufacturing overhead costs that were included in the company's total application of
overhead to WIP during the period. That amount's based on: Total 7,000 (U) *
Total application of overhead ($[Link]. x 10,000 hours) $80,000
Deduct: Applied overhead attributable to variable costs * The difference between the total actual overhead costs
($3.50/hr. x 10,000 hours) (35,000) incurred and the total standard overhead cost applied to WIP.
Fixed costs included in the application of overhead to WIP $45,000

** Reflects the benefit of having fixed costs in a period of higher than expected production volume. A
company's fixed cost per unit goes down with increasing volume. That's because a company's fixed
costs are effectively spread out over more units, resulting in a lower cost per unit. In this case, the
company's average monthly production was budgeted at 80,000 shirts per month (960,000 total shirts
12 months). However, in the month of October, the company's actual production was 100,000 shirts,
which effectively reduced the company's fixed costs per unit for the period.

33 34

Problem 14-3
Perry Shirt Manufacturing
Variable Manufacturing Overhead Variances
Actual Costs/October
Basic Extra-Large Men's T-Shirt Given the following information for Harper, Inc. in the year 20X6:
Production # Units Cost Quantity Quantity Price or Budgeted amounts for the year:
Costs Produced per Unit Usage per Unit Rate
Total direct labor hours 200,000 hours
Direct materials $240,000 100,000 $2.40 160,000 yds. 1.6 yds. $1.50/yd.
Total variable manufacturing overhead costs $400,000
Direct labor $165,000 100,000 $1.65 11,000 hours .11 hr. $15.00/hr.
Total fixed manufacturing overhead costs $300,000
Manufacturing Overhead $ 87,000 100,000 $ .87 11,000 hours .11 hr. $7.91/hr.
Total units of production 10,000 units
Total $492,000 $4.92
Data provided for the month of March:
Standard Cost Card - Basic Extra-Large Men's T-Shirt
Budgeted units of production 1,000 units
Standard Standard
Actual number of units produced 800 units
Quantity Price or Rate Cost/Unit
Actual variable manufacturing overhead costs $34,200
Direct materials 1.5 yards x $1.40/yd. = $2.10
Actual fixed manufacturing overhead costs $26,500
Direct labor .10 hour x $16/hr. = $1.60
Actual direct labor hours worked 15,000 hours
Mfg. overhead .10 hour x $8/hr. = $ .80
Total $4.50 Determine the following for the month of March assuming the company applies
Variance Analysis manufacturing overhead to WIP on the basis of direct labor hours:
Actual Standard Variance # Units
Cost/Unit - Cost/Unit = per Unit x Produced = Variance A. Variable manufacturing overhead rate used in the application of variable
Total $4.92 - $4.50 = $.42 (U) x 100,000 = $42,000 (U) manufacturing overhead costs to WIP inventory.
Breakdown: B. Variable manufacturing overhead spending variance.
Direct materials $2.40 - $2.10 = $.30 (U) x 100,000 = $30,000 (U) C. Variable manufacturing overhead efficiency variance.
Direct labor $1.65 - $1.60 = $.05 (U) x 100,000 = $ 5,000 (U)
Mfg. overhead $ .87 - $ .80 = $.07 (U) x 100,000 = $ 7,000 (U) Question: Generally speaking, what causes an unfavorable variable manufacturing
$42,000 (U) overhead efficiency variance?

35 36

14-6
 Problem 14-3 - Answer Problem 14-3 - Answer
Variable Manufacturing Overhead Variances
A. Variable manufacturing overhead rate used in the application of Question: Generally speaking, what causes an unfavorable variable
variable manufacturing overhead costs to WIP inventory. manufacturing overhead efficiency variance?
Variable manufacturing overhead rate:
Answer: The basic cause of an unfavorable efficiency
$400,000 200,000 hrs. = $2.00/hr.
variance is a higher than budgeted level of direct labor
hours, or other activity or cost serving as the basis for
B. Variable manufacturing overhead spending variance.
the company's standard predetermined overhead rate.
( Actual Rate - Standard Rate ) x Actual Hours Whether that basis is direct labor hours, machine hours,
( $2.28/hr. - $2.00/hr. ) x 15,000 hrs. direct material costs or any other activity or cost that
$ .28/hr. x 15,000 hrs. drives the company's manufacturing overhead, an
$4,200 Unfavorable unfavorable variance results if more of those hours or
costs are incurred in the production process than would
C. Variable manufacturing overhead efficiency variance. be expected given the company's current level of
production.
( Actual Hours - Standard Hours ) x Standard Price
( 15,000 hrs. - 16,000 hrs.* ) x $2.00/hr.
1,000 hrs. x $2.00/hr.
$2,000 Favorable

37 38

Problem 14-4 Problem 14-4 - Answer

Closing Variance Accounts Closing entries:
Labor Rate Variance 12,000
Given the following information for Corbin, Inc. at the end of the year: Cost of Goods Sold 12,000

Cost of Goods Sold 9,000

Cost of goods sold (before closing entries) . . . . . . $730,000 Labor Efficiency Variance 9,000
Labor rate variance . . . . . . . . . . . . . . . . . . . . . . . . . $12,000 favorable
Cost of Goods Sold 14,000
Labor efficiency variance . . . . . . . . . . . . . . . . . . . . $9,000 unfavorable Materials Price Variance 14,000
Materials price variance . . . . . . . . . . . . . . . . . . . . . $14,000 unfavorable
Materials Quantity Variance 8,000
Materials quantity variance . . . . . . . . . . . . . . . . . . $8,000 favorable Cost of Goods Sold 8,000
Over-applied manufacturing overhead . . . . . . . . . . $30,000
Manufacturing Overhead 30,000
Cost of Goods Sold 30,000
Compute Corbin's final cost of goods sold for financial reporting purposes
assuming the company originally records its inventory and cost of goods Or combined closing entry:
sold at standard costs. (Also assume the company's entire WIP inventory Labor Rate Variance 12,000
is completed and sold as of the end of the year.) Materials Quantity Variance 8,000
Manufacturing Overhead 30,000
Cost of Goods Sold 27,000
Labor Efficiency Variance 9,000
Materials Price Variance 14,000
Cost of Goods Sold = $730,000 - $27,000 = $703,000

39 40

Advantages of a Standard Cost System Disadvantages and Potential Pitfalls of a

1. Simply involving various management personnel in the establishment of a Standard Cost System
company's standard costs can encourage improved communication and
coordination among a company's various departments. In fact, the actual 1. The cost associated with implementation. The process of establishing and
process of setting standards can often help identify opportunities for improved regularly updating a company's standard costs can take considerable time and
performance even before those costs are implemented in a standard cost effort, and as a result, the costs of setting up and effectively running a standard
system. cost system can be substantial.

2. Standards that are viewed as reasonable and achievable can motivate 2. Variances between actual and standard costs can often be misinterpreted and
employees to reach higher levels of performance. The key is having standards misused in a way that can have actually have a negative affect on employee
employees accept and then evaluating performance based on factors within the morale. If unfavorable variances are used to browbeat workers rather than
employee's control. identify opportunities for improvement, then the use of standards could
ultimately prove to be detrimental to a company's overall performance.
3. The timely determination of variances between actual and standard costs can
help management prioritize and focus their efforts on problem areas that 3. In some cases, employee efforts to avoid unfavorable variances can also have
present the greatest opportunities for improvement. unintended consequences. For example, employees seeking to avoid
unfavorable labor efficiency variances might seek shortcuts in the
4. The use of standards costs can facilitate the preparation of a company's manufacturing process that could negatively affect the product's quality. That
operating budgets with respect to future purchases of direct materials and could lead to customer dissatisfaction and ultimately to declining sales.
projected expenditures for direct labor and manufacturing overhead. Those
budgets are crucial in the determination of a company's future cash needs and 4. Meeting a company's established standards may actually discourage continuous
the use of standard costs can simplify those projections and often improve their improvement if those standards are not set and updated in a way that stretches
accuracy. management's creativity and effort.

41 42

14-7
 Responsibility Accounting
Refers to an information system designed to provide reports that assess the
performance of management personnel assigned to specific areas of
responsibility within the company. Such reports are necessary when companies
increase in size and complexity over time leading to the decentralization of
management responsibilities. In a decentralized company, responsibility accounting
Decentralization refers to the delegation or spreading out of management is absolutely crucial.
decision making to lower levels of a company's management personnel.
Benefits of decentralization: Management reports identifying an employee's area of
1. Free up top management to concentrate on more important matters responsibility and his or her performance relative to
involving business strategy.
established standards or goals are invaluable when
2. Moves the day-to-day operating decisions to those who are closer to the
action and may be in a position to make better decisions. decision making is dispersed among a large number of
3. Can improve the job satisfaction of lower level employees and provide employees.
enhanced opportunities for their personal growth in the company.
Disadvantages of decentralization:
1. Some decisions will be made at lower levels without consideration for the
overall affect on the company's goals and objectives.
2. Can make the coordination of operations between a company's various
departments more difficult.

43 44

Clark
Clothing
Cost center - A department or organizational unit in which
International the assigned manager has control over and is
accountable for the costs incurred in the
operation of that department or unit.

Western North Far

European American East Profit center - A department or organizational unit which has
Operations Operations Operations
both revenues and costs over which the
assigned manager has ultimate control and
accountability.
Burnett Perry Shirt Jordan
Shoes Manufacturing Jeans
Investment center - An organizational unit over which the assigned
manager has accountability for the allocation
and use of assets as well as revenues and costs.
Sales Production Purchasing Personnel Accounting
Department Department Department Department Department

45 46

Clark Clothing International

Clark North American Division
Segment-Margin Income Statement
Clothing
October, 20X5
International Segment Breakdown
North
American Burnett Perry Jordan
Division Shoes Shirt Mfg. Jeans
Sales revenues $6,972,000 $2,556,000 $828,000 $3,588,000
Less: Direct costs of each segment -
Western North Far Cost of goods sold (4,365,000) (1,740,000) (492,000) (2,133,000)
European American East Selling and admin. expenses (1,725,000) (582,000) (90,000) (1,053,000)
Operations Operations Operations Segment margin/profit 882,000 $ 234,000 $ 246,000 $ 402,000
Less: Indirect/uncontrollable costs 150,000
Net income (loss) $ 732,000
Total assets $1,170,000 $1,025,000 $1,909,000
Returns on investment (ROI) 20% 24% 22%
Burnett Perry Shirt Jordan
Shoes Manufacturing Jeans Let's also assume that each of these three segments is considered an investment center given that
their general managers have responsibility for and control over each subsidiary's assets. In that
Budgeted vs. Actual case, each segment's return on investment or ROI would be a useful measure of performance.
Income Statement
Segment Margin
Return on Investment (ROI) =
Segment Total Assets
Sales Production Purchasing Personnel Accounting If the North American division was given an additional $500,000 for expansion of one or all of
Department Department Department Department Department its three segments, that money would best be put to use expanding Perry Shirt Manufacturing's
operation assuming its manager could continue to generate a comparable rate of return on those
Variance Reports additionally invested assets.

47 48

14-8
Let's assume for a moment that Clark Clothing International's overall return on
investment, or in other words, return on its total assets invested in all of its division's
worldwide, amounted to 14%. Obviously, in that case, the North American division is
doing very well compared to the results achieved in the company's other divisions.

Let's also assume that the North American general manager has become aware of an Standard costs and responsibility accounting
investment opportunity that would yield the company a rate of return amounting to 18%. are all about setting goals and expectations for
In that case, the general manager may decide that it's not in his or her best interests to a company's managers and employees, and, if
pursue this investment on behalf of the company because it would lower the division's properly used, they can be effective tools in
overall rate of return, even though it would have a positive affect on Clark Clothing
International's total rate of return. improving a company's operating performance.
In this case, the use of ROI to measure the performance of division managers may
actually work against the company's overall best interests. As a result, most companies
today choose to measure performance based on what's referred to as residual income,
which is the amount of profit a division or investment center generates above the
company's established minimum rate of return.

For example, if a division manager controls $10,000,000 of assets and the company's
minimum ROI is set at 15% then the manager will be evaluated on the amount of profit
generated in excess of 15% of $10,000,000 or $1,500,000. In this case, the overall rate
of return is not the goal; it's the dollar amount of profits over $1,500,000. Under this
approach, managers are motivated to achieve results that are consistent with the
company's overall goals and objectives.

49 50

Problem 14-5 Problem 14-5 - Answer

Questions Questions
Briefly respond to the following questions: 1. What are the major advantages and disadvantages of a standard cost
system?
1. What are the major advantages and disadvantages of a standard cost
system? Advantages:
1. Improved communication and coordination among department
2. Why is responsibility accounting important for most businesses? managers.
2. Potential source of motivation.
3. When might responsibility accounting have a negative affect on 3. More efficient management by exception (variance analysis).
employee morale? 4. Facilitates operational budgeting.
4. What distinguishes cost, profit and investment centers and which of the
Disadvantages:
following reports or measures is most commonly associated each?
1. High cost of implementation.
a. Variance reports on actual versus standard costs. 2. Possible misuse resulting in decreasing employee morale.
b. ROI or residual income. 3. Possible misinterpretation of results.
c. Segment-margin income statements. 4. Could actually discourage continuous improvement.
5. Why is residual income often considered a more useful measure of an
investment center's performance than ROI?

51 52

Problem 14-5 - Answer Problem 14-5 - Answer

2. Why is responsibility accounting important for most businesses? 4. What distinguishes cost, profit and investment centers and which of the
following reports or measures is most commonly associated each?
Answer: Most businesses rely on a certain degree of a. Variance reports on actual versus standard costs.
decentralization to operate effectively. When management
b. ROI or residual income.
responsibilities are spread out among various personnel, some
means of evaluating performance is essential. Responsibility c. Segment-margin income statements.
accounting is the means whereby delegated responsibilities are
measured and performance is assessed. Answer: The distinguishing characteristic between cost, profit
and investment centers is the extent of the related manager's
3. When might responsibility accounting have a negative affect on responsibility and control over the costs, revenues and assets of
employee morale? the department or organizational unit. In a cost center, the
manager's control is limited to costs, and variance reports are
Answer: If employees perceive that goals and standards exist to commonly used to help improve performance in that area.
punish rather than encourage improved performance, those goals Managers of profit centers are responsible for both revenues and
can have a detrimental affect on employee morale. Standards and costs and segment-margin income statements are often used to
goals must also be viewed as reasonable and employees should not measure the performance of those units. Finally, managers of
be held accountable for results they can't control. investment centers have responsibility over assets, revenues, and
costs and the key performance measure is the center's ROI or
residual income.

53 54

14-9
 Problem 14-5 - Answer

5. Why is residual income often considered a more useful measure of an

investment center's performance than ROI?

Answer: Most businesses rely on a certain degree of

decentralization to operate effectively. When management
responsibilities are spread out among various personnel, some
means of evaluating performance is essential. Responsibility
accounting is the means whereby delegated responsibilities are
measured and performance is assessed.

55

14-10
 Lesson 16

CVP analysis is used to project the impact of changing sales volume

on a company's costs and profits.

For startup companies, that means it can be used to determine the

volume of sales required to reach breakeven or some targeted amount
Lesson 16 of net income. Figuring out how many units must be sold for a
company to simply breakeven or reach a minimum amount of profits
is extremely useful in analyzing the feasibility of any new business.
Cost-Volume-Profit
(CVP) Analysis In addition, CVP analysis can be used to project the impact of
different business strategies and proposals on a company's profits.
For example, the potential impact on profits associated with a sales
manager's proposal to increase sales volume through increased
advertising expenditures can be analyzed through the use of CVP
analysis.

1 2

Problem 16-1
Cost Behaviors with Changing Volume

Define the following costs, give an example of each and provide a graph
reflecting that example. (Note any assumptions made for purposes of
The key to effective implementation of this management tool is CVP analysis.)
to first understand how a company's costs behave with changes in
volume. In fact, the first step required in any CVP analysis is to Variable costs
first identify all of a company's operating costs, including both
product and period costs, and then distinguish them as either Fixed costs
fixed or variable costs given changes in volume. Stepped costs
Mixed costs

3 4

Problem 16-1 - Answer Problem 16-1 - Answer

Cost Behaviors with Changing Volume Few costs are ever perfectly variable given that significant changes in volume can often
have an impact on the amount of the variable cost per unit. For example, if materials are
Variable costs - Any costs that change in total over a period of time with changes in a purchased in especially large quantities, then purchase discounts can usually be negotiated
company's volume of production or sales. For example, if a manufacturing company's direct reducing the cost per unit of production. However, CVP analysis can be greatly simplified if
material costs amount to $5 per unit, the monthly total of direct material costs will vary a company's variable costs are assumed to be perfectly variable with unchanging variable
based on the number of units produced during the period. If the company produces 1,000 costs per unit within the company's relevant range of production. Relevant range refers to a
units, the total direct material cost will amount to $5,000. On the other hand, if the volume company's reasonably anticipated range of production or sales volume for the period.
of production is 2,000 units, the total cost of direct materials will be $10,000. Obviously, in
this case, direct material costs are variable given that the total cost varies with any changes Fixed costs - Any costs that remain unchanged in amount over a period of time regardless of
in the volume of production. the volume of production or sales. For example, an equipment lease that costs $2,000 per
month, regardless of the number of units a company produces or sells, would be a fixed cost.
Total Direct
Material Costs per Month Total Equipment
(y) Lease Costs per Month
Slope = Variable Cost/Unit (y)
Rise
$15,000 =
Run $3,000
$10,000 $5,000
= = $5/unit $2,000
1,000 units
$5,000 $1,000

(x) Volume (x) Volume

1,000 2,000 3,000 4,000 1,000 2,000 3,000 4,000
units units units units units units units units

5 6

16-1
 Problem 16-1 - Answer Problem 16-1 - Answer

In reality, no cost is ever perfectly fixed under conditions of unlimited volume. If a company triples Any CVP analysis that includes a stepped cost will be inherently imprecise in its ultimate
production, additional equipment will probably be required increasing the company's total lease results. However, as long as we can get close in distinguishing a company's total costs as
costs for the period. However, for CVP analysis, fixed costs are assumed to be perfectly fixed within either fixed or variable, the results generated through CVP analysis should be useful for
a company's relevant range. most management decisions.
Stepped costs - Costs that aren't fixed or variable in their behavior with changes in volume. A
stepped cost tends to be fixed over a range of volume, but then increases to new higher amount as Mixed costs - Costs that have both a fixed and variable cost component. For example,
certain increased levels of production or sales are reached. An example of such a cost would be a utility costs are often mixed given that the monthly cost typically includes a fixed hookup fee
progressively higher bonus paid to sales personnel as they reach various benchmark levels of sales plus additional charges based on the volume of usage.
volume.
Total Sales Bonuses per Month Total Utility Costs per Month
(y) (y)
$8,000
$6,000
$6,000 Slope = $1 Variable Cost Per Unit
$4,000
$2,000
$4,000
(x) Volume
100,000 200,000 300,000 400,000
units units units units $2,000
For purposes of CVP analysis, which requires that all costs be classified and quantified as either
perfectly fixed or perfectly variable, this kind of stepped cost presents real problems. The solution is (x) Volume
to evaluate the cost's behavior within the relevant range and then subjectively determine whether 2,000 4,000 6,000
that cost appears to be more fixed or variable. In this case, if the relevant range is 100,000 to units units units
200,000 units of sales, then the bonus is a fixed cost equal to $4,000. However, if the relevant range
is 100,000 to 300,000 units, the cost is neither fixed nor variable and management will be forced to For purposes of CVP analysis, all of a company's mixed costs must be broken down into
assume the cost is either perfectly fixed at an average cost of $5,000 per month, or perfectly variable their fixed and variable components to determine the company's total fixed and total
at a rate of 2 cents per unit sold. variable costs for the period.

7 8

Problem 16-2 Problem 16-2 - Answer

Mixed Cost Analysis - Scattergraph, High-Low Methods Cost Behaviors with Changing Volume
Given the following information for a company's total utility costs over its a. How would one apply the scattergraph method to determine the fixed and
variable cost components of this mixed cost?
last four months of actual operations:
Plot each month on a graph with the vertical and horizontal axes
Actual designated as "Monthly Utility Cost" and "Monthly Production
Production Actual
Months Volume Utility Costs Volume", respectively. Then visually fit a straight line through the
February 10,000 units $30,000 points trying to minimize the average distance between all of the points
and the line. The slope of this line is the variable cost per unit
March 8,000 units $21,000
component of the mixed cost and the point of intersection with the
April 15,000 units $35,000 vertical axis is the fixed cost component.
May 12,000 units $32,000
b. Determine the fixed and variable cost components of this mixed cost
a. How would one apply the scattergraph method to determine the fixed and using the high-low method.
variable cost components of this mixed cost? At the high and low point in terms of volume:
Change in costs $14,000
b. Determine the fixed and variable cost components of this mixed cost = = $2 VC per unit
using the high-low method. If June's budgeted volume of production is Change in volume 7,000 units
20,000 units, what would be the amount of total utility costs budgeted for Fixed cost component at high point:
the month? Total cost = Variable cost + Fixed cost
$35,000 = ($2 × 15,000 units) + FC
c. Which of the two methods noted above is the best approach for the real FC
$5,000* =
world? . . . for an exam?
* The same fixed cost amount would result if calculated at the low point.

9 10

Problem 16-2 - Answer

Least Squares or Linear Regression Method
If June's budgeted volume of production is 20,000 units, what would be This is probably the best of all the methods given that it uses all of the data
the amount of total utility costs budgeted for the month? reflected in the scattergraph and applies an objective statistical approach to
determine the one straight-line that best fits, given all of the graph's plotted
Budgeted utility cost at a volume of 20,000 units of production: points.
Total cost = Variable cost + Fixed cost
Monthly Utility Costs
TC = ($2 x 20,000) + $5,000 (y)
= $45,000 $40,000

c. Which of the two methods noted above is the best approach for the real $32,000 Feb
May April Slope
world? . . . for an exam?
$24,000
March
The scattergraph method uses more data and is therefore less $16,000
susceptible to faulty results from unusually high or low monthly costs Intercept
and volume. However, the high-low method is better for exams because $8,000
it is entirely objective.
(x) Volume
4,000 8,000 12,000 16,000 20,000
units units units units units

Using keystrokes on an HP calculator, let's now determine the y-intercept or

fixed cost component, and slope or variable cost component of this mixed
utility cost.

11 12

16-2
 Actual Production Actual Utility
Months Volume ("x") Costs ("y")
February 10,000 units $30,000
March 8,000 units $21,000
April 15,000 units $35,000
May 12,000 units $32,000
First the calculator's statistical register is cleared by pressing:
CL A 1.0 coefficient ("R²") implies a perfect 100% correlation
Next the volume and cost values of all data points are entered: where every data point on the graph is on the regression line.
10,000 INPUT 30,000 +
By the way, a zero R² means the regression line is a poor fit, or
8,000 INPUT 21,000 +
in other words, there is no correlation between the company's
15,000 INPUT 35,000 + production volume and utility costs. Obviously, the higher this
12,000 INPUT 32,000 + coefficient (up to a maximum 1.0) the better in terms of
The regression line's y-intercept or the fixed cost component can be determined by: accurately breaking down the fixed and variable utility cost
0 y,m 8,682 components and predicting any future utility costs based on
The slope of the line or variable cost per unit can then be determined: projected production volume.
SWAP 1.85
A coefficient measuring the quality of the correlation between the number of units produced and the utility
costs incurred, can be determined
"R Squared"
x,r SWAP 0.917 Correlation Coefficient
In this case, it means there's a 91.7% correlation between the company's production volume and utility costs.

13 14

Problem 16-3 Problem 16-3 - Answer

Mixed Cost Analysis - Least Squares Method Mixed Cost Analysis - Least Squares Method
Given the following information for a company's total manufacturing Parts A and B: Fixed cost component - $8,773 (rounded)
overhead costs over the last five months: Variable cost component - $6.64 per unit (rounded)
(Using HP10BII) Correlation coefficient (R²) - .93 (rounded)
Actual Actual Total
Production Manufacturing First the calculator's statistical register is cleared by pressing:
Months Volume Overhead Costs
CL
January 1,200 units $17,900
Next the volume and cost values of all data points are entered:
February 800 units $14,300
March 1,000 units $15,300 1,200 INPUT 17,900 +
April 1,500 units $18,200 800 INPUT 14,300 +
May 900 units $14,000
1,000 INPUT 15,300 +
A. Using your financial calculator, apply the least squares method to
determine the fixed and variable cost components of the company's total 1,500 INPUT 18,200 +
manufacturing overhead costs. 900 INPUT 14,000 +
The regression line's y-intercept can be determined by:
B. What is the correlation coefficient (R²) given the above information and
interpret its meaning. 0 y,m 8,773 displayed
The slope of the line can then be determined by:
C. Determine the total anticipated manufacturing overhead costs for the
month of June assuming 1,400 units of budgeted production.
SWAP 6.64 displayed
The correlation coefficient (R²) is then determined by:
D. Do you think the June projection would be more reliable if actual data
from the preceding 12 months were available?
x,r SWAP 0.93 displayed

15 16

Problem 16-3 - Answer Problem 16-3 - Answer

(Using TI BA II Plus)
Select statistics worksheet: 2nd DATA Interpret the correlation coefficient: A .93 or 93% correlation coefficient
indicates a strong correlation between the number of units produced and
The calculator's statistical register is cleared by pressing:
the company's total manufacturing overhead costs. A 100% (R²) would
2nd CLR WORK
be a perfect correlation and 0% would indicate no correlation. In this
Next the volume and cost values of all data points are entered: case 93% of the change in total manufacturing overhead costs is
1,200 ENTER 17,900 ENTER explained by the change in production volume.

800 ENTER 14,300 ENTER

1,000 ENTER 15,300 ENTER

1,500 ENTER 18,200 ENTER

900 ENTER 14,000 ENTER

Then 2nd STAT 2nd CLR WORK

The regression line's y-intercept can be determined by:

Press until you find on diplay a = 8,773 displayed
The slope of the line can then be determined by:
Press until you find on diplay b = 6.64 displayed
The correlation coefficient (R²) is then determined by:
Press until you find on diplay r = 0.93 displayed

17 18

16-3
 Problem 16-3 - Answer Problem 16-4
Contribution Margin Income Statement
Part C. Determine the total anticipated manufacturing overhead costs for the Given the following information for Plaxco, Inc. for the year ended 12/31/X5:
month of June assuming 1,400 units of budgeted production.
Accounts Receivable $ 50,000
Total cost = Variable cost + Fixed cost Fixed Selling and Admin. Expenses $ 125,000
TC = ($6.64 x 1,400) + $8,773 Sales Revenues $ 760,000
TC = $9,296 + $8,773 Variable Portion of Costs of Goods Sold $ 346,000
TC = $18,069 Fixed Portion of Costs of Goods Sold $ 127,000
Variable Selling and Admin. Expenses $ 85,000
Accounts Payable $ 47,000
Part D. Do you think the June projection would be more reliable if actual data
from the preceding 12 months were available? a. Prepare a contribution margin income statement.
Generally speaking, the more data the better, although older b. What is the company's variable cost ratio?
data may become progressively less reliable in projecting future c. What is the company's contribution margin ratio?
correlating relationships. In most cases, however, data from a
d. Does it make sense that the variable cost ratio plus the contribution
company's previous 12 months of operations is probably still
relevant in predicting current and future costs and would
margin ratio is equal to 100%?
probably improve the quality of the company's June projection. e. If Plaxco sold 100,000 units during the year, what was the company's
sales price per unit, variable cost per unit, contribution margin per unit,
and the fixed cost per unit of sales? Do variable and fixed costs per unit
change with changes in volume?

19 20

Problem 16-4 - Answer Problem 16-4 - Answer

Contribution Margin Income Statement e. If Plaxco sold 100,000 units during the year, what was the company's sales
a. Prepare a contribution margin income statement. price per unit, variable cost per unit, contribution margin per unit, and the
Sales Revenues $760,000 fixed cost per unit of sales?
Less: Variable COGS (346,000) SP/unit = $760,000 100,000 units = $7.60
Variable Selling & Admin. (85,000) VC/unit = $431,000 100,000 units = $4.31
Contribution Margin 329,000 CM/unit = $329,000 100,000 units = $3.29
Less: Fixed COGS (127,000) FC/unit = $252,000 100,000 units = $2.52
Fixed Selling & Admin. (125,000)
Net Income $ 77,000 Do variable and fixed costs per unit change with changes in volume?
In performing CVP analysis, an assumption is made that variable cost per unit
b. What is the company's variable cost ratio? remain unchanged within the company's relevant range.
Total Variable Costs = $431,000 = .57 or 57%
Total Sales Revenues $760,000 As far as fixed costs are concerned, fixed costs are never incurred on a per unit basis.
However, if a company's fixed costs are divided by the volume of production or sales
c. What is the company's contribution margin ratio? during the period, a fixed cost per unit amount can be calculated, although that
Contribution Margin = $329,000 amount will change with any changes in volume. In effect, a company's fixed cost
= .43 or 43% per unit reflects the sales price that would have to be charged to cover total fixed
Total Sales Revenues $760,000
costs without consideration for any of the company's other costs. For example, if a
d. Does it make sense that the variable cost ratio plus the contribution bicycle manufacturer's building rent is fixed at $20,000 a month, at a volume of 1
margin ratio is equal to 100%? bike produced during the entire month that bike would have to sell for $20,000 to
simply cover the company's cost of building rent. On the other hand, if the company
Yes, since the contribution margin is the difference between sales produced 100,000 bikes during the period, then the price per bike required to cover
revenues and variable costs, the contribution margin plus variable the building rent would fall to 20 cents. In other words, with increasing volume fixed
costs is equal to 100% of sales revenues. costs per unit go down and vice versa.

21 22

Basic CVP Equation Problem 16-5

CVP Analysis
Utilize this information provided from the previous problem for Plaxco, Inc.

Ratios $/Unit
Sales revenues (SR) - Variable costs (VC) - Fixed costs (FC) = Net income(NI)
Sales Revenues $760,000 100% $7.60
(SP/unit x #Units) - (VC /unit x #Units) -
(VC Ratio x SR)
FC = NI Less: Variable COGS
Variable Selling & Admin.
(346,000)
(85,000) } 57% 4.31

Contribution Margin 329,000 43% 3.29

Less: Fixed COGS
Fixed Selling & Admin.
(127,000)
(125,000) } 2.52
Net Income $ 77,000 $ .77
Sales revenues (SR) - Variable costs (VC) - Fixed costs (FC) = Net income(NI)
To determine:
Contribution margin (CM) - FC = NI
(CM/unit x #units) [Link] company's breakeven point in # of units and sales revenues.
(CM Ratio x SR) [Link] volume of sales (in # of units) required to reach a targeted net income
of $100,000

C. The sales price per unit required to reach the $100,000 targeted net
income at a volume of 100,000 units.

23 24

16-4
 Problem 16-5 - Answer Problem 16-6
CVP Analysis CVP Analysis
A. The company's breakeven point in # of units and sales revenues. Respond to each of the following scenarios:
SR - VC - FC = NI A. Given the following:
($7.60 X) - ($4.31 X) - $252,000 = 0 Variable cost ratio 45%
$3.29 X = $252,000 Total fixed costs for the period $100,000
X = 76,595.74 units What must sales revenues be for the period to generate a $1,000,000 profit?
Breakeven sales revenues: 76,596 units
B. Given the following:
$7.60/unit × 76,596 units = $582,130 rounded
Contribution margin per unit $ 70
B. The volume of sales (in # of units) required to reach a targeted net income of $100,000 Total fixed costs for the period $ 50,000
SR - VC - FC = NI How many units must be sold to reach breakeven?
($7.60 X) - ($4.31 X) - $252,000 = $100,000
$3.29 X = $352,000
C. Given the following:
Sales price per unit $ 100
X = 106,990.88 units
Breakeven volume 1,000 units
106,991 units Total fixed costs $ 30,000
C. The sales price per unit required to reach the $100,000 targeted net income at a volume
Determine the volume required to achieve a targeted net income of $180,000.
of 100,000 units.
SR - VC - FC = NI D. Given the following:
(X 100,000) - ($4.31 100,000) - $252,000 = $100,000 Sales price per unit $ 120
100,000 X $431,000 $252,000 = $100,000 Variable cost per unit $ 80
100,000 X = $783,000 Breakeven sales revenues $360,000
X = $7.83/unit Determine the number of units that must be sold to achieve a profit of $100,000.

25 26

Problem 16-6 - Answer Problem 16-6 - Answer

CVP Analysis
A. SR - VC - FC = NI
SR - (.45 SR) - $100,000 = $1,000,000
D. SR - VC - FC = NI
$120 X - $80 X - FC = $100,000
.55 SR = $1,100,000
SR = $2,000,000 First determine FC at breakeven:
B. SR - VC - FC = NI SR - VC - FC = NI
- FC = NI $360,000 - ($80 x 3,000*) - FC = 0
CM
- $50,000 = 0 $360,000 - $240,000 - FC = 0
$70 X
$70 X = $50,000 $120,000 = FC
X = $715 units (rounded up) * $360,000 ÷ $120 SP/unit = 3,000 breakeven units

C. SR - VC - FC = NI Then complete the original equation:

$100 X - VC - $30,000 = $180,000 $120 X - $80 X - FC = $100,000
First determine VC/unit at breakeven: $120 X - $80 X - $120,000 = $100,000
SR - VC - FC = NI $40 X = $220,000
($100 x 1,000) - (VC/unit x 1,000) - $30,000 = 0 X = 5,500 units
$100,000 - 1,000 Y - $30,000 = 0
1,000 Y = $70,000
Then complete the original equation: Y = $70/unit
$100 X - VC - $30,000 = $180,000
$100 X - $70 X - $30,000 = $180,000
$30 X = $210,000
X = 7,000 units

27 28

Problem 16-7 Problem 16-7 - Answer

CVP Analysis - Changes in Variables CVP Analysis - Changes in Variables
Barton, Inc.'s budget for the upcoming year reflects the following: Both proposals generate less projected net income
A. The company's sales manager believes that sales volume can be increased by 20%
Sales price $36 per unit with a 5% decrease in the sales price per unit and an additional 3% commission
Sales volume 200,000 units paid to sales personnel on total sales revenues.
Direct material costs $12 per unit Projected net income before proposal:
Direct labor costs $7 per unit SR - VC - FC = NI
Variable manufacturing overhead costs $4 per unit ($36 × 200,000) - ($26 × 200,000) - $1,200,000 = NI
$7,200,000 - $5,200,000 - $1,200,000 = $800,000
Fixed manufacturing overhead costs $800,000
Projected net income with proposal:
Variable selling & administrative costs $3 per unit
SR - VC - FC = NI
Fixed selling & administrative costs $400,000 ($34.20 × 240,000) - [($26 × 240,000) + (.03 × $8,208,000)] - $1,200,000 = NI
$8,208,000 - $6,486,240 - $1,200,000 = $521,760
Which of the following two proposals presents the best opportunity for
improved profits in the upcoming year? B. The company's production manager believes that direct labor and variable
manufacturing overhead costs could be decreased by 10% if new equipment is
A. The company's sales manager believes that sales volume can be increased leased at an annual cost of $250,000.
by 20% with a 5% decrease in the sales price per unit and an additional 3% Projected net income with proposal:
commission paid to sales personnel on total sales revenues. SR - VC - FC = NI
($36 × 200,000) - ($24.90* × 200,000) - $1,450,000 = NI
B. The company's production manager believes that direct labor and variable $7,200,000 - $4,980,000 - $1,450,000 = $770,000
manufacturing overhead costs could be decreased by 10% if new equipment
* Direct labor costs ($7/unit) and variable manufacturing overhead costs ($4/unit) = $11/unit,
is leased at an annual cost of $250,000. a 10% reduction equals a $ 1.10 decrease in total variable costs per unit.

29 30

16-5
 Problem 16-8 Problem 16-8 - Answer
Graphical CVP Analysis Graphical CVP Analysis
Using the graph below respond to the following: 1. - 3.
Total Revenues And Costs Total Revenues And Costs
(y) (y)
$500,000 Total Sales Revenues
$500,000
Slope = Sales Price Per Unit
= $50
$400,000 $400,000
Total Costs
Slope = Variable Cost Per Unit
$300,000 $300,000 = $16.67
Variable Costs
$200,000 $200,000 $100,000 Breakeven Point:
Volume - 6,000 units
$100,000 $100,000 Fixed Costs Revenues - $300,000
$200,000
(x) Volume (x) Volume
4,000 8,000 12,000 4,000 8,000 12,000
units units units units units units

1. Identify the total revenue and total cost lines.

2. Determine the sales price per unit, variable cost per unit and total fixed costs.
3. Determine the breakeven point in both # of units and total sales revenues.
4. At a sales volume of 4,000 units, determine the company's fixed costs,
approximate variable costs and profit.
5. At a sales volume of 8,000 units, determine the company's fixed costs,
approximate variable costs and profit.

31 32

Problem 16-8 - Answer Problem 16-8 - Answer

4. 5.
Total Revenues And Costs Total Revenues And Costs
(y) (y)
Total Sales Revenues Total Sales Revenues
$500,000 $500,000
Total Revenues = $400,000
$400,000 $400,000
Total Costs Net Income = $67,000 Approx. Total Costs
$300,000 $300,000 Total Costs = $333,000
Total Costs = $333,000 Variable Costs
Variable Costs $67,000 $133,000 Approx.
$200,000 Total Revenues = $200,000 $200,000
Net Income = $67,000 Approx.
$100,000 Fixed Costs Net Loss = $67,000 Approx. $100,000 Fixed Costs
$200,000 $200,000
(x) Volume (x) Volume
4,000 8,000 12,000 4,000 8,000 12,000
units units units units units units

33 34

Operating Leverage
Airline Company
Total Revenues Companies with higher fixed costs and lower variable
And Costs
Total Revenues costs have higher operating leverage which results in
greater potential profits and increased risk of loss with
Total Costs
any changes in volume.

As a result, many companies seeking to increase profits

Volume
as quickly as possible will often seek to convert their
variable costs to a fixed cost basis, whereas, companies
Window Washing Company wishing to avoid the risk of significant losses will do
Total Revenues
And Costs
Total Revenues the reverse and seek to convert their fixed costs to
Total Costs variable costs.

Volume

35 36

16-6
 Problem 16-9 Problem 16-9 - Answer
Operating Leverage Operating Leverage
Given the following graph for ABC Company: Given the following graph for ABC Company:
Total Revenues And Costs Total Revenues And Costs
Total Revenues Total Revenues
$400,000 $400,000
Net Income = $85,000 Approx.
Total Costs Total Costs
$300,000 $300,000

$200,000 $200,000

$100,000 $100,000

Volume Volume
5,000 10,000 5,000 10,000
units units units units
A. Determine the company's approximate amount of profit at a sales volume of 10,000 units. A. Determine the company's approximate amount of profit at a sales volume of 10,000 units.
B. If management converted all of its sales personnel from a salary-based to "commission
only" compensation plan (based on sales volume), how would this graph be affected $85,000 Approximately
assuming the breakeven point remained unchanged? Given this change, is the company's
operating leverage higher or lower?
C. Given the change in B above, would the company's profits be higher or lower at a volume
of 10,000 units?
D. Why would management ever implement such a "commission only" plan if it results in
lower profits?

37 38

Problem 16-9 - Answer Problem 16-9 - Answer

B. If management converted all of its sales personnel from a salary-based to "commission C. Given the change in B above, would the company's profits be higher or lower at a volume
only" compensation plan (based on sales volume), how would this graph be affected of 10,000 units?
assuming the breakeven point remained unchanged?
Answer: Lower.
Total Revenues And Costs
Total Revenues
$400,000 D. Why would management ever implement such a "commission only" plan if it results in
New Total Costs
lower profits?
Total Costs
$300,000
Answer: This change results in lower profits at every level of volume above
breakeven, but it reduces the extent of losses below breakeven. The only reason
$200,000 management would implement this shift to a "commission only" plan would be to
reduce future anticipated losses.
$100,000

Volume
5,000 10,000
units units

Given this change, is the company's operating leverage higher or lower?

Answer: Lower. Operating leverage refers to the extent of fixed costs relative to
variable costs. In this case, fixed costs were reduced and variable costs increased.

39 40

Limiting Assumptions A final additional assumption has been implicit in all of our previous CVP problems
and examples to date. In each and every case, we've assumed the company sold a
To Simplify the Process of CVP Analysis single product.
Basic CVP Equation
SR - VC - FC = NI
(SP/unit x #Units)
1. In all of our examples we've assumed the company's sales price per
unit is the same regardless of the number of units sold. Most companies sell a variety of products having different sales prices and different
variable costs per unit.
2. In addition, we've assumed that all costs are either perfectly variable
or perfectly fixed and behave on a linear basis within the company's In that case, this basic CVP equation can still be used, but the sales price and
relevant range. variable cost per unit must be adjusted to reflect the average price and cost of each
unit sold given the company's sales mix.
3. We've also assumed that any mixed costs can be broken down Sales mix refers to the proportion of total sales associated with each of the
accurately into their fixed and variable cost components. company's various products.
Product A Product B
Sales price per unit $5.00 $4.00
As a result of these various assumptions, the results produced through a Variable cost per unit $3.00 $2.50
company's CVP analysis won't be entirely accurate. However, in most cases Sales mix 40% 60%
the results are probably close enough to reality to provide useful information
Total
to management Weighted average:
Sales price per unit $2.00 $2.40 $4.40
Variable cost per unit $1.20 $1.50 $2.70

41 42

16-7
 Problem 16-10
Breakeven units and sales revenues:
Changing Sales Mix
SR - VC - FC = NI
($4.40 X) - ($2.70 X) - $170,000 = 0 Johnson Industries sells a premium and standard brand of potato chips. The following
$1.70 X - $170,000 = 0 schedule reflects the company's budget for the upcoming month of operations:
$1.70 X = $170,000 Premium Standard
X = 100,000 units Sales price per unit $3.00 $2.00
Variable cost per unit $2.20 $1.60
Breakeven number of units and sales revenues: Sales mix 20% 80%
Product A: 100,000 units × 40% = 40,000 units Given total budgeted fixed costs for the month amounting to $96,000, determine
40,000 units × $5.00/unit = $200,000 the company's:

Product B: 100,000 units × 60% = 60,000 units A. Breakeven point in terms of units and sales dollars by product.
60,000 units × $4.00/unit = $240,000
B. Breakeven point in terms of units and sales dollars by product, assuming a
sales mix of 50% for the premium brand and 50% for the standard brand.
Total: 100,000 units × $4.40/unit = $440,000
C. Why is the breakeven point lower in terms of total sales dollars under the sales
When more than one product is involved, a company's sales mix must also mix in A versus B.
be assumed in any calculations projecting the volume of sales required for D. If the company decided to spend $50,000 on a new marketing campaign,
that company to reach breakeven or some targeted amount of net income. which of the two products should be emphasized?

43 44

Problem 16-10 - Answer Problem 16-10 - Answer

Changing Sales Mix B. Breakeven point in terms of units and sales dollars by product, assuming a sales mix of
A. Breakeven point in terms of units and sales dollars by product. 50% for the premium brand and 50% for the standard brand.
Premium Standard Premium Standard
Sales price per unit $3.00 $2.00 Sales price per unit $3.00 $2.00
Variable cost per unit $2.20 $1.60 Variable cost per unit $2.20 $1.60
Sales mix 20% 80% Sales mix 50% 50%
Weighted average: Total Weighted average: Total
Sales price per unit $0.60 $1.60 $2.20 Sales price per unit $1.50 $1.00 $2.50
Variable cost per unit $0.44 $1.28 $1.72 Variable cost per unit $1.10 $0.80 $1.90

Breakeven point in total units: Breakeven point in total units:

SR - VC - FC = NI SR - VC - FC = NI
($2.20 X) - ($1.72 X) - $96,000 = 0 ($2.50 X) - ($1.90 X) - $96,000 = 0
$0.48 X - $96,000 = 0 $0.60 X - $96,000 = 0
$0.48 X = $96,000 $0.60 X = $96,000
X = 200,000 units X = 160,000 units
Breakeven point in total sales dollars (revenues): Breakeven point in total sales dollars (revenues):
200,000 units × $2.20/unit = $440,000 160,000 units × $2.50/unit = $400,000

Breakeven point by product: Breakeven point by product:

Premium brand - 200,000 units × 20% = 40,000 units Premium brand - 160,000 units × 50% = 80,000 units
40,000 units × $3.00/unit = $120,000 80,000 units × $3.00/unit = $240,000

Standard brand - 200,000 units × 80% = 160,000 units Standard brand - 160,000 units × 50% = 80,000 units
160,000 units × $2.00/unit = $320,000 80,000 units × $2.00/unit = $160,000

45 46

Problem 16-10 - Answer

C. Why is the breakeven point lower in terms of total sales dollars under the sales mix
in A versus B.

Answer: The contribution margin per unit for the Premium brand is higher than it
is for the Standard brand. As a result, any increase in the sales mix towards the
Premium brand improves the company's weighted average contribution margin and
reduces the total number of units that must be sold to reach breakeven.

D. If the company decided to spend $50,000 on a new marketing campaign, which of

the two products should be emphasized?

Answer: It depends. If the marketing campaign promises an equal increase in

sales volume for either brand, then the company would be better off emphasizing
the premium brand given its higher contribution margin per unit ($.80/unit vs.
$.40/unit). On the other hand, if the marketing campaign promises to produce 2 or
more units of increased sales of the standard brand for every 1 unit of increased
sales of the premium brand, then emphasis on the standard brand will produce
equal or better results given it's equal or higher weighted average contribution
margin per unit of sales.

47

16-8
 Lesson 12
Problem 12-1
Managerial vs. Financial Accounting

Respond to the following questions:

1. What is the primary purpose behind managerial as

Lesson 12 opposed to financial accounting and note some of the
key distinguishing characteristics of each?
Introduction to Managerial
Accounting and Review 2. Why do you suppose some people suggest that the
of Product Costing development of a company's managerial accounting
information is the result of an evolutionary process
over time?

1 2

Problem 12-1 - Answer Problem 12-1 - Answer

Managerial vs. Financial Accounting
1. What is the primary purpose behind managerial as opposed to financial 2. Why do you suppose some people suggest that the development of a company's
accounting and note some of the key distinguishing characteristics of each? managerial accounting information is the result of an evolutionary process over
time?
Answer: The primary purpose behind financial accounting is to provide useful
information to external users (investors, creditors, analysts, government regulatory Answer: In a constantly changing and competitive marketplace, only those
agencies and others). This is done through a company's general-purpose financial companies that adapt and continually improve ultimately survive. A big part
statements, its balance sheet, income statement, statement of cash flows and of any company's continuous improvement is the ongoing development of
supplemental notes prepared in accordance with standardized rules of accounting or better and more-timely management information. As companies experiment
generally accepted accounting principles. These statements provide summarized with new systems, access new data and explore new methods of analysis,
information reflecting a company's financial position and results of operations for information tools that add competitive value are incorporated and those that
recently completed periods. don't are quickly discarded. Even in the arena of information, only the strong
The primary purpose behind managerial accounting is to provide a company's survive.
management personnel with the kind of information that's needed to successfully plan,
control, and evaluate a business' day-to-day operations. Now, it's true that managers
are interested in the summarized historical results reported in a company's periodic
financial statements, but good managers need detailed and immediate information to
successfully manage a company. That's what managerial accounting is all about and
it involves the development and use of forecasts and budgets as well historical data
arising from a company's current and past transactions. In managerial accounting
there are no governing rules or standards of presentation, the bottom-line is the
development of information that gives managers the ability to lead a company in
today's competitive and dynamic business environment.

3 4

Regardless of the kind of business a company engages in, whether it

involves manufacturing, merchandising or the providing of services,
all of a company's operating costs can be categorized as either
Product or Period Costs.
Much of managerial accounting Product costs: All costs incurred in the acquisition or manufacture of
goods offered for sale, or costs incurred in the providing of services to a
focuses on a company's costs. customer.
Merchandiser - Costs of goods acquired from suppliers for sale to
customers.
The goal is to plan for, control and Manufacturer - All the costs of direct materials, direct labor and
evaluate costs in a way that helps manufacturing overhead (indirect materials, indirect
labor and other costs) incurred in the manufacturing
maximize a company's profits. process of its products.
Service company - Costs of any salary, wages, supplies and other
costs incurred in providing services to customers.

For financial reporting purposes, all product costs are accounted for as
assets (inventory or unbilled service costs) until the product is sold or
services are billed to the customer, at which time the costs become an
expense (cost of goods sold or cost of services sold).

5 6

12-1
 Problem 12-2
Product vs. Period Costs
Hit-it-Long, Inc. (HIL) manufactures custom golf clubs for customers
interested in hitting a golf ball exceptionally long distances. During the
production process, HIL incurs the following types of costs. Identify each
Period costs: All of the non-product costs incurred in the cost as either a period or a product cost and for each product cost, indicate
operation of a business. This includes the costs whether its part of direct materials, direct labor, or manufacturing overhead.
of marketing and selling the company's In the case of manufacturing overhead, also distinguish the cost as an indirect
products or services, plus any costs incurred in material, indirect labor or other cost of manufacturing overhead.
the general administration of the business. A. Depreciation of equipment used to shape golf clubs.
(Selling and administrative costs) B. Advertising costs.

For financial reporting purposes, these period costs are C. Wages for janitors responsible for keeping the factory production floor
clean.
simply accounted for as an expense in the period incurred.
D. Freight-in costs on direct materials used in the manufacture of the golf
clubs.
E. Cost of oil and grease used to maintain the manufacturing equipment.
F. Cost of steel, graphite, titanium and other materials incorporated in the
final product.
G. Freight-out costs of shipping finished goods to customers.

7 8

Problem 12-2 Problem 12-2 - Answer

Product vs. Period Costs Product vs. Period Costs
Hit-it-Long, Inc. (HIL) manufactures custom golf clubs for customers
Product vs. Type of
interested in hitting a golf ball exceptionally long distances. During the Description Period Cost Product Cost
production process, HIL incurs the following types of costs. Identify each
cost as either a period or a product cost and for each product cost, indicate A. Depreciation of equipment used to shape Product Mfg. Overhead
whether its part of direct materials, direct labor, or manufacturing overhead. golf clubs. (other cost)
In the case of manufacturing overhead, also distinguish the cost as an indirect B. Advertising costs. Period
material, indirect labor or other cost of manufacturing overhead.
C. Wages for janitors responsible for keeping Product Mfg. Overhead
H. Wages for company accountants. the factory production floor clean. (indirect labor)
I. Commissions for sales personnel. D. Freight-in costs on direct materials used in Product Direct Materials
J. Wages for golf club assemblers. the manufacture of the golf clubs.
K. Salaries of factory supervisors. E. Cost of oil and grease used to maintain the Product Mfg. Overhead
L. Wages of production quality control personnel. manufacturing equipment. (indirect mtls.)
M. Factory utility costs. F. Cost of steel, graphite, titanium and other Product Direct Materials
materials incorporated in the final product.
N. Corporate office utility costs.
O. Factory property taxes. G. Freight-out costs of shipping finished Period
goods to customers.
P. Corporate office property taxes.
H. Wages for company accountants. Period
Q. CEO salary.

9 10

Problem 12-2 - Answer

Product vs. Period Costs
It's absolutely crucial for a company to
Product vs. Type of
Description Period Cost Product Cost understand and accurately accumulate
I. Commissions for sales personnel. Period and account for its product costs.
J. Wages for golf club assemblers. Product Direct Labor
K. Salaries of factory supervisors. Product Mfg. Overhead For financial accounting purposes a company's product costs
(indirect labor) affect the amount of inventory reported on the company's balance
L. Wages of production quality control Product Mfg. Overhead sheet and the cost of goods sold reflected in its income statement.
personnel. (indirect labor)
From a managerial standpoint, knowing a product's cost of
M. Factory utility costs. Product Mfg. Overhead
(other costs)
production is essential in setting sales prices, understanding
operating results and coming up with plans for improved
N. Corporate office utility costs. Period performance.
O. Factory property taxes. Product Mfg. Overhead
(other costs)
P. Corporate office property taxes. Period
Q. CEO salary Period

11 12

12-2
The two methods used by manufacturing companies to accumulate Job order costing - Typically used by companies producing a variety
and account for their product costs: of products from a common factory or manufacturing process.
Process costing - Typically used by companies that manufacture a
common product in a separate manufacturing facility or process.

Furniture
Wheaties Cheerios Factory
Factory Factory

Direct Materials cheerios

Direct Materials Tables Bookcases Chairs
+ Direct Labor + Direct Labor
+ Manufacturing Overhead + Manufacturing Overhead Allocate the factory's direct material, direct labor and manufacturing
Total Costs ($) Total Costs ($) overhead costs based on the relative costs incurred in the production of
Cost # of Boxes Produced Cost # of Boxes Produced each product.

13 14

Problem 12-4 Problem 12-4

Review of Job-Order Costing
Job Cost Record
Custom Boat Manufacturing ("CBM") uses a job order cost system to account
for its product costs. Job Order #: 303 Date Started: 1/4/X4
Product Description: Bullet sailboat Date Completed:
# of Units: 4
A. Prepare journal entries to record the following CBM transactions and
events during the month of January, 20X4:
Direct Materials:
Date Requisition Number Amount
a. CBM purchases on account $100,000 of direct materials (lumber,
sails, glue, nails, paint, etc.) and $10,000 of indirect materials
(factory supplies, sandpaper, paint brushes, etc.) Direct Labor: Time Cards
Date Number Hours Rate Amount
b. On January 4th, CBM receives a customer order for two "Bullet"
sailboats and initiates a manufacturing job (job order #303) to Manufacturing Overhead:
produce four boats to meet the current order and build inventory for Date Rate Labor Hours Amount
future sales. The following job cost record is set up for job #303:

Total Cost $
Cost Per Unit: = $

15 16

Problem 12-4 Problem 12-4

c. On January 5th, direct materials costing $12,000 are requisitioned g. Total manufacturing supervisor and production maintenance salaries
from raw materials (Requisition # 2255) and placed into production paid for the month amount to $30,000. (Ignore payroll tax
exclusively for job #303. (Also make an appropriate entry to the Job withholdings and employer payroll taxes.)
#303 Job Cost Record)
h. Total factory utility, rent, insurance, property taxes and other costs
d. Indirect materials amounting to $3,000 (sandpaper, paint brushes, amounting to $40,000 for the month are paid.
etc.) are requisitioned for used in the production of Job #303 and
other jobs. i. Depreciation of factory equipment for the month amounts to $8,000.

e. Nails and glue costing $1,500 are requisitioned and placed into j. Assume manufacturing overhead is applied to WIP jobs based on a
production for Job #303 and other jobs. predetermined rate of $32 per direct labor hour. (Also make an
appropriate entry to the Job #303 Job Cost Sheet)
f. Total wages paid to direct manufacturing employees for the month
amount to $50,000 (2,500 total hours at an average rate of $20/hr.) of k. Job #303 's production is completed.
which time card #'s 222 and 224 show a total of 320 hours at a rate of
$20/hour for Job #303. (Ignore payroll tax withholdings and l. Two of the four Bullet boats completed in Job #303 are shipped to
employer payroll taxes. Also make an appropriate entry to the Job the customer. The customer has agreed to pay a price of $15,000
#303 Job Cost Record) each for the boats within 30 days of delivery.

17 18

12-3
 Problem 12-4 Problem 12-4 - Answer
Review of Job-Order Costing
B. Determine the gross margin made on this sale. Is this the amount of A.
net income made by CBM on these two boats? a. CBM purchases on account $100,000 of direct materials (lumber,
sails, glue, nails, paint, etc.) and $10,000 of indirect materials
C. Prepare journal entries for the following: (factory supplies, sandpaper, paint brushes, etc.)
Raw Materials Inventory 110,000
a. Sales, accounting and all administrative salaries and wages for the
Accounts Payable 110,000
month totaling $40,000 are paid.
b. On January 4th, CBM receives a customer order for two "Bullet"
b. Total selling and administrative building rent, utilities, supplies, sailboats and initiates a manufacturing job (job order #303) to
insurance, property taxes, and other costs amounting to $25,000 are produce four boats to meet the current order and build inventory for
paid during the month. future sales.
No journal entry is made.
c. The manufacturing overhead account is closed-out at the end of the
month. c. On January 5th, direct materials costing $12,000 are requisitioned
from raw materials (Requisition # 2255) and placed into production
D. What journal entry would be required at the end of the month if exclusively for job #303. (Also make an appropriate entry to the Job
manufacturing overhead had been over-applied by $2,500. #303 Job Cost Record)
WIP Inventory 12,000
Raw Materials Inventory 12,000

19 20

Problem 12-4 - Answer Problem 12-4 - Answer

d. Indirect materials amounting to $3,000 (sandpaper, paint brushes,

Job Cost Record
etc.) are requisitioned for used in the production of Job #303 and
Job Order #: 303 Date Started: 1/4/X4 other jobs.
Product Description: Bullet sailboat Date Completed:
# of Units: 4 Manufacturing Overhead 3,000
Raw Materials Inventory 3,000

Direct Materials: e. Nails and glue costing $1,500 are requisitioned and placed into
Date Requisition Number Amount production for Job #303 and other jobs.
1/5/X4 2255 $12,000
Manufacturing Overhead 1,500
Direct Labor: Time Cards Raw Materials Inventory 1,500
Date Number Hours Rate Amount
f. Total wages paid to direct manufacturing employees for the month
Manufacturing Overhead:
amount to $50,000 (2,500 total hours at an average rate of $20/hr.) of
Date Rate Labor Hours Amount
which time card #'s 222 and 224 show a total of 320 hours at a rate of
$20/hour for Job #303. (Ignore payroll tax withholdings and
employer payroll taxes. Also make an appropriate entry to the Job
Total Cost $ #303 Job Cost Record)
Cost Per Unit: = $ WIP Inventory 50,000
Cash 50,000

21 22

Problem 12-4 - Answer Problem 12-4 - Answer

g. Total manufacturing supervisor and production maintenance salaries

Job Cost Record
paid for the month amount to $30,000. (Ignore payroll tax
Job Order #: 303 Date Started: 1/4/X4 withholdings and employer payroll taxes.)
Product Description: Bullet sailboat Date Completed: Manufacturing Overhead 30,000
# of Units: 4 Cash 30,000

Direct Materials: h. Total factory utility, rent, insurance, property taxes and other costs
Date Requisition Number Amount amounting to $40,000 for the month are paid.
1/5/X4 2255 $12,000 Manufacturing Overhead 40,000
Direct Labor: Cash 40,000
Time Cards
Date Number Hours Rate Amount i. Depreciation of factory equipment for the month amounts to $8,000.
1/31/X4 222, 224 320 $20 $6,400
Manufacturing Overhead 8,000
Manufacturing Overhead: Accumulated Depreciation 8,000
Date Rate Labor Hours Amount
j. Assume manufacturing overhead is applied to WIP jobs based on a
predetermined rate of $32 per direct labor hour. (Also make an
Total Cost $ appropriate entry to the Job #303 Job Cost Sheet)
Cost Per Unit: = $ WIP Inventory ($32 x 2,500 hours) 80,000
Manufacturing Overhead 80,000

23 24

12-4
 Problem 12-4 - Answer Problem 12-4 - Answer

k. Job #303 's production is completed.

Job Cost Record Finished Goods Inventory 28,640
Job Order #: 303 Date Started: 1/4/X4 WIP Inventory 28,640
Product Description: Bullet sailboat Date Completed: l. Two of the four Bullet boats completed in Job #303 are shipped to
# of Units: 4
the customer. The customer has agreed to pay a price of $15,000
each for the boats within 30 days of delivery.
Direct Materials:
Date Requisition Number Amount Accounts Receivable 30,000
1/5/X4 2255 $12,000 Sales Revenues 30,000
Cost of Goods Sold ($7,160 x 2) 14,320
Direct Labor: Time Cards Finished Goods Inventory 14,320
Date Number Hours Rate Amount
1/31/X4 222, 224 320 $20 $6,400 B. Determine the gross margin made on this sale.
Manufacturing Overhead: Sales revenues $ 30,000
Date Rate Labor Hours Amount Less: Cost of goods sold 14,320
1/31/X4 $32 320 $10,240 Gross margin $ 15,680
Total Cost $ 28,640 Is this the amount of net income made by CBM on these two boats?
Cost Per Unit: 28,640 4 = $ 7,160 No.
(It doesn't take into consideration selling and administrative costs.)

25 26

Problem 12-4 - Answer Problem 12-4 - Answer

C. Prepare journal entries for the following:
D. What journal entry would be required at the end of the month if
a. Sales, accounting and all administrative salaries and wages for the month
totaling $40,000 are paid. manufacturing overhead had been over-applied by $2,500.
Selling and Administrative Expense 40,000 Manufacturing Overhead 2,500
Cash 40,000 Cost of Goods Sold 2,500
b. Total selling and administrative building rent, utilities, supplies, insurance,
property taxes, and other costs amounting to $25,000 are paid during the Manufacturing Overhead
month.
Selling and Administrative Expense 25,000 3,000
Cash 25,000 1,500
c. The manufacturing overhead account is closed-out at the end of the month. 30,000
40,000
Cost of Goods Sold 2,500
Manufacturing Overhead 2,500 8,000 85,000
2,500 Over-applied
Manufacturing Overhead
Adjustment 2,500
3,000
1,500 0
30,000
40,000
8,000 80,000
Under-applied 2,500
2,500 adjustment
0

27 28

In a job order cost system, the allocation of direct material and direct labor A correlating relationship between a company's direct labor hours and
costs on a job-by-job basis is simplified through the use of material manufacturing overhead costs is fairly common. For some companies with
requisition forms and employee time cards that provide breakdowns by job more automated manufacturing facilities, manufacturing overhead costs may
of the materials used and time worked on each job. Where things become correlate more directly with machine hours (the number of hours the company's
difficult is in the allocation of manufacturing overhead costs. Generally manufacturing equipment is in operation) than with direct labor hours. In
speaking, as these costs are incurred, no job-by-job breakdown is provided. other cases, the amount of direct materials used may be the primary driving
force behind a company's overhead costs.
Example: A company's factory utility bill doesn't designate utility usage In those cases, the predetermined overhead rate should be based on machine
by job; the amount payable is typically stated in a single monthly amount. hours or direct material costs as long as those hours or costs can be determined
on a per job basis.
As a result, the allocation of such costs must be made on an estimated basis, Total budgeted manufacturing overhead
usually through the use of a predetermined overhead rate. Predetermined costs for the upcoming period
Overhead Rate = Total budget for the measurable activity or cost that
Example: In the previous problem for Custom Boat Manufacturing correlates with or drives overhead costs over the same period
("CBM"), overhead was applied to work-in-process jobs at a rate of $32 per
direct labor hour. This means that based on the company's past experience, Example: If a company's total budget for manufacturing overhead costs for
there's an apparent correlation between the number of direct labor hours the next year amounts to $500,000 and total budgeted machine hours, the
worked and the amount of manufacturing overhead costs incurred. The company's measurable cost driver of overhead for the same period, is 25,000
more direct laborers work, the higher the company's overhead costs. In hours, then: Predetermined $500,000
fact, for CBM, that correlation apparently runs at a rate of about $32 per Overhead Rate = 25,000 hrs. = $20 per machine hour
direct labor hour and by keeping track of the number of direct labor hours
worked on each job, a reasonable allocation of total overhead costs can be If a specific job is processed using 100 machine hours:
made to specific jobs.
100 hrs. x $20 = $2,000 allocated to that job

29 30

12-5
 Problem 12-5 Problem 12-5
Predetermined Manufacturing Overhead Rates Predetermined Manufacturing Overhead Rates
Jones Manufacturing, Inc. provides the following data from its last three Jones Manufacturing, Inc. provides the following data from its last three
years of operations: years of operations:
20X3 20X4 20X5 20X3 20X4 20X5
Manufacturing overhead costs $305,000 $450,000 $640,000 Manufacturing overhead costs $305,000 $450,000 $640,000
Machine hours 15,000 12,000 10,000 Machine hours 15,000 12,000 10,000
Direct material costs $600,000 $800,000 $750,000 Direct material costs $600,000 $800,000 $750,000
Direct labor hours 17,000 25,000 35,000 Direct labor hours 17,000 25,000 35,000

A. Based on the above information, identify the measurable activity that C. How much manufacturing overhead cost should be applied to Job #111
best correlates with or seems to drive manufacturing overhead costs in 20X6 using the data provided in part B above, if 50 total direct labor
and, as a result, would best serve as the basis for the company's hours are incurred on the job?
predetermined manufacturing overhead rate in 20X6.
D. Prepare the 20X6 year-end adjusting entry to close out the company's
B. Compute the predetermined overhead rate to be used in applying manufacturing overhead account if actual manufacturing overhead
manufacturing overhead to jobs in progress for the upcoming year costs for the year amounted to $784,000 and actual direct labor totaled
20X6 if budgeted manufacturing overhead costs and direct-labor hours 43,200 hours.
are projected at $765,000 and 42,000 hours, respectively. Questions: What was the actual manufacturing overhead rate for the year
20X6? Why use a predetermined overhead rate to allocate overhead costs
when the actual rate can be determined at the end of the period?

31 32

Problem 12-5 - Answer Problem 12-5 - Answer

Predetermined Manufacturing Overhead Rates
D. Manufacturing Overhead
A. Direct labor hours reflect the most consistent correlating relationship
Actual costs 784,000
with total manufacturing overhead costs.
786,672 Applied costs
20X3 20X4 20X5 (43,200 hrs. x $18.21)
Manufacturing overhead costs $305,000 $450,000 $640,000 2,672
Machine hours 15,000 12,000 10,000 Adjusting entry 2,672
Direct material costs $600,000 $800,000 $750,000 0
Direct labor hours 17,000 25,000 35,000
Adjusting entry:
Overhead cost/ machine hour $20.33 $37.50 $64.00 Manufacturing Overhead 2,672
Overhead cost/ $ of direct matls. $ .51 $ .56 $ .85 Cost of Goods Sold 2,672
Overhead cost/ direct labor hour $17.94 $18.00 $18.29
Questions: What was the actual manufacturing overhead rate for the year 20X6?
B. 20X6: Actual $784,000
Overhead Rate = = $18.15 per direct labor hour
Predetermined $765,000 43,200 hrs.
Overhead Rate = = $18.21 per direct labor hour
42,000 hrs.
Why use a predetermined overhead rate to allocate overhead costs when the
C. Manufacturing overhead allocated to Job #111: actual rate can be determined at the end of the period?
Answer: Management simply can't afford to wait around until the end of the
50 hours x $18.21 = $910.50 year to determine and account for its product costs. Management information is
always better sooner rather than later as long as it's reasonably accurate.

33 34

Custom Boat Manufacturing, Inc. Custom Boat Manufacturing

January, 20X4 Cost of Goods Manufactured Schedule
For the month of January, 20X4
Raw Materials Inventory WIP Inventroy Direct Materials:
Beginning raw materials inventory, 1/1/X4 $ 30,000
Beg. Balance 30,000 Beg. Balance 40,000
Add: Raw materials purchased 110,000
Purchases 110,000 105,000 To Production Dir. Materials 100,500 220,500 Completed Total raw materials available 140,000
End Balance 35,000 Dir. Labor 110,000 Less: Ending raw materials inventory, 1/31/X4 (35,000)
Total raw materials put into production 105,000
Ind. Mtls. 4,500 Applied OH 80,000
Less: Indirect materials put into production (4,500)
End Balance 50,000 Direct materials input to WIP $ 100,500
Manufacturing Overhead Direct Labor 50,000
Finished Goods Inventory Manufacturing Overhead:
Ind. Materials 4,500 Indirect materials $ 4,500
Ind. Labor 30,000 Beg. Balance 35,000 Indirect labor 30,000
Completed 220,500 225,500 Goods Sold Utilities 10,000
Utilities 10,000 80,000 Applied to WIP
Rent 20,000
Rent 20,000 End Balance 30,000 Depreciation 8,000
Depreciation 8,000 Other manufacturing overhead costs 10,000
Cost of Goods Sold Actual manufacturing overhead costs 82,500
Other 10,000
Less: Under-applied overhead (2,500)
Under Applied 2,500 Goods Sold 225,500 Manufacturing overhead applied to WIP 80,000
2,500 Closed Under Applied 2,500 Total manufacturing costs added to WIP 230,500
Beginning WIP inventory, 1/1/X4 40,000
0 228,000
Total costs of goods in process 270,500
Less: Ending WIP inventory, 1/31/X4 (50,000)
Total cost of goods manufactured $220,500

35 36

12-6
 Problem 12-6
Custom Boat Manufacturing Schedules for Cost of Goods Manufactured and Cost of Goods
Cost of Goods Sold Schedule For Johnson Industries, use the information provided below to prepare schedules reflecting
For the month of January, 20X4 the company's September, 20X1 cost of goods manufactured and cost of goods sold.
Johnson applies manufacturing overhead to work-in-process jobs on the basis of direct labor
Cost of goods manufactured $220,500 hours. The 20X1 budgets for manufacturing overhead costs and direct labor hours were:
Add: Beginning finished goods inventory, 1/1/X4 35,000
Goods available for sale 255,500 Manufacturing overhead …………$2,400,000
Direct labor hours………………… 400,000
Less: Ending finished goods inventory (30,000)
Unadjusted cost of goods sold 225,500 September, 20X1 events and transactions:
Add: Under-applied overhead 2,500 Raw materials purchased $630,000
Cost of goods sold $228,000 Direct labor costs incurred (40,000 hrs. x $15/hr.) $600,000
Indirect labor costs incurred $ 75,000
Indirect materials put into production $ 70,000
Selling, general and administrative expenses $200,000
Manufacturing overhead costs incurred:
Plant depreciation (factory) $ 40,000
Equipment depreciation (factory) $ 16,000
Utilities (factory) $ 12,000
Factory maintenance $ 6,000
Factory taxes and insurance $ 7,000
Miscellaneous manufacturing overhead $ 9,000
Inventory balances: 9/1/X1 9/30/X1
Raw materials $44,000 $34,000
Work-in-process $75,000 $87,000
Finished goods $65,000 $85,000

37 38

Problem 12-6 - Answer Problem 12-6 - Answer

Schedules for Cost of Goods Manufactured and Cost of Goods Johnson Industries
Johnson Industries Cost of Goods Sold Schedule
Cost of Goods Manufactured Schedule For the month of September, 20X1
For the month of September, 20X1
Direct Materials:
Cost of goods manufactured $1,398,000
Beginning raw materials inventory, 9/1/X1 $ 44,000
Add: Raw materials purchased 630,000 Add: Beginning finished goods inventory, 9/1/X1 65,000
Total raw materials available 674,000 Goods available for sale 1,463,000
Less: Ending raw materials inventory, 9/30/X1 (34,000) Less: Ending finished goods inventory, 9/30/X1 (85,000)
Total raw materials put into production 640,000
Less: Indirect materials put into production (70,000) Unadjusted cost of goods sold 1,378,000
Direct materials input to WIP $ 570,000 Less: Over-applied overhead (5,000)
Direct Labor 600,000 Cost of goods sold $1,373,000
Manufacturing Overhead:
Indirect materials $ 70,000
Indirect labor 75,000
Plant depreciation (factory) 40,000
Equipment depreciation (factory) 16,000
Utilities (factory) 12,000
Factory maintenance 6,000
Factory taxes and insurance 7,000
Miscellaneous manufacturing overhead 9,000
Add over-applied overhead* 5,000 * Actual overhead costs $235,000
Manufacturing overhead applied to WIP 240,000 Applied overhead costs
Total manufacturing costs added to WIP 1,410,000 ($6/hr. x 40,000 hrs.) 240,000
Over-applied $ 5,000
Beginning WIP inventory, 1/1/X4 75,000
Total costs of goods in process 1,485,000
Less: Ending WIP inventory, 1/31/X4 (87,000)
Total cost of goods manufactured $1,398,000

39 40

12-7
 Lesson 13
Process Costing in a Manufacturing Business
Job order costing is a system of accounting used by manufacturing
companies producing a variety of different products from a common
manufacturing facility or process.
Process costing is a system of accounting used by companies that operate
factories or manufacturing processes that produce the same product over and
over on a continuous basis.
Lesson 13 The two key characteristics that call for the use of process costing as
opposed to job order costing are:
Product Costing 1. The company's manufacturing procedures are essentially the same
for every unit produced, and
Continued… 2. The final completed units are all basically the same.
Companies that use process costing are typically businesses that mass-
produce their products through some kind of a production line or standardized
manufacturing process. Businesses that make their products using an
assembly line, including automobile manufacturers, or makers of appliances
like washing machines or television sets, will typically use process costing, at
least to some extent, to determine the cost of each unit produced. Oil
refineries, mining companies, food processors, pharmaceutical companies and
other businesses involved in the mass production of standardized products
will all typically use process costing.

1 2

Direct labor costs incurred: Completion of production:*

WIP Inventory XXX Finished Goods Inventory XXX
Cash or Wages Payable XXX WIP Inventory XXX

Indirect labor costs incurred: Sale of finished units:

Manufacturing Overhead XXX Cost of Goods Sold XXX
Cash or Salaries/Wages Payable XXX Finished Goods Inventory XXX

Other indirect costs, including factory rent, utilities, depreciation, and * In a job order cost system this entry is made as each separate job is completed
other overhead costs incurred: with the amount transferred to finished goods taken from the job cost record
maintained for each completed job.
Manufacturing Overhead XXX
Cash XXX
In a process cost system, because production is continuous, this entry is made
Utilities or Other Payables XXX
once at the end of each accounting period, and assuming all units in production
Accumulated Depreciation XXX are completed at the end of the period, the full amount included in the WIP
account is credited out and transferred to finished goods.
Manufacturing overhead costs applied (predetermined overhead rate):
WIP Inventory XXX Cost Per Unit Total cost transferred to finished goods
Manufacturing Overhead XXX of Production
=
Total number of units completed during the period

3 4

Allocation of direct material costs:

If there are unfinished units in ending WIP, this process costing
approach becomes a lot more complicated. In that case, a portion of First determine-
the production costs added to WIP must be left in the WIP inventory $119,520
Cost per finished
account at the end of the period to reflect the costs incurred to date = = $1.20 cost per unit
equivalent 99,600 units
on unfinished units. In other words, when there's ending WIP
inventory, a company's total production costs must be allocated (98,000 + 1,600)
between the finished and unfinished units to determine the cost of Then allocate-
units transferred to finished goods and the costs of units in ending
WIP. To the 98,000 units transferred to finished goods-

98,000 units x $1.20 per unit = $117,600

How should a company's product costs, including its
direct materials, direct labor and applied manufacturing To the 2,000 units in ending WIP-
overhead costs, be allocated between its finished and
1,600 units x $1.20 per unit = $1,920
unfinished units at the end of the period?

5 6

13-1
 Direct Labor and Applied Manufacturing Overhead Costs Finished Goods Inventory WIP Inventory
("Conversion Costs"): Cost/ # FE Cost/
Assume Kreamy Peanut Butter's total conversion costs for the month of Costs # Units Unit Costs Units Unit
June amounted to $49,400 and the 2,000 units in ending WIP are only Direct material costs $117,600 98,000 $1.20 $1,920 1,600 $1.20
40% complete in terms of those conversion costs. That means the Conversion costs $ 49,000 98,000 $ .50 $ 400 800 $ .50
allocation of a portion of the $49,400 to those 2,000 units will be based on Total $166,600 $1.70 $2,320 $1.70
2,000 units x 40% = 800 finished equivalent units
Allocate the $49,400 of conversion costs between finished goods and WIP: Journal entry to record the completed production for the month:
First determine- Finished Goods Inventory 166,600
Cost per finished $49,400 WIP Inventory 166,600
= = $ .50 cost per unit
equivalent 98,800 units
(98,000 + 800)
Then allocate- Journal entry to record any subsequent sale of the finished units:
To the 98,000 units transferred to finished goods- Cost of Goods Sold (# units sold x $1.70) XXX
Finished Goods Inventory XXX
98,000 units x $ .50 per unit = $49,000
To the 2,000 units in ending WIP-
800 units x $ .50 per unit = $400

7 8

A final complicating factor: Production Cost Report

(June, 20X5)
In this case, we'll assume that in addition to the 98,000 units of production started and
Finished Equivalent Units of Production for the Month
completed in the month of June, and 2,000 partially completed units in process at the
end of the month, an additional 3,000 unfinished units were carried over from the prior Direct Material Costs Conversion Costs
month's production and finished in the current period. In other words, we'll assume the % Completed Finished % Completed Finished
company had 3,000 units in beginning WIP that were then completed in the current # of in Current Equivalent in Current Equivalent
period and transferred to finished goods. Units Period Units Period Units
Beginning WIP 3,000 20% 600 30% 900
We'll also assume that at the beginning of the period, those 3,000 units were 80%
Started and completed 98,000 100% 98,000 100% 98,000
complete as to direct materials at a cost of $2,832, and 70% complete as to conversion, Ending WIP 2,000 80% 1,600 40% 800
at a cost of $987. In addition, we'll assume the total costs of production for the month 100,200 99,700
increased from $119,520 to $120,240 for direct materials and from $49,400 to $49,850
for conversion costs given the additional costs required to complete the 3,000 units of Cost Per Unit of Production
beginning inventory. Total Equivalent Cost per
Costs Units Unit
Direct Materials Conversion Current Period:
# of % % Direct material costs $120,240 100,200 = $1.20
Units Completed Costs Completed Costs Conversion costs $ 49,850 99,700 = $ .50
$170,090 $1.70
Beginning WIP inventory 3,000 80% $2,832 70% $987
Units started and completed 98,000 Beginning WIP (3,000 units)
Costs added during the month $120,240 $49,850 Direct material costs $ 2,832 2,400 (80%) = $1.18
Ending WIP inventory 2,000 80% 40% Conversion costs $ 987 2,100 (70%) = $ .47
$ 3,819 $1.65
Begin by calculating Kreamy Peanut Butter's current cost per unit of production. $173,909

9 10

Production Cost Report WIP Inventory - Mixing Department

(continued) Beginning inventory XXX
Cost added during the month:
Allocation of Costs to Finished Goods Direct material costs XXX
Cost per Equivalent Allocated Conversion costs XXX
Beginning WIP (3,000 units): Unit Units Cost XXX Completed production
Costs from prior period Ending inventory XXX
Direct material costs $ 2,832
Conversion costs 987 WIP Inventory - Baking Department
Beginning inventory XXX
Costs from current period:
Production from mixing dept. XXX
Direct material costs $1.20 x 600 (20%) = 720 Cost added during the month:
Conversion costs $ .50 x 900 (30%) = 450 Direct material costs XXX
Started and completed (98,000 units) $1.70 x 98,000 = 166,600 Conversion costs XXX
Total allocation $ 171,589 XXX Completed production
Allocation of Costs to Ending WIP Ending inventory XXX

Cost per Equivalent Allocated WIP Inventory - Packaging Department

Unit Units Cost Beginning inventory XXX
Ending WIP (2,000 units): Production from baking dept. XXX
Direct material costs $1.20 x 1,600 (80%) = $ 1,920 Cost added during the month:
Conversion costs $ .50 x 800 (40%) = 400 Direct material costs XXX
Total allocation $ 2,320 Conversion costs XXX
XXX Completed production
Grand total $ 173,909 Ending inventory XXX

Journal entry to record the completed production for the month: Finished Goods Inventory
Beginning inventory XXX
Finished Goods Inventory 171,589 Production from packaging dept. XXX
WIP Inventory 171,589 XXX Cost of goods sold
Ending inventory XXX

11 12

13-2
 Manufacturing Overhead Summary
Actual costs:
The primary purpose behind both job order and process costing is the
Utilities XXX
determination of a company's cost per unit of production.
Rent XXX
Indirect Labor XXX That's crucial information from both a managerial as well as a financial
Indirect materials XXX XXX Applications to WIP accounting perspective. Without an accurate knowledge of a company's
Depreciation XXX cost per unit of production successful management of a company's
Etc. XXX operations is virtually impossible. From a financial reporting standpoint,
Balance before adjustment XXX a company's costs of goods transferred to finished goods and resulting
(under-applied)
balances in ending WIP, finished goods and cost of goods sold are
ultimately based on a company's costs per unit of production.
Adjusting entry:
In a job order cost system used by companies that manufacture a variety
Cost of Goods Sold XXX
of products from a common factory or process, this per unit cost is
Manufacturing Overhead XXX
determined through job cost records maintained for each separate batch
of units produced. In a process cost system used by companies that
continuously produce the same product, the cost per unit of production is
determined through production cost reports prepared for each of
product's manufacturing processes.

13 14

Problem 13-1
The basic steps reflected in those production cost reports include:
Production Cost Report
1. The determination of the number of units produced during the period. (If After reviewing the production cost Excel Industries
there are partially completed units in beginning and ending WIP inventory report provided below, respond to the Production Cost Report
requirements that follow: (April, 20X9)
then the number of units produced for the period must be stated in terms of
finished equivalent units of production as to both direct materials and Finished Equivalent Units of Production for the Period
conversion costs. Direct Material Costs Conversion Costs
% Completed Finished % Completed Finished
2. The company's actual direct material and conversion costs added to # of in Current Equivalent in Current Equivalent
Units Period Units Period Units
production during the period are then divided by those finished equivalent
Beginning WIP 500 30% 150 40% 200
units to determine the company's cost per unit of production. Started and completed 8,000 100% 8,000 100% 8,000
Ending WIP 600 80% 480 50% 300
3. For managerial purposes, that cost per unit of production is then usually 8,630 8,500
compared to the prior period cost per unit for purposes of evaluation. Cost Per Unit of Production
Total Equivalent Cost per
4. For financial reporting purposes, the cost of units completed and Current Period: Costs Units Unit
transferred to finished goods during the period is determined by adding Direct material costs $ 72,492 8,630 = $ 8.40
Conversion costs $ 44,200 8,500 = $ 5.20
any costs of beginning WIP, the costs incurred in completing those units $116,692 $13.60
and costs incurred on new units started and completed during the current Beginning WIP (500 units)
period at the current period's cost per unit of production. The cost of Direct material costs $ 2,940 350 (70%) = $ 8.40
ending WIP inventory can also be determined by using that same cost per Conversion costs $ 1,530 300 (60%) = $ 5.10
unit times the finished equivalent units in WIP at the end of the period. $ 4,470 $13.50
$121,162

15 16

Problem 13-1 Problem 13-1

Requirements:
Production Cost Report
A. Identify the following for Excel Industries for the month of April, 20X9:
(continued)
1. Percentages of completion in beginning WIP inventory in terms of direct materials,
Allocation of Costs to Finished Goods direct labor and manufacturing overhead costs.
Cost per Equivalent Allocated 2. Percentages of completion in ending WIP inventory in terms of direct materials, direct
Beginning WIP (500 units): Unit Units Cost labor and manufacturing overhead costs.
Costs from prior period 3. Finished equivalents units of production in the current period to complete the
Direct material costs $ 2,940 beginning WIP inventory in terms of both direct materials and conversion costs.
Conversion costs 1,530 4. Total finished equivalent units of production for the month in terms of both direct
Costs from current period: materials and conversion costs.
Direct material costs $8.40 x 150 (30%) = 1,260 5. Direct material cost per unit of production during the month.
Conversion costs $5.20 x 200 (40%) = 1,040 6. Conversion cost per unit of production during the month.
Started and completed (8,000 units) $13.60 x 8,000 = 108,800 7. Total cost of beginning WIP inventory.
Total allocation $ 115,570 8. Total costs added to WIP during the month.
9. Total cost of units completed during the month.
Allocation of Costs to Ending WIP 10. Total cost of ending WIP inventory.
Cost per Equivalent Allocated
Unit Units Cost
B. What is the combined cost of beginning WIP inventory and costs added to WIP during
Ending WIP (600 units): the period and does that amount equal the combined cost of units completed during
Direct material costs $8.40 x 480 (80%) = $ 4,032 the period and ending WIP inventory? Will those amounts always be same and why?
Conversion costs $5.20 x 300 (50%) = 1,560
Total allocation $ 5,592 C. What journal entry would be made to record the company's completed production for
the month?
Grand total $ 121,162
D. How did the company's April production costs per unit compare to the same costs in
March?

17 18

13-3
 Problem 13-1 - Answer Problem 13-1 - Answer
Production Cost Report
A. Identify the following for Excel Industries for the month of April, 20X9: 5. Direct material cost per unit of production during the month. $8.40

1. Percentages of completion in beginning WIP inventory in terms of direct materials, 6. Conversion cost per unit of production during the month. $5.20
direct labor and manufacturing overhead costs.
7. Total cost of beginning WIP inventory. $4,470
Direct material cost: 70%
Conversion costs (including direct labor and manufacturing overhead): 60% 8. Total costs added to WIP during the month. $116,692

2. Percentages of completion in ending WIP inventory in terms of direct materials, direct

9. Total cost of units completed during the month. $115,570
labor and manufacturing overhead costs. 10. Total cost of ending WIP inventory. $5,592
Direct material cost: 80%
B. What is the combined cost of beginning WIP inventory and costs added to WIP during
Conversion costs (including direct labor and manufacturing overhead): 50%
the period and does that amount equal the combined cost of units completed during
3. Finished equivalents units of production in the current period to complete the the period and ending WIP inventory?
beginning WIP inventory in terms of both direct materials and conversion costs. $121,162
Direct material cost: 150 units Will those amounts always be same and why?
Conversion costs : 200 units
Answer: Yes, assuming the production cost report is accurately prepared.
4. Total finished equivalent units of production for the month in terms of both direct The total cost of beginning WIP inventory plus costs added during the
materials and conversion costs. period must be equal to the costs transferred out of WIP (cost of completed
Direct material cost: 8,630 units production) and costs left in ending inventory.
Conversion costs : 8,500 units

19 20

Problem 13-1 - Answer Problem 13-2

Process Costing
C. What journal entry would be made to record the company's completed production for
the month? Adams, Inc. utilizes two process centers (processing and packaging) to
manufacture boxes of laundry detergent. Assuming all direct materials used in
Finished Goods Inventory 115,570 the processing department are added at the beginning of the production process,
WIP Inventory 115,570 and given the following information for the center's September, 20X8 activities:
D. How did the company's April production costs per unit compare to the same costs in Conversion
March? Direct
# of Material %
Answer: The same for direct material costs and higher for conversion costs. Units Costs Completed Costs
Beginning WIP inventory 6,000 $18,600 60% $5,400
Costs Per Unit of Production Units started and completed 280,000
March April Costs added during the month $894,900 $434,568
Direct material costs $8.40 $8.40 Ending WIP inventory 5,000 70%
Conversion costs 5.10 5.20
Total $13.50 $13.60 A. Prepare the company's journal entry to record the processing center's completed
production for the month of September.

B. Compare the processing center's September costs per unit of production with the
costs from the prior month and explain what could give rise to the increase or
decrease.

21 22

Problem 13-2 - Answer Problem 13-2 - Answer

Process Costing Production Cost Report - Processing Center
A. Prepare the company's journal entry to record the processing center's completed (September, 20X8)
production for the month of September.
Finished Equivalent Units of Production for the Period
WIP Inventory - Packaging Center 1,332,448 Direct Material Costs Conversion Costs
WIP Inventory - Processing Center 1,332,448 % Completed Finished % Completed Finished
# of in Current Equivalent in Current Equivalent
Units Period Units Period Units
B. Compare the processing center's September costs per unit of production with the
Beginning WIP 6,000 0% 0 40% 2,400
costs from the prior month and explain what could give rise to the increase or Started and completed 280,000 100% 280,000 100% 280,000
decrease. Ending WIP 5,000 100% 5,000 70% 3,500
Costs Per Unit of Production 285,000 285,900
August September
Cost Per Unit of Production
Direct material costs $3.10 $3.14 Total Equivalent Cost per
Conversion costs 1.50 1.52 Current Period: Costs Units Unit
Total $4.60 $4.66 Direct material costs $ 894,900 285,000 = $3.14
Conversion costs $ 434,568 285,900 = $1.52
Answer: The increasing cost of direct materials could be the result of $1,329,468 $4.66
increasing material prices or less efficient use of the materials in the Beginning WIP (500 units)
production process as a result of increased waste or other factors. Direct material costs $ 18,600 6,000 (100%) = $3.10
Conversion costs 5,400 3,600 (60%) = $1.50
The increasing conversion costs could be the result of increasing wage rates, $ 24,000 $4.60
increasing overhead costs or less efficiency in the production process. $1,353,468

23 24

13-4
 Problem 13-2 - Answer

Production Cost Report - Processing Center

(continued)

Allocation of Costs to Completed Units Transferred to Packaging Center

Cost per Equivalent Allocated
Beginning WIP (6,000 units): Unit Units Cost
Costs from prior period All of the process costing examples and problems we've used in this
Direct material costs $ 18,600 lesson up to this point in time have assumed a first-in first-out, or FIFO,
Conversion costs 5,400 inventory cost flow. That means we've assumed all units in beginning
Costs from current period: WIP were completed first in the current period before any new units were
Direct material costs $3.14 x 0 =
Conversion costs $1.52 x 2,400 (40%) = 3,648
started in the production process. As a result, all costs in beginning WIP
Started and completed (280,000 units) $4.66 x 280,000 = 1,304,800 inventory were allocated to units completed during the period. No
Total allocation $1,332,448 beginning WIP costs were carried over to ending WIP inventory.

Allocation of Costs to Ending WIP - Processing Center

Cost per Equivalent Allocated
Unit Units Cost
Ending WIP (5,000 units):
Direct material costs $3.14 x 5,000 (100%) = $ 15,700
Conversion costs $1.52 x 3,500 (70%) = 5,320
Total allocation $ 21,020
Grand total $1,353,468

25 26

Production Cost Report - Processing Center

Allocation of Costs to Completed Units Transferred to Packaging Center

Cost per Equivalent Allocated
Beginning WIP (6,000 units): Unit Units Cost
Costs from prior period
Direct material costs $ 18,600
An alternative to this FIFO process costing assumption is a weighted
Conversion costs 5,400 average approach which assumes that all beginning WIP units and costs
Costs to complete in current period: are simply mixed in with the new units started in the current period, such
Direct material costs $3.14 x 0 = that the beginning costs are spread out evenly over both finished and
Conversion costs $1.52 x 2,400 (40%) = 3,648
Started and completed (280,000 units) $4.66 x 280,000 =
unfinished units at the end of the period. Although this approach is
1,304,800
Total allocation $1,332,448 sometimes used for financial reporting purposes to smooth out the effect
of changing costs over time, from a managerial perspective this weighted
Allocation of Costs to Ending WIP - Processing Center average approach really doesn't make much sense. It ignores the actual
Cost per Equivalent Allocated physical flow of goods and fails to reflect the true cost per unit of
Ending WIP (5,000 units):
Unit Units Cost production from one period to the next.
Direct material costs $3.14 x 5,000 (100%) = $ 15,700
Conversion costs $1.52 x 3,500 (70%) = 5,320
Total allocation $ 21,020
Grand total $1,353,468

27 28

In some cases, companies will actually use a combination of both process and job
order costing to determine their costs per unit of production. When companies
Merchandising Businesses
manufacture a variety of similar products in batches or jobs that undergo a Serve as channels of distribution in getting a manufacturer's
number of common manufacturing processes, then both job order and process finished product to its final end user or consumer.
costing methods will be used to determine the cost of each unit produced.
Wholesale distributors are in the business of buying finished products from
For example, a clothing manufacturer making the same shirt in a variety of different manufacturers and then selling those products to a large number of different retail
fabrics will use a combination of both process and job order costing to merchandisers. Most wholesalers focus on products in a particular industry.
determine their total production cost per shirt. If the cutting and sewing
of each shirt is exactly the same regardless of the fabric used, then To operate effectively, wholesalers typically enter into distribution contracts with key
process costing will be used to determine the company's cutting and manufacturers that provide favorable pricing on large volume purchases. The
sewing, or conversion costs per unit. On the other hand, direct material wholesaler then makes a profit if they're able to sell the products to retailers at a price
costs will depend on the specific fabric used to make each shirt. that covers not only the cost of the merchandise purchased but also all of the
Assuming batches of shirts are produced according to the fabric used, company's other operating costs, including costs incurred in the handling and shipping
then job order costing will be used to determine the direct material cost of merchandise. Handling refers to the process of breaking down large shipments
per unit. The combined total of both the direct material costs and
from manufacturers and then picking and re-packaging those goods for smaller
conversion costs per unit will then be added together to determine each
deliveries to specific retail customers. A wholesaler's ability to perform this function
shirt's total cost.
efficiently and then ship the goods at the lowest possible cost is crucial to the
company's ultimate success. That's why most wholesale distributors operate from
The point here is that both process and job order costing can be used on a large warehouses located near airports, train yards, shipping docks or major freeways.
combined basis in a company's product cost system. The determination of which
method should be used for each of a company's specific costs will depend entirely Retail distributors operate stores and shops that typically buy goods from a large
on the nature of the company's products and production processes. number of different wholesale distributors or purchase goods directly from
manufacturers and then sell those goods to final customers.

29 30

13-5
The Flow of Product Costs in a Merchandising Business Example: A wholesaler of landscape maintenance equipment and garden tools
purchased 1,000 lawn mowers from a Chinese manufacturer at a price
of $75 dollars per unit.
Inventory
Purchase price $75,000
Beginning balance
Freight costs 5,000
Cost of merchandise purchased* XXX XXX Cost of merchandise sold Import fees and duties 2,000
Ending balance In-transit insurance 500
Total $82,500
Cost of Goods Sold 1,000 units
Total cost per unit $ 82.50
Cost of merchandise sold XXX
A merchandising company should probably also include in this cost some
allocation of costs associated with the company's purchasing department, plus
other costs incurred in the handling and storing of purchased goods. Those are
* Includes the net price paid to suppliers plus any freight costs, import fees, certainly costs incurred to acquire the merchandise and get it ready for its
insurance premiums paid to cover the risk of lost or damaged goods in transit intended use…. to be shipped or provided for sale to customers.
from the supplier, and any other direct costs incurred in the acquisition and
receipt of the purchased goods. Although that makes sense in theory, in actual practice most companies simply
expense those costs when incurred as part of the company's general and
administrative expenses. Meaningful allocations of those costs to specific
Total Capitalized Costs products are difficult and efforts to understand and control those costs can be
Total Cost Per Unit = more effectively accomplished through a method referred to as activity based
Total Number of Units Purchased
costing, which will be discussing in a subsequent lesson.

31 32

Problem 13-3 Problem 13-3 - Answer

Merchandising Questions Merchandising Questions
1. Some manufacturers successfully sell their products direct to final end users or
1. Some manufacturers successfully sell their products direct to final consumers. For example, Dell is a personal computer manufacturer that uses no
end users or consumers. For example, Dell is a personal computer wholesalers or retailers in the distribution of its products. All sales are made
manufacturer that uses no wholesalers or retailers in the distribution direct to hundreds of thousands of individual customers. Why do you suppose,
of its products. All sales are made direct to hundreds of thousands of most manufacturers limit their channels of distribution to wholesale and/or retail
distributors, when higher prices could be charged on direct sales to end users and
individual customers. Why do you suppose, most manufacturers
consumers?
limit their channels of distribution to wholesale and/or retail
distributors, when higher prices could be charged on direct sales to Answer: Direct sales to end users and consumers usually takes a significant investment of
end users and consumers? resources and requires management expertise that may be very different from that typically
found in a manufacturing business. In short, the costs incurred in a successful direct sales
effort could easily exceed any additional revenues earned on higher prices.
2. Why do you think a retail business might choose to buy products
from a wholesaler, when the same product could be purchased direct The fact is Dell is an unusual company. In fact, its really two companies in one. It's
from the manufacturer at a lower price? combines both manufacturing and merchandising and is totally committed in terms of
management effort and resources to both phases of the business. In today's world most
manufacturers have chosen to focus their efforts and limited resources on what they do
best… manufacture quality products at the lowest possible cost. In effect, they've decided
to leave the merchandising to other company's that specialize in the distribution process.
In most cases that's not a bad decision, and in many ways that makes a lot of sense in terms
of a more efficient and cost effective economy. The effective distribution of goods can be
an expensive and complicated logistical process, and the development of companies that
specialize in that process is a big reason why the US economy is as prosperous as it is.

33 34

Problem 13-3 - Answer

Service Businesses
2. Why do you think a retail business might choose to buy products from a A service business is any company that doesn't manufacture or
wholesaler, when the same product could be purchased direct from the distribute a physical product, or at least that's not its primary purpose.
manufacturer at a lower price?
Answer: Wholesalers may provide a variety of services that can more than
Common service businesses include:
compensate for their product's higher price. For one, wholesalers usually offer CPA firms
a wide variety of merchandise that can greatly simplify a retailer's purchasing
process. The savings in terms of time and effort in dealing with a few Law firms
wholesalers as opposed to numerous manufacturers can be significant. In Hospitals and other medical service providers
addition, wholesalers are usually set up to make smaller more frequent
shipments of merchandise. This allows retailers to reduce the amount of Banks
inventory that must be maintained at any point in time to meet continuing Real estate brokerage firms
customer demand. The maintenance of excess inventory can be extremely
expensive; it eats up valuable floor space, increases handling and financing
Insurance companies
costs and can sometimes result in increased write-downs due to product Consulting firms
obsolescence. The use of wholesalers to reduce a company's inventory levels Software programming companies
and related costs might more than offset a wholesaler's higher product prices.
Airlines
Trucking and delivery companies
Educational institutions
Etc.

35 36

13-6
 Effective management of a service company requires a knowledge and understanding
of the company's product costs, just as it does for a manufacturing or merchandising
business. However, in this case, product costs refer to the costs incurred in providing For most service companies, direct material costs are relatively
the company's services rather than the costs associated with the manufacture or insignificant, if they exist at all. For example, a law firm may use
purchase of a physical product. miscellaneous office supplies in the performance of its services but those
Example: A hospital's product costs will include all of the costs incurred in
costs aren't significant enough to account for them separately as raw
providing patient services, including: materials inventory or even as an asset ("Supplies"). Instead those costs
are simply included as part of the company's overhead costs.
Direct labor costs - Salaries and wages of any doctors, nurses or other employees of the
hospital involved in the direct care of patients. For some service businesses, like a hospital, certain supplies including
Overhead costs* - Any salaries and wages of indirect support personnel, depreciation
drugs, syringes, bandages and other items may be accounted for
of buildings, equipment rent, utilities, insurance, and all of the other separately as materials inventory or supplies due to their considerable
costs associated with the operation of the hospital. cost. When those items are then requisitioned and used in a patient's care,
those costs become a direct material cost of the service provided. In fact,
* In many cases, service companies will also include any general and administrative those costs are usually reflected in a patient's billing as a separately
costs as part of their product overhead costs. For example, a hospital may include recorded charge.
the costs of its accounting department and other administrative personnel as part of
the product overhead costs allocated to its various services. That way billing rates
for those services or procedures can be set in a way that's designed to cover all of
the hospital's anticipated costs. For example, the billing rate for an X-ray may be
set at an amount to cover not only the direct costs associated with the X-ray but
also a portion of all of the other costs of the hospital.

37 38

Flow of Product Costs In A Service Business

Supplies WIP - Services

Supplies Purchased XXX XXX Supplies Used XXX
Any balance in the WIP - Services Account represents the
Direct Labor XXX XXX Completed Services company's investment in partially completed services that will
XXX Applied Overhead XXX ultimately produce future economic benefit when those services are
XXX completed and provided to customers. That sounds like an asset to
Overhead me, and the expensing of those costs when services are finally
Cost of Services
Actual Overhead XXX XXX Applied Overhead
complete and revenues are recognized from customers is consistent
Under-Applied XXX XXX Over-Applied Completed Services XXX
Close Over-Applied XXX XXX Close Under-Applied Under-Applied XXX XXX Over-Applied
with the requirements of the matching principle.
Overhead Overhead
0
XXX

39 40

Product Costing Example for a Service Business Example: Use job order costing to do the accounting for the Jones &
Our ultimate goal from a managerial standpoint is the determination of a company's
Company, CPA firm and determine the costs incurred in
cost per service provided. That's important information in determining the price of their performance of a financial statement audit for the
services to customers, as well as efforts to monitor and control costs, evaluate Jordan Company for a fee of $25,000.
performance and prepare budgets for the future.
Similar to a manufacturing company, the actual accounting used to determine the cost
of services provided will naturally require the use of either a process or job order- Job Cost Record
costing approach, or some combination of the two depending on the nature of
the services provided. Job Description: Jordan Company Audit Date Started: 1/5/X6
Amount of Fee: $25,000 Date Completed:
For example, a bank's determination of the costs incurred in processing each of its
customer checks will naturally use a process costing approach where all of the direct Direct Labor: Time Sheets
and indirect costs associated with the operation of the bank's check processing
Employee
department are accumulated and then divided by the number of checks processed
Date Name Hours Rate Amount
during the period.
On the other hand, the determination of a CPA firm's costs associated with the
performance of a financial statement audit will require the use of a job order cost Applied Overhead: Direct Labor
system. The costs of auditing the financial statements of General Motors will be Date Rate Amount
Costs
different from the costs incurred in the performance of an audit of a small start-up
company. There is no standardization of procedures in the performance of audits, and
in that case, a separate job cost record will be maintained for each of the firm's
various jobs. Total Cost $
In reality, most service companies use job order costing because most services are
tailored to meet the individual and unique needs of each customer.

41 42

13-7
 Accounting given the following transactions and events: Job Cost Record
Salaries paid by the firm to its professional employees totaled $50,000 Job Description: Jordan Company Audit Date Started: 1/5/X6
for the month. Based on time sheets, the portion of that total associated Amount of Fee: $25,000 Date Completed:
with the Jordan Company audit amounted to $14,000. Direct Labor: Time Sheets
Employee
Work-in Process - Services* 50,000
Date Name Hours Rate Amount
Cash 50,000
$14,000
* Sometimes referred to as "Unbilled Service Costs."
Applied Overhead: Direct Labor
In addition to this entry, the company's individual job cost records Date Rate Costs Amount
maintained for each of its various jobs will be updated for each
job's respective share of the $50,000 total.
Total Cost $

43 44

Predetermined Total budgeted overhead costs for the upcoming period Assume that the Jones & Company CPA firm allocates its
=
Overhead Rate Total budget for the measurable activity or cost that correlates overhead on the basis of direct labor costs, and the firm's budgeted
with or drives overhead costs over the same period overhead costs for the year amounted to $350,000 with direct
labor costs budgeted at $620,000.
For many service companies the measurable activity or cost used in
determining its overhead rate also serves as the basis for billing Predetermined $350,000
customers or establishing the price of its services. = = $ .56 per direct labor dollar
Overhead Rate $620,000

Such an approach makes sense given that profitable companies must

In the current month, the firm's total overhead application:
charge a price for each service that covers all of its direct costs and all
of its overhead costs allocated on a job-by-job basis. If the same basis
$50,000 direct labor costs (x) $ .56 = $28,000
used for allocating overhead is also used to establish billing rates and
prices, then coverage of those costs can be reasonably assured.
Work-in Process - Services 28,000
Overhead 28,000

45 46

Assume the firm's audit of the Jordan Company financial

statement is completed at the end of the month at which time a bill
Job Cost Record is sent out for the firm's $25,000 fee.
Job Description: Jordan Company Audit Date Started: 1/5/X6
Amount of Fee: $25,000 Date Completed: Accounts Receivable 25,000
Fee Revenues 25,000
Direct Labor: Time Sheets
Employee
Date Name Hours Rate Amount Cost of Services 21,840
$14,000 Work-in Process - Services 21,840

Applied Overhead: Direct Labor

Date Rate Costs Amount
$ .56 $14,000 $ 7,840

Total Cost $

47 48

13-8
 Assume the firm's audit of the Jordan Company financial
Job Cost Record statement is completed at the end of the month at which time a bill
is sent out for the firm's $25,000 fee.
Job Description: Jordan Company Audit Date Started: 1/5/X6
Amount of Fee: $25,000 Date Completed:
Accounts Receivable 25,000
Direct Labor: Time Sheets Fee Revenues 25,000
Employee
Date Name Hours Rate Amount
Cost of Services 21,840
$14,000
Work-in Process - Services 21,840
Applied Overhead: Direct Labor
Date Rate Costs Amount Gross profit earned = $3,160
$ .56 $14,000 $ 7,840

Total Cost $ 21,840

49 50

Problem 13-4
At the end of firm's accounting period, the temporary overhead Job Order Costing in a Service Company
account should be closed out for any over or under-application of Custom Software, Inc. provides software programming services to customers and bills
overhead made during the period. those customers based on hourly rates associated with each of its three programmers.
The hourly billing rate for each programmer is equal to 200% of the combined amount
Overhead of the programmer's hourly wage rate plus allocated overhead costs. Allocations of
overhead are made based on the company's total budgeted overhead costs for the year
Actual costs 25,800
as a percentage of total anticipated programmer wages (direct labor costs).
28,000 Applied overhead
($50,000 x $ .56)
2,200 Over-applied
A. Given the following information, determine the hourly billing rate to be charged
to customers for each programmer's services during the current year.

Closing entry: Programmer Budget for the Year Overhead Budget for the Year
Overhead 2,200 Programmer Wage Rate Anticipated Hours
Building rent $ 12,000
Cost of Services 2,200 Mary Hart $40/hr. 2,000 Utilities 4,200
Bob Smith $30/hr. 1,800 Office salaries 28,000
Eric Smart $25/hr. 1,600 Office supplies 8,800
Office equipment depreciation 2,400
Taxes and insurance 6,600
Other costs 7,600
Total $ 69,600

51 52

Problem 13-4 Problem 13-4 - Answer

B. Prepare journal entries for the following during the month of January: Job Order Costing in a Service Company
A. Given the following information, determine the hourly billing rate to be
1. Purchased $1,000 of supplies on account. (Assume a separate asset account charged to customers for each programmer's services during the current year.
"Supplies" is used to account for supplies on hand.)
Billing Rates for the Year
2. Paid programmer wages totaling $14,000. Overhead at Wage and
3. Paid various overhead costs including, rent, utilities, office salaries, etc. Wage 40%* of Overhead Billing
Programmer Rate Wage Rate Rate Rate
totaling $4,800.
Mary Hart $40/hr. + $16/hr. = $56/hr. x 200% = $112/hr.
4. Recorded $200 of depreciation on office equipment. Bob Smith $30/hr. $12/hr. $42/hr.
+ = x 200% = $84/ hr.
5. The cost of supplies used up totaled $700. Eric Smart $25/hr. + $10/hr. = $35/hr. x 200% = $70/hr.
6. Applied overhead to customer projects.
Total Budgeted Overhead Costs
7. Billed customer (Axim Enterprises) for project started and completed during * Overhead Rate =
Total Anticipated Programmer Wages
the month. (Total programmer hours incurred: Mary Hart - 120 hrs., Eric
Smart - 30 hrs.) $69,600
= 40 % of wages
$174,000**
C. What was the company's markup on cost used in establishing billing rates
and determine the gross margin percentage earned on the Axim Enterprises ** Anticipated Total Anticipated
project. Programmer Wage Rate Hours Wages

Mary Hart $40/hr. x 2,000 = $ 80,000

D. Prepare the closing entry at the end of the year if total actual overhead costs Bob Smith $30/hr. x 1,800 = $ 54,000
incurred during the year amounted to $70,750 and total wages paid to Eric Smart $25/hr. x 1,600 = $ 40,000
programmers came to $180,000. $174,000

53 54

13-9
 Problem 13-4 - Answer Problem 13-4 - Answer
6. Applied overhead to customer projects.
B. Prepare journal entries for the following during the month of January:
Work-in-Process Services 5,600*
1. Purchased $1,000 of supplies on account. (Assume a separate asset account Overhead 5,600
"Supplies" is used to account for supplies on hand.)
* $14,000 (programmer wages) x 40% = $5,600
Supplies 1,000 7. Billed customer (Axim Enterprises) for project started and completed during
Accounts Payable 1,000 the month. (Total programmer hours incurred: Mary Hart - 120 hrs., Eric
2. Paid programmer wages totaling $14,000. Smart - 30 hrs.)
Work-in-Process Services 14,000 Accounts Receivable* 15,540
Cash 14,000 Fee Revenues 15,540
*Axim Enterprises Billing
3. Paid various overhead costs including, rent, utilities, office salaries, etc.
Mary Hart 120 hrs. x $112/hr. = $13,440
totaling $4,800. Eric Smart 30 hrs. x $70/hr. = $ 2,100
Overhead 4,800 $15,540
Cash 4,800 Cost of Services** 7,770
4. Recorded $200 of depreciation on office equipment. Work-in-Process Services 7,770
Overhead 200 **Axim Enterprises Job Cost Record
Accumulated Depreciation 200 Direct Labor:
Mary Hart 120 hrs x $40/hr. = $4,800
5. The cost of supplies used up totaled $700. Eric Smart 30 hrs. x $25/hr. = 750
5,550
Overhead 700 Overhead Applied $5,550 x 40% = 2,220
Supplies 700 Total Cost $7,770

55 56

Problem 13-4 - Answer Problem 13-4 - Answer

C. What was the company's markup on cost used in establishing billing rates D. Prepare the closing entry at the end of the year if total actual overhead costs
and determine the gross margin percentage earned on the Axim Enterprises incurred during the year amounted to $70,750 and total wages paid to
project. programmers came to $180,000.

Fee revenues $15,540 Closing entry:

Less: Cost of services 7,770
Gross margin or profit $ 7,770 50% gross margin/profit Overhead 1,250
Cost of Services 1,250

Markup $7,770
Markup on Cost = = = 100% Overhead
Cost $7,770
Actual costs 70,750 72,000 Applied overhead ($180,000 x 40%)
Answer: Billing rates based on 200% of cost produce a 100% markup 1,250 Over-applied
and a 50% gross margin. Closing entry 1,250
0

57 58

13-10
 Lesson 15
How much does it cost to make my product?

Traditional product costing

Direct Materials
Direct Labor
Overhead
Lesson 15 Overhead - Allocated in proportion to Direct Labor cost.
ACTIVITY-BASED COSTING
ABC: Innovative method of assigning
overhead costs to products Activity-based costing
Direct Materials
Direct Labor
Overhead
Overhead - Identify specific activities that cause overhead costs.

1 2

Example Example
Computing the total cost of cooking Computing the total cost of cooking
Chinese food in the Stice kitchen Chinese food in the Stice kitchen
Traditional approach ABC approach
Direct Materials - chicken, vegetables, tofu. Direct Materials - chicken, vegetables, tofu.
Direct Labor - time required for the chef (Ramona) to combine and monitor. Direct Labor - time required for the chef (Ramona) to combine and monitor.
Overhead - allocate a portion of overall kitchen overhead: Overhead - allocate a portion of overall kitchen overhead:
Use of spices, seasonings, etc. Use of spices, seasonings, etc.
Cutting, chopping and other preparation. Cutting, chopping and other preparation.
CLEANING. CLEANING.
Serving. Serving.
Many different courses. Many different courses.

Allocate a portion of total kitchen overhead based on how much chef time Assign overhead based on the specific activities that create overhead cost:
(direct labor) is taken in cooking the Chinese meal. Count the number of spices and seasonsings used.
ASSUMES that the amount of direct labor time spent by the chef is Count the number of courses.
proportionate to the amount of overhead created. Count the number of pots, pans, dishes, and utensils used.
Vastly UNDERSTATES overhead created by the cooking of Chinese food The ABC approach to assigning overhead costs gives a better reflection of the
in the Stice kitchen. economic cost created in the production of a particular product or service.

3 4

More Detailed Example

Some Cautions
Lily's Ice Cream Company
1. For many products and services, the amount of direct labor
time is a good reflection of the amount of overhead created. Lily manufactures ice cream.
Traditionally has produced and sold just plain vanilla.
If all products are similar, then the direct labor time is probably
proportionate to the amount of overhead created. Solid profits.
The advantage of an ABC system comes when the types of Lily has decided to start making and selling her own flavors of
products and services differ substantially. gourmet ice cream.

2. An ABC accounting system typically is more expensive to New overhead costs:

operate. Flavor chemist.
Many new quality control inspectors.
3. The objective is to make better business decisions. - Inspection at start and end of every batch.
New machine workers, setup for the many new batches.
The cost to acquire additional, better data must be weighed
Machines need to be cleaned more frequently.
against the benefit in terms of better decisions.
Accounting costs have gone up (had to hire more people).
- Ordering different ingredients.

5 6

15-1
 More Detailed Example More Detailed Example
Lily's Ice Cream Company Lily's Ice Cream Company

Traditionally, Lily has had a very simple method of Here are Lily's problems:
overhead allocation.
Overall profitability has slipped since the introduction of
the new flavors.
Total overhead divided by number of gallons of ice
cream produced.
The vanilla ice cream is now being sold at a loss.
Each gallon of ice cream allocated the same amount
of overhead.
Lily is considering whether to stop
selling vanilla ice cream.

She first wants to do a more detailed overhead cost analysis

using the ABC approach.

7 8

Five Steps in implementing Step 1

and using an ABC system Identify overhead cost activities

Total overhead for Lily Ice Cream Company for the

1. Identify overhead cost activities. most recent year is $1,740,000.
2. Analyze individual overhead costs in terms of
cost activities. The number of gallons of ice cream produced
during the year was 1,500,000.
3. Identify measurable cost drivers.
Traditional overhead assigned to each gallon of ice
4. Assign overhead. cream.
5. Use the ABC data to make decisions. ($1,740,000 / 1,500,000 gallons)
$1.16 per gallon

9 10

This total of $1,740,000 in overhead cost is We need a better understanding of the

broken down into the following categories.
Overhead
key production activities that
Costs create overhead costs!!!!
Electricity $200,000
Machine depreciation 400,000
Factory cleaners 300,000
Machine repairpersons 100,000 Lily has created the following list of key overhead cost
Production supervisor 200,000 activities.
Flavor chemist 170,000
Accounting department 150,000
Building depreciation 80,000
1. Operating the ice cream production process.
Security guards 90,000
Building insurance 50,000 2. Producing a specific batch of ice cream.
Total $1,740,000
3. Servicing the special needs of each individual
Does the production of a gallon of each flavor: ice cream flavor.
Use the same amount of electricity?
Create same amount of factory cleanup? 4. Keeping the factory open.
Require the same amount of ingredient testing by the chemist?

11 12

15-2
 Operating the ice cream production process Producing a specific batch of ice cream

Electricity to operate the machines. Clean out the old flavor residue.

Wear and tear on the machines themselves. More stopping, more machine repairs.

Mess that the factory cleaners must clean. Production supervisor quality inspection of each
batch.
Machine repair.
Accounting - tracking costs, supplies and creating
Production supervision. reports for each batch.
Accounting - preparation of production reports.

13 14

Servicing the special needs of each Keeping the factory open

individual ice cream flavor
Accounting -- prepare financial statements,
Hire flavor chemist. periodic income tax filings, payroll tax reports.
Production supervisor monitors recipes. Building depreciation
Accounting - ordering various ingredients. Insurance

Security

15 16

We need a better understanding of the The four general categories of overhead cost activities are:
key production activities that 1. Unit
2. Batch
create overhead costs!!!! 3. Product line
4. Facility support

Lily has created the following list of key overhead cost Unit level Batch level
activities. Machine maintenance Inspections
Machine depreciation Machine setups
1. Operating the ice cream production process. Electricity and other energy costs. Movement of and accounting for materials.

2. Producing a specific batch of ice cream. Product line Facility support

Engineering product design. Property taxes
3. Servicing the special needs of each individual Managing by a special supervisor of all Factory insurance
activities associated with a particular
ice cream flavor. product line.
Security
Landscaping
Storage in special warehouses.
4. Keeping the factory open. General accounting
Ordering, purchasing, and receiving
materials unique to a particular product General factory administration
line.

17 18

15-3
 Problem 15-1 Problem 15-1 - Answer
Identifying overhead cost activities Identifying overhead cost activities
Below is a list of overhead cost activities. For each activity, determine whether
it is a Unit Level, Batch Level, Product Line, or Facility Support activity. 1. Employee training . . . . . . . . . . . . . . . . . . . . Product Line
1. Employee training. Employees need special training to work with each of the 2. Product inspection . . . . . . . . . . . . . . . . . . . . Batch Level
company's different products.
2. Product inspection. No inspection is performed on each unit produced. 3. Electricity . . . . . . . . . . . . . . . . . . . . . . . . . . . Unit Level
Instead, a sample of units from each production batch is inspected.
3. Electricity. The production machines are powered by electricity. 4. Liability insurance . . . . . . . . . . . . . . . . . . . . Facility Support
4. Liability insurance. Because of hazardous chemicals used throughout the
plant, the company is required to buy a liability insurance policy. 5. Product design . . . . . . . . . . . . . . . . . . . . . . . Product Line
5. Product design. A staff of design engineers generates refinements to the
designs of each of the products. 6. Vice president in charge of production . . . . Facility Support
6. Vice president in charge of production. This company vice president has
specific responsibility for overseeing all aspects of the production facility. 7. Machine setup . . . . . . . . . . . . . . . . . . . . . . . Batch Level
7. Machine setup. The production machines must be repositioned and
inspected at the beginning of each production batch. 8. Machine setup . . . . . . . . . . . . . . . . . . . . . . . Product Line
8. Machine setup. The production machines must be repositioned and
inspected only when production is changed from one type of product to another. 9. Product inspection . . . . . . . . . . . . . . . . . . . . Unit Level
9. Product inspection. An inspection is performed on each unit produced.
10. Machine maintenance. The production machines need constant preventative 10. Machine maintenance . . . . . . . . . . . . . . . . . Unit Level
maintenance in order to extend their operating lives.

19 20

Step 2
Analyze individual overhead costs in Overhead Costs
terms of cost activities and Overhead Cost Activities
Lily Ice Cream Company overhead costs Four identified overhead cost activities.
Overhead Cost Overhead Cost Activity
Overhead 1. Operating the ice cream
Costs production process. Electricity Operating the ice cream production process
Electricity $200,000
2. Producing a specific batch of Machine depreciation Operating the ice cream production process
Machine depreciation 400,000 ice cream.
Factory cleaners 300,000
3. Servicing the special needs of Building depreciation Keeping the factory open
Machine repairpersons 100,000
each individual ice cream
Production supervisor 200,000 Security guards Keeping the factory open
flavor.
Flavor chemist 170,000
Accounting department 150,000 4. Keeping the factory open Building insurance Keeping the factory open
Building depreciation 80,000
Security guards 90,000
Building insurance 50,000
Total $1,740,000

21 22

Summary of ABC overhead analysis Percentage of Time Spent

to this point on Each Activity
Keeping
Overhead Cost Activities Ice Cream Ice Cream Ice Cream Factory
Keeping Production Batches Flavors Open
Overhead Ice Cream Ice Cream Ice Cream Factory
Costs Production Batches Flavors Open
Factory cleaners 30% 70% 0% 0%
Electricity $200,000 $200,000 $0 $0 $0
Machine depreciation 400,000 400,000 0 0 0 Machine repairpersons 15% 85% 0% 0%
Factory cleaners 300,000 ??? ??? ??? ???
Machine repairpersons 100,000 ??? ??? ??? ???
Production supervisor 15% 50% 35% 0%
Production supervisor 200,000 ??? ??? ??? ??? Flavor chemist 0% 0% 100% 0%
Flavor chemist 170,000 ??? ??? ??? ???
Accounting department 150,000 ??? ??? ??? ??? Accounting department 10% 30% 20% 40%
Building depreciation 80,000 0 0 0 80,000
Security guards 90,000 0 0 0 90,000
Building insurance 50,000 0 0 0 50,000
Example -- Factory Cleaners Overhead Cost:
Total $1,740,000 Ice cream production $300,000 × 0.30 = $90,000
Ice cream batches $300,000 × 0.70 = $210,000

23 24

15-4
 Problem 15-2
Complete Analysis Computing cost pools
of Overhead Cost Items Percentage of Time Spent on Each Activity
Hiring and Creating
Overhead Cost Activities Repairing Training Inspecting Ordering Clothing
Equipment Workers Clothing Materials Designs
Keeping
Overhead Ice Cream Ice Cream Ice Cream Factory Maintenance people 100% 0% 0% 0% 0%
Costs Production Batches Flavors Open Production foreman 10% 60% 20% 10% 0%
Electricity $200,000 $200,000 $0 $0 $0 Accounting department 0% 50% 0% 50% 0%
Machine depreciation 400,000 400,000 0 0 0 Design staff 0% 0% 10% 20% 70%
Factory cleaners 300,000 90,000 210,000 0 0 Factory superintendent 0% 30% 40% 10% 20%
Machine repairpersons 100,000 15,000 85,000 0 0
Production supervisor 200,000 30,000 100,000 70,000 0 The total overhead cost associated with each of the categories of factory
Flavor chemist 170,000 0 0 170,000 0 employee is as follows.
Accounting department 150,000 15,000 45,000 30,000 60,000 Maintenance people . . . . . $100,000
Building depreciation 80,000 0 0 0 80,000 Production foreman . . . . . . . . 80,000
Security guards 90,000 0 0 0 90,000 Accounting department . . . . 150,000
Building insurance 50,000 0 0 0 50,000 Design staff . . . . . . . . . . . . . 200,000
Factory superintendent . . . . 120,000
Total $1,740,000 $750,000 $440,000 $270,000 $280,000

Cost Pools Compute the amount of each of the five cost pools.

25 26

Problem 15-2 - Answer

Computing cost pools Step 3
Hiring and Creating Identify measurable cost drivers
Repairing Training Inspecting Ordering Clothing
Equipment Workers Clothing Materials Designs
Maintenance people $100,000 $100,000 $0 $0 $0 $0
Production foreman 80,000 8,000 48,000 16,000 8,000 0
Accounting department 150,000 0 75,000 0 75,000 0
Design staff 200,000 0 0 20,000 40,000 140,000 Cost driver
Factory superintendent 120,000 0 36,000 48,000 12,000 24,000
Total $650,000 $108,000 $159,000 $84,000 $135,000 $164,000

Numerical measure of the amount of effort

Maintenance people Accounting department Factory superintendent
$100,000 × 1.00 = $100,000 $150,000 × 0.50 = $75,000 $120,000 × 0.30 = $36,000 involved in each overhead cost activity.
$150,000 × 0.50 = $75,000 $120,000 × 0.40 = $48,000
Production foreman $120,000 × 0.10 = $12,000
$80,000 × 0.10 = $8,000 Design staff $120,000 × 0.20 = $24,000
$80,000 × 0.60 = $48,000 $200,000 × 0.10 = $20,000
$80,000 × 0.20 = $16,000 $200,000 × 0.20 = $40,000
$80,000 × 0.10 = $8,000 $200,000 × 0.70 = $140,000

27 28

Cost Activity Overhead Cost Driver Lily Ice Cream Company makes six flavors of ice cream.
Operating the ice cream Gallons of ice cream Vanilla
production process. produced. Marshmallow Caramel Delight
Gingerbread Cheesecake Supreme
Strawberry Banana Surprise
Producing a specific batch Batches produced. Double Dutch Chocolate Brownie
of ice cream.
Peanut Butter Swirl

Servicing the special needs Cost Activity Overhead Cost Driver

of each individual ice cream Operating the ice cream Gallons of ice cream
flavor. production process. produced.

Producing a specific batch Batches produced.

of ice cream.

Servicing the special needs Number of ingredients.

of each individual ice cream
flavor.

29 30

15-5
 Cost Activity Overhead Cost Driver
Five Steps in implementing
Operating the ice cream Gallons of ice cream and using an ABC system
production process. produced.

Producing a specific batch Batches produced. 1. Identify overhead cost activities.

of ice cream.
2. Analyze individual overhead costs in terms of
cost activities.
Servicing the special needs Number of ingredients.
of each individual ice cream 3. Identify measurable cost drivers.
flavor.
4. Assign overhead.
Keeping the factory open. Not applicable.

31 32

Step 4
Cost Drivers
Assign overhead
Summary of the analysis of the individual overhead items.
Overhead Cost Activities Number of
Cost driver
Keeping cost driver events
Overhead Ice Cream Ice Cream Ice Cream Factory
Costs Production Batches Flavors Open
Gallons of ice cream
Electricity $200,000 $200,000 $0 $0 $0 1,500,000 gallons
Machine depreciation 400,000 400,000 0 0 0 produced
Factory cleaners 300,000 90,000 210,000 0 0
Machine repairpersons 100,000 15,000 85,000 0 0
Production supervisor 200,000 30,000 100,000 70,000 0
Batches produced 500 batches
Flavor chemist 170,000 0 0 170,000 0
Accounting department 150,000 15,000 45,000 30,000 60,000 Number of ingredients 100 ingredients
Building depreciation 80,000 0 0 0 80,000
Security guards 90,000 0 0 0 90,000
Building insurance 50,000 0 0 0 50,000
Total $1,740,000 $750,000 $440,000 $270,000 $280,000
Cost Pools
33 34

Number of Number of Number of

Flavors Gallons Batches Ingredients
Vanilla 500,000 25 5
Marshmallow Caramel Delight 250,000 50 20
Number of Overhead Cost
Overhead Cost Pool Gingerbread Cheesecake Supreme 200,000 235 25
Cost Driver per
cost activity Amount
Events Cost Driver Event Strawberry Banana Surprise 50,000 60 10
Ice cream production $750,000 1,500,000 gallons $0.50 per gallon Double Dutch Chocolate Brownie 400,000 30 10
Peanut Butter Swirl 100,000 100 30
Ice cream batches 440,000 500 batches $880 per batch
Total 1,500,000 500 100
Ice cream flavors 270,000 100 ingredients $2,700 per ingredient
Keeping the factory open 280,000 not assigned not assigned
Overhead Cost Assigned to Gingerbread
Cheesecake Supreme
Ice cream production: 200,000 gallons × $0.50 per gallon $100,000
Ice cream batches: 235 batches × $880 per batch 206,800
Ice cream ingredients: 25 ingredients × $2,700 per ingredient 67,500
Total overhead assigned to Gingerbread Cheesecake Supreme $374,300

35 36

15-6
 Problem 15-3
Overhead Assigned Using Cost Drivers
to Each Ice Cream Flavor
Manufacturing
Overhead
Cost Pools Division 1 Division 2
Ice Cream Ice Cream Ice Cream Total Overhead
Flavors Production Batches Ingredients Assigned Unit-level overhead $210,000 7,500 units 13,500 units
Vanilla $250,000 $22,000 $13,500 $285,500
Batch-level overhead $280,000 50 batches 90 batches
Marshmallow Caramel Delight 125,000 44,000 54,000 223,000
Gingerbread Cheesecake Supreme 100,000 206,800 67,500 374,300 Product line overhead $210,000 10 lines 18 lines
Strawberry Banana Surprise 25,000 52,800 27,000 104,800 $700,000
Double Dutch Chocolate Brownie 200,000 26,400 27,000 253,400
Peanut Butter Swirl 50,000 88,000 81,000 219,000
Total $750,000 $440,000 $270,000 $1,460,000 Using an ABC analysis, compute how much of the $700,000 in total
- $1,740,000 overhead cost should be assigned to each of the two divisions.
$280,000

37 38

Problem 15-3 - Answer Step 5

Using Cost Drivers
Overhead Cost
Use the ABC data to make decisions
Cost Pool Total Number of per
Overhead cost activity Amount Cost Driver Events Cost Driver Event Double
Marshmallow Gingerbread Strawberry Dutch Peanut
Caramel Cheesecake Banana Chocolate Butter
Unit-level overhead $210,000 21,000 units $10 per unit Vanilla Delight Supreme Surprise Brownie Swirl Total

Batch-level overhead 280,000 140 batches $2,000 per batch Number of gallons 500,000 250,000 200,000 50,000 400,000 100,000 1,500,000
Product line overhead 210,000 28 product lines $7,500 per product line
Sales $750,000 $625,000 $600,000 $125,000 $800,000 $350,000 $3,250,000
Production cost:
Overhead Cost Assigned to Division 1 Direct materials 200,000 200,000 250,000 50,000 300,000 150,000 1,150,000
Unit-level overhead: 7,500 units × $10 per unit $75,000 Direct labor 125,000 100,000 100,000 15,000 200,000 50,000 590,000
Overhead ($1.16 per gallon) 580,000 290,000 232,000 58,000 464,000 116,000 1,740,000
Batch-level overhead: 50 batches × $2,000 per batch 100,000
Total flavor production cost 905,000 590,000 582,000 123,000 964,000 316,000 3,480,000
Product line overhead: 10 product lines × $7,500 per line 75,000
Flavor gross profit ($155,000) $35,000 $18,000 $2,000 ($164,000) $34,000 ($230,000)
Total overhead assigned to Division 1 $250,000
Four items of concern for Lily Ice Cream Company.
Overhead Cost Assigned to Division 2 1. Overall company gross profit is actually a loss of $230,000.
Unit-level overhead: 13,500 units × $10 per unit $135,000 2. The historical backbone of the company, Vanilla ice cream, is reporting a loss of $155,000.
Batch-level overhead: 90 batches × $2,000 per batch 180,000 3. One of the new flavors, Double Dutch Chocolate Brownie, is also reporting a loss.
Product line overhead: 18 product lines × $7,500 per line 135,000 4. The two money-losing flavors are also the two flavors with the highest sales volume -
Total overhead assigned to Division 2 $450,000 500,000 gallons for Vanilla and 400,000 gallons for Double Dutch Chocolate Brownie.

39 40

Flavor Profitability Report Based on the ABC Analysis Flavor Gross Profit
Double
Marshmallow Gingerbread Strawberry Dutch Peanut
Caramel Cheesecake Banana Chocolate Butter
Vanilla Delight Supreme Surprise Brownie Swirl Total

Number of gallons 500,000 250,000 200,000 50,000 400,000 100,000 1,500,000

Flavors Traditional ABC
Sales $750,000 $625,000 $600,000 $125,000 $800,000 $350,000 $3,250,000
Production cost: Vanilla (155,000) 139,500
Direct materials
Direct labor
200,000
125,000
200,000
100,000
250,000
100,000
50,000
15,000
300,000
200,000
150,000
50,000
1,150,000
590,000
Marshmallow Caramel Delight 35,000 102,000
Overhead (using ABC):
Gallons of ice cream 250,000 125,000 100,000 25,000 200,000 50,000 750,000
Gingerbread Cheesecake Supreme 18,000 (124,300)
Number of batches
Number of ingredients
22,000
13,500
44,000
54,000
206,800
67,500
52,800
27,000
26,400
27,000
88,000
81,000
440,000
270,000
Strawberry Banana Surprise 2,000 (44,800)
Total flavor production cost 610,500 523,000 724,300 169,800 753,400 419,000 3,200,000 Double Dutch Chocolate Brownie (164,000) 46,600
Flavor gross profit $139,500 $102,000 ($124,300) ($44,800) $46,600 ($69,000) $50,000
Peanut Butter Swirl 34,000 (69,000)
Facility support costs 280,000
Company gross profit ($230,000) ($230,000) $50,000
Marshmallow Caramel Delight - $280,000
Selling price per gallon is $2.50 Overhead
($625,000 / 250,000 gallons) Ice cream production: 250,000 gallons × $0.50 per gallon = $125,000
Ice cream batches: 50 batches × $880 per batch = $44,000
($230,000)
Direct materials cost of $0.80 per gallon Ice cream ingredients: 20 ingredients × $2,700 per ingredient = $54,000
($200,000 / 250,000 gallons)
Direct labor cost of $0.40 per gallon Flavor gross profit: $625,000 - $523,000 = $102,000
($100,000 / 250,000 gallons)

41 42

15-7
 Flavor Profitability Report Based on the Traditional System
Marshmallow Gingerbread Strawberry
Caramel Cheesecake Banana
Double
Dutch
Chocolate
Peanut
Butter
Average size of the ice cream batches
Vanilla Delight Supreme Surprise Brownie Swirl Total

Number of gallons 500,000 250,000 200,000 50,000 400,000 100,000 1,500,000

Sales $750,000 $625,000 $600,000 $125,000 $800,000 $350,000 $3,250,000 Gallons

Production cost: Flavors Gallons Batches Per Batch
Direct materials 200,000 200,000 250,000 50,000 300,000 150,000 1,150,000
Direct labor
Overhead ($1.16 per gallon)
125,000
580,000
100,000
290,000
100,000
232,000
15,000
58,000
200,000
464,000
50,000
116,000
590,000
1,740,000
Vanilla 500,000 25 20,000
Total flavor production cost 905,000 590,000 582,000 123,000 964,000 316,000 3,480,000 Marshmallow Caramel Delight 250,000 50 5,000
Flavor gross profit ($155,000) $35,000 $18,000 $2,000 ($164,000) $34,000 ($230,000)
Gingerbread Cheesecake Supreme 200,000 235 851
Flavor Profitability Report Based on the ABC Analysis
Marshmallow Gingerbread Strawberry
Double
Dutch Peanut
Strawberry Banana Surprise 50,000 60 833
Caramel Cheesecake Banana Chocolate Butter
Vanilla Delight Supreme Surprise Brownie Swirl Total
Double Dutch Chocolate Brownie 400,000 30 13,333
Number of gallons 500,000 250,000 200,000 50,000 400,000 100,000 1,500,000
Sales $750,000 $625,000 $600,000 $125,000 $800,000 $350,000 $3,250,000 Peanut Butter Swirl 100,000 100 10,000
Production cost:
Direct materials 200,000 200,000 250,000 50,000 300,000 150,000 1,150,000
Direct labor 125,000 100,000 100,000 15,000 200,000 50,000 590,000
Overhead (using ABC):
Gallons of ice cream 250,000 125,000 100,000 25,000 200,000 50,000 750,000
Number of batches 22,000 44,000 206,800 52,800 26,400 88,000 440,000
Number of ingredients 13,500 54,000 67,500 27,000 27,000 81,000 270,000
Total flavor production cost 610,500 523,000 724,300 169,800 753,400 419,000 3,200,000
Flavor gross profit $139,500 $102,000 ($124,300) ($44,800) $46,600 ($69,000) $50,000
Facility support costs 280,000
Company gross profit ($230,000)

43 44

Flavor Profitability Report Based on the ABC Analysis Flavor Profitability Report Based on the Traditional System
Double
Marshmallow Gingerbread Strawberry Dutch Peanut Double
Caramel Cheesecake Banana Chocolate Butter Marshmallow Gingerbread Strawberry Dutch Peanut
Vanilla Delight Supreme Surprise Brownie Swirl Total Caramel Cheesecake Banana Chocolate Butter
Vanilla Delight Supreme Surprise Brownie Swirl Total
Number of gallons 500,000 250,000 200,000 50,000 400,000 100,000 1,500,000
Number of gallons 500,000 250,000 200,000 50,000 400,000 100,000 1,500,000
Sales $750,000 $625,000 $600,000 $125,000 $800,000 $350,000 $3,250,000
Production cost: Sales $750,000 $625,000 $600,000 $125,000 $800,000 $350,000 $3,250,000
Direct materials 200,000 200,000 250,000 50,000 300,000 150,000 1,150,000
Production cost:
Direct labor 125,000 100,000 100,000 15,000 200,000 50,000 590,000
Direct materials 200,000 200,000 250,000 50,000 300,000 150,000 1,150,000
Overhead (using ABC):
Direct labor 125,000 100,000 100,000 15,000 200,000 50,000 590,000
Gallons of ice cream 250,000 125,000 100,000 25,000 200,000 50,000 750,000
Number of batches 22,000 44,000 206,800 52,800 26,400 88,000 Overhead ($1.16 per gallon) 580,000 290,000 232,000 58,000 464,000 116,000 1,740,000
440,000
Number of ingredients 13,500 54,000 67,500 27,000 27,000 81,000 270,000 Total flavor production cost 905,000 590,000 582,000 123,000 964,000 316,000 3,480,000
Total flavor production cost 610,500 523,000 724,300 169,800 753,400 419,000 3,200,000 Flavor gross profit ($155,000) $35,000 $18,000 $2,000 ($164,000) $34,000 ($230,000)
Flavor gross profit $139,500 $102,000 ($124,300) ($44,800) $46,600 ($69,000) $50,000
Facility support costs 280,000
Company gross profit ($230,000)

45 46

Flavor Profitability Report Based on the ABC Analysis What if Lily doesn't want to stop producing these three flavors, but
Double
instead wants to do something with the production process to reduce
Marshmallow Gingerbread
Caramel Cheesecake
Strawberry
Banana
Dutch
Chocolate
Peanut
Butter
the cost of producing these flavors so that they can be sold at a profit?
Vanilla Delight Supreme Surprise Brownie Swirl Total

Number of gallons 500,000 250,000 200,000 50,000 400,000 100,000 1,500,000 The ABC overhead system highlights actions that can be taken to
Sales $750,000 $625,000 $600,000 $125,000 $800,000 $350,000 $3,250,000 improve profitability.
Production cost:
Direct materials
Direct labor
200,000
125,000
200,000
100,000
250,000
100,000
50,000
15,000
300,000
200,000
150,000
50,000
1,150,000
590,000
Two characteristics of a good managerial accounting measure are
Overhead (using ABC): that it:
250,000 125,000 100,000 25,000 200,000 50,000
Gallons of ice cream
Number of batches 22,000 44,000 206,800 52,800 26,400 88,000
750,000
440,000
1. Reflects economic reality and
Number of ingredients 13,500 54,000 67,500 27,000 27,000 81,000 270,000 2. Motivates correct behavior.
Total flavor production cost 610,500 523,000 724,300 169,800 753,400 419,000 3,200,000
Flavor gross profit $139,500 $102,000 ($124,300) ($44,800) $46,600 ($69,000) $50,000
Overhead Cost
Facility support costs 280,000
per
Company gross profit ($230,000) Cost Driver Event

What to do about the three flavors that are losing money? $0.50 per gallon
Lily could increase profits by $124,300 by stopping the production $880 per batch
of Gingerbread Cheesecake Supreme, by another $44,800 by $2,700 per ingredient
stopping the production of Strawberry Banana Surprise, and by
another $69,000 by stopping the production of Peanut Butter Swirl.

47 48

15-8
 Problem 15-4

Two characteristics of a good Using ABC to compute product costs and make decisions
managerial accounting measure The company makes two products - guns and butter. Production cost data are as follows.
Production volume 1,000 guns 500,000 pounds
Direct materials $50,000 $100,000
Direct labor $120,000 $30,000
Overhead
Cost Pools Guns Butter

1. Reflects economic reality. Unit-level overhead

Batch-level overhead
$200,000
50,000
4,000 hours
450 batches
1,000 hours
50 batches
Product line overhead 250,000 7 models 3 types
$500,000
2. Motivates correct behavior. The remaining $100,000 in overhead ($600,000 total - $500,000 assigned to the
overhead cost pools) was determined to be related to facility support.
Total revenue from the sale of guns was $450,000. Total revenue from the sale of
butter was $500,000.
Using the ABC overhead analysis, do the following.
1. Compute the gross profit from the sale of guns
2. Compute the gross profit from the sale of butter
3. Compute overall company gross profit
4. Estimate what gun gross profit would be if only two gun models were produced.

49 50

Problem 15-4 - Answer Problem 15-4 - Answer

Using ABC to compute product costs and make decisions Using ABC to compute product costs and make decisions

Number of Cost per

Cost Cost Driver Cost Driver Company profitability report
Pool Events Event Answers:
Guns Butter
Unit level $200,000 5,000 $40 1. Guns lost $100,000
Number of units 1,000 guns 500,000 pounds
2. Butter made $250,000
Batch level 50,000 500 100 Sales $450,000 $500,000 $950,000 3. Total company profit was $50,000
Product line 250,000 10 25,000 Production cost: 4. If only two gun models were produced,
Direct materials 50,000 100,000 150,000 the ABC analysis suggests that the
Direct labor 120,000 30,000 150,000 amount of overhead assigned to the
Guns Butter Overhead (using ABC): production of guns would decrease by
Unit-level 160,000 40,000 200,000 $125,000, computed as follows.
Unit level overhead Batch-level 45,000 5,000 50,000
Product line 175,000 75,000 250,000 7 gun models x $25,000 per line $175,000
4,000 hours x $40 per hour = $160,000 1,000 hours x $40 per hour = $40,000
Total production cost 550,000 250,000 800,000 2 gun models x $25,000 per line 50,000
Gross profit ($100,000) $250,000 $150,000 Decrease in overhead assigned $125,000
Batch level overhead
Facility support costs 100,000
This decrease in overhead would increase
450 batches x $100 per batch = $45,000 50 batches x $100 per batch = $5,000 Company gross profit $50,000 gun gross profit by $125,000, from a loss
of $100,000 to a profit of $25,000.

Product line overhead

7 models x $25,000 per line = $175,000 3 types x $25,000 per line = $75,000

51 52

Summary and Conclusion

The five steps in implementing and using an ABC system
are as follows:

1. Identify overhead cost activities.

2. Analyze individual overhead costs in
terms of cost activities.
3. Identify measurable cost drivers.
4. Assign overhead.
5. Use the ABC data to make decisions.

The ABC overhead analysis results in overhead cost

assignments that accomplish two things that are
characteristics of a good managerial accounting measure.

1. Reflects economic reality.

2. Motivates correct behavior.

53

15-9
 Lesson 17
Example
Should we make the building more
energy efficient?
At a cost of $300,000, an office building can be made more energy efficient. It is
estimated that the company owning the building will save $20,000 per year in energy
costs. The building will last for 20 more years.

Lesson 17 1. Payback period

$300,000 cost / $20,000 annual savings = 15 years to recover the initial cost
CAPITAL BUDGETING 2. Unadjusted rate of return (or accounting rate of return)
Net income increase of $20,000 from energy cost savings.
Net income decrease of $15,000 ($300,000 / 20 years) from depreciation.
$20,000 - $15,000 = net income increase of $5,000 per year.
Unadjusted rate of return
$5,000 annual net income increase/$300,000 initial investment = 1.7%

1 2

Example
Remember that your business calculator has the following keys:
Should we make the building more
energy efficient? N I PV PMT FV

At a cost of $300,000, an office building can be made more energy efficient. It is where
estimated that the company owning the building will save $20,000 per year in energy
costs. The building will last for 20 more years.
N is the number of periods involved.
3. What is the present value of the energy savings?
Assume that the interest rate is 10%.
I is the interest rate per period.
A $20,000 energy savings this year is worth more, in terms of the time value of
money, than a $20,000 energy savings to occur 20 years from now.
PV is the present value of the cash flows.
It is incorrect to say that the energy efficiency investment of $300,000 will
ultimately save $400,000.
PMT is the amount of a series of equal payments made each period.
($20,000 per year × 20 years)
Compute the present value of the $20,000 savings each year for 20 years.
FV is the future value of the cash flows.

3 4

Example Example
Should we make the building more Should we make the building more
energy efficient? energy efficient?
At a cost of $300,000, an office building can be made more energy efficient. It is At a cost of $300,000, an office building can be made more energy efficient. It is
estimated that the company owning the building will save $20,000 per year in energy estimated that the company owning the building will save $20,000 per year in energy
costs. The building will last for 20 more years. costs. The building will last for 20 more years.

3. What is the present value of the energy savings? 3. What is the present value of the energy savings?
Assume that the interest rate is 10%. Assume that the interest rate is 10%.
Clear memory: C ALL

20 N : 20 because the length of the cash savings interval is 20 years. Net Present Value = Present value of the cash inflows minus
10 I : 10% which was given as the appropriate interest rate. (or NPV) present value of the cash outflows.
20,000 PMT : $20,000 which is the amount of the annual cash savings.
= $170,271 - $300,000
0 FV : $0 because there is no additional cash savings at the end of
the project.
= negative $129,729
PV : For the answer.
$170,271

5 6

17-1
 Example
Should we make the building more Four different capital budgeting techniques:
energy efficient?
At a cost of $300,000, an office building can be made more energy efficient. It is
estimated that the company owning the building will save $20,000 per year in energy
costs. The building will last for 20 more years.
1. Payback period
4. After adjusting for the time value of money, what rate of return
will be earned on the $300,000 investment in energy efficiency
2. Unadjusted rate of return
equipment? Clear memory: C ALL
3. Net present value, or NPV
300,000 +/- PV : Negative $300,000 to represent the initial cash outflow.

20,000 PMT : Positive $20,000 which is the amount of the annual cash inflow.

20 N : 20 because the length of the cash savings interval is 20 years.

4. Internal rate of return, or IRR
0 FV : $0 because there is no additional cash savings at the end of
the project.
I : For the answer.
2.91% INTERNAL RATE OF RETURN (or IRR)

7 8

Example Example
Buying a Weekend Car in Hong Kong Buying a Weekend Car in Hong Kong
A few years ago my family and I lived in Hong Kong. When we arrived, we considered A few years ago my family and I lived in Hong Kong. When we arrived, we considered
buying a car. We didn't really want a good car; we just intended to use it for family buying a car. We didn't really want a good car; we just intended to use it for family
trips on weekends. We found that the cost of a cheap weekend car was HK$40,000. trips on weekends. We found that the cost of a cheap weekend car was HK$40,000.
Note: There are about 7.7 Hong Kong dollars to one U.S. dollar, Note: There are about 7.7 Hong Kong dollars to one U.S. dollar,
so HK$40,000 is the equivalent of $5,195. so HK$40,000 is the equivalent of $5,195.
We estimated that our family of seven could save HK$10,000 per year in bus, taxi, and We estimated that our family of seven could save HK$10,000 per year in bus, taxi, and
MTR (subway) costs by buying the weekend car. The car was expected to last for 5 years. MTR (subway) costs by buying the weekend car. The car was expected to last for 5 years.
Should we have purchased the car? Should we have purchased the car?
1. Payback period 3. Net Present Value (NPV) Clear memory: C ALL

HK$40,000 cost / HK$10,000 annual savings = 4 years to recover the cost of the car 5 N : 5 years
2. Unadjusted rate of return (or accounting rate of return) 10 I : 10%
Net income increase of HK$10,000 from energy cost savings. 10,000 PMT : HK$10,000 which is the amount of the annual cash savings.
Net income decrease of HK$8,000 (HK$40,000 / 5 years) from depreciation. 0 FV : $0 because there is no additional cash savings at the end of
HK$10,000 - HK$8,000 = net income increase of HK$2,000 per year. the project.
Unadjusted rate of return: PV : For the answer.
$HK$2,000 annual net income increase/HK$40,000 initial investment = 5.0% HK$37,908

9 10

Example Example
Buying a Weekend Car in Hong Kong Buying a Weekend Car in Hong Kong
A few years ago my family and I lived in Hong Kong. When we arrived, we considered A few years ago my family and I lived in Hong Kong. When we arrived, we considered
buying a car. We didn't really want a good car; we just intended to use it for family buying a car. We didn't really want a good car; we just intended to use it for family
trips on weekends. We found that the cost of a cheap weekend car was HK$40,000. trips on weekends. We found that the cost of a cheap weekend car was HK$40,000.
Note: There are about 7.7 Hong Kong dollars to one U.S. dollar, Note: There are about 7.7 Hong Kong dollars to one U.S. dollar,
so HK$40,000 is the equivalent of $5,195. so HK$40,000 is the equivalent of $5,195.
We estimated that our family of seven could save HK$10,000 per year in bus, taxi, and We estimated that our family of seven could save HK$10,000 per year in bus, taxi, and
MTR (subway) costs by buying the weekend car. The car was expected to last for 5 years. MTR (subway) costs by buying the weekend car. The car was expected to last for 5 years.
Should we have purchased the car? Should we have purchased the car?
3. Net Present Value (NPV) 4. Internal Rate of Return (IRR) Clear memory: C ALL

40,000 +/- PV : Negative HK$40,000 to represent the initial cash outflow.

Net Present Value = Present value of the cash inflows minus
(or NPV) present value of the cash outflows.
10,000 PMT : Positive HK$10,000 which is the amount of the annual cash
inflow.

= HK$37,908 - HK$40,000 5 N : 5 because the expected life of the car is 5 years.

0 FV : $0 because there is no additional cash savings at the end of the

project.
= negative HK$2,092
I : For the answer.
7.93%
11 12

17-2
 Example
Buying a Weekend Car in Hong Kong Review of time value of money calculations
A few years ago my family and I lived in Hong Kong. When we arrived, we considered
buying a car. We didn't really want a good car; we just intended to use it for family The essence of the concept of the time value of money is as follows:
trips on weekends. We found that the cost of a cheap weekend car was HK$40,000.
Note: There are about 7.7 Hong Kong dollars to one U.S. dollar, A dollar received now is worth more than a dollar to be received in the
so HK$40,000 is the equivalent of $5,195. future because the dollar received now can be invested and will grow in
We estimated that our family of seven could save HK$10,000 per year in bus, taxi, and value. For example, if the interest rate is 10%, receiving a dollar now is
MTR (subway) costs by buying the weekend car. The car was expected to last for 5 years. the same as receiving $1.10 one year from now; the dollar received now
Should we have purchased the car? can be invested and will have grown in value to $1.10 by the end of the
1. Payback period: year.
4 years to recover the cost of the car. $1.00 $1.10
2. Unadjusted rate of return (or accounting rate of return):
5.0% Now One Year
3. Net Present Value (NPV):
Negative HK$2,092 Present Value = $1.00
4. Internal Rate of Return (IRR): Interest Rate = 10%
7.93%

13 14

Examples Examples
Computing the present value of a single amount Computing the present value of a single amount
1. What is the present value of $10,000 to be received 4 years from now if the 2. What is the present value of $100,000 to be received 25 years from now if the
interest rate is 12%? interest rate is 14%?
??? $10,000 ??? $100,000

Now Year 1 Year 2 Year 3 Year 4 Now Year 1 Year 2 Year 3 Year 25

To compute the present value, we input the following into the calculator: To compute the present value, we input the following into the calculator:
Clear memory: C ALL Clear memory: C ALL

4 N : 4 because the time until we receive the cash is 4 years. 25 N : 25 because the time until we receive the cash is 25 years.

12 I : 12% which was given as the appropriate interest rate. 14 I : 14% which was given as the appropriate interest rate.

0 PMT : $0 because this is a one-time cash flow, not a series of equal 0 PMT : $0 because this is a one-time cash flow, not a series of equal
cash flows. cash flows.

10,000 FV : $10,000 because this is the amount of cash we will receive in 100,000 FV : $100,000 because this is the amount of cash we will receive
the future. in the future.
PV : For the answer. PV : For the answer.

$6,355 $3,779
15 16

Examples Examples
Computing the present value of an annuity, Computing the present value of an annuity,
or series of equal payments or series of equal payments
1. What is the present value of $10,000 to be received at the end of each year for 2. You expect to receive $8,000 at the end of each year for the next 4 years. In
the next 4 years? The interest rate is 7%. addition, you expect to receive an additional payment of $25,000 at the end of
??? $10,000 $10,000 $10,000 $10,000
4 years. What is the present value of these payments? The interest rate is 11%.
$25,000
Now Year 1 Year 2 Year 3 Year 4 ??? $8,000 $8,000 $8,000 $8,000

To compute the present value, we input the following into the calculator: Now Year 1 Year 2 Year 3 Year 4

Clear memory: C ALL To compute the present value, we input the following into the calculator:
Clear memory: C ALL
4 N : 4 because four equal payments are expected in the future.
4 N : 4 because four equal payments are expected in the future, and
7 I : 7% which was given as the appropriate interest rate. the additional payment occurs at the end of 4 years.
10,000 PMT : $10,000 which is the amount of each equal cash flow.
11 I : 11% which was given as the appropriate interest rate.
0 FV : $0 because no extra amount is received at the end of 4 years
8,000 PMT : $8,000 which is the amount of each equal cash flow.
when the final annuity payment of $10,000 is received.
PV : For the answer.
25,000 FV : $25,000 which is the amount of the extra payment at the end
of 4 years.
$33,872 PV : For the answer. $41,288
17 18

17-3
 Examples Examples
Computing the internal rate of return Computing the internal rate of return
1. You have $10,000 you wish to invest in an account. You want to be able to 2. You have $100,000 you wish to invest in one of two business projects. Project 1
withdraw $15,000 from the account at the end of 5 years. What rate of return will pay you a lump sum of $220,000 at the end of 10 years. Project 2 will pay
on the account would make this possible? you $17,000 at the end of each year for 10 years. Which project offers the higher
internal rate of return?
$10,000 $15,000
$100,000 $220,000
Project 1:
Now Year 1 Year 2 Year 3 Year 4 Year 5
Now Year 1 Year 2 Year 3 Year 10
To compute the internal rate of return, we input the following into the calculator: To compute the internal rate of return on Project 1, we input the following into
Clear memory: C ALL the calculator:
Clear memory: C ALL
10,000 +/- PV : Negative $10,000 to represent the initial cash outflow.

0 PMT : $0 because we are not expecting yearly withdrawals. 100,000 +/- PV : Negative $100,000 to represent the initial cash outflow.

5 N : 5 because we want to be able to withdraw the $15,000 at the 0 PMT : $0 because we are not expecting yearly cash flows.
end of 5 years.
10 N : 10 because we expect the $220,000 cash flow at the end of 10
years.
15,000 FV : $15,000 because this is the amount of the cash inflow at the
end of 5 years.
220,000 FV : $220,000 because this is the amount of the cash inflow at the
I : For the answer. end of 10 years.

8.45% : For the answer. 8.20%

19 20

Examples Examples
Computing the internal rate of return Computing the internal rate of return
2. You have $100,000 you wish to invest in one of two business projects. Project 1 2. You have $100,000 you wish to invest in one of two business projects. Project 1
will pay you a lump sum of $220,000 at the end of 10 years. Project 2 will pay will pay you a lump sum of $220,000 at the end of 10 years. Project 2 will pay
you $17,000 at the end of each year for 10 years. Which project offers the higher you $17,000 at the end of each year for 10 years. Which project offers the higher
internal rate of return? internal rate of return?
$100,000 $17,000 $17,000 $17,000 $17,000
Project 2:
Now Year 1 Year 2 Year 3 Year 10 Project 2
To compute the internal rate of return on Project 2, we input the following into
the calculator: IRR = 11.03%
Clear memory: C ALL Total Cash Inflow = $170,000 ($17,000 x 10 years)
100,000 +/- PV : Negative $100,000 to represent the initial cash outflow.

17,000 PMT : $17,000 because this is the amount of the yearly cash inflows.
Project 1
10 N : 10 because we expect the $17,000 yearly cash inflows for 10
years. IRR = 8.20%
0 FV : $0 because there is no extra cash inflow at the end of 10 years.
Total Cash Inflow = $220,000
I : For the answer. 11.03%

21 22

Problem 17-1 Problem 17-1 - Answer

Review of present value calculations Review of present value calculations
Compute the following: 1. The present value of $40,000 to be received 8 years from now if the
interest rate is 15%.
1. The present value of $40,000 to be received 8 years from now if the
??? $40,000
interest rate is 15%.
2. The present value of $40,000 to be received 8 years from now if the Now Year 1 Year 2 Year 3 Year 8

interest rate is 9%.

To compute the present value, we input the following into the calculator:
3. The present value of $21,000 to be received at the end of each year for Clear memory: C ALL
the next 50 years if the interest rate is 18%.
4. The present value of $21,000 to be received at the end of each year for 8 N : 8 because the time until we receive the cash is 8 years.
the next 60 years if the interest rate is 18%. 15 I : 15% which was given as the appropriate interest rate.
5. The internal rate of return on a business project that requires an initial 0 PMT : $0 because this is a one-time cash flow, not a series of equal
investment of $600,000. The project will generate cash flows of $75,000 cash flows.
at the end of each year for the next 14 years.
40,000 FV : $40,000 because this is the amount of cash we will receive in
6. The internal rate of return on a business project that requires an initial the future.
investment of $600,000. The project will generate cash flows of $105,000 PV : For the answer.
at the end of each year for the next 10 years.
$13,076

23 24

17-4
 Problem 17-1 - Answer Problem 17-1 - Answer
Review of present value calculations Review of present value calculations
2. The present value of $40,000 to be received 8 years from now if the 3. The present value of $21,000 to be received at the end of each year for
interest rate is 9%. the next 50 years if the interest rate is 18%.
??? $40,000
??? $21,000 $21,000 $21,000 $21,000

Now Year 1 Year 2 Year 3 Year 8

Now Year 1 Year 2 Year 3 Year 50

To compute the present value, we input the following into the calculator: To compute the present value, we input the following into the calculator:
Clear memory: C ALL
Clear memory: C ALL

8 N : 8 because the time until we receive the cash is 8 years.

50 N : 50 because fifty equal payments are expected in the future.
9 I : 9% which was given as the appropriate interest rate.
18 I : 18% which was given as the appropriate interest rate.
0 PMT : $0 because this is a one-time cash flow, not a series of equal
21,000 PMT : $21,000 which is the amount of each equal cash flow.
cash flows.
0 FV : $0 because no extra amount is received at the end of 50 years
40,000 FV : $40,000 because this is the amount of cash we will receive in when the final annuity payment of $21,000 is received.
the future.
PV : For the answer.
PV : For the answer.
$116,637
$20,075

25 26

Problem 17-1 - Answer Problem 17-1 - Answer

Review of present value calculations Review of present value calculations
4. The present value of $21,000 to be received at the end of each year for 5. The internal rate of return on a business project that requires an initial
the next 60 years if the interest rate is 18%. investment of $600,000. The project will generate cash flows of $75,000
at the end of each year for the next 14 years.
??? $21,000 $21,000 $21,000 $21,000
$600,000 $75,000 $75,000 $75,000 $75,000
Now Year 1 Year 2 Year 3 Year 60
Now Year 1 Year 2 Year 3 Year 14

To compute the present value, we input the following into the calculator:
To compute the internal rate of return on the project, we input the following
Clear memory: C ALL
into the calculator:
60 N : 60 because fifty equal payments are expected in the future. Clear memory: C ALL

18 I : 18% which was given as the appropriate interest rate.

600,000 +/- PV : Negative $600,000 to represent the initial cash outflow.

21,000 PMT : $21,000 which is the amount of each equal cash flow.
75,000 PMT : $75,000 because this is the amount of the yearly cash inflows.

0 FV : $0 because no extra amount is received at the end of 60 years

14 N : 14 because we expect the $75,000 yearly cash flows for 14
when the final annuity payment of $21,000 is received. years.
PV : For the answer. 0 FV : $0 because there is no extra cash inflow at the end of 14 years.

$116,661 : For the answer. 8.52%

27 28

Problem 17-1 - Answer

Review of present value calculations Payback Period and Unadjusted Rate of Return
6. The internal rate of return on a business project that requires an initial Capital Budgeting Technique Computation Decision Rule
investment of $600,000. The project will generate cash flows of $105,000
at the end of each year for the next 10 years. Payback Period Compute the length of Accept the project if the
$600,000 $105,000 $105,000 $105,000 $105,000 time until total net cash computed payback
inflow equals the initial period is less than a
Now Year 1 Year 2 Year 3 Year 10 investment cost. predetermined length of
time.
To compute the internal rate of return on the project, we input the following
into the calculator: Unadjusted Rate of Return Compute the additional Accept the project if the
yearly accounting computed unadjusted
Clear memory: C ALL earnings, divided by the rate of return is greater
initial investment cost. than a predetermined
600,000 +/- PV : Negative $600,000 to represent the initial cash outflow. percentage.
105,000 PMT : $105,000 because this is the amount of the yearly cash inflows.
Advantages: Easy to understand and easy to compute.
14 N : 10 because we expect the $105,000 yearly cash flows for 10
Disadvantage: Do not take into account the time value of money.
years.

0 FV : $0 because there is no extra cash inflow at the end of 10 years. Net Present Value
: For the answer. 11.73% and
Internal Rate of Return

29 30

17-5
 Payback Period Unadjusted Rate of Return
Example: You are considering purchasing a new machine to increase your
Project A costs $50,000 and will provide net cash inflows each year production. The machine costs $80,000. Operation of the machine will
of $10,000. Is Project A a good project? generate cash revenues of $40,000 per year and cash expenses of $12,000.
The machine is expected to last for 10 years. The estimated impact of this
$50,000 cost machine on annual net income is computed as follows.
= 5 years to recover the initial cost
$10,000 annual net cash inflow
Net income increase of $28,000 ($40,000 - $12,000) from the
cash revenues and expenses.
Is 5 years a sufficiently quick payback period? Well, that depends
on the nature of the project. Consider the following two scenarios. Net income decrease of $8,000 ($80,000 / 10 years) from
depreciation.
Scenario 1: Project A is an investment in an office building. The
cash inflows will come from annual rent payments to be received. $28,000 - $8,000 = net income increase of $20,000 per year.

Scenario 2: Project A is an investment in a Web-based order

tracking system that is expected to save $10,000 each year in $20,000 annual net income increase
order tracking costs. = 25%
$80,000 initial investment

31 32

Problem 17-2 Problem 17-2 - Answer

Computation of payback period and unadjusted rate of return Computation of payback period and unadjusted rate of return
For each of the following long-term projects, compute: a. Computation of payback period:
Annual Annual Annual Payback
(a) the payback period and Initial Cash Cash Net Cash Period
Cost Revenues Expenses Inflow [Cost / Inflow]
(b) the unadjusted rate of return.
Project 1 $100,000 $45,000 $30,000 $15,000 6.7 years
Project 2 400,000 50,000 5,000 45,000 8.9 years
Also, for each project state whether you think that the company
Project 3 700,000 110,000 40,000 70,000 10.0 years
should or should not undertake the project:
Project 4 800,000 205,000 15,000 190,000 4.2 years

Annual Annual b. Computation of unadjusted rate of return:

Initial Cash Cash Project Unadjusted
Cost Revenues Expenses Life Annual Annual Increase Rate of
Initial Net Cash Project Depreciation in Annual Return
Project 1 $100,000 $45,000 $30,000 8 years Cost Inflow Life [Cost/Life] Net Income [Income/Cost]

Project 2 400,000 50,000 5,000 10 years Project 1 $100,000 $15,000 8 years $12,500 $2,500 2.50%
Project 2 400,000 45,000 10 years 40,000 5,000 1.30%
Project 3 700,000 110,000 40,000 10 years
Project 3 700,000 70,000 10 years 70,000 0 0.00%
Project 4 800,000 205,000 15,000 20 years Project 4 800,000 190,000 20 years 40,000 150,000 18.80%

33 34

Problem 17-2 - Answer

Computation of payback period and unadjusted rate of return
Net Present Value
Capital Budgeting Technique Computation Decision Rule
For each project state whether you think that the company should or should
not undertake the project: Net Present Value (NPV) Compute the present Accept the project if the
value of all cash net present value (NPV)
Answer: Project 1 and Project 2 both have relatively long payback inflows and outflows is greater than zero.
and add them together.
periods compared to the total expected life of the projects. This is
confirmed by the low unadjusted rates of return for both projects
(2.5% and 1.3%). Project 3 is even worse; the payback period is There are five general steps associated with Net Present Value (NPV) analysis.
exactly the same length of time as the expected project life, so even if 1. Estimate the amount and timing of all cash inflows and outflows associated
the projects lasts as long as it is expected to last, you still will have with the project.
just barely recovered your initial investment in the project. This bad
news is confirmed with an unadjusted rate of return of 0.0%. So these 2. Evaluate the riskiness of the project in order to select an appropriate
numbers suggest that you should reject Project 1, Project 2, and required rate of return.
Project 3. 3. Use time value of money calculations to adjust all cash flows to a common
point in time in order to make the cash flows comparable. "Now" is the
Project 4 has a quick payback period of just 4.2 years, especially point in time traditionally used.
compared to the 20-year expected life of the project. Project 4 also has
a relatively high unadjusted rate of return of 18.8%. These numbers 4. Add up the discounted cash flows.
suggest that it is a good idea to go ahead with Project 4. 5. Make a decision. If the total of the discounted cash flows is positive, the
project is a good one, meaning that it generates an above-normal return
and thus adds value to the company.

35 36

17-6
 1. Estimate the amount and timing of all cash inflows and 2. Evaluate the riskiness of the project in order to select
outflows associated with the project. an appropriate required rate of return.

Since we can't tell the future the best we can do is estimate the amount High Risk: A project that could result in very good cash flows or very bad
and timing of all future cash flows. cash flows.
Example: Developing commercial spacecraft to cater to space tourists.

This requires a very thorough understanding of: Evaluated using: High Intrest Rates.

Low Risk: A project that will result in about the same cash flows no
the project. matter whether things turn out very well or very poorly is said
the market for my products. to have .
Example: Building a McDonald's location in a high-traffic area.
the markets for my raw materials.
Evaluated using: Low Intrest Rates.
my workers.
other important inputs into my production process. We will usually just assume a certain interest rate, although we will
briefly discuss one technique (the weighted-average cost of capital) that
is used in computing an interest rate that can be used in an NPV analysis.

37 38

3. Use time value of money calculations to adjust all cash 4. Add up the discounted cash flows.
flows to a common point in time in order to make the
cash flows comparable. We learned how to do this years ago in second grade.
"Now" is the point in time traditionally used.
The reason we compute the present value of the cash flows is that we need to line up
all of the cash flows at the same point in time for them to be comparable. Remember We just add up the numbers.
that the key insight of the concept of the time value of money is that a dollar in cash
flow today is not the same as a dollar in cash flow next year, and is certainly not the
same as a dollar in cash flow 20 years from now. By using time value of money Be careful to treat:
computations to adjust all of the cash flows to a common point in time, we can then be
comfortable about comparing them.
When first doing an NPV analysis, many students grasp the importance of the time The cash outflows as negative numbers.
value of money computations, but they want to compute the value of all of the cash
flows as of the END of the project rather than as of the beginning of the project.
NFV (or Net Future Value) Analysis
and
The reason that we do an NPV, or present value, analysis rather than an NFV, or future
value, analysis, is twofold: The cash inflows as positive numbers.
1. The tradition for NPV analysis is deeply ingrained.
2. An NPV analysis makes sense because it involves computing the value of all of
the project's cash flows in terms of "right now" dollars.

39 40

Example
5. Make a decision. If the total of the discounted cash Purchase of equipment
flows is positive, the project is a good one, meaning that Ryan Company is considering whether to invest in a piece of equipment that requires an
it generates an above-normal return and thus adds investment of $500,000 today. The project will provide net operating cash inflows of
value to the company. $150,000 at the end of each year for five years, and it will have a salvage value of $0 at the
end of five years. Ryan Company uses straight-line depreciation. The appropriate interest
A positive NPV project; is one that we should do. The project earns a normal rate rate is 10%.
of return, as represented by the interest rate used in the present value calculations, ($500,000) $150,000 $150,000 $150,000 $150,000 $150,000
plus some extra.
Now Year 1 Year 2 Year 3 Year 4 Year 5
A negative NPV project; is one that we should not do because it earns less than a
The present value of the annuity of $150,000 for 5 years is computed as follows.
normal rate of return.
Clear memory: C ALL
A NPV of exactly zero; should we do it or not? For a zero NPV project, it doesn't
matter whether the company does it or not; the project earns a normal rate of return, 5 N : 5 because five equal payments are expected in the future.
but we could get that same return from any number of other "normal" projects.
10 I : 10% which was given as the appropriate interest rate.
Another way to interpret the amount of a project's NPV is that this is the amount by
which the value of the entire company changes the instant that the decision is made 150,000 PMT : $150,000 which is the amount of each equal cash flow.

to go forward with the project. The theoretical value of a company is the present 0 FV : $0 because no extra amount is received at the end of 5 years
value of the future cash flows expected to be generated by the company. The instant when the final annual cash inflow of $150,000 is generated.
that a company decides to undertake a positive NPV project, the present value of the
future cash flows to be generated by that company have increased, so the value of PV : For the answer.
the company itself increases. $568,618
41 42

17-7
 Example Example
Purchase of equipment Purchase of a doughnut-making machine
Ryan Company is considering whether to invest in a piece of equipment that requires an Franklin Bakery is considering buying a new doughnut-making machine. The cost of the machine
investment of $500,000 today. The project will provide net operating cash inflows of is $10,000. The machine will last for ten years and is expected to be worth $1,000 as scrap at that
$150,000 at the end of each year for five years, and it will have a salvage value of $0 at the time. The new machine will reduce operating costs by $700 per year. In addition, the new
end of five years. Ryan Company uses straight-line depreciation. The appropriate interest machine will allow for an increase in production of 10,000 doughnuts per year. Franklin makes
rate is 10%. 10 cents in contribution margin on each doughnut it sells. The required rate of return on this
project is 16 percent.
($500,000) $150,000 $150,000 $150,000 $150,000 $150,000 Salvage value of $1,000
$1,000 $1,000 $1,000 $1,000
($10,000) $700 $700 $700 $700
Now Year 1 Year 2 Year 3 Year 4 Year 5
Now Year 1 Year 2 Year 3 Year 10
The present value calculations with respect to this piece of equipment are summarized in
this table. $700 Annual Cost Savings: Clear memory: C ALL

Interest rate is 10% Present 10 N : 10 because ten equal payments are expected in the future.
Amount Value
Original Cost ($500,000 now) (500,000) (500,000)
16 I : 16% which was given as the appropriate interest rate.

700 PMT : $700 which is the amount of each equal cost savings cash inflow.
Net cash inflows ($150,000 per year) $150,000 × 5 yrs 568,618
0 FV : $0 because no extra cost savings is realized at the end of 10 years
Net Present Value (or NPV) 68,618 when the final cost savings amount of $700 is generated.

PV : For the answer.

Depreciation expense each year is $100,000 ($500,000 cost / 5-year life).
$3,383

43 44

Example Example
Purchase of a doughnut-making machine Purchase of a doughnut-making machine
Franklin Bakery is considering buying a new doughnut-making machine. The cost of the machine Franklin Bakery is considering buying a new doughnut-making machine. The cost of the machine
is $10,000. The machine will last for ten years and is expected to be worth $1,000 as scrap at that is $10,000. The machine will last for ten years and is expected to be worth $1,000 as scrap at that
time. The new machine will reduce operating costs by $700 per year. In addition, the new time. The new machine will reduce operating costs by $700 per year. In addition, the new
machine will allow for an increase in production of 10,000 doughnuts per year. Franklin makes machine will allow for an increase in production of 10,000 doughnuts per year. Franklin makes
10 cents in contribution margin on each doughnut it sells. The required rate of return on this 10 cents in contribution margin on each doughnut it sells. The required rate of return on this
project is 16 percent. project is 16 percent.
Salvage value of $1,000 Salvage value of $1,000
$1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000
($10,000) $700 $700 $700 $700 ($10,000) $700 $700 $700 $700

Now Year 1 Year 2 Year 3 Year 10 Now Year 1 Year 2 Year 3 Year 10

$1,000 Annual Contribution Margin Increase: The $1,000 salvage value at the end of 10 years is a one-time cash inflow. The present value of
Clear memory: C ALL
this cash inflow is computed as follows.
10 N : 10 because ten equal payments are expected in the future.
Clear memory: C ALL

16 I : 16% which was given as the appropriate interest rate.

10 N : 10 because the time until we receive the salvage value is 10 years.
1,000 PMT : $1,000 which is the amount of each annual increase in contribution margin.
16 I : 16% which was given as the appropriate interest rate.
0 FV : $0 because no extra contribution margin is realized at the end of 10 years
when the final increased contribution margin amount of $1,000 is generated. 0 PMT : $0 because this is a one-time cash flow, not a series of equal cash flows.

PV : For the answer. 1,000 FV : $1,000 because this is the amount of cash we will receive in the future.

$4,833 : For the answer. $227

45 46

Example
Purchase of a doughnut-making machine Computation of the Weighted-Average Cost of Capital
Franklin Bakery is considering buying a new doughnut-making machine. The cost of the machine There are two ways to think of this choice of the correct interest rate.
is $10,000. The machine will last for ten years and is expected to be worth $1,000 as scrap at that
time. The new machine will reduce operating costs by $700 per year. In addition, the new 1. Use the interest rate that can be earned on comparable investments.
machine will allow for an increase in production of 10,000 doughnuts per year. Franklin makes
10 cents in contribution margin on each doughnut it sells. The required rate of return on this This is an OPPORTUNITY COST approach.
project is 16 percent. 2. Use the weighted-average cost of acquiring the funds to finance the project.
Salvage value of $1,000
$1,000 $1,000 $1,000 $1,000
($10,000) $700 $700 $700 $700 This is an OUT-OF-POCKET COST approach.
Now Year 1 Year 2 Year 3 Year 10 Cost of debt. The cost of borrowing is reflected in the interest rate that must be
paid on the debt.
The present value calculations with respect to the doughnut machine are summarized in this table.
Cost of new equity. In order to induce investors to purchase newly-issued shares
Interest rate is 16% Present of stock, the investors must expect a return on their investment. Accordingly, the
Amount Value issuance price of the shares must be low enough so that investors can expect the
share price to rise over time, on average, to give them a return on their investment.
Original Cost ($10,000 now) (10,000) (10,000) This return that investors expect can be thought of as the implicit
Scrap Value ($1,000 after 10 years) 1,000 227 cost associated with capital raised through issuance of new shares of stock.

Operating Cost Savings ($700 per year for 10 years) Cost of retained earnings. A very convenient way for a company to raise new
$700 × 10 yrs 3,383
capital is to simply retain some or all of the company's profits. At first glance, this
Increased Profits from Sales (10,000 units @ $.10) $1,000 × 10 yrs 4,833 may seem like a costless way to raise financing. However, the shareholders, to
whom all of the profits belong, expect some return on the profits that are retained
Net Present Value (or NPV) (1,557) in the business. This expected return can be thought of as the implicit cost of
financing obtained through retaining earnings.

47 48

17-8
 Example Problem 17-3
Computation of the weighted-average cost of capital (WACC) Computation of NPV

Twenty percent of a company's total capital is debt, 35 percent is MaScare Company is considering whether to purchase a
from the issuance of stock, and 45 percent is equity from retained new store. The store will cost $2,500,000. The store will generate
earnings. The company has determined that the cost of its debt net cash inflows of $400,000 at the end of each year for the next
capital is 8 percent and the cost of its equity capital is 20 percent 20 years. At the end of 20 years, it is expected that the store can
from stock and 15 percent from retained earnings. Compute the be sold for $700,000. The appropriate interest rate is 14%.
company's weighted-average COST OF CAPITAL.
Compute the net present value (NPV) of the store purchase
and state whether you think MaScare Company should purchase
Cost of Average Cost the store.
Type Capital Weight of Capital
Debt . . . . . . . . . . . . . . . . . . . . 8% x 20% = 1.60%
Equity (stocks) . . . . . . . . . . . . 20% x 35% = 7.00%
Equity (retained earnings) . . . 15% x 45% = 6.75%
WACC 100% 15.35%

49 50

Problem 17-3 - Answer Problem 17-3 - Answer

Computation of NPV Computation of NPV
Clear memory: C ALL
A timeline of the cash flows associated with this store is as follows.
Note that the initial purchase price of $2,500,000 is shown on the timeline 20 N : 20 because the length of the operating life of the store is 20
as a negative amount representing a cash outflow. years.

14 I : 14% which was given as the appropriate interest rate.

Salvage value of $700,000
(2,500,000) $400,000 $400,000 $400,000 $400,000 400,000 PMT : $400,000 which is the amount of each equal net cash inflow.
Now Year 1 Year 2 Year 3 Year 20 700,000 FV : $700,000 because this additional cash inflow is to be
received at the end of 20 years when the store is sold.

Three cash flows are associated with the store - the immediate $2,500,000 PV : For the answer.
cash outflow to purchase the store, the $400,000 net cash inflow per year for
20 years that will be generated by the store, and the $700,000 cash inflow at
$2,700,185
the end of 20 years from the sale of the store. Of course, computation of the Note that we took a little shortcut here and computed the present value of
present value of the immediate $2,500,000 cash outflow is easy - the present the $400,000 annual cash inflows and the present value of the $700,000 to
value of $2,500,000 out right now is just $2,500,000. The combined present be received at the end of 20 years all in one step. This works because the
value of the annuity of $400,000 for 20 years as well as the $700,000 selling length of the annuity is 20 years and the time until the store is sold is also
price of the store at the end of 20 years is computed as follows. 20 years. If the store were to be sold at, say, the end of 21 years, then we
would have to compute these two present values in separate steps.

51 52

Problem 17-3 - Answer Problem 17-4

Computation of NPV Computation of WACC
The present value calculations with respect to this piece of equipment are Harold Company receives its financing from four different sources in various
summarized in this table. proportions, as follows.
Proportion of
Interest rate is 14% Present Total Financing
Amount Value
Short-term debt 10%
Original Cost ($2,500,000 now) (2,500,000) (2,500,000)
Long-term debt 45%
Net cash inflows $400,000 × 20 yrs
New stock issues 15%
$700,000 at end of 20 yrs 2,700,185
Net Present Value (or NPV) $200,185 Retained earnings 30%
Total 100%
Because the present value of the cash inflows ($2,700,185) is greater than
the present value of the cash outflows ($2,500,000), the project has a The cost of short-term debt is 6 percent; the cost of long-term debt is 9 percent.
positive NPV and should be undertaken. In addition, Harold Company has estimated the cost of its equity capital to be
22 percent from stock and 16 percent from retained earnings. Compute Harold
Company's weighted-average COST OF CAPITAL (WACC).

53 54

17-9
 Problem 17-4 - Answer Problem 17-5
Computation of WACC NPV and a Least-Cost Decision
Harold Company's weighted-average cost of capital (WACC) is 12.75%, as
shown below. Kamili Company is required to install a new piece of safety
equipment. The company has two alternatives for the equipment.
Cost of Average Cost One alternative would cost $260,000 immediately but would not
Type Capital Weight of Capital add to operating costs over the five-year life of the equipment.
Short-term debt . . . . . . . . . . . . 6% x 10% = 0.60% The second alternative costs $75,000 immediately but would add
$45,000 to annual operating costs for five years. Kamili Company
Long-term debt . . . . . . . . . . . . 9% x 45% = 4.05%
uses an 8 percent interest rate in evaluating long-term projects.
Equity (stocks) . . . . . . . . . . . . 22% x 15% = 3.30%
Equity (retained earnings) . . . 16% 30% 4.80% Which alternative should Kamili Company purchase?
WACC 100% 12.75%

55 56

Problem 17-5 - Answer

Internal rate of return
NPV and a Least-Cost Decision
Kamili Company should choose the second alternative because it has a lower Capital Budgeting Technique Computation Decision Rule
outlay cost, in present value terms, as shown below. Internal Rate of Return Compute the interest rate Accept the project if the
(IRR) that makes the present internal rate of return
Clear memory: C ALL
value of the cash inflows (IRR) is greater than a
equal to the present value predetermined hurdle rate.
5 N : 5 because operating costs are increased in each year for 5 years.
of the cash outflows.
8 I : 8% which was given as the appropriate interest rate.

45,000 PMT : $45,000 which is the amount of the increase in annual operating Internal rate of return, or IRR, is the interest rate that makes the present value of
costs. the cash inflows equal to the present value of the cash outflows. In other words,
the IRR is the interest rate that causes the NPV to be equal to zero.
0 FV : $0 because no extra cost exists at the end of 5 years.
PV : For the answer. Savings Account: 0.5% Intrest
$179,672 Certificate of Deposit: 3.5% Intrest
The first alternative costs $260,000. The internal rate of return, or IRR, is the measure of what rate of return you can
earn on a long-term project.
The second alternative costs just $254,672 ($75,000 + $179,672) in present
value terms.

57 58

Example Example
Purchase of equipment Purchase of equipment
Ryan Company is considering whether to invest in a piece of equipment that Ryan Company is considering whether to invest in a piece of equipment that
requires an investment of $500,000 today. The project will provide net operating requires an investment of $500,000 today. The project will provide net operating
cash inflows of $150,000 at the end of each year for five years, and it will have a cash inflows of $150,000 at the end of each year for five years, and it will have a
salvage value of $0 at the end of five years. The appropriate interest rate is 10%. salvage value of $0 at the end of five years. The appropriate interest rate is 10%.
NPV = $68,618 NPV = $68,618
To compute the NPV of this project with an interest rate of 20%, we compute the The present value calculations with respect to this piece of equipment are
present value of the annuity of $150,000 each year for 5 years, as follows. summarized in this table.
Clear memory: C ALL

5 N : 5 because five equal payments are expected in the future. Interest rate is 20% Present
Amount Value
20 I : 20% which is the interest rate that we are trying.
Original Cost ($500,000 now) (500,000) (500,000)
150,000 PMT : $150,000 which is the amount of each equal cash flow.
Net cash inflows ($150,000 per year) $150,000 × 5 yrs 448,592
0 FV : $0 because no extra amount is received at the end of 5 years
when the final annual cash inflow of $150,000 is generated.
Net Present Value (or NPV) (51,408)
PV : For the answer.

$448,592

59 60

17-10
 Example Example
Purchase of equipment Purchase of equipment
Ryan Company is considering whether to invest in a piece of equipment that Ryan Company is considering whether to invest in a piece of equipment that
requires an investment of $500,000 today. The project will provide net operating requires an investment of $500,000 today. The project will provide net operating
cash inflows of $150,000 at the end of each year for five years, and it will have a cash inflows of $150,000 at the end of each year for five years, and it will have a
salvage value of $0 at the end of five years. The appropriate interest rate is 10%. salvage value of $0 at the end of five years. The appropriate interest rate is 10%.
NPV with a return of 10% = $68,618 NPV with a return of 10% = $68,618
NPV with a return of 20% = ($51,408) NPV with a return of 20% = ($51,408)
It looks like the return that will result in an NPV of exactly zero will be somewhere Let's verify this by computing the present value of the $150,000 annuity using an
around 15%, but we can compute this return exactly, as follows. interest rate of 15.2382%.
Clear memory: C ALL Clear memory: C ALL

500,000 +/- PV : Negative $500,000 to represent the initial cash cost of the project. 5 N : 5 because five equal payments are expected in the future.

150,000 PMT : Positive $150,000 which is the amount of the annual cash inflow.
15.2382 I : 15.2382% which is the interest rate that we are trying.

5 N : 5 because the length of the project is 5 years.

150,000 PMT : $150,000 which is the amount of each equal cash flow.

0 FV : $0 because there is no additional cash inflow at the end of the

project.
0 FV : $0 because no extra amount is received at the end of 5 years
when the final annual cash inflow of $150,000 is generated.
I : For the answer. 15.2382% : For the answer. $500,000

61 62

Example Example
Purchase of equipment Computing the IRR of a business project
Ryan Company is considering whether to invest in a piece of equipment that A business project requires the initial outlay of $200,000 in cash. The project will
requires an investment of $500,000 today. The project will provide net operating generate cash inflows of $40,000 at the end of each year for the next 15 years. What
cash inflows of $150,000 at the end of each year for five years, and it will have a is the internal rate of return of this project?
salvage value of $0 at the end of five years. The appropriate interest rate is 10%.
The following inputs into our business calculator will allow us to compute the IRR.
NPV with a return of 10% = $68,618
NPV with a return of 20% = ($51,408) Clear memory: C ALL

The present value calculations with respect to this piece of equipment, with an
interest rate of 15.2382%, are summarized in this table. 200,000 +/- PV : Negative $200,000 to represent the initial cash cost of the
project.

Interest rate is 15.2382% Present

40,000 PMT : Positive $40,000 which is the amount of the annual cash
inflow.
Amount Value
Original Cost ($500,000 now) (500,000) (500,000) 15 N : 15 because the length of the project is 15 years.

Net cash inflows ($150,000 per year) $150,000 × 5 yrs 500,000 0 FV : $0 because there is no additional cash inflow at the end of
the project.
Net Present Value (or NPV) -0- I : For the answer.

18.41546%

63 64

Example Example
Computing the IRR of a business project Computing the IRR of a business project
A business project requires the initial outlay of $200,000 in cash. The project will A business project requires the initial outlay of $200,000 in cash. The project will
generate cash inflows of $40,000 at the end of each year for the next 15 years. What generate cash inflows of $40,000 at the end of each year for the next 15 years. What
is the internal rate of return of this project? is the internal rate of return of this project?

Let's check this answer to see whether the interest rate 18.41546% does indeed yield The present value calculations with respect to this piece of equipment, with an
an NPV of zero. We compute the present value of the annuity of $40,000 per year as interest rate of 18.41546%, are summarized in this table.
follows.
Clear memory: C ALL Interest rate is 18.41546% Present
Amount Value
15 N : 15 because fifteen equal cash flows are expected in the future. Original Cost ($200,000 now) (200,000) (200,000)
18.41546 I : 18.41546% which is the interest rate that we are trying.
Net cash inflows ($40,000 per year for 15 years) $40,000 × 15 yrs 200,000
40,000 PMT : $40,000 which is the amount of each equal cash flow.
Net Present Value (or NPV) -0-
0 FV : $0 because no extra amount is received at the end of 15 years
when the final annual cash inflow of $40,000 is generated.
PV : For the answer. If the minimum rate of return is 15%, then we should undertake this project.
If the minimum rate of return is 20%, then we should reject this project.
$200,000

65 66

17-11
 Example Problem 17-6
Computing the IRR of a piece of equipment Computation of IRR
Aina Company is considering whether to invest in a piece of equipment that
requires an investment of $250,000 today. The project will provide net cash inflows MaScare Company is considering whether to purchase a
of $50,000 per year for eight years, and it will have a salvage value of $51,509 at new store. The store will cost $2,500,000. The store will generate
the end of eight years. Calculate the INTERNAL RATE OF RETURN. net cash inflows of $400,000 at the end of each year for the next
20 years. At the end of 20 years, it is expected that the store can
The following inputs into our business calculator will allow us to compute the IRR. be sold for $700,000. The minimum required rate of return on
Clear memory: C ALL
projects such as this is 14%.

250,000 +/- PV : Negative $250,000 to represent the initial cash cost of the project. Compute the internal rate of return (IRR) of the store
purchase and state whether you think MaScare Company should
50,000 PMT : Positive $50,000 which is the amount of the annual cash inflow.
purchase the store.
8 N : 8 because the life of the equipment is 8 years.

51,509 FV : Positive $51,509 because this is an additional cash inflow at the

end of 8 years.

I : For the answer. 14.0%

If the minimum rate of return is 15%, then we should buy this equipment.
If the minimum rate of return is 20%, then we should we should not buy the equipment.

67 68

Problem 17-6 - Answer

Computation of IRR Capital Rationing (ranking projects)
The following business calculator inputs will allow us to compute the IRR.
Clear memory: C ALL

2,500,000 +/- PV : Negative $2,500,000 to represent the initial cash cost of the store.

400,000 PMT : Positive $400,000 which is the amount of the annual cash inflow.
Screening
20 N : 20 because the life of the store is 20 years.
Identifying which projects are good and which are bad.
700,000 FV : Positive $700,000 because this is the amount for which the store
can be sold at the end of 20 years.

I : For the answer. 15.3%

The internal rate of return, or IRR, for this project is 15.3%; this is the interest rate that yields an
NPV of exactly zero. Because the minimum rate of return on a project such as this is 14%, then
Ranking
these IRR calculations suggest that we should buy the store.
You may recall that this is exactly the same capital budgeting decision that we examined in
Choosing the best among a set of good projects.
Walkthrough Problem 17-3. In that problem we computed the NPV of the store purchase; the NPV,
with an interest rate of 14%, is positive $200,185 indicating that we should buy the store. In this
problem we computed the IRR of the store purchase to be 15.3%; when compared to the minimum
rate of return of 14%, we see that the decision is again that we should buy the store. The NPV and
the IRR calculations will always identify the same projects as being attractive and the same
projects as being ones that we should reject.

69 70

The Good News Example

We don't have to learn any new time value of money tools in order to
Ranking Capital Budgeting Projects
rank projects. Mimi Company is considering three projects. Mimi has already determined that each of the
projects has a positive NPV. However, Mimi can only undertake one of the projects, so she
Internal Rate of Return (IRR) - excellent tool for ranking projects. would like to identify which one of the projects is the best. Each of the projects involves
an initial investment and results in an annuity of cash inflows in the future. The details for
The one with the highest IRR is the best. each of the three projects are as follows.
Net Present Value (NPV) - not a good measure to use for ranking. Initial Annual Length
Investment Cash Inflow of Project
The biggest project, or the project with the largest initial investment.
Always gives preference to LARGE projects, when a series of small projects Project 1 $200,000 $35,000 8 years
could yield a higher overall NPV. Project 2 300,000 60,000 7 years
Profitability Index Project 3 170,000 27,000 10 years
Easier to compute the NPV of a project than it is to compute the project's IRR. Which one of the projects should Mimi Company undertake?
The project evaluation systems of many companies are designed around the Note: Mimi Company has established a minimum required rate of return of 8%.
computation of NPV. Initial Profitability
It is often the case that we know the NPV of a project but we don't know the Investment IRR NPV Index
project's IRR. Project 1 $200,000 8.15% $1,132 1.006
In these cases, we can easily compute the project's Profitability Index Project 2 300,000 9.20% 12,382 1.041
from the NPV.
Project 3 170,000 9.44% 11,172 1.066
Profitability Index = (NPV / Initial Investment) + 1 Profitability Index = (NPV / Initial Investment) + 1

71 72

17-12
 Screening Problem 17-7
Ranking Long-term Projects
Which projects have a positive NPV.
A real estate company is considering four different investments.
Which projects have a negative NPV. Each of the investments involves an initial cash outflow now with a
single cash inflow a number of years in the future. The company's
Which projects have IRR above or below the required rate of return is 12%. Your job is to rank the investments.
required rate of return. To do so, compute both the IRR and the Profitability Index for each
of the four investments.

Ranking Initial
Single
Cash
Years Until
Cash
Investment Inflow Inflow
Rank projects to pick the best one using either:
Investment 1 $10,000 $37,000 10
IRR
Investment 2 10,000 90,000 15
Profitability Index
Investment 3 100,000 400,000 10
Investment 4 100,000 700,000 15

73 74

Problem 17-7 - Answer Problem 17-7 - Answer

Ranking Long-term Projects Ranking Long-term Projects

We can use our business calculators to calculate the NPV and the IRR of each of Profitability Index computations for each of the four investments reveal the
the projects. following.
Initial Initial Profitability
Investment NPV IRR Investment NPV Index
Investment 1 $10,000 $1,913 13.98% Investment 1 $10,000 $1,913 1.1913
Investment 2 10,000 6,443 15.78% Investment 2 10,000 6,443 1.6443
Investment 3 100,000 28,789 14.87% Investment 3 100,000 28,789 1.2879
Investment 4 100,000 27,887 13.85% Investment 4 100,000 27,887 1.2789

Using the IRR numbers, we see that Investment 2, with an IRR of 15.78%, is the Again we see that Investment 2 is the best of the four investments because it has
best of the four investments and is the one investment that we should choose if the highest Profitability Index. So whether we use the IRR or the Profitability
we can only choose one of the four investments. Note again that all of the Index, Investment 2 is shown to be the best.
investments are good in that they all have a positive NPV and an IRR above the
minimum required rate of return of 12%, but Investment 2 is the best of the four.

75 76

Impact of Income Taxes on

The impact of income taxes on Cash Revenues and Cash Expenses
NPV and IRR analysis
The existence of income taxes makes good news not so good and bad
news not so bad.

Example: Assume that you have earned $1,000.

The two primary impacts of income taxes: Assume that the income tax rate is 40%.

After-tax cash flow = Before-tax cash flow × (1 - Tax Rate) Your before-tax earnings $1,000
Income tax (40%) (400)
Depreciation tax shield = Depreciation Deduction × (Tax Rate) After-tax earnings $600

We can express this in a formula:

After-tax earnings = Before-tax earnings × (1 - Tax Rate)
After-tax earnings = $1,000 × (1 - 0.40)
After-tax earnings = $600

After-Tax Cash Flows

77 78

17-13
 Example
Impact of Income Taxes on
After-tax earnings
Cash Revenues and Cash Expenses
You earn $100. The income tax rate is 99%.
The existence of income taxes makes good news not so good and bad
news not so bad.
What are your after-tax earnings?
Example: You pay $1,000 for advertising. The income tax rate is 40%.
After-tax earnings = Before-tax earnings × (1 - Tax Rate) What is the after-tax cost of the advertising?
After-tax earnings = $100 × (1 - 0.99) Before-tax cost $1,000
After-tax earnings = $1 Reduction in taxes (400)
After-tax cost $600

We can express this in a formula:

In doing a capital budgeting analysis, the only relevant number
is the after-tax earnings which is what you get to keep. After-tax cost = Before-tax cost × (1 - Tax Rate)
After-tax cost = $1,000 × (1 - 0.40)
After-tax cost = $600

79 80

Example
After-tax cost
You pay $100 for advertising. The income tax rate is 99%.

What is the after-tax cost of the advertising? The existence of income taxes means that you don't
get to keep all of the cash inflows that you generate,
After-tax cost = Before-tax cost × (1 - Tax Rate) but you also get a tax subsidy (in essence) for all of
After-tax cost = $100 × (1 - 0.99) your tax-deductible business expenses.
After-tax cost = $1

In doing a capital budgeting analysis, the only relevant number

is the after-tax cost which is what you end up paying.

81 82

Depreciation Tax Shield

Example: Assume that you report a $1,000 depreciation deduction Remember, depreciation is a non-cash expense.
on your tax form. The income tax rate is 40%. How much does this
depreciation deduction save you in income taxes? By lowering your Thus, in doing time value of money calculations, we ignore
taxable income by $1,000, the depreciation deduction will save you
$400 ($1,000 × 0.40) in income taxes. A formula to compute the depreciation because it doesn't involve any cash flow.
amount of the depreciation tax savings is as follows.
Except when we are considering the impact of income
Depreciation tax savings = Depreciation Deduction × (Tax Rate) taxes. When you write down the amount of the non-cash
= $1,000 × 0.40 depreciation expense on your income tax form, you reduce
= $400 your taxable income and therefore reduce the amount of
income tax that you pay. So in the specific context of
Example: You report a $100 depreciation deduction on your tax
income taxes, depreciation does result in a cash inflow in
form. The income tax rate is 99%. How much does this depreciation the form of an income tax savings.
deduction save you in income taxes?

Depreciation tax savings = Depreciation Deduction × (Tax Rate)

Depreciation tax savings = $100 × 0.99
Depreciation tax savings = $99

83 84

17-14
 Example Example
Computing NPV in a setting with income taxes Computing NPV in a setting with income taxes
Ryan Company is considering whether to invest in a piece of equipment that requires an Ryan Company is considering whether to invest in a piece of equipment that requires an
investment of $500,000 today. The project will provide net before-tax operating cash inflows investment of $500,000 today. The project will provide net before-tax operating cash inflows
of $150,000 at the end of each year for five years, and it will have a salvage value of $0 at the of $150,000 at the end of each year for five years, and it will have a salvage value of $0 at the
end of five years. Ryan Company uses straight-line depreciation. The interest rate is 10%. end of five years. Ryan Company uses straight-line depreciation. The interest rate is 10%.
The income tax rate is 30%. Calculate the NET PRESENT VALUE of the piece of The income tax rate is 30%. Calculate the NET PRESENT VALUE of the piece of
equipment and state whether the equipment should be purchased. equipment and state whether the equipment should be purchased.
1. Cash outflow of $500,000 today for the purchase of the equipment.
The after-tax operating cash inflow of $105,000 is an annuity with a present value of $398,033
The existence of income taxes does not change this amount.
computed as follows.
The deduction does not occur immediately.
The $500,000 cost of the equipment is deducted as depreciation expense Clear memory: C ALL
over the 5-year life of the equipment.

2. After-tax operating cash inflow of $105,000 at the end of each year for five years.
5 N : 5 because five equal cash inflows are expected in the future.

After-tax operating cash inflow = Before-tax operating cash inflow × (1 - Tax Rate) 10 I : 10% which is given as the appropriate interest rate.
After-tax operating cash inflow = $150,000 × (1 - 0.30)
After-tax operating cash inflow = $150,000 × 0.70 105,000 PMT : $105,000 which is the amount of each after-tax cash inflow.
After-tax operating cash inflow = $105,000
0 FV : $0 because no extra amount is received at the end of 5 years when
3. Annual depreciation tax shield of $30,000 at the end of each year for five years. the final annual after-tax cash inflow of $105,000 is generated.
The anual amount of depreciation is $100,000 ($500,000/5 years). PV : For the answer.
Depreciation tax savings = Depreciation Deduction × (Tax Rate)
Depreciation tax savings = $100,000 × 0.30 $398,033
Depreciation tax savings = $30,000

85 86

Example Example
Computing NPV in a setting with income taxes Computing NPV in a setting with income taxes
Ryan Company is considering whether to invest in a piece of equipment that requires an Ryan Company is considering whether to invest in a piece of equipment that requires an
investment of $500,000 today. The project will provide net before-tax operating cash inflows investment of $500,000 today. The project will provide net before-tax operating cash inflows
of $150,000 at the end of each year for five years, and it will have a salvage value of $0 at the of $150,000 at the end of each year for five years, and it will have a salvage value of $0 at the
end of five years. Ryan Company uses straight-line depreciation. The interest rate is 10%. end of five years. Ryan Company uses straight-line depreciation. The interest rate is 10%.
The income tax rate is 30%. Calculate the NET PRESENT VALUE of the piece of The income tax rate is 30%. Calculate the NET PRESENT VALUE of the piece of
equipment and state whether the equipment should be purchased. equipment and state whether the equipment should be purchased.

The depreciation tax shield of $30,000 is also an annuity with a present value of $113,724 These present value calculations are summarized in this table.
computed as follows.
Clear memory: C ALL Interest rate is 10% Present
Amount Value
5 N : 5 because five equal cash inflows (from tax savings) are expected in
the future. Original Cost ($500,000 now) (500,000) (500,000)

10 I : 10% which is given as the appropriate interest rate. Depreciation tax shield ($100,000 depreciation × 0.30) $30,000 × 5 yrs 113,724
Net cash inflows ($150,000 × [1 – 0.30]) $105,000 × 5 yrs 398,033
30,000 PMT : $30,000 which is the amount of each depreciation tax savings.
Net Present Value (or NPV) 11,757
0 FV : $0 because no extra depreciation tax savings is generated at the end
of 5 years.
PV : For the answer.

$113,724
87 88

Example Example
Computing NPV in a setting with income taxes Computing IRR in a setting with income taxes
1. In the absence of income taxes, this same project has a net present value of $68,618. Lorien Company is considering whether to invest in a piece of equipment that requires
Introduction of income taxes has lowered the NPV of this project. an investment of $600,000 today. The project will provide net before-tax operating
cash inflows of $150,000 at the end of each year for 10 years, and it will have a salvage
With an income tax rate of 40% the NPV for this project would be negative. value of $0 at the end of 10 years. Lorien Company uses straight-line depreciation. The
minimum required rate of return is 12%. The income tax rate is 60%. Calculate the
It is an important fact of business to remember that higher income tax rates can
INTERNAL RATE OF RETURN of the piece of equipment and state whether the
transform attractive projects into unattractive projects.
equipment should be purchased.
2. In this problem, note that without the income tax savings generated by the
depreciation tax shield, this project would have a negative NPV rather than a 1. Cash outflow of $600,000 today for the purchase of the equipment.
positive NPV. 2. After-tax operating cash inflow of $60,000 at the end of each year for 10 years.
The depreciation tax shield is an important part of the cash inflows associated with With an income tax rate of 60%, the after-tax operating cash inflow is computed as follows.
many projects. After-tax operating cash inflow = Before-tax operating cash inflow × (1 - Tax Rate)
After-tax operating cash inflow = $150,000 × (1 - 0.60)
In recognition of this fact, government bodies all over the world often allow After-tax operating cash inflow = $60,000
companies to depreciate the cost of their capital projects very quickly in order to
increase the present value of the depreciation tax savings. 3. Annual depreciation tax shield of $36,000 at the end of each year for 10 years.
The annual amount of straight-line depreciation is $60,000 ($600,000 / 10 years). With an
In the United States, Congress allows companies to use double-declining-balance income tax rate of 60%, the amount of the depreciation tax shield is computed as follows.
depreciation in computing their depreciation deductions for income tax purposes.
By allowing more rapid depreciation, the present value of the depreciation tax Depreciation tax savings = Depreciation Deduction × (Tax Rate)
savings is increased, even though the total amount of depreciation tax savings is Depreciation tax savings = $60,000 × 0.60
the same. Depreciation tax savings = $36,000

89 90

17-15
 Example Problem 17-8
Computing IRR in a setting with income taxes Computing NPV and IRR with income taxes
Lorien Company is considering whether to invest in a piece of equipment that requires Lily Company is considering purchasing a machine. The associated cash inflows and
an investment of $600,000 today. The project will provide net before-tax operating outflows are as follows:
cash inflows of $150,000 at the end of each year for 10 years, and it will have a salvage
value of $0 at the end of 10 years. Lorien Company uses straight-line depreciation. The a. Cost of the machine is $100,000.
minimum required rate of return is 12%. The income tax rate is 60%. Calculate the
b. Net before-tax cash inflows from the output from the machine are
INTERNAL RATE OF RETURN of the piece of equipment and state whether the
equipment should be purchased. expected to be $40,000 per year for 5 years.
c. The required rate of return on this project is 10%.
The following inputs into our business calculator will allow us to compute the IRR.
Clear memory: C ALL
d. All cash flows occur at the end of the appropriate year, except for the
$100,000 initial cost.
600,000 +/- PV : Negative $600,000 to represent the initial cash cost of the project.
e. The machine will be depreciated for tax purposes on a straight-line basis
96,000 PMT : Positive $96,000 which is the sum of the $60,000 after-tax operating
cash inflow and the $36,000 depreciation tax savings.
with an assumed salvage value of $0.
f. The tax rate is 40%.
10 N : 10 because the life of the equipment is 10 years.
COMPUTE:
0 FV : $0 because there is no additional cash inflow at the end of 10 years.

: For the answer. 1. The net present value (NPV) of this machine.
I
2. The internal rate of return (IRR) of this machine.
9.61%

91 92

Problem 17-8 - Answer Problem 17-8 - Answer

Computing NPV and IRR with income taxes Computing NPV and IRR with income taxes
First, let's calculate the amount of each of the three types of cash flow associated 1. Compute the net present value (NPV) of this machine.
with this equipment.
Now that we have computed the amount of the cash flows, we can compute
a. Cash outflow of $100,000 today for the purchase of the machine.
their present values. The present value of the $100,000 purchase price is just
b. After-tax operating cash inflow of $24,000 at the end of each year for five years. $100,000. The after-tax operating cash inflow of $24,000 is an annuity with a
The amount of the before-tax operating cash inflow is $40,000 per year. With an income tax present value of $90,979 computed as follows.
rate of 40%, the after-tax operating cash inflow is computed as follows.
Clear memory: C ALL
After-tax operating cash inflow = Before-tax operating cash inflow × (1 - Tax Rate)
After-tax operating cash inflow = $40,000 × (1 - 0.40) 5 N : 5 because five equal cash inflows are expected in the future.
After-tax operating cash inflow = $24,000
10 I : 10% which is given as the appropriate interest rate
c. Annual depreciation tax shield of $8,000 at the end of each year for five years.
The annual amount of straight-line depreciation is $20,000 ($100,000 / 5 years). With an 24,000 PMT : $24,000 which is the amount of each after-tax cash inflow.
income tax rate of 40%, the amount of the depreciation tax shield is computed as follows.
Depreciation tax savings = Depreciation Deduction × (Tax Rate)
0 FV : $0 because no extra amount is received at the end of 5 years
when the final annual after-tax cash inflow of $24,000 is
Depreciation tax savings = $20,000 × 0.40 generated.
Depreciation tax savings = $8,000
PV : For the answer.

$90,979

93 94

Problem 17-8 - Answer Problem 17-8 - Answer

Computing NPV and IRR with income taxes Computing NPV and IRR with income taxes
1. Compute the net present value (NPV) of this machine. 1. Compute the net present value (NPV) of this machine.

The depreciation tax shield of $8,000 is also an annuity with a present value These present value calculations are summarized in this table.
of $30,326 computed as follows.
Interest rate is 10% Present
Clear memory: C ALL
Amount Value

5 N : 5 because five equal cash inflows (from tax savings) are Original Cost($100,000 now) (100,000) (100,000)
expected in the future. Depreciation tax shield($20,000 depreciation × 0.40) $8,000 × 5 yrs 30,326
10 I : 10% which is given as the appropriate interest rate. Net cash inflows($40,000 × [1 – 0.40]) $24,000 × 5 yrs 90,979
8,000 PMT : $8,000 which is the amount of each depreciation tax savings. Net Present Value (or NPV) 21,305
0 FV : $0 because no extra depreciation tax savings is generated at
the end of 5 years. We see that this project has a positive NPV so we should undertake it.
PV : For the answer.

$30,326

95 96

17-16
 Problem 17-8 - Answer Problem 17-9
Computing NPV and IRR with income taxes Impact of depreciation rules on NPV
2. Compute the internal rate of return (IRR) of this machine. Hilly Pice Company is considering whether to invest in a piece of equipment
that requires an investment of $600,000 today. The project will provide net
The following inputs into our business calculator will allow us to compute before-tax operating cash inflows of $120,000 at the end of each year for 10
the IRR. years, and it will have a salvage value of $0 at the end of 10 years. The
Clear memory: C ALL
minimum required rate of return is 12%.

100,000 +/- PV : Negative $100,000 to represent the initial cash cost of the The income tax rate is 30%. Calculate the NET PRESENT VALUE of the
project piece of equipment and state whether the equipment should be purchased
under each of the following two assumptions about depreciation.
32,000 PMT : Positive $32,000 which is the sum of the $24,000 after-tax
operating cash inflow and the $8,000 depreciation tax savings.
1. Hilly Pice Company uses straight-line depreciation for income tax
5 N : 5 because the life of the machine is 5 years. purposes.

0 FV : $0 because there is no additional cash inflow at the end of 5 2. Instead of using straight-line depreciation, Hilly Pice Company is
years. able to deduct the entire cost of the equipment as an expense in the
year the equipment is purchased. The equipment is paid for at the
I : For the answer. 18.03% beginning of the first year, but the tax savings from being able to
The internal rate of return, or IRR, for this project is 18.03%. Because the deduct the cost of the equipment don't occur until the end of the
minimum rate of return on a project such as this is 10%, these IRR calculations first year.
suggest that we should buy this equipment.

97 98

Problem 17-9 - Answer Problem 17-9 - Answer

Impact of depreciation rules on NPV Impact of depreciation rules on NPV
1. Straight-line depreciation 1. Straight-line depreciation

Let's start by computing the amount of the three cash flows associated with the Now that we have computed the amount of the cash flows, we can compute
purchase of this equipment. their present values. The present value of the $600,000 purchase price is just
$600,000. The after-tax operating cash inflow of $84,000 is an annuity with a
a. Cash outflow of $600,000 today for the purchase of the equipment.
present value of $474,619 computed as follows.
b. After-tax operating cash inflow of $84,000 at the end of each year for 10 years.
Clear memory: C ALL
With an income tax rate of 30%, the after-tax operating cash inflow is computed as follows.
After-tax operating cash inflow = Before-tax operating cash inflow × (1 - Tax Rate)
10 N : 10 because ten equal cash inflows are expected in the future.
After-tax operating cash inflow = $120,000 × (1 - 0.30)
After-tax operating cash inflow = $84,000 12 I : 12% which is given as the appropriate interest rate.

c. Annual depreciation tax shield of $18,000 at the end of each year for 10 years. 84,000 PMT : $84,000 which is the amount of each after-tax cash inflow.
The annual amount of straight-line depreciation is $60,000 ($600,000 / 10 years). With an
income tax rate of 30%, the amount of the depreciation tax shield is computed as follows. 0 FV : $0 because no extra amount is received at the end of 10 years
when the final annual after-tax cash inflow of $84,000 is
Depreciation tax savings = Depreciation Deduction × (Tax Rate) generated.
Depreciation tax savings = $60,000 × 0.30
Depreciation tax savings = $18,000
PV : For the answer.

$474,619

99 100

Problem 17-9 - Answer Problem 17-9 - Answer

Impact of depreciation rules on NPV Impact of depreciation rules on NPV
1. Straight-line depreciation 1. Straight-line depreciation

The depreciation tax shield of $18,000 is also an annuity with a present value These present value calculations are summarized in this table.
of $101,704 computed as follows.
Interest rate is 12% Present
Clear memory: C ALL
Amount Value

10 N : 10 because ten equal cash inflows (from tax savings) are Original Cost ($600,000 now) (600,000) (600,000)
expected in the future.
Depreciation tax shield ($60,000 depreciation × 0.30) $18,000 × 10 yrs 101,704
12 I : 12% which is given as the appropriate interest rate. Net cash inflows ($120,000 × [1 – 0.30]) $84,000 × 10 yrs 474,619
18,000 PMT : $18,000 which is the amount of each depreciation tax savings. Net Present Value (or NPV) (23,677)
0 FV : $0 because no extra depreciation tax savings is generated at
the end of 10 years.
We see that this project has a negative NPV so we should reject it.
PV : For the answer.

$101,704

101 102

17-17
 Problem 17-9 - Answer Problem 17-9 - Answer
Impact of depreciation rules on NPV Impact of depreciation rules on NPV
2. Immediate depreciation of equipment cost instead of straight-line depreciation. 2. Immediate depreciation of equipment cost instead of straight-line depreciation.

Again, let's start by computing the amount of the three cash flows associated Now that we have computed the amount of the cash flows, we can compute
with the purchase of this equipment. their present values. The present value of the $600,000 purchase price is just
$600,000. The after-tax operating cash inflow of $84,000 is an annuity with a
a. Cash outflow of $600,000 today for the purchase of the equipment.
present value of $474,619 computed as follows.
b. After-tax operating cash inflow of $84,000 at the end of each year for 10 years.
Clear memory: C ALL
With an income tax rate of 30%, the after-tax operating cash inflow is computed as follows.
After-tax operating cash inflow = Before-tax operating cash inflow × (1 - Tax Rate)
10 N : 10 because ten equal cash inflows are expected in the future.
After-tax operating cash inflow = $120,000 × (1 - 0.30)
After-tax operating cash inflow = $84,000 12 I : 12% which is given as the appropriate interest rate.

c. Immediate depreciation tax shield of $180,000 at the end of the first year. 84,000 PMT : $84,000 which is the amount of each after-tax cash inflow.
With this special tax arrangement, Hilly Pice Company is allowed to deduct the entire
$600,000 cost of the equipment in the year that it is purchased. You can think of this as 0 FV : $0 because no extra amount is received at the end of 10 years
when the final annual after-tax cash inflow of $84,000 is
immediate depreciation. With an income tax rate of 30%, the amount of this first-year
depreciation tax shield is computed as follows..
generated.
Depreciation tax savings = Depreciation Deduction × (Tax Rate) PV : For the answer.
Depreciation tax savings = $600,000 × 0.30
Depreciation tax savings = $180,000 $474,619

103 104

Problem 17-9 - Answer Problem 17-9 - Answer

Impact of depreciation rules on NPV Impact of depreciation rules on NPV
2. Immediate depreciation of equipment cost instead of straight-line depreciation. 2. Immediate depreciation of equipment cost instead of straight-line depreciation.

The first-year depreciation tax shield of $180,000 is a one-time cash flow These present value calculations are summarized in this table.
with a present value of $160,714 computed as follows. Interest rate is 12% Present
Clear memory: C ALL Amount Value
Original Cost ($600,000 now) (600,000) (600,000)
1 N : 1 because with this special immediate depreciation deduction
the tax savings all occur at the end of the first year. Depreciation tax shield ($600,000 depreciation × 0.30) $180,000 160,714
at end of first year
12 I : 12% which is given as the appropriate interest rate.
Net cash inflows ($120,000 × [1 – 0.30]) $84,000 × 10 yrs 474,619
0 PMT : $0 because this is a one-time cash flow.
Net Present Value (or NPV) 35,333
180,000 FV : $180,000 because the depreciation tax savings is generated in
one lump at the end of the first year. We see that this project has a positive NPV so we should undertake it. The only
difference between (1), when the project had a negative NPV, and (2), when the
PV : For the answer. project had a positive NPV, is depreciation policy. You can see that allowing
companies to rapidly depreciate the cost of their capital equipment increases the
$160,714 NPV of the equipment. Governments all over the world allow rapid depreciation
(although not usually as rapid as this example) in order to increase the NPVs of
capital projects, causing companies to undertake more projects and thus
stimulating the economy.

105 106

Summary Summary
Both Net Present Value (NPV) and Internal Rate of Return (IRR) involve
Capital Budgeting Technique Computation Decision Rule
present value calculations, so this lesson involved an extensive review of how to
Payback Period Compute the length of time Accept the project if the use our business calculators.
until total net cash inflow computed payback period is
equals the initial investment less than a predetermined Screening capital budgeting projects involves separating the good projects from
cost. length of time. the bad projects.
Unadjusted Rate of Return Compute the additional Accept the project if the
yearly accounting earnings, computed unadjusted rate of
Ranking those projects involves identifying the best among a set of good
divided by the initial return is greater than a projects.
investment cost. predetermined percentage. Both IRR and Profitability Index can be used to identify the best project.
Net Present Value (NPV) Compute the present value Accept the project if the net
of all cash inflows and present value (NPV) is In this lesson we learned how income taxes impact the cash flows associated with a
outflows and add them greater than zero. long-term project. We learned how to compute after-tax cash flows and also how to
together. compute the amount of the depreciation tax shield.

Internal Rate of Return (IRR) Compute the interest rate Accept the project if the Capital budgeting involves making decisions with respect to long-term decisions.
that makes the present value internal rate of return (IRR)
of the cash inflows equal to is greater than a
By definition, the consequences of a capital budgeting decision will be with a
the present value of the predetermined hurdle rate. company for many years. For this reason, these decisions must be made only after
cash outflows. careful analysis. This lesson has given you an introduction to the common
techniques for doing this analysis.

107 108

17-18