Elementary Financial Accounting
Elementary Financial Accounting ACCT 201
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Chapter 10 What is a Current Liability Liabilities are classified as current or longterm Current liabilities are present obligations that are expected to be satisfied within one year or within the normal operating cycle whichever is longer Longterm liabilities are expected to be satisfied beyond that period Current liabilities are expected to be satisfied with current assets or through the incurrence of another current liability Types of Current Liabilities ShortTerm Notes Payable Shortterm notes payable are current obligations evidenced by promissory notes that are due within one year of the date of the balance sheet Promissory notes usually require the payment of interest Interest can be stated separately or included in the face amount In the latter case the actual amount borrowed is less than the face amount The journal entry to record issuing promissory note in exchange for cash is as follows D Cash 5000 Cr Notes Payable 5000 The journal entry to record issuing promissory note to replace Account Payable is as follows D Account Payable 5000 Cr Notes Payable 5000 The journal entry to record payment of note with interest stated separately is as follows D Notes Payable 5000 Interest Expense 500 Cr Cash 5500 The journal entry to record accrued interest expense on note with interest stated separately at the end of the fiscal year with no actual payment of the interest is as follows D Interest Expense 250 Cr Interest Payable 250 The journal entry to record payment of note with interest stated separately at its maturity when some of the interest has been accrued in the previous year is as follows D Notes Payable 5000 Interest Expense 250 lnterest Payable 250 Cr Cash 5500 Discounted Promisory Notes Not In Book Sometimes Promisory Notes are issued without interest payments being specified In order to get interest the payee requires that the face amount of the note includes the principal owed plus the interest amount In other words if you give someone 100 and then sign a note promising to pay you 110 no interest specified You are really paying 10 interest The fact that you got less than the face amount is called a discount The journal entry for the issuance of such a note would be as follows D Cash 100 Discount on Note Payable 10 Cr Notes Payable 110 When the interest has accrued D Interest Expense 10 Cr Discount on Note Payable 10 Some people debit Interest Expense immediately ratherthan Discount on Note Payable You really shouldn t debit the interest account until the interest has accrued Under this approach you would make the following journal entry when the note is issued D Cash 100 Interest Expense 10 Cr Notes Payable 110 When the promissory note is paid you would make the following journal entry D Notes Payable 110 Cr Cash 110 Sales Taxes Payable Most states and many cities levy a sales tax on retail transactions and the federal government also charges an excise tax on some products The merchant must collect the taxes from the customer at the time of the sale and record the receipt of cash and the proper tax liabilities The merchant is not paying the tax The merchant is the collection agent for the government The merchant is collecting the tax from the customer on behalf of the government Thus the sales taxes are not an expense of the merchant The journal entry for the sale including the collection of the sales tax is as follows D Cash 109 Cr Sales 100 Sales Taxes Payable 9 It might be easier for you to understand this journal entry if you divide it into its two parts First there is the actual sale D Cash 100 Cr Sales 100 Second there is the collection of the sales tax which is a receipt of cash that must be handed over to the government So the collection increase s the merchant s cash but also creates a liability to the government D Cash 9 Cr Sales Taxes Payable 9 Payroll and Payroll Taxes Payroll liabilities consist of the laborrelated obligations incurred by a business They relate to two distinct functions Employer s Expenses Not only is the business responsible for paying wages paid at an hourly rate and salaries paid at a monthly or yearly rate earned by its employees it is obligated for such items as Social Security taxes Medicare tax and unemployment taxes These are all expenses of the employer and are referred to as payroll tax expense Employee s Payments In addition to the employer s payroll tax expense employees are required to contribute a portion their wages for various government and private programs The employer is again acting as a collection agent in withholding from its employees amounts that must be remitted to governments other agencies and companies These amounts are not expenses of the employer Instead they are taken out of funds that belong to the employees the employee s wages First let s focus on the employers acting as a collection agent for the collection of amounts owed by its employees for various purposes You are collecting these amounts out of the employees salaries so this journal entry also reflects the employer s salary expense Look at the various component parts If we pay a worker 500 we have an expense payment D Salary amp Wage Expense 500 Cr Salary Payable 500 The worker then says don t pay me 15 that you owe me Instead give the 15 to the government for social security This is FICA Our liability to the employee goes down by 10 and the employer has an obligation to pay 10 to the government D Salary Payable 15 Cr Social Security Taxes FICA Payable 15 If you net the two journal entries together D Salary amp Wage Expense 500 Cr Salary Payable 485 Social Security Taxes FICA Payable 15 Thus you can see that the salary expense is debited for the full amount owed to the employee You then credit all of the amounts that you collected from the employee for the employee s contributions to various programs You also credit the salary payable for amount that you have to actual pay to the employee the take home pay D Salary amp Wage Expense gross amount 500 Cr Salary Payable 350 Employees Federal Income Taxes Payable 50 Employees State Income Taxes Payable 5 Social Security Taxes FICA Payable 15 Medicare Taxes Payable 5 Medical Insurance Payable 50 Pension Contributions Payable 10 Charitable Contribution 15 Now we have to pay the employer s payroll tax expense These are not the amounts owed by the employee that we withhold from their salaries These amounts are the taxes owed by the employer So there is purely the debit to the payroll tax expense not salary expense and the credits for the amount of taxes owed by the employer The journal entry for the payroll tax expense is as follows D Payroll Tax Expense gross amount 90 Cr Unemployment Insurance Payable 10 Social Security Taxes FICA Payable 15 Medicare Taxes Payable 5 Medical Insurance Payable 50 Pension Contributions Payable 10 Unearned Revenues Unearned or Deferred Revenues represent obligations to deliver goods or services in return for advance payment When delivery takes place Deferred Revenue is debited and a revenue account is credited When the advance payment is received the following journal entry is made D Cash 15 Cr Unearned Subscriptions 15 When the service or product is delivered to the customer the following journal entry is made D Unearned Subscriptions 15 Cr Subscription Revenues 15 Current Maturities of LongTerm Debt If a portion of longterm debt is due within the next year and is to be paid from current assets then the current portion of longterm debt is classified as a current liability The remaining debt is classified as a longterm liability Contingent Liabilities A contingent liability is a potential liability that may or may not become an actual liability They include pending lawsuits tax disputes discounted notes receivable the guarantee of indebtedness of others and failure to comply with government regulations The occurrence or nonoccurrence of a future event resolves the uncertainty regarding its outcome The two criteria for recording a contingent liability in the accounts are that occurrence of a liability is probable and the amount can be reasonably estimated If a contingent liability is probable but cannot be reasonably estimated then it cannot appear on the financial statements but it should be disclosed in the notes to the financial statement Other Current Liabilities Not In Book Warranty Expense A manufacturer must estimate its liability for warranties relating to sales made during the current year and record it as an expense This is an estimated expense like uncollectible account expense We do it in order to match the expense with the revenue that it helps to generate The warranty expense and liability must be recorded in the period of the sale regardless of when the company makes good on its warranties Therefore at the end of each accounting period the company should estimate the future warranty expense that applies to the present period s sales To record estimated product warranty expense D Product Warranty Expense 15 Cr Estimated Product Warranty Liability 15 To replace a part under warranty D Estimated Product Warranty Liability 15 Cr Merchandise Inventory 15 Vacation Pay In most companies employees earn vacation pay for working a certain length of time Therefore the company must estimate the vacation pay applicable to each payroll period debit Vacation Pay Expense and credit Estimated Liability for Vacation Pay When vacation pay is accrued you make the following journal entry D Vacation Pay 15 Cr Estimated Liability for Vacation Pay 15 When the employee is paid while on vacation you make the following journal entry D Estimated Liability for Vacation Pay 500 Cr Cash or Wages Payable 500 Pensions A pension plan is a program whereby a company agrees to pay benefits to its employees after they retire Benefits to retirees are usually paid out of a pension fund Pension plans are classified as defined contribution plans and defined benefit plans With a defined contribution plan the plan specifies defines the contribution that the employer is to make to the plan on behalf of the employee After the contribution is made the employer has no further obligation to the employee If the plan s assets increase in value then the employee will receive a larger amount upon his or her retirement If the plan s assets decrease in value then the employee will receive a smaller amount upon his or her retirement When the contribution is made into the pension plan an eXpense is debited D Pension Expense 15 Cr Cash 15 With a defined benefit plan the plan specifies the amount that the plan will give the employee upon his or her retirement The employer still makes annual contributions to the plan on behalf of the employee but if the plan s assets decrease in value the employer must make up the shortfall Similarly the employer not the employee benefits if the plan s assets increase in value The liability owed or asset owned by reason of a defined benefit plan is a longterm liabilityasset unless it will be paid or collected within the current year In that case it is a current assetliability Post Retirement Benefits Other than Pensions Other postretirement benefits such as for health care should be estimated and accrued while the employee is still working in accordance with the matching rule They are treated in a manner similar to Vacation Pay Accounts Payable These are current obligations due to suppliers of goods and services Accrued Liabilities An accrued liability is an actual or estimated liability that exists at the balance sheet date but is unrecorded An endofperiod adjustment is needed to record both expenses and accrued liabilities Income Taxes A corporation s income tax expense is dependent on its net income but its actual taxes payable is based upon its taxable income as computed on the corporation s tax return These are rarely the same figures This difference is caused by the fact that financial reporting income is governed by generally accepted accounting principles whereas taxable income is governed by the Internal Revenue Code The difference between the two is placed in Deferred Taxes Deferred Taxes says that there is a timing difference between the taxes owed on the income statement and the taxes owed on the tax return It can be an asset or liability It can be shortterm or longterm If there is no difference between tax expense on the income tax return and on the tax return D Income Tax Expense 1500 Cr Income Tax Payable 1500 If there is a difference between the tax return and income statement D Income Tax Expense 15 Deferred Taxes asset or liability as needed Cr Income Tax Payable 15 Bank Lines of Credit and Commercial Paper Companies often obtain a line of credit at the bank to finance operations The company may borrow a varying amount over time subject to a ceiling depending upon the needs of the company In addition a company may borrow shortterm funds by issuing commercial paper unsecured shortterm notes sold to the public Dividends Payable Dividends payable represent an obligation to distribute a corporation s earnings to its stockholders This arises only when the board of directors declares a dividend Property Taxes Property taxes are taxes levied on real and personal property Very often a company s accounting period ends before property taxes are assessed Therefore it must make an estimate and debit Property Taxes Expense and credit Estimated Property Taxes Payable D Property Taxes Expense 1500 Cr Estimated Property Taxes Payable 1 500 LongTerm Liabilities Bonds Corporations frequently issue longterm bonds or notes to obtain funds Bonds are publicly traded debts of corporations universities and government entities The fact that they are publicly traded is very important to investors because it provides the investors with liquidity Bonds usually are issued in denominations of 1000 or some multiple of 1000 and have a variety of features General Facts Not In Book lssuing bonds has three advantages over issuing stock as a means of obtaining financing Control of the company is not diluted because bondholders do not have voting rights The interest paid to bondholders is tax deductible dividends are not Financial leverage or trading on the equity occurs when a company earns more on the borrowed funds than it pays in interest increasing net income for the excess There are also disadvantages to issuing bonds Amounts borrowed must be repaid at maturity unlike investments by stockholders which are not paid Cash is required for periodic interest payments on bonds whereas dividend payments on stock are discretionary Financial leverage will decrease net income if an insufficient return is earned on the borrowed funds Bonds are debt instruments and bondholders are creditors of the corporation who are entitled on some specified date to periodic interest plus the principal of the debt As is true for all creditors the claims of bond holders for interest and principal take priority over stockholders claims Bonds normally are due ten to fifty years after issue and interest is usually paid semiannually A bond issue is made up of the total number of bonds available at the same time When all the bonds of an issue mature on the same date they are called term bonds When the bonds mature over several maturity dates they are called serial bonds the principal is repaid in installments When registered bonds are issued the corporation maintains a record of all bondholders and pays interest by check to the bondholders of record Coupon bonds Bearer Bonds entitle the bearer to interest when the detachable coupons are deposited at a bank Bonds payable that are due in the current period can be classified as a current liability only if they will be paid with current assets In addition the characteristics of all bonds should be disclosed in the notes to the financial statements Types of Bonds Secured bonds give the bondholders a claim to certain assets of the company on default unsecured bonds called debenture bonds do not When bonds can be converted into other securities of the issuer eg stock at a specified rate at the option of the bond holders they are referred to as converitible bonds When bonds can be repaid early at the option of the company they are referred to as callable bonds When bonds can be redeemed early at the option of the bond holders they are referred to as redeemable bonds Very often callable bonds will have a conversion feature This allows the company to call the bonds at a time that it is economically beneficial to the bondholder to convert his or her bonds into stock Under these circumstances most bond holders convert their bonds into stock and the company never has to repay the bonds Issuing Procedures When bonds are issued the corporation executes a contract with the bondholders called a bond indenture In addition the company issues bond certificates as evidence of its indebtedness The rights of the bond holders are usually represented by a thirdparty trustee The face value of the bond is the amount that must be paid on the maturity date of the bond The maturity date is the date that the final payment is due to the investor from the bond issuer the company The contractual interest rate the stated interest rate is the rate that is used to determine the amount of cash interest that the issuer must pay to the bond holder Interest on bonds is usually paid semiannually Determining the Market Value of Bonds The value of a bond is equal to the sum of the present values of the periodic interest payments and the single payment of principal at maturity For example assume that a bond which pays interest at a rate of 8 interest compounded semiannually is being sold Financial markets require an interest rate of 10 compounded semiannually The bond has a term of ten years The face value of the bond issue is 100000 The value of the bond is computed as follows Present Value of the Interest Payments Annuity Every siX months investors will receive 4000 The present value of an annuity of 4000 every siX months discounted at an interest rate of 10 compounded semi annually is computed as follows PVamuwy P 1r 1 11r 4000 105 1 11052 4000 20 1 1265329 4000 20 1 376889 4000 20 623110517 4000 1246221034 4984884 Present Value of the Principal Payment Lump Sum The bond holder will receive the face value of the bond at the maturity date PV P 11r 100000 11052 100000 376889 3768890 Present Value Price of the Bond 4984884 3768890 8753774 The current market rate of interest should be used for the forgoing computations The rate used in the present value computations is referred to as the discount rate On the Balance Sheet the Carrying Value of the Bonds is 8753774 Bonds Payable 10000000 Less Bond Discount 12 46226 Carrying Value 8753774 Accounting For Bond Issues Bond prices are expressed as a percentage of face value par value For example when bonds with a face value of 100000 are issued at 97 the company receives 97000 Issuing Bonds At Face Value When the face interest rate equals the market interest rate for similar bonds on the issue date the company usually receives face value for the bonds Regardless of the issue price bondholders are entitled to the contractual interest rate Sold bonds at face value par D Cash 100000 Cr Bonds Payable 100000 Accrue interest to bondholders D Bond Interest Expense 10000 Cr Bond lnterest Payable 10000 Pay accrued interest to bondholders D Bond lnterest Payable 10000 Cr Cash 10000 Issuing Bonds At A Discount As can be seen in the above example when the face interest rate is less than the market interest rate for similar bonds on the issue date the bonds usually sell at a discount less than face value Unamortized Bond Discount is a contraliability account to Bonds Payable in the balance sheet The difference between the two is called the carrying value an amount that increases as the discount is amortized and that equals the face value of the bonds at maturity Sold bonds at a discount D Cash 98000 Unamortized Bond Discount 2000 Cr Bonds Payable 100000 The Bond Discount represents additional interest that will be paid to the bond holders The company will pay the contractual interest rate and at the maturity date the company will pay 2000 more than it actually borrowed Remember that the company only received borrowed 98000 Under the matching principle this 2000 extra interest must be expensed over the whole bond period not just the time when it is paid The allocation of this extra interest is call amortizing the Bond Discount A portion of the Bond Discount will be expensed in every year of the bond Issuing Bonds At A Premium When the face interest rate is greater than the market interest rate for similar bonds on the issue date the bonds usually sell at a premium more than face value Unamortized Bond Premium is added to Bonds Payable in the balance sheet to produce the carrying value A separate account should be established for bond issue costs these are amortized over the life of the bonds D Cash 102000 Cr Bonds Payable 100000 Unamortized Bond Premium 2000 The Bond Premium reflects additional borrowing by the company In effect the bond holders have told the company that you are paying too much in interest for the loan you are getting The bondholders are telling the company that for the interest payments you are making you can borrow more money and this amount will be repaid together with interest from the extra interest that you are already paying Redeeming Bonds At Maturity At maturity the company makes the following journal entry when it pays its bonds D Bonds Payable 100000 Cr Cash 100000 Redeeming Bonds Before Maturity As noted above callable bonds are bonds that may be retired by the corporation prior to their maturity date called early extinguishment of debt When the market rate for bond interest drops a company may decide to call its bonds and substitute debt with a lower interest rate When bonds are called for whatever reason an entry is needed to eliminate Bonds Payable and any unamortized premium or discount and to record the payment of cash at the call price In addition an extraordinary gain or loss on the retirement of the bonds is recorded Retire bonds at a loss D Bonds Payable 100000 Unamortized Bond Premium 400 Loss on Retirement of Bonds 2600 Cr Cash 103000 The loss equals the excess of the call price over the carrying value Note If appropriate an unamortized bond discount or a gain on retirement would have been credited in the entry Retire bonds at a gain D Bonds Payable 100000 Unamortized Bond Premium 400 Cr Cash 99000 Gain on Retirement of Bonds 1400 Conversion of Bonds Not In Book Convertible bonds are bonds that can be exchanged for other securities usually common stock at the option of the bondholder When a bondholder converts his or her bonds into common stock the common stock is recorded by the company at the carrying value of the bonds Specifically the entry eliminates Bonds Payable and any unamortized discount or premium and records Common Stock and Paidin Capital in Excess of Par Value Common no gain or loss is recorded Converted bonds payable into common stock D Bonds Payable 100000 Unamortized Bond Premium 400 Cr Common Stock 10000 Paidin Capital in Excess of Par Value Common 90400 Note No gain or loss recorded also an unamortized bond discount would have been credited in the entry if appropriate Bond Sinking Funds Not In Book Sometimes the bond indenture requires that the issuer set aside a certain amount of cash each year in order to ensure that the corporation will have sufficient cash with which to retire the bonds at maturity This is called a sinking fund If a sinking fund is required it is usually disclosed in the notes to the financial statements and the cash is carried on the issuer s balance sheet as an investment eg Sinking Fund Cash and Sinking Fund Investment Earnings on the sinking fund are Sinking Fund Revenue Financial Statement Analysis Liguidity As noted previously liquidity is the ability of a business to meet its current cash needs As mentioned in a previous chapter a popular ratio used to evaluate a company s liquidity is the current ratio Current Assets Current Liabilities Although your book does not mention it a popular variation of the current ratio is the quick ratio also known as the acidtest ratio Quick Assets Current Liabilities Quick Assets are cash cash equivalents and accounts receivable It does not include prepaid expenses and inventory Solvency As noted previously the ability of a business to meet pay its debts in the long term is referred to as solvency As noted in an earlier chapter a popular ratio to measure solvency is the ratio of debt to total assets Another popular ratio is the Times Interest Earned Ratio indicates the ability of a business to make its interest payments Times Interest Earned Ratio also called Number of Times Interest Charges Earned is calculated as follows Net Income Interest Expense Income Tax Expense Interest Earned The numerator is the pretax operating income Amortizing Bond Discounts and Premiums When bonds are issued at a discount or premium the interest payments on the bond are not the only interest being paid by the issuing corporation The original discount amount represents additional interest on the bond and the original premium amount represents a rebate of the interest being paid by the corporation It reduces the interest cost of the corporation A zero coupon bond is a promise to pay a fixed amount at maturity with no periodic interest payment Investors receive their interest from the large discount on issue which in turn is amortized by the issuing corporation over the life of the bond Amortization generally is recorded on the interest payment dates using either the straightline or the effective interest method StraightLine Amortization Under the straightline method of amortization the amount to be amortized each interest period equals the bond discount divided by the number of interest payments during the life of the bond Earlier we calculated the fair market value of a 100000 bond issue that pays interest at a rate of 8 interest compounded semiannually is being sold Financial markets require an interest rate of 10 compounded semiannually The bond has a term of ten years We calculated that the company selling that bond issue would receive 8753774 The face value of the bond issue is 100000 and the discount is 100000 8753774 1246226 With straightline amortization every six months you amortize the Bond Discount by 124622620 62311 The journal entry for cash interest payment every six months is as follows D Bond Interest Expense 4000 Cr Cash 4000 The journal entry for amortization of bond discount every six months is as follows D Bond Interest Expense 62311 Cr Bond Discount 62311 Balance Sheet after first six months of bond discount amortization Bonds Payable 10000000 Less Bond Discount 11 83915 Carrying Value 8816085 Amortization of a premium acts as an offset against interest paid in determining interest expense to be recorded Under the straightline method the premium to be amortized in each period equals the bond premium divided by the number of interest payments during the life of the bond For example assume that a bond which pays interest at a rate of 10 interest compounded semiannually is being sold Financial markets require an interest rate of 8 compounded semiannually The bond has a term of ten years The face value of the bond issue is 100000 The value of the bond is computed as follows Present Value of Interest Payments Every siX months investors will receive 5000 The present value of an annuity of 5000 every siX months discounted at an interest rate of 8 compounded semi annually is computed as follows Pvawty P 1r 1 11r 20 5000 104 1 1104 5000 25 1 12191123 5000 25 1 4563869 5000 25 543513 5000 1359032 5795153 Present Value of Principal Payment The bond holder will receive the face value of the bond at the maturity date PV P 11r 100000 11042 100000 4563869 4563869 Price present value of the Bond 6795163 4563869 11359032 On the Balance Sheet the Carrying Value of the Bonds is 11359032 Bonds Payable 10000000 Bond Premium 13 59032 Carrying Value 11359032 Using the straightline method of amortization the Bond Premium would be amortized every six months With straightline amortization every six months you amortize the Bond Premium by 135903220 67952 The journal entry for cash interest payment every six months is as follows D Bond Interest Expense 5000 Cr Cash 5000 The journal entry for amortization of bond premium every six months is as follows D Bond Premium 67952 Cr Bond Interest Expense 67952 Balance Sheet after first six months of bond premium amortization Bonds Payable 10000000 Bond Premium 12 91080 Carrying Value 11291080 Effective Interest Amortization Using the straightline method is very simple but it is not very accurate A discount means that you are delaying the payment of interest until the bond matures That is a long time from the issue date The bond holders are going to want interest paid on that delayed interest interest compounding The effective interest method takes interest compounding into account when amortizing a discount or premium The effective interest method of amortization is more difficult to apply than the straightline method but under GAAP it should be used when the amounts differ significantly To apply the effective interest method when a discount is involved the market rate of interest for similar securities when the bonds were issued called the effective rate of interest first must be determined This interest rate halved for semiannual interest is multiplied by the existing carrying value of the bonds for each interest period to obtain the bond interest expense to be recorded The actual interest paid is then subtracted from the bond interest expense recorded to obtain the discount amortization for the period Because the unamortized discount is now less the carrying value is greater This new carrying value is applied to the next period and the same amortization procedure is followed Using the discount example described above the Bond Discount of 1226226 is amortized as follows Interest for the first six month period Carrying Value of Bond x Market Interest Rate for Six Months 8753774 x 05 437689 The Corporation paid interest at a rate of 8 4000 Therefore the Corporation still owes 37689 in interest to the Bond Holders So the Corporation reduces its Bond Discount by 37689 This has the effect of raising the carrying value of the Bonds Payable The journal entry to pay interest D Bond Interest Expense 437689 Cr Cash 400000 Unamortized Bond Discount 37689 Balance Sheet after first six months of bond discount amortization Bonds Payable 10000000 Less Bond Discount 11 88537 Carrying Value 8811463 Interest for the second six month period Carrying Value of Bond x Market Interest Rate for Six Months 8811463 x 05 440573 The Corporation paid interest at a rate of 8 4000 Therefore the Corporation still owes 40573 in interest to the Bond Holders So the Corporation reduces its Bond Discount by 40573 This has the effect of raising the carrying value of the Bonds Payable The journal entry to pay interest D Bond Interest Expense 440573 Cr Cash 400000 Unamortized Bond Discount 40573 Balance Sheet after second six months of bond discount amortization Bonds Payable 10000000 Less Bond Discount 11 47964 Carrying Value 8852036 The effective interest method is applied to bond premiums in the same way that it is applied to bond discounts The only difference is that the amortization for the period is computed by subtracting the bond interest expense recorded from actual interest paid the reverse is done for amortizing a discount Using the premium example described above with the effective interest method the premium amortization would be as follows Interest for the first six month period Carrying Value of Bond X Market Interest Rate for Six Months 11359032 X 04 454361 The Corporation paid interest at a rate of 10 5000 Therefore the Corporation has repaid 45639 of the amount borrowed 5000 454361 So the Corporation reduces its Bond Premium by 45639 This has the effect of reducing the carrying value of the Bonds Payable The journal entry to pay interest D Bond Interest Expense 454361 Unamortized Bond Premium 45639 Cr Cash 500000 Balance Sheet after first six months of bond premium amortization Bonds Payable 10000000 Bond Premium 1313393 Carrying Value 11313393 Interest for the second six month period Carrying Value of Bond x Market Interest Rate for Six Months 11313393 x 04 452535 The Corporation paid interest at a rate of 10 5000 Therefore the Corporation has repaid 47465 of the amount borrowed So the Corporation reduces its Bond Premium by 47465 This has the effect of reducing the carrying value of the Bonds Payable The journal entry to pay interest D Bond Interest Expense 452535 Unamortized Bond Premium 47465 Cr Cash 500000 Balance Sheet after second six months of bond premium amortization Bonds Payable 10000000 Bond Premium 12 65928 Carrying Value 11265928 Issuing Bonds Between Interest Dates Not In Book When bonds are issued between interest dates the interest that has accrued since the last interest date is collected from the investor on issue and returned to the investor along with the interest earned on the next interest date For example assume that you sell 100000 of 10 bonds dated April 1 one month after the date on the bonds May 1 One month of interest 100000 1012 83333 80 you collect 100000 83333 from the bond holders when you sell the bonds D Cash 10083333 Cr Bond Interest Expense 83333 Bonds Payable 10000000 At the first interest payment Oct 1 the Corporation pays out a full six months worth of interest repaying the one month interest collected at the sale D Bond Interest Expense 5000 Cr Cash 5000 Sales Revenue Cost of Goods Sold Gross Profit or Gross Margin erentIy on Income Statement Reported at the top of an income statement 1 2 Service business earns tees Chapter 5 FIevenues recorded Merchandising business seIIs inventory Revenue from saIes Expense of Inventory Cost v Oust I Guuds Said 3 4 The Cost of Goods Sold An expense Treated diff Two Inventory Systems Periodic Inventory System Perpetuai Inventory System 5 6 Periodic Inventory System Company keeps track of Purchases during the peri CaIcuIates COGS at end of year Beginning inventory Purchas Guuds Avaiiabie Fur Saie Ending inventory Oust I Guuds Said Periodic Inventory System Assumes anything not there was soId v Nu iniurmatiun un Iheit ur spoiiage Disadvantage Company doesn t know COGS untii physicaI inventory taken Disadvantage Easy to maintain Advantage 7 Perpetual Inventory System yaiways keeps track oi COGS amp inventory Still need physical inventory Endoi ear Anydscrepanoywiri books melt aridspoiiage Used to be very expensive mpuiers amines no iorigerirue increasing in popular Preiious class discLssion is perpetual system Wiii continue to use ii in his Chaplet i 8 When you purchase inventory with cash D Merchandise inventory 5000 Cr Cash 5000 9 When you purchase inventory on credit 10 Purchase Returns amp Allowances You return inventory purchased Purchases Return D Merchandise inventory 5000 Cr Accounts Payable 5000 v Reverse purchase Supplier reduces price of merchandise alter the sale Purchases Allowance v Write down inventoryto amount paid 1 1 1 2 A return of entire 5000 purchase D AccountsPayabie 5000 Cr Merchandiseinvenlory 5000 The receipt ot1000 allowance on 5000 purchase D AccountsPayabie 1000 Cr Merchandiseinvertory 1000 1 3 Inventory cost includes Price paid iess discounts trei t insurance in transit T axes Taritts Inspection costs Preparation costs Everything paid inventory to iocation amp ready to seii 14 quotFOB shipping point Stands for Free On Board Seiier transfers titie to inventory at the seiier s iocation Buyer pays shipping costs Eg you order car from Ford v invuicesays FOB Detruit quu payshipping custs quu uwn car during shipment vSumething gues wrung Yuur prubiem 1 5 quotFOB destination Seiier transfers titie to inventory when deiivered v At buyer s piace u1 business Seiier pays shipping costs Eg you order car from Ford v invuicesays FOB Lus Angeies v Furd pays shippin cust v Furd uwns car during shipment v i1 sumething gues wrung Furd s pruUem 16 Transportation Costs on purchases Part of cost of inventory Caiied Freight in or Transportation In Under perpetuai inventory system increase cost of the inventory 0 Merchandise inventury 150 Cr Accuunts PayabieCash 150 17 Transportation Costs on sales An expense Called Transportation Outquot or Freight Outquot D Freight Out 150 Cr Accuunts PayabieCash 150 18 Purchases Discounts We buy inventory Seiier offers credit terms to encourage us to pay quicky Caiied purchase discounts When we are seiier Caiied saies discounts 19 Examples 210 nGO twoten net th1rty v ii buyer pays wnDie1nVD1ce w1tn1n 1 0 days 761913 2 011 v Otnerw1se ent1re b1ii due 1n 30 days 110 EONI v ii buyer pays wnDie 1nVD1cedur1ng 1amp110days D1 mDntn 761913170011 v Otnerw1se ent1re b1ii due by end D1 next mDntn 20 It seerdoes not wish to offer discount Invo1ce says when payment 15 due nSO v ND diSCEILII39iI vErt1re inVD1ce due 1n 30 days n10 EOIVI vErt1re 1nVD1ce due 1n11rst 1 Odays D1nex1 mDntn 21 Passing up purchase discounts is very unwise Interest cost for deiay1ng payment for at days 15 very h1gh Eg 220 nGO v Means yDu are pay1ng 21Dr a 20dayiDan 39Annuai1zed rate 1 36 5 per anan 22 You buy inventory for 3500 Supplier offers you 210 nSO When you receive inventory Ignore potent1ai d1scount D Merchand1seinventDry 3500 Cr ACCDunisPayabie 3500 23 If payment made during discount period Show NF 15 d1scharged 1n Iuii Show amount pa1d Wr1te down Inventory to pr1ce actuaiiy pa1d o ACCDunIs Payabie 3500 Cas 3130 Merchand1se inventDry 24 If payment not made during discount peri D ACCDunts Payabie 3500 Cr Cash 3500 25 Cash sae revenue side of transaction D Cash 2200 Cr Saies Revenue 2200 Cash sae cost side of transaction 26 Credit sae revenue side of transaction D Accuunts Receivade 2200 Cr Saies Revenue 2200 Credit sae cost side of transaction D CnsiuiGuudsSnid mo D CustuiGnndsSnid woo Cr Merchandiseinventury 11400 Ci Merchandiseinventury smog 27 28 Customer returns merchandise you undo sale Debit Saies Returns amp Aiiowances 39 Cuntrarevenue accuun v it Wiii be deducted irum Saies Revenue We keep track of this in separate account to gives management important information about companys returns histor Undo revenue side of transaction D Saies Returns ampAiiuwances 2200 Cr Accuunts Receivabie 2200 Undo cost side of transaction v OtherWise we cuuid have iust reduced Saies D ngchandisg immmy 1400 us Or Oust ui Grands Suid 1 400 29 30 Sales Discounts When we are seiier We can offer customers credit terms to encourage qUick pa men Same notations as in Purchase Discounts 39Eg manso Contra Revenue account v Reduces Saies Revenue When sale is made Ignore potentiai saies discount D Accuunts Receivabie 3500 Cr SaiesSaies Revenue 3500 31 If payment received during discount period Record the Cash received reduced price Show AR discharged in fuii originai price 32 If payment received after discount period D Cash 3500 The Difference is Saies Discount difference Cy mums meabyg 3 500 D Cash 30 Saies DiSCEILii39iiS 70 Cr Accounts Receivabie 3500 33 34 Trade Discounts ffer customers cheaper prices v Nut for paying quic vAn After Christmas Saie Eg Voiume Discounts If you buy 100 price drops 2 Record sale at cheaper price Net Sales is Sales Revenue reduced by the contrarevenue accounts Saies Revenue 400000 Less Saies Returns and Aiiuwances f 2000 Saies DiSCEILii39iiS 0000 Credit Card DiSCEILii39iiS treated as a no account for trade discounts mmmgm mum L 000 39 Net Saies 454000 35 incomes merit For Veai Ending Decembei3110XX Singlestep Income Statement NelSaies swotom One Revenues section iists aii revenues L 39 mmemssw m Gross MarginProfit smtom One Expenses section iists aii expenses Multiplestep Income Statement operating xpenses m i r o I am Contains many subcategories mm m M W n gt other Revenue seams atom Less her Expenses amp Losses m income Before income Taxes mm Less income Tax Expense 10 100 Net income I 500 37 Gross Profit Net Saies Cost of Goods Soid Aiso caIIed Gross Margin Gives you the markup on the goods soId Merchandising profit Gives information about market pIace High gross margii39s market isn t very competitive Eg PC market in 19705 amp f 9805 high gross margins During 19905 the PC market became competitive e Hadsiiriiikiiu gross nrargrns 38 Operating Expenses are saIes expenses and generaI amp administrative expenses Direct result of Management activities Not Iike Gross Margin v Resuit from marketpiace How good is the company in controIIing its expenses 39 Income From Operations Gross Margin Operating Expenses Considered very important Represents major operations Good indication of future performance vapicaIIy Viewed as sLotainabIe in the future 40 Other Revenues and Expenses Nonoperating revenues amp gains v diVidends income v interest income v gains from saIes of assets Less nonoperating expenses amp Iosses v interest expense v Iosses from saIes of assets Follows Income From Operations 41 Income Before Income Taxes Income From Operations Other Revenues and Expenses Net Income Income Before Income Taxes Income Taxes Earnings Per Share Reported BeIow Net Income Corporation s Net Income earned for each share of common stock 42 Shaiei Auto Pans Corporation Income rrrenr For me Vear Ended December ii zoxx Revenues irorrr saies muse eosroi Goods Said 191 160 Grog Margin irorrrsaies grows Operating Expenses Seiiing Ex swan Generai and Administrative Expenses m Toiai Operating Expenses u Imomeiiom Operations 19M 43 5mm Aula PansCarpmlian Shaier Auto Pans Corporation immestzlemem income Statement Far lireVeerEnded December ZOXX For me Vear Ended Decembere iLZOXX new income ironiOperations mm x amass other Revenues and Expenses inure imme 5L muesli one gt400 Tatzi Revenues SZQWEG Lew interest Expense 1 631 Cass amp P was semiomer Expenses gtiner 4131 CMMGWMW 5mm Revenues Seiiing Expengs GUM income Below income Taxes 511331 Genemi and Mminismive Expengs M504 income Taxes 4 car intend Ex em 25 imme Tax Ex use 12 Melincome mam Tatzi Cu and Expengs 476 556 Earnings pershare 5190 Net inwme 14500 Earnings persham 290 Gross Profit Rate Aiso caiied Gross ProfitMargin Percentage Gives Gross ProfitMargin in terms that are not infiuenced by size Gross ProfitMargin Net Saies Profit Margin Ratio Net Income Net Sales This ratio allows you to compare profitability among firms of different sizes 47 Operating Expenses To Sales Ratio Focuses on management s abiiity to controi operating expenses Operating Expenses Net Sales Chapter 12 2 The statement of cash fiows ts a mayor statement tnanctai as are the tncome statement baiance sheet and statement of stockhoiders equtty The statement of cash fiows ts requtred whenever an tncome statement ts prepared The statement of cash fiows shows the effects n cash of the operattng tnvesttng and ftnanctng acttvtttes of a companyf ran accounttng pertod 3 The principal purpose of the statement of cash flows is to provide information about a company39s cash receipts and cash payments during an accounting period t aiso provtdes tnformatton mpany s operattng tnvesttng and ftnanctng acttvtttes durtng the pertod 4 The statement of cash flows categorizes cash receipts and cash payments as operating investing and financing activities Operattng acttvtttes tnciude recetvtng cash from customers for the sai of goods and servtces recetvtng tnterest and dtvtdends on ioans and tnv t ents and maktng cash payments for wages goods and servtces purchased tnterest and taxes 5 nvesting acttvtttes tnciude purchastng and seiitng iongterm assets and marketabie securtttes other than cash equtvaients as weii as maktng and coiiecttng on io Ftnanctng acttvtttes tnciude tssutng and buytng ba capttai stoc as weii as borrowtng and repaytng ioans on a short or iongterm pasts tssutng bonds and notes v tvtdends patd are aiso tnciuded tn thts category but he p d I re aymert of accounts payabie or accrue itabtitttes ts not 6 The statement of cash fiows shouid be accompanted by a scheduie of noncash tnvesttng and ftnanctng transacttons Such transacttons re nt stmuitaneous tnvesttng and ftnanctng acttvtttes that do not ho r resui tn an tn iow or outfiow of cash These acttvtttes tnciude the tssuance of stocktor assets the converston of bonds tnto stock the tssuance of debt for assets and the exchange of piant assets 7 v AH products go thruu ha serres ut phases cattedthe ruduct trte cycte an a curpuratrun s cash ttuw rdtects hese phases The phases rn order at therr occurrence are utten reterredtu as uttuws e ntrdductdm Phase Dunngthrs phasethe earparanarr rs trkety to have amsh detrcrt rn rts operath bemuse r the products sates areswatt am the prurnatranetexpemesere gee r There may abo beegreetdeetotexpemnures torreseereh am deveb memacnymes 7 Burma ths phase the earparanarr rs therth have a detrcrt rn rts rnyestrng aennnes bemuse rt s spendth a greatdeat on rnyestrng rn pram assets 7 These detrcrts wrrr be wvered through trnancrng transactrdns 8 Growth Phase Durrng thrs phase v the sates revenue wrtt rncrease rDesptetrrrerregrdwtrr rnr1 rnyentdrres rrdsupphes arr t e heed to rncrease the amount crt credrtdttered to a customers represenlastqn mntneedtorwsh rh ourpdratrdn39s dperatrdns rTrrrs phase rs usuatty charactenzed by addrtrdnat on research and deyetdpment act v Durrng thrs phase there rs strtt a srgnrtrcant need tor rnvestments tn ptant assets vAH at these needs wrtt strH requrre a cash rntusrun trumtrnancrng transactrur39s i 9 Maturrty Phase A product rn thrs phase rs often referred to as a cash c vAcumpanys uperatruns shuutd produce cash ttuw v andthere rs a shrrnkrng demand tor rnvestments rn tant assets vAs re 1tuttheturegurngthererstrttteneedtura cash rntusrun trum trnancrng transactrur39s 10 o Decline Phase During this phase 0 cash from operatrons decreases 0 Cash from rnvestrng may become posrtrve as the company trqurdates unneeded ptant assets 0 Agarn there rs trttte need for cash tnt usrons from trnancrng transactrons 11 1 2 Investors and credrtors may use the statement of cash ows to assess such tth as the company s abrtrtytu generate pusrtrve tuture cash Hows rts abrtrtytu pay rts trabrtrtres rts abrtrtytu pay drvrdends and rts needtur addrtrunat trna ncrng Management uses the statement of cash ows among other tth s to as ess the busrness s debtpayrng abrtrty determrne rts drvrdend putrcy and ptan rts rnvestrng and trnancrng needs The Statement of Cash Ftows atso provrdes use ut rnformatron to rnvestors regardrng the foHowrng The Quatrty d tncume Corpuratruns may be very prutrtabte but th accumpanred bythe recerpt ut cas tnvestments The Statement at Cash Ftuws rs the unty tac where a curpuratrun s rnvestment rn ptart assets rs detarted e e d t rmrnrng whether a curpuratrun rs pursed to cuntrnue to grow tn the tutur 1 appear to t be e accruats may no Thrs can be very rmpurtant rn 13 To prepare the statement of cash flows a comparative balance sheet the current income statement and additional information about transactions affecting noncurrent accounts during the period 14 Cash flows from operating activities may be determined using either the direct method or the indirect method The choice of which method to use only affects the calculation of the Cash Flow From Operations There is no ditterence in the Cash Flow From Investing Activities and the Cash Flow From Financing Activities 15 v The direct and indirect methods 7 produoethesameresultsand e bothereoonsidered aw v The FASB however recommends thedirect method accompanied by a separate schedule the indirect method reconciling net income to net cash 1 ows v Despite this the indirect method is used by approximately 99 o1 all com an es v Whenthe direct method is used the net cash llowlrom operating actiVities as computed using the indirect method must also be reported in a separate schedule 16 With the Direct Method the cash tlowtrom operations is calculated directly from scratch With the Indirect Method however the cash tlowtrom operations is calculated by taking the net income of the company and then making adjustments These ad yustments are required because net income is calculated using the accrual method and we are interested only in cash receipts reduced by cash disbursements the cash odl 17 These adjustments include Adding back expenses that were deducted from net income but did not cost anything v e g depreciation expense amortization expense anddepletion expense Taking out capital gains and losses that do not relateto operations v e g sale o1 plant assets Taking out expenses that were accrued but not et paid v e g income taxes accrued but not paid in the current year 18 Taking out expenditures that cost cash but were not expensed this year v e g the purchase o1 inventorythat was not sold or supplies that were not used up andthe payment o1 prepaid expenses still outstanding at the end ol the year Taking out income that was accrued but not yet rece ved v e g credit sales where the accourt receivable is still outstanding accrued interest not yet received 1 9 20 Adding back cash receipts that were not treated as income Consider the balance sheet equation v e g custumers payments ul accuunts receivable that were generated in a priur year Because of its widespread use we will Assets Liabilities Owner s Equity focus on the Indirect Method Cash Curr Assets LT Assets Curr Liab LT Liab Equity A 01er Assets A Curr Liab A TLiab A Aeqtrty A dash A Curr Assets A LTAssets A A Curr Liam A LT Liab A A Equity So cash changes in the opposite wayirom other assets and the same way as liabilities and equity 21 22 With the Indirect Method we assume that a change in a balance sheet account is matched by a change in cash This is trueior every change in the balance sheet accounts except for changes due to noncash transaction Actrer CMMES InTIuese Accounts FailWimiri mummy s eg the purchase of an asset in exchange for stock Operations Current As ets Cu v As a general rule the changes lurthe lulluwmg balance sheet accuunts are assumed tn allect the lulluwmg actiVities rreril Liabtlilres Nellrmme and Lc s Also add back non wsn expenses like deprecation Investing Long Term Assets Financing LorigTerm Ltabtlities Stoc noicters Equity excluding Net Income 23 24 We are going to use the TAccount Look At The Handout For Problem We Will approach to the Indirect Method It is a DISCUSS very simple approach to use because You mechanically go through every balance sheet accoun You note every change with an equal amount of debits and redits Because of these characteristics it is difficult to skip an item D Bonds Payab e 100000 CV Common Stock 300000 Add mona Pamm Cap lal 60000 31 mm mu E S g a mom 39 33 34 D Em 11300 Moumu ated Deueomn mac Cr Furmmre and qures 35600 Gem 1000 39 The Direct Method Under the direct method net cash flows from operating activities are determined by taking cash receipts from sales adding interest and dividends received and deducting cash payments for purchases operating expenses interest and income taxes 40 Free Cash Flow Interpreting the Statement of Cash FIows inc udes examining important reIationships such as cashgenerating efficiency and free cash ow v Cashgenerating eiiiciency is the abiIity at a cumpanytu generate cash Irum uperatiuns v Free cash How is thecash avaiiade Iur new pruyects Free Cash Fbw Casi Homepeiaiw Capnai Expenditures r Dmdends 41 Current Cash Debt Coverage Ratio When xamining a corporation s abiIity to pay its debts in the short term quuidity IinanciaI anaIysts ook at the Current C h Deb Coverage Ratio In this ratio you divide a corporation s cash from operations by average current IiabiIities Cash FIow From Operations Average Current LiabiIities 42 Cash Debt Coverage Ratio When examining a corporation s abiIity to pay its debts in the Iongterm soIvencyI IinanciaI anaIysts Iook at the Cash Debt Coverage Ratio In this ratio you divide a corporation s cash from operations by average totaI IiabiIities Cash FIow From Operations AverageTotaI Liabiiities Chapter 13 2 Sustainable Income Sustainable Income Is likely to contInue Into t ears That Is why we have a multIstep Income statement The most lIkelysustaInabie Income Is Income From OperatIons Income belore other gaIns and losses ou ook contends that all Income belore Irregular Items constItutes sustaInable Income 3 Irregular Items Net Income before Irregular Items appears after Income tax ex nse Irregular Items are then reported Irregular Items are reported net of Income tax FICEIITIE a quot33 t xtaken ou Eg GaIn at 1 0000 has tax at 1 000 09000 Is reported r egular Items consIs of three Items that begIn wIth the letters D C IscontInued OperatIons ExtraordInary Items and Changes In AccountIng PrInprles 4 Discontinued Operations When a company has decided to sell a line of business The Income from the operatIon of that business shIttstrom Income From Operations to DIscontInued Operations The gaIn or loss on the sale Is also reported In thIs sectIon The Incomegain Is reported net of tax 5 Extraordinary Items Extraordinary Items are supposed to be very rare Extraordinary items must meet two tests v unusual In nature and 39 ll39lllquJEl39lI ll39l EICCLIIIEHCE It only one test met probably Other Flevenue Eg Volcanoes amp Expropriation Shown Net of Tax Comprehensive Income Some gaIns or losses are not reported on the ncreases 6 Income statement GaIns onsome ForeIgn Currency TranslatIons UnrealIzed gains on some Marketable SecurItIes nstead these gaIns and losses are shown as or decreases to shareholder equity WIthout appearIng In the Income statement FASB now requires that the company add or subtract these Items from net Income and report the figure as Comprehensive Income 7 When you hold marketable securtttes AdHust your portlolto up or down to tts latr market vaue It you actively trade marketable securities the tncrease tn your portlolto ts shown onthe tncome statement even though the gatn or loss ts unrealtzed you haven t sol tt yet hold marketable securtttes thh the tntentton to sell tt when the ttme t rtght it ts constdered to be Atatlable For Sale ll portlolto tncreases VS wttte upthe ponlolto on the tett Side at the balance s et lt o Vou write up Equtwontrte ttgm side or the balance sheet But Unrealtzed eatquot ts not reported on ttmtte Statement 8 Financial Statement Analysis v Ftnanctal statement analysts ts rooted tn ltnanctal statements t We ate Lstng ltnanctal statements as the basts to make Judgments about the com an 7 9g ts trte wttpattysotvettt 0t ts na good Weslmenl v Whtie our dectston ts dtrected towards the luture we ate lookth at the ltnanctal records oi past perlormance tn ma tngt ose ectstot39s v You have to look beyond the ltnanctal statements 7 cu veto mmtdetsmrttrttttgs as how ts trte bustttess envttottmetttortattgttgtottrte outtpattvtrtquesttott e Trtts involves kookth ateoonomy wrde tasters tndustrylactors aswellas ttuwuuatoampanvteetors 9 A comparison of key figures from financial statements can be made thhtn A Company Between Compantes thhtn the Same Industry thh lndustry Averagesior those itgures 10 lt ts tmportant that you make meantngiul compartsons when you compare dtiierent Compantes have to be tn the same tndustry tn order for the compartson to make any sense Flattos vary wtdely between tndustrtes For example the next two sltdes show ke itgures for a number of dtiierent tndustrtes tn 1987 RATlOS FOR SELECTED lNDUSTRlES 1987 11 m u w a 2 9 Airlines 0 9 a W NM t ta 9 a 2 tt Auto t te w a 71 e Bankxa arkHohtngCos 77 22 NM ermes ta 9 7 2 ts Butldtrg Maber 2t 9 7W 9 t ts 7 0 t2 Corgiomerales t7 W a 71 to n t ts2 a w t2 at 2 9 t 22 ta Emmet and elechonkx ta w 50 t7 Foodptooesstrg 207 w ts Food and lodgtrg za 9 59 ts General machinery a 9 t 9 M rm 39llot mntttttgttt39 m Kn a W m sztss M Lekureltmetrvduslrbs my 552 ta mama mekbmtntrg 77 W u Ollbeequmnlandoonmbr may 22 u Otlandooal my 19V 713 Paperandbreslproduck to2 62 t2 Personalcare duc taa w 2t warm radka and etam ta 2 7 w 2t Rail a 7 w e 2 la neatttng load te7t t w t7 Rektltng nonbod la 71 a 0 ts Servnelrdtsms My 27 ts Steel 6 w 2 9 2 Telwommurtmlrans ta 2 a 0 la Tent lesardapmrel tow W t2 TiredMMer 20W 29 to doaooo 22 w e 9 t2 7mm 9 W 2w ta unites Hey may to 13 When making the comparisons financial analysts engage in Horizontal Analysis Vertical Analysis and Ratio Analysis 14 Horizontal Analysis Imagine a comparative financial statement with results for different years presented in separate columns The term horizontal means that you make your comparison horizontally over the different years eg changes in revenues from year to year 15 You can compare horizontal trends over a number of years for one company between different companies or with industry averages For example You could note that our sales revenue has grown 10 in each year for the past three year You could also note that our sales revenue has grown 10 a year for that period while our competitors have grown 12 a year over the same period You could also note that that our sales revenue growth has been 10 a year while the industry average was 9 a year over the same period 16 Vertical Analysis The term vertical means that you make your comparison vertically down and up the financial statement With vertical analysis you convert financial statements to commonsize financial statements Balance sheet figures are divided by Total Assets and Income statement figures are divided by Gross Revenues 17 The vertical analysis can involve one company different companies or industry averages For example You could note that our research and development expenses are 5 of our net sales You could also note that our research and development expenses are 5 of our net sales while our competitors only spend 4 of its net sales You could also note that we spend 5 of our net sales on research and development expenses while the industry average is 7 The Percenta e of Sales Column Column D is an example 0 Vertical Analysis The Difference Between 2002 and 2003 Columns Columns H amp l are examples of Horizontal Analysis 19 Ratio Analysis 20 With ratio analysis you examine key financial ratios of companies Liguidity Ratios Liquidity refers to the company39s ability to meet its current obligations Thus liquidity tests often focus on the size of and relationships between current liabilities and current a e Current assets presumably will be converted into cash in order to pay the current liabilities 21 v in order to examine the relationship between current assets and currert liabilities you could look at the current ratio the quick ratio also called the acidtest ratio and the doomsday ratio also called the cash ra io 22 A variation of the Doomsday Ratio is the Current Cash Coverage Ratio Current CurrentAssets Ratio Current Liabilrtres Current Cash Coverage E as rorn Oigrati Ratio Average Current Liabilitres Quick Current Assets Prewd Exigrtserlnventory Ratio Current Liabilrtres Doomsdayor Cash Cash Cash Equivalent Ratio Current Lrabilities 23 24 In making an examination of liquidity you should also examine the quality of the shortterm assets If these assets are of poor quality they may not be very liquid lnventoryTurnover coes Average inventory NumberotDaysSares in inventory verage inventory coesnes For example you should examine the quality of a company s inventory If it has too much inventory then it will take a long time to convert it in 0 cas A long period could also expose the inventory to an increased possibility of in obsolete which would make it more difficult to convert into cas lt7 m o o 3 An examination of liquidity should also include an examination of the quality of a company s accounts receivable ii a cumpanytakes a lung time to collect its accounts receivable it ubViuuslytakes a lung time to convert them to cash Moreover it may indicate that the company may have 26 v The Cash Cunversiun Cycle Nut in Bunk is an li39idlCallEIi39i d li udty e ltqives you an approXimatioriol how iorig it takes a eornpany to oanven its investrnent in inventory irto msn reeeipts trorn tne saieottnatinventory r The Cash Oanversiori Olole is wbulated as tollows a dillicult time ever collecting the accounts receivable Tile Takes 00 9 quot W l W V ib e 3 Numberot Days Sales in neeeivapiesi Plus Time it Takes To Sell inventory g neeeivapie Turnover Net CreditSales Numberot Days Sales in inventory Average Aeeounts neeeivapie Opeya m cm Less Time Company Can Deiay Payment ot its Own Amounts Numberot Days Sales in Aver e Aeeounts neeenapie Pa We neeeivapies NetSaiesisss Casn Oanversion Cyeie E The time that the company can delay the payment of its own accounts payables can be approximated as follows v Solvency pertains to the company s abilitytu meet the interest casts and repayment schedules associated With its lungterm ubligatiuns e Anaiysts iooxattne size ot tne Long Term Debt in eornparison win otner iterns on tne balanoe sneet Dept To Total Assets natio m Days payapies Gigialim Payables Rial Assets Pre tamsn expenses rues natio ot Fixed Assets to Long Term Debt Net Fixed Assets Long Term Liabtlilres Dept to Equity natvo Total Lapiiities Stockholders Equity asn Debt Oaveraqe natvo Cash Fkaw From owauons Average Total tiapiiities You also can look at the ability of a company to pay the interest expense associated with its LongTerm Debt Times irterest Net inwrne mg Expense interest Expense Earned natio irterest Expense Your book also notes that you can look at a company s tree cash flow Free Cash Flow is the amount of annual cash flow generated by the company that is not needed for capital expenditures and dividends is available to repay LongTerm Debt Freecasthw e Cash FrainOperamnsrCapital Expenditures DNidends 31 32 Profitability Ratio In evaluating a firm39s profitability there are arnings per share EPS are used by a number of returns you could consider Investors to judge a company39s profitability to estimate its future earnings and to compare it with other companies EPS is calculated as follows EPS e Netlncdirie neVearsDiVidendsanr tened tack Weghted Average Numberdtshaies dthinindn StdckOutstandirg 33 34 39 EPS is reported 0 the Income Statement riceEarnings Ratios PE Ratios are the EPS gures ShOUId be 9W9 for the broadest and most widely used overall WHOWWIQ Income 39t9m53 measure of performance Income Before Irregular Items PIE Ratio Market Qme wskar Irregular Items and Net mmepershare Net Income39 7 ltyuu cansiderastuck s priceas acapitalizatiun a future expected winin sthena relatively high PE ratio indicates that the inancial market thinks that thewmpany s earnin Will lh0l 7 Similarly a relatively low PE ratiu indicates that the financial market thinks that the company s earnings Will decrwe 35 36 The PE ratio is a good indicator of how Gross pro Rat Gross Mar R 0 quotWWW JUdge the rm Slp mmance indicates of the competitiveness of the Ma agement ofcourseis interested in companyvs market Elgar rrgltfglhgpgxalgfncgglilg thae Smaller gross margins indicate the companys y p competitors have reduced their prices and the general decline in stock market prices is company must Mathew We or me cause for concern usmess 39 Management Compares 5 PE ram w th v PC industry gross margins shrank as the PC market those of similar companies to determine the bmmg mm campgmwg marketplace s relative rankings of the firms Grcss Profit Ratio Gross Profit Netsales 37 rofit Margins are a measure of the overall profitability of a firm Proiil Margin 7 Net Imme Net Sales 38 eturn On Assets ROA reflects how much the firm has earned on the investment of all the financial resources committed to the firm Return on Assets 7 Net inwme nterest i Tax rate TotalAssets 39 v Yuur bunk indicates that the numeratur iii the FIOA calculatiun is Net lncume This is incurrect This can be shuwn wrth twu exam les 7 ssume triat you buy propenyior steam and sell ta yeai iateitoi st tantra Vou made 10 ontrie asset 7 Now assumethat you bougrittrie same piopenythiouqh tinanoing Witri a stance down ymem and a mortgage 590900 and you riad to pay iiteiestot 5 oisasaa toi triat you ownedthe properly Noni you made 5500 v This is the same prupertyin buth examples v The return an the asset is a ot theyear 55 e shou nowansrdertheinlerestexpensewhenmakingthat determinatran 40 Interest should be considered in determining return on equit In the first example you had equity of 100000 and the return was 10 In the second example 10000 and made 5 This is a return at 55 Interest is important with the return on equity because the size of the equity affects the interest expense you had equity of 00 41 eturn on Common Eguim ROE reflects how much the firm has earned on the funds invested by the common shareholders either directly or through retained earnings ROE Neiirmme tyearsneteneoonoenos A erage Common Shareholders Equity 42 v inancial Leverage is the abilitytu increase the return an yuur investment by burruwrngiunds at a rate that is beluw rate at return an the assets at the cm 7 For example you an beneiit by borrowing at 3 and investing the money at 10 v Yuur bunk quantifies this by subtracting the return an the assets at the cumpanyirum the return an the cummun equity at the cumpany v Cunsider the print example irum slide A0 Financial Leverage netumon Common Equity ReturnonAssets 45 55 i0 e 43 Asset Turnover Ratio is indicates the company s utilization productivity of its ets Asset Turnover nato Net Saves Average Totai Assets 44 The reiatioriship between Return on Assets Protit Margin and Asset Turnover Pietro Protit Margin gtlt AssetTurnoverRatio Net inwmev interest i Tg rate Net inoome X A Net Saves verage TotaiAssets tSaies Average Totai Assets r rites Nialmships suggestth tviida riieriiai wayettianne RDAcaii be improved r Firati ilcail be improved by increasirg the pro t riiargiri 7 meaning mampra lperdoiiaralsoias r Seating ilcail be improved by increasingttieaeet turnover 7 bygemmlingmamsaiesvuivmewiliilhesameamavnlmasasar e bymtvcingliieamavmMamsreqvimthragivenieveialsaies Winnie 45 Dividend Poiicy Two other ratios are of tinanciai condition They are reiated to another aspect oft management dividend poiicy These ratios are the dividend payout and dividend yieid not strictiy speaking tests inanciai Aiteinative Accounting Met ods Management so many options that you can39t doripare oripariies Dividend payout Divdends Pro Forma income Net income Management issues sustainabie inwrne wrtriout needirig to ioivowarivruies improper Recognition oi income D de d id D d ds na M quot We Ma efgme 3 xixgementandCPAs straintrieir reading otGMPtoo 46 Quality of Earnings A Company vnth high qoaiity earnings provides toii an transparent information that does not confuse or misiead users of the tinanciai statements Some of the factors contributing to a reduction in the qoaiity of earnings inciode39 CHAPTER 12 Purpose of the Statement of Cash Flows The statement of cash flows is considered a major financial statement as are the income statement balance sheet and statement of stockholders equity The statement of cash flows provides a great deal of information and answers certain questions that the other three statements do not lts presentation is required whenever an income statement is prepared The statement of cash flows shows the effects on cash and cash equivalents of the operating investing and financing activities of a company for an accounting period The principal purpose of the statement of cash flows is to provide information about a company s cash receipts and cash payments during an accounting period The secondary purpose of the statement of cash flows is to provide information about a company s operating investing and financing activities during the period Classification of Cash Flows The statement of cash flows categorizes cash receipts and cash payments as operating investing and financing activities Operating activities include receiving cash from customers for the sale of goods and services receiving interest and dividends on loans and investments and making cash payments for wages goods and services purchased interest and taxes Investing activities include purchasing and selling longterm assets and marketable securities other than cash equivalents as well as making and collecting on loans Financing activities include issuing and buying back capital stock as well as borrowing and repaying loans on a short or longterm basis issuing bonds and notes Dividends paid are also included in this category but the repayment of accounts payable or accrued liabilities is not Significant NonCash Activities The statement of cash flows should be accompanied by a schedule of noncash investing and financing transactions Such transactions represent simultaneous investing and financing activities that do not however result in an inflow or outflow of cash These activities include the issuance of stock for assets the conversion of bonds into stock the issuance of debt for assets and the exchange of plant assets Format Of The Statement of Cash Flows The cash flows from operating activities always appears first It is followed by the investing activities section and then the financing activities section In the formal statement of cash flows individual cash inflows and outflows from investing and financing activities are shown separately in their respective categories eg inflows from sale of plant assets is reported separately from outflows from investing in plant assets The Corporate Life Cycle All products go through a series of phases called the product life cycle and a corporation s cash flow reflects these phases The phases in order of their occurrence are often referred to as follows Introductory Phase During this phase the corporation is likely to have a cash deficit in its operations because the product s sales are small and the promotional expenses are great There may also be a great deal of expenditures for research and development activities During this phase the corporation is likely to have a deficit in its investing activities because it is spending a great deal on investing in plant assets These deficits will be covered through financing transactions Growth Phase During this phase the sales revenue will increase Despite this the growth in its inventories and supplies and the need to increase the amount of credit offered to customers represent a significant need for cash in a corporation s operations This phase is usually characterized by additional spending on research and development activities During this phase there is still a significant need for investments in plant assets All of these needs will still require a cash infusion from financing transactions Maturity Phase A product in this phase is often referred to as a cash cowquot A company s operations should produce cash flow and there is a shrinking demand for investments in plant assets As a result of the foregoing there is little need for a cash infusion from financing transactions Decline Phase During this phase cash from operations decreases Cash from investing may become positive as the company liquidates unneeded plant assets Again there is little need for cash infusions from financing transactions Usefulness of the Statement of Cash Flows Investors and creditors may use the statement of cash flows to assess such things as the company s ability to generate positive future cash flows its ability to pay its liabilities its ability to pay dividends and its need for additional financing Management uses the statement of cash flows among other things to assess the business s debtpaying ability determine its dividend policy and plan its investing and financing needs The Statement of Cash Flows also provides useful information to investors regarding the following The Quality of Income Corporations may appear to be very profitable but the accruals may not be accompanied by the receipt of cash The Cash Flow Statement can be useful in determining whether the cash flows from operations match the financial picture painted by the Income Statement or whether cash from financing is being used to mask problems with a corporation s operations Investments The Statement of Cash Flows is the only place where a corporation s investment in plant assets is detailed This can be very important in determining whether a corporation is poised to continue to grow in the future Preparing The Statement of Cash Flows To prepare the statement one needs a comparative balance sheet the current income statement and additional information about transactions affecting non current accounts during the period The four steps in statement preparation are determining cash flows from operating activities determining cash flows from investing activities determining cash flows from financing activities and presenting all this information in the form of a statement of cash flows Indirect and Direct Methods Cash flows from operating activities may be determined using either the direct method or the indirect method The choice of which method to use only affects the calculation of the Cash Flow From Operations There is no difference in the Cash Flow From Investing Activities and the Cash Flow From Financing Activities The direct and indirect methods produce the same results and both are considered GAAP The FASB however recommends the direct method accompanied by a separate schedule the indirect method reconciling net income to net cash flows Despite this the indirect method is used by approximately 99 of all companies When the direct method is used the net cash flow from operating activities as computed using the indirect method must also be reported in a separate schedule With the Direct Method the cash flow from operations is calculated directly from scratch With the lndirect Method however the cash flow from operations is calculated by taking the net income of the company and then making adjustments These adjustments are required because net income is calculated using the accrual method and we are interested only in cash receipts reduced by cash disbursements the cash method These adjustments include Adding back expenses that were deducted from net income but did not cost anything eg depreciation expense amortization expense and depletion expense Taking out capital gains and losses that do not relate to operations eg sale of plant assets Taking out expenses that were accrued but not yet paid eg income taxes accrued but not paid in the current year Taking out expenditures that cost cash but were not expensed this year eg the purchase of inventory that was not sold or supplies that were not used up and the payment of prepaid expenses still outstanding at the end of the year Taking out income that was accrued but not yet received eg credit sales where the account receivable is still outstanding accrued interest not yet received and Adding back cash receipts that were not treated as income eg customers payments of accounts receivable that were generated in a prior yea0 Because of its widespread use we will focus on the lndirect Method Indirect Method Consider the balance sheet equation Assets Liabilities Owner s Equity Cash Curr Assets LT Assets Curr Liab LT Liab Equity A Cash A Curr Assets A LT Assets A Curr Liab A LT Liab A Equity A Cash A Curr Assets A LT Assets A CurrLiab A LT Liab A Equity 80 cash changes in the opposite way from other assets and the same way as liabilities and equity With the Indirect Method we assume that a change in a balance sheet account is matched by a change in cash This is true for every change in the balance sheet accounts except for changes due to noncash transactions eg the purchase of an asset in exchange for stock As a general rule the changes for the following balance sheet accounts are assumed to affect the following activities Activity Changes In These Accounts Fall Within The Activity In Question Operations Current Assets Current Liabilities Net Income and Loss Also add back non cash expenses like depreciation Investing Long Term Assets Financing Long Term Liabilities Stockholder s Equity excluding Net Income Illustration of the Indirect Method We are going to use the TAccount approach to the Indirect Method It is a very simple approach to use because You mechanically go through every balance sheet account and You note every change with an equal amount of debits and credits Because of these characteristics it is difficult to skip an item A company has the following financial statements for the current and last years Balance Sheet Assets Cash Accounts Receivable Merchandise Inventory Prepaid Rent Furniture and Fixtures Accumulated Depreciation Furniture and Fixtures Total Assets Liabilities Accounts Payable Income Taxes Payable Notes Payable LongTerm Bonds Payable Equity Common Stock 20 par value Paidln Capital in Excess of Par Value Retained Earnings Total Liabilities amp Equity Current Year Last Year 164800 50000 165200 200000 350000 450000 2000 3000 148000 144000 42000 24000 788000 823000 143400 200400 1400 4400 40000 20000 100000 200000 240000 200000 181440 121440 81760 76760 788000 823000 Income Statement Net Sales 1609000 Cost of Goods Sold 1127800 Gross Margin 481200 Operating Expenses including Depreciation Expense of 46800 449400 Income From Operations 31800 Other IncomeExpense Gain on Sale of Furniture and Fixtures 7000 Interest Expense 23200 Total Other IncomeExpense 16200 Income Before Income Taxes 15600 Income Tax Expense 4600 Net Income 11000 Additional information for the current year Furniture and fixtures that cost 35600 with accumulated depreciation of 28800 were sold at a gain of 7000 Furniture and fixtures were purchased in the amount of 39600 A 20000 note payable was paid and 40000 was borrowed on a new note Bonds Payable in the amount of 100000 were converted into 2000 shares of common stock 6000 in cash dividends were declared and paid From the Above Information we can produce the following Statement of Cash Flows Statement of Cash Flows Cash Flows From Operating Activities Net Income 11000 Adjustments To Reconcile Net Income To Net Cash Provided By Operating Activities Depreciation Expense 46800 Decrease in Accounts Receivable 34800 Decrease in lnventories 100000 Decrease in Prepaid Expenses 1000 Decrease in Accounts Payable 57000 Decrease in Taxes Payable 3000 Gain on Furniture and Fixtures 7 000 Total Adjustments 1 15 800 Net Cash Provided By Operating Activities 126600 Cash Flows From Investing Activities Sale of Furniture and Fixtures 13800 Purchase of Furniture and Fixtures 39 600 Net Cash Used By Investing Activities 25800 Cash Flows From Financing Activities lssue Notes Payable 40000 Payment of Dividends 6000 Payment of Notes Payable 20 000 Net Cash Provided By Financing Activities 14 000 Net Increase In Cash 114800 Cash At Beginning of Period 50 000 Cash At End of Period 164 800 NonCash Investing and Financing Activities Conversion of Bonds lnto Common Stock 100 000 We will now produce the information that you need to construct this Statement Using the TAccount approach you create a Taccount for every account on the Balance Sheet except Cash In each Taccount indicate the change in the asset from last year to the current year For example if an asset has increased by 8000 Then place 8000 on the debit side of that asset s TAccount Similarly if a liability has increased by 6000 then place 6000 on the credit side of that liability s TAccount In the above example you would set up the following TAccounts The Accounts Receivable have decreased by 34800 This would be represented by a credit to the Accounts Receivable TAccount Accounts Receivable 34800 The Merchandise lnventory has decreased by 100000 Merchandise lnventory 100000 The Prepaid Rent has decreased by 1000 Prepaid Rent The Furniture and Fixtures have increased by 4000 1000 Furniture amp Fixtures 4000 The Accumulated Depreciation has increased by 18000 Remember that this is a contraasset account and it has a credit balance Accumulated Depreciation 18000 The Accounts Payable have decreased by 57000 Accounts Payable 57000 The Income Taxes Payable have decreased by 3000 Income Taxes Payable 3000 The Notes Payable have increased by 20000 Notes Payable 20000 The Bonds Payable have decreased by 100000 Bonds Payable 100000 The Common Stock has increased by 40000 Common Stock 40000 The Additional Paidln Capital has increased by 60000 Additional P idln CaQital 60000 The Retained Earnings has increased by 5000 Retained Earnings 5000 All of these figures above the line drawn in each TAccount represents the total change in the account and we must now duplicate it below the line in each account Except for the noncash transactions we will explain the change with a corresponding entry in a large Cash TAccount that has been divided into three parts for Operations Investing and Financing Cash Operations Investing Financing With the Indirect Method we will work from the Net Income from the Income Statement The Net Income increased the Corporation s Retained Earnings The Net Income is also the basis for the calculation of Cash Flow From Operations 80 we enter the Net Income 11000 as a credit to Retained Earnings It increased Retained Earnings and a debit to Cash It increased Cash Thus we have equal debits and credits Retained Earnings 5000 11000 Cash Operations Net Income 11000 Next look at the additional information We are told that 6000 in cash dividends were declared and paid Dividends reduce Retained Earnings debit and the payment of a cash dividend is an outflow of Cash Thus Cash is reduced credit We have equal debits and credits of 6000 Retained Earnings 5000 6000 11000 If you net the credit of 11000 Net Income and debit of 6000 Dividends we have explained how Retained earnings had a net increase of 5000 The payment of a dividend involves equity and therefore should be recorded as a financing transaction Having explained the change in Retained Earnings we draw a double line below the account to show that we are finished with this account Cash Operations Net Income 11000 lnvesting Financing Pay Dividends 6000 Look at the Additional Information again We see that Bonds Payable in the amount of 100000 were converted into 2000 shares of common stock With a bond conversion you take the carrying value of the bonds off the balance sheet and issue stock for the exact amount of the carrying value D Bonds Payable 100000 Cr Common Stock 40000 Additional Paidln Capital 60000 The 2000 shares of common stock have a par value of 20 80 40000 is placed in Common Stock and the remainder of the carrying value of the bonds is placed in Additional Paidln Capital Bonds Payable 100000 100000 Common Stock 40000 40000 Additional Pa dln Capital I 60000 60000 We have now explained all of the changes to Bonds Payable Common Stock and Additional Paidln Capital and we are through with these accounts Cash was not involved in this transaction and the transaction will appear in the schedule of noncash transactions Look at the Additional Information again We see that a 20000 note payable was paid and 40000 was borrowed on a new note Take each of these items separately The payment of the 20000 promissory note is a decrease to Notes Payable Debit of 20000 and a decrease to Cash Credit of 20000 The payment of a Note Payable involves a LongTerm Liability and therefore involves a financing transaction We have equal debits Notes Payable and credits Cash of 20000 Notes Payable I 20000 20000 Cash Operations Net Income 11000 Investing Financing Pay Dividends 6000 Pay Notes Payable 20000 The borrowing of 40000 increases Notes Payable credit and Cash debit Because it involves a LongTerm Liability it is a financing transaction Notes Payable 20000 20000 40000 Cash Operations Net Income 11000 Investing Financing Issue Notes Payable 40000 Pay Dividends 6000 Pay Notes Payable 20000 We have explained the change in Notes Payable Look at the Additional Information Furniture and fixtures were purchased in the amount of 39600 This is an increase to Furniture and Fixtures debit and a decrease in Cash credit The purchase involves LongTerm Assets and thus is an investing transaction Furniture amp Fixtures I 4000 39600 Cash Operations Net Income 11000 Investing Purchase of Furniture 39600 Financing Issue Notes Payable 40000 Pay Dividends 6000 Pay Notes Payable 20000 From the Income Statement we can see that the depreciation expense for the current year is 46800 Depreciation Expense increases Accumulated Depreciation credit Depreciation does not cost any cash but under the accrual method it reduced Net Income The purpose of the Indirect Method is to convert the accrual method Net Income into a cash method Net Income Thus we want to increase Cash From Operations by the amount of Depreciation Expense If you have trouble with this logic remember that we need an equal amount of debits and credits You know that Depreciation Expense increases Accumulated Depreciation with a credit 80 Cash needs a debit of 46800 Accumulated Depreciation 18000 46800 Cash Operations Net Income 11000 Plus Depreciation 46800 Investing Purchase of Furniture 39600 Financing Issue Notes Payable 40000 Pay Dividends 6000 Pay Notes Payable 20000 Look at the Additional Information Furniture and fixtures that cost 35600 with accumulated depreciation of 28800 were sold at a gain of 7000 Note the journal entry from that sale D Cash 13800 Accumulated Depreciation 28800 Cr Furniture and Fixtures 35600 7000 Gain You want to do this journal entry to the TAccounts noted in the journal entry Accumulated Depreciation I 18000 28800 46800 Furniture amp Fixtures 4000 39600 35600 The debit to Cash for 13800 is a cash inflow from the sale of a LongTerm Asset which is an investing activity We received 13800 from that sale The 13800 sales price includes the gain from the sale But the gain is part of Net Income which appears under Operations You are counting the gain twice Once in Operations and Once in Investing You take the credit to gain and place it in operations to take the gain out of the Net Income The Credit will offset the Net Income which is a Debit to Cash From Operations Cash Operations Net Income 11000 Furniture Gain 7000 Plus Depreciation 46800 Investing Sale of Furniture 13800 Purchase of Furniture 39600 Financing Issue Notes Payable 40000 Pay Dividends 6000 Pay Notes Payable 20000 We have explained the changes to Furniture amp Fixtures and Accumulated Depreciation The only accounts left unexplained are the current assets and current liabilities These changes to the accounts are entered below the line in each TAccount and an offsetting debit or credit is entered to Cash Flow From Operations Accounts Receivable 34800 34800 Merchandise Inventory 100000 100000 Prepaid Rent 1000 1000 Accounts Payable I 57000 57000 Income Taxes Payable 3000 3000 Cash Operations Net Income 11000 Depreciation 46800 Decrease in AIR 34800 Decrease in Inven 100000 Decrease in Prep Rent 1000 Furniture Gain 7000 Decrease in AP 57000 Decrease in Tax Pay 3000 Cash Flow From Operations 126600 Investing Sale of Furniture 13800 Purchase of Furniture 39600 Cash Flow From Investing 25800 Financing Issue Notes Payable 40000 Pay Dividends 6000 Pay Notes Payable 20000 Cash Flow From Financing 14000 Total Cash Flow For Current Year 114800 Plus Beginning Balance of Cash 50000 Ending Balance of Cash 164800 The Direct Method Under the direct method net cash flows from operating activities are determined by taking cash receipts from sales adding interest and dividends received and deducting cash payments for purchases operating expenses interest and income taxes Free Cash Flow Interpreting the Statement of Cash Flows includes examining important relationships such as cashgenerating efficiency and free cash flow Cashgenerating efficiency is the ability of a company to generate cash from operations Free cash flow is the cash available for new projects It is the cash remaining after current operating commitments such as commitments for operations interest income taxes dividends and net capital expenditures have been met Free Cash Flow Cash From Operations Capital Expenditures Dividends Financial Statement Analysis Cash From Operations is used to evaluate a corporation s liquidity and solvency Current Cash Debt Coverage Ratio When examining a corporation s ability to pay its debts in the short term liquidity financial analysts look at the Current Cash Debt Coverage Ratio In this ratio you divide a corporation s cash from operations by average current liabilities Cash Flow From Operations Average Current Liabilities Cash Debt Coverage Ratio When examining a corporation s ability to pay its debts in the longterm solvency financial analysts look at the Cash Debt Coverage Ratio In this ratio you divide a corporation s cash from operations by average total liabilities Cash Flow From Operations Average Total Liabilities 2 1 Receivables amounts owed to company Chapter 8 Accounts Receivable Company yust bills its customersclients Result from rendering services or selling products to the public 3 4 Notes Receivable Evidenced with promissory notes v Furmal written debt instruments v Usually bear interest v Usually has lixed maturity date 7 Doesn t have to Demand Mote v When custumers pay AR sluwly 7 Make customers sign promissory note a pay interest Company should write off AR where no hope of collecting the AR Conservatism Don t show worthless AR as v This is misleading 5 Two methods to write ott bad AR Direct method 39 Nut GAAP Allowance method 6 Another GAAP principle is materiality It amount is not material you don t need to follow GAAP Something is material it person s actions would be different i he or she ltnewthe item in question It bad AR not a material amount quu can use direct met in Othervnse must use allowance method 7 Direct WriteOtt Method Charge uncollect ble accounts to an expense in the period of detau vA selling experse v May nut cuincide With the periud ml the related sale rViolales Matching Principle 8 It you write ott AFl amp customer eventually First reinstate AFl v Reverse the priur yuurnal ertry D Accuunts Receivable 0100 D Uncullectide Accuunts Expense 0100 Or Uncullectible Accuunts Expense 0100 Or Accuunts Receivable 100 9 10 Allowance Method Second you record that the NH has been paid D Cash 100 Cr Accuunts Receivable 100 Matching Principle v Expense shuuld be recurded in the same periud as the relate sae v Need tn estimate bad debts each year v Cumpany dues nut knuw which custumer want a prysoyoudon t write many particular NR 7 instead you reduce NR wt in a conlla account 1 Allowance For Bad Debts D UncullectibleAccuunts Expense 12000 Cr AlluwancelurUncullectible 12000 Accuunts 1 1 Allowance for UncollectibleAccounts is contra account to Reduces AFl to amount estimated to be collectible Net number is the net realizable value of the NH Accuunts Receivable 200000 Less Alluwance lur Uncullectible Accuunts 12000 100000 12 Write ott AFl when clear that it won t be paid39 Note that there is no expense involved in the entry v Nu Bad Debt Expense v Expense happened in year at sale D AlluwancelurUncullectibieAccuunts 0100 Or Accuunts Receivable 100 13 After writeoft 14 AFl net value does not change v Specilic AFl was written all v Alluwancelur Uncullectible Accuunts decrease by the same amuunt When customer pays atterAR written oi39i First reinstate customer s AFl D Accuunts Receivable 100 Cr AlluwancelurUncullectible 100 Separate AFl by age categories The total amounts in each category are multiplied by a different percentage a different probability of default for each age category Add up products or estimate of total bad debts 1 5 16 Second record conec on Most common methods for estimating uncollectible D Cash 100 Accounts receivable aging method and Cr Accuunts Recewabie 100 Percentage of net sales method 17 18 Aging of accounts receivable method Percentage of receivables basis Adjusting entry is for amount that brings Allowance for Uncollectible Accounts to the computed iigure It you estimate a total of 3000 of you re AFl will not be pai a Your allowance has a credit balance of 1 00 Credit the allowance and debit bad debt expense for 2 000 19 20 Percentage of sales method Esttmated percentage for uncoiiecttbie accounts ts muittpited by net saies or net credtt saies tor the perto The resuittng ttgure ts then used tn adyusttng entry Prevtous baiance tn Aiiowance tor Uncoiiecttbie Accounts amu nts trum prettuus years nut yet been wrttten nit trreietant tn maktng adtusttng entry It Yuu hate net sates Di 300 0 Yuu beitete that t quota at yuursaies wtii nut be cuiiected Piace 3000 tntu the aiiuwan Fiecetved tn the saie of expenstve merchandtse or ot er asse v Extended aymen p ts v Eg sates ut autumubties In exchange for deitnquent AFi When promissory note replaces AR Maker ts customer who can t pay NE on ttme Company gtves more ttme but wants tnterest Company converts AFi tnto tnterest beartng promtssory note 21 22 I I Promissory note A promtssory note has two parties Jammy debt mstmmem Maker debtor and Usuatty beam te 39 Payee tender v interest un nutes wtthterms at a year at iess e inletestusuaiiy pa at maturtty Usuaiiy has maturtty date v C n nute v Maturtty vaiue ts the amuunt awed by maker at maturtty 23 24 Promissory notes Loan to someone 25 26 Assume a 6000 10 sixmonth When the note matures the maker pays promissory note is issued in place of AR the principle and the accrued interest D C h D NutesReceivabie 6000 as 6000 0 6300 Cr Accounts Receivabie Nutes Receivabie 6000 interest Revenue 300 27 28 lithe note is dishonored Supposed to accrue interest revenue in the 00mpany W has AR again period earned even though not yet paid No more interest wiii accrue thereafter 39 You need to do an AdJUSth ENVY 0 Account Receivabie Cr Nutes Receivabie interest Revenue 6300 6000 300 29 30 Assume 3month promissory note is issued I A promissory note is honored when it is m December paid in full at its maturity date Marchi D Cash 615 Deci D NntesRecevabie Ci NutesReceivabie 5000 Cr AccuuntsReceivabie 6000 inigyesipigcgwabig interest Revenue 100 Decai D interest Receivabie 50 Or irterest Revenue 50 31 32 Managing Accounts Receivable Company with AR needs to watch the following steps carefully Extendin Credit Who should get edit v Eg luuk at credit repurts asklur guarantees ur letters at credit Your credit policies have to be competitive v But yuu still want In make sure yuu Will get paid 33 34 Establishing a Payment Period You have to be competitive Consider offering incentives or customers to pay early eg sales discounts Monitoring Collections Make sure customers are paying you Prepare an AR aging schedule v Helps tn identity prublem accuunts 35 36 ii Average Collection Period Evaluating the Receivable Balance When evaluating companys credit policies management looks at two me asures il Receivables39iurnover Ratio and Receivables Turnover Ratio tells you how many times you give and collect credit ARl during the year on average Net Credit Sales Average Net Accuunts Receivable 37 Avera e Collection Period Reflects the number of days it takes to collect a firm s NR 355 Receivables Tumuver Ratiu 38 I calculate the Average Collection Period differently Same Ratio First calculate credit sales per day Net Credit Sales 39 Then divide one day s worth of credit sales into your average A Rs Average Net Accuunts Receivable One Day s Credit Sales 40 Accelerating Cash Receipts Company needs cash faster than customers are paying A company can sell its AR to a factor Factor charges a fee to purchase the AR v Treated as an ex ense Opeialinq expenseor rmherexpense 41 Cash 588000 SerVice Charge Expense 12000 Cr Accuurts Receivable 600000 42 Similar to treatment of VISA or MasterCard credit card sale Credit card company is agreeing to issue credit to your customers so that you don t have to D Cash Senme Chavge Expense Cv a es 970 30 1000 Chapter 11 Characteristics of a Corporation A corporation is a business organization authorized by the state to conduct business it is considered a separate legal entity from its owners It is the dominant form of American business because it makes possible the accumulation of large quantities of capital Corporations have the following characteristics that distinguish them from partnerships Separate Legal Existence A corporation is a separate entity from its shareholders A partnership is often treated by the law as a group of individuals acting together rather than one entity Limited Liability of Stockholders Because the corporation is a separate legal entity the owners are not usually liable for the corporation s debt Thus a shareholder s liability for a corporate debt is limited to the shareholder s investment in the corporation Sometimes creditors can pierce the corporate veil but if corporate formalities are followed this is not usually possible In the case of a partnership the law views the partnership s actions as that of its owners and therefore the partners have unlimited liability Creditors may seize all of the partners wealth including assets not connected with the partnership in order to satisfy a partnership debt Transferable Ownership Rights In a partnership a partner may not transfer his or her interest to another without the permission of all of the other partners but in a corporation a shareholder may transfer his or her shares to anyone he or she wishes Ability To Acguire Capital American capital markets eg stock exchanges are geared to raise capital for corporations rather than partnerships Thus it is much easier for corporations to raise capital than it is for partnerships This is more of an advantage of a corporation over a partnership than a characteristic Continuous Life In a partnership if a partner dies the partnership dies and a new partnership must be formed On the other hand a corporation s existence is not affected by the death of one or all of its shareholders Corporation Management In a partnership any partner may bind the partnership in agreements This is called mutual agency Any partner is an agent of all of the other partners On the other hand a shareholder has no authority to execute a contract on behalf of his or her corporation In a partnership all the partners must vote on any decision On the other hand the shareholders do not participate in the management of a corporation s affairs In a corporation the board of directors runs the business through its officers This is called centralized management Your book also list two more characteristics of corporations These are not really characteristics but disadvantages of a corporation compared with a partnership Government Regulations Because a corporation is a separate legal entity corporations have more governmental filings than do partnerships Additional Taxes Because a corporation is a separate legal entity corporations have to pay income taxes and shareholders pay taxes on any dividends received from corporations This is called double taxation On the other hand because partnerships are treated for the most part as a group of individuals conducting business together each partner pays tax on his or her share of partnership income Later if a partner receives a distribution from the partnership the distribution is not taxed a second time Forming A Corporation In California you form a corporation by filing its articles of incorporation with the Secretary of State After it is approved the organizers select the board of directors who then adopt the bylaws which are thge rules and procedures for conducting the corporation s affairs The articles contains such information as i the name of the corporation ii the purpose of the corporation and iii the types and number of stock that the corporation is authorized to sell Organization Costs Not In Book The costs of forming a corporation such as attorneys fees and incorporation fees are debited to an intangible asset account called Organization Costs Because the corporation has an indefinite life no amortization is required These costs typically are amortized straightline amortization over the first five years of the corporation s life This matches the tax treatment of these costs Fee for services rendered in corporate organization D Organization Costs 5000 Cr Cash 5000 Amortization of Organization Costs D Amortization Expense 5000 Cr Organization Costs 5000 Stockholder Rights There may be different classes of stock Every corporation must have a class of stock referred to as common stock Common stockholders elect members of the Board of Directors which i elects the officers of the corporation and ii oversees the operations of the corporation Common stockholders are the residual owners of the corporation They are entitled to all of the assets of the corporation after all of the claims against the corporation are satisfied Ownership in a corporation is evidenced by a document called a stock certificate which the shareholder receives when he or she purchases shares in the corporation The stock certificate states how many shares of stock is owned by the shareholder If the stockholder wishes to sell his shares he or she endorses the stock certificate and sends it to the corporation s secretary or its transfer agent The secretary or transfer agent is responsible for transferring the corporation s stock maintaining stockholders records and preparing a list of stockholders for stockholders meetings and for the payment of dividends Issuance of Stock A corporation may sell stock directly to its shareholders This is called a direct issue This is typical for small corporations eg you form a corporation and purchase all of the shares of stock In the case of large offerings of stock to the public an indirect issue is typically used In an indirect issue the corporation retains investment bankers to sell the corporation s stock to the investment banker s clients Par and OnPar Value Stocks Par value is an arbitrary amount assigned to each share of stock that constitutes the legal value of a share of stock The common stock is not supposed to be sold initially by the corporation for less than the par value Thus creditors and other shareholders know that the stock must be issued for a price above the par value Also the par value cannot be returned to the shareholders at a later date Dividends can only be paid out of earnings not par value Some states allow earnings to be paid out of paidin capital in excess of par value Par value is stated in the articles of incorporation Sometimes corporations simulate par value on their own This is called stated value The corporation commits itself not to issue the stock less than the stated value Stated value is handled in a manner similar to par value Legal capital equals the number of shares issued times the par value it is the minimum amount that can be reported as contributed capital When only one type of stock is issued it is called common stock A second type of stock called preferred stock also can be issued Preferred Stock also may have a par or stated value In California and other states stocks do not need to have a par or stated value They are referred to a nopar stock Your book notes that nopar stock is common today Nike and Proctor amp Gamble are nopar stocks Accountinq For Common Stock Issues A corporation s balance sheet contains assets liabilities and a stockholders equity section Stockholders equity is made up of contributed capital which is also called paidin capitalquotthe stockholders investment and retained earnings earnings that have remained in the business When par value stock is issued the Capital Stock account is credited for the legal capital par value and any excess is recorded as PaidIn Capital in Excess of Par Value lssue par value common stock for par value D Cash 1000 Cr Common Stock 1000 lssue par value common stock for amount in excess of par value D Cash 5000 Cr Common Stock 1 000 Paidin Capital in Excess of Par Value 4000 Nopar stock is stock for which par value has not been established it may be issued with or without a stated value D Cash 5000 Cr Common Stock 5000 Stated value which is established by the board of directors constitutes the legal capital for a share of nopar stock The total stated value is recorded in the Common Stock account Any amount received in excess of the stated value is recorded as Paidin Capital in Excess of Stated Value lssue stated value common stock for stated value D Cash 1000 Cr Common Stock 1000 lssue stated value common stock for amount in excess of stated value D Cash 5000 Cr Common Stock 1000 Paidin Capital in Excess of Stated Value 4000 Other Stock Issuance Topics Not In Book In the stockholders equity section of the balance sheet the entire amount received from the shareholders is labeled Total Contributed Capital On rare occasions stock is issued at a discount less than par value creating a contingent liability for the amount of the discount for those stockholders if the corporation cannot pay its debts When stock is issued in exchange for assets or for services rendered the stock should be recorded at the fair market value of the assets or services unless the fair market value of the stock is more easily determined lssued par value common stock with a market value in excess of par value for a parcel of land D Land 5000 Cr Common Stock 1000 Paidin Capital in Excess of Par Value 4000 Sometimes a corporation receives gifts or donations from civic groups andor governments For example if you agree to open up a plant in our state or community we will give you this land andor facility States and Communities do this to lure businesses away from other locations This is called Donated Capital D Land 5000 Cr Donated Capital 5000 Accounting For Treasury Stock As noted above the articles of incorporation indicate the number of shares of stockthat a corporation is authorized to issue This is called authorized stock lssued stock is the number of shares transferred to stockholders Stock not sold is unissued Stock that has been issued to stockholders and has not been bought back by the corporation is called outstanding stock Treasury stock consists of shares bought back and held In the equity section of a balance sheet you will find information regarding the number of shares authorized issued and outstanding Treasury stock is purchased to distribute to officers and employees through stock option plans to maintain a favorable market for the company s stock to use in purchasing other companies to increase earnings per share and to prevent a hostile takeover of the company Purchase of Treasury Stock Treasury stock can be held indefinitely reissued or canceled and it has no rights until it is reissued Treasury stock appears on the balance sheet as the last item in the stockholders equity section as a deduction Treasury Stock is a contraequity account Under the cost method when treasury stock is purchased Treasury Stock Common is debited for the purchase cost D TreasuryStock Common 32000 Cr Cash 32000 Reissue of Treasury Stock Not In Book The Treasury Stock may be reissued at cost above cost or below cost When cash received from reissuance exceeds the cost the difference is credited to Paidin Capital Treasury Stock and Retained Earnings if needed Reissued shares of treasury stock at cost D Cash 32000 Cr Treasury Stock Common 32000 Sale of onehalf of shares of treasury stock at above cost D Cash 18000 Cr Treasury Stock Common 16000 Paidin Capital Treasury Stock 2000 Sale of shares of treasury stock at below cost D Cash 13000 Paidin Capital Treasury Stock Retained Earnings 1000 Cr Treasury Stock Common 16000 In no instance should a gain or loss account be established When stock is retired all of the contributed capital associated with the retired shares must be removed from the accounts Preferred Stock In addition to common stock a company can also issue preferred stock which is used to attract investors by giving them certain preferences over common stockholders Holders of preferred stock are given preference over common shareholders when dividends and liquidating dividends are declared Each share of preferred stock entitles its owner to a dollar amount or percentage of par value each year before common stockholders receive anything Once preferred stockholders have received the annual dividends to which they are entitled however common stockholders may receive dividends A dividend does not have to be paid at all because it is not debt With non cumulative preferred stock if no dividend is paid in one year then the preferred stockholders are never entitled to receive that dividend in future years With cumulative preferred stock all current dividends plus any missed dividends from prior years dividends in arrears must be paid prior to any dividends being paid to common shareholders Dividends in arrears should be disclosed either in the balance sheet or as a footnote The journal entries related to preferred stock are similar to those of common stock except that preferred stock is used rather than common stock For example if you issue par value preferred stock for amount in excess of par value D Cash 5000 Cr Preferred Stock 1 000 Paidin Capital in Excess of Par Value 4000 Additional Preferred Stock Discussion Not In Book An owner of convertible preferred stock has the option to exchange each share of preferred stock for a set number of shares of common stock Some preferred stock is callable meaning that the corporation has the right to buy it back for cancellation at a specified call or redemption price If the preferred stock is convertible then holders of convertible preferred stock can choose instead to convert it to common stock Sometimes preferred stock is participating which means that after they receive all of their dividends and liquidation preferences then they may receive additional funds Thus they quotparticipatequot in the upside if there are sufficient profits This is rarely used Most preferred stock is nonparticipating Preferred stockholders do not usually have the right to vote for directors of a corporation Very often however preferred shareholders will be given the right to vote for directors if the preferred stock is cumulative and preferred dividends have been in arrears for a specified number of years Cash Dividends A dividend is a distribution of assets by a corporation to its stockholders normally in cash Dividends usually are stated as a specified dollar amount per share of stock and are declared by the board of directors Dividends are declared on the date of declaration specifying that the owners of the stock on the date of record will receive the dividends on the date of payment A liquidating dividend is the return of contributed capital to the stockholders The corporation pays out more than the retained earnings lt normally is paid when a company is going out of business or reducing operations When cash dividends are declared the Dividends Declared account is debited and Dividends Payable is credited when they are paid Dividends Payable is debited and Cash is credited Declaration of a cash dividend to common stockholders D Dividends Declared 50000 Cr Dividends Payable 50000 Your book also notes that Retained Earnings may be debited instead of Dividends Declared Payment of cash dividends declared above D Dividends Payable 50000 Cr Cash 50000 No journal entry is made on the date of record After the date of record stock is sold eX dividend without dividend rights The temporary account Dividends Declared will be closed out to Retained Earnings at the end of the year D Retained Earnings 50000 Cr Dividends Declared 50000 Stock Dividends A stock dividend is a pro rata distribution of shares of stock to a corporation s stockholders A Stock dividends conserves cash tends to lower the stock s market price and allows for a nontaxable distribution of additional stock to a corporation s present shareholders When stock dividends are declared the general journal entry treats it as if the corporation declared a cash dividend and then the stockholders turned around and bought stock The result of a stock dividend is the transfer of a portion of retained earnings to contributed capital Imagine these two hypothetical transactions Declare Cash Dividends D Dividends Declared 5000 Cr Cash 5000 Stockholders use money to buy stock D Cash 5000 Cr Common Stock 5000 If you net these two transactions you get D Stock Dividends 5000 Cr Common Stock 5000 If the stock dividend is less than 2025 it is a small stock dividend The dividend is assumed to have little impact on the value of the stock so we value the stock dividend at the current market value of the stock If that results in a value greater than par value then the additional amount is credited to Paid ln Capital ln Excess of Par D Stock Dividends Declared 5000 Cr Common Stock Distributable 1000 Paidin Capital in Excess of Par Value 4000 If the stock dividend is more than 2025 it is a large stock dividend The dividend is assumed to affect the value of the stock so we just use the par value of the stock D Stock Dividends Declared 1000 Cr Common Stock Distributable 1000 Stock Dividends is closed out to Retained Earnings A stock dividend does not affect total shareholder equity but it does transfer amounts from Retained Earnings to Contributed Capital D Retained Earnings 5000 Cr Stock Dividends Declared 5000 When the stock is actually distributed D Common Stock Distributable 5000 Cr Common Stock 5000 Stock Splits A stock split is an increase in the number of shares of stock outstanding with a corresponding decrease in the par or stated value of the stock For example a 3 for 1 split on 40000 shares of 30 par value stock results in the distribution of 80000 additional shares that is a former owner of one share now owns three shares and the reduction of par value to 10 The amount for each component of stockholders equity is not affected A memorandum entry should be made for a stock split disclosing the decrease in par or stated value as well as the increase in shares of stock outstanding The purpose of a stock split is to improve the stock s marketability by decreasing the stock s market price In the above example if the stock were selling for 180 per share a 3 for 1 split probably would cause the market price to decline to approximately 60 per share Retained Earnings As we have mentioned before a corporation s equity is divided into two parts i the portion contributed by its shareholders and others PaidIn or Contributed Capital and ii the portion generated by the corporation through its operations Retained Earnings A corporation s net income increases its Retained Earnings A corporate loss or the payment of dividends reduces a corporation s Retained Earnings Retained Earnings normally has a credit balance A debit balance in the Retained Earnings is called a deficit Retained Earnings Restrictions Retained earnings can be divided into unrestricted and restricted retained earnings What we have dealt with so far has been unrestricted retained earnings Unrestricted retained earnings indicate the amount if available that can be distributed to stockholders as dividends Restricted retained earnings cannot be used to pay dividends Restriction on retained earnings indicates the amount that is to be retained in the business for other purposes Retained earnings may be restricted for contractual legal or voluntary reasons by the board of directors only State law may require restrictions on retained earnings when treasury stock is acquired Companies might also do this because loan arrangement require it or because it wants readers to know that it will not be paying dividends because of some policy eg expansion Retained Earnings is not a cash account The restriction of Retained Earnings is just a transfer from one account to another to give notice of the intention not to pay dividends No money is transferred anywhere Restrictions on retained earnings are disclosed in the retained earnings portion of the balance sheet or as notes to the financial statements A restriction on retained earnings will not change total retained earnings Presentation of Stockholders E uit in Balance Sheet Not In Book When reporting stockholder s equity on a Balance Sheet the preferred stock is listed first because it has preference on distributions over the common stock The common stock appears next Donated capital appears last The following gives you an idea of how all of the different equity accounts are represented on the Balance Sheet Stockholders Equity Contributed Capital Preferred stock Common stock Preferred stock subscribed Common stock subscribed Common stock distributable Paidin capital in excess of par value Total contributed capital Retained Earnings Total contributed capital and retained earnings Less treasury stock Total stockholders equity Statement of Retained Earnings Not In Book Any changes in the retained earnings of a company is shown in its Statement of Retained Earnings Statement of Retained Earnings January 1 2004 43933 Net Income 14 500 Subtotal 58433 Less Dividends 20 000 Retained Earnings December 31 2004 38 433 When a corporation wishes to restrict the payment of dividends out of certain Retained Earnings it moves that amount out of unrestricted Retained Earnings into Restricted Retained Earnings D Retained Earnings 50000 Cr Restricted Retained Earnings 50000 Prior Period Errors Not In Book When you find that you made a mistake in a prior financial statement you have to correct it The income effect of the mistake doesn t belong in the current income statement and you don t change the old income statement Instead you calculate what the retained earnings would have been after correcting the mistake and you fiX them with an adjustment to the beginning balance of the Retained Earnings Statement Statement of Stockholders E uit Not In Book When an item of shareholders equity changes other than retained earnings then you use a Statement of Stockholder s Equity Here every item in the shareholder equity section of the balance sheet gets a column and you show the beginning balance and how it changed during the year and its ending balance Common PIC Retained In excess Total Stock 0 par Earnings Balance January1 2004 1000000 500000 300000 1800000 Net Income 80000 80000 Dividends 30000 30000 Issue Additional Common 300000 300000 600000 Stock Balance December 31 2004 1300000 800000 350000 2450000 Financial Statement Analysis For shareholders who are interested in the corporation s ability to pay dividends and its history of paying dividends two ratios are important i the dividend payout ratio and ii the dividend yield Dividend Payout Ratio The dividend payout ratio measures the percentage of a corporation s earnings that it pays out to its common shareholders Total Cash Dividends Paid To Common Shareholders Net Income Dividend Yield Financial analysts use dividend yield to describe a company s dividend policies in terms similar to interest received Dividend Per Share of Common Stock Market Price Per Share of Common Stock Return on Eguity When measuring corporate profitability a popular ratio is the Return on Common Stockholders Equity This ratio shows how many dollars of net income were earned for each dollar invested by common stockholders Net Income Preferred Dividends Average Stockholders Equity Chapters 14 Part One Profession of Accounting The accounting profession is varied It includes private accounting where accountants work for their clients eg Controllers It also includes public accounting where accountants are independent of their clients eg CPAs Financial accounting refers to the preparation of financial statements primarily for outsiders eg investors government regulators and creditors This is done by the internal accountants and then certified by the public accountants Managerial or management accounting refers to the preparation of internal reports for the management of the company Tax accounting refers to the preparation of federal state and local tax returns Forms of Business Organizations We will focus on corporate financial statements but there are other entities and their financial statements look different There are sole proprietorships one owner partnerships two or more owners and other entities as well With these two forms of doing business the law treats the owners as doing business Any debts of the business are debts of the owners and they unlimited liability for the debts of the business Corporations are legal entities that are separate from their owners It is the corporation that is conducting the business not the owner Therefore the debts of the business are the corporation s debts not the owner s debts Shareholders of corporations have limited liability In other words the shareholders can lose their investment in the corporation but usually creditors of the corporation may not come after the shareholders for any additional amounts This is a major advantage of using the corporate form Another reason that corporations are favored is because our capital markets are geared towards selling stock rather than partnership interests and it is easier to sell stock than to sell partnership interests Therefore corporations find it easier to raise equity capital than do other investment vehicles Partnerships and sole proprietorships however have tax advantages over corporations Because corporations are separate from their owners they pay taxes on their income When corporations pay dividends to their shareholders the dividends are treated as taxable income to their shareholders who pay a second tax on that income With partnerships and sole proprietorships the business does not pay taxes the owners pay taxes once on the income earned The owners are then free to withdraw the income from the business free of income tax Your book mentions that the total number of partnerships and sole proprietorships exceeds the number of corporations by 5 to 1 but the amount of equity capital of corporations exceeds that of partnerships and sole proprietorships by 81 According to another source More than 70 of the businesses in the United States are organized as proprietorships About 10 of businesses are organized as partnerships About 20 of businesses are organized as corporations however they generate over 90 of the total dollars of business receipts Limited Liability Companies LLCs and Limited Liability Partnerships are newer forms of doing business Users of Financial Information There are several groups of users of financial information Sometime these users are called business stakeholders A business stakeholder is quota person or entity that has an interest in the economic performance of the businessquot Stakeholders include internal and external users of financial information Internal users include marketing managers production supervisors finance directors and other company officers External users include investors creditors employees customers and various government agencies These stakeholders use accounting data to gauge the economic performance of businesses The following table provides examples of the type of financial information that would of interest to various internal and external users of financial information Stakeholder Interested In Reason A Owner Sales ls advertising effective Profit Can I take home more money each week Cash Can I afford to buy more equipment B Investors Stockholders Profit Is my investment making money Dividends What dividends are being paid C Bankers Debts Can this business repay a loan D IRS Profit What taxes does this business owe E Managers Expenses Am I keeping expenses within my budget Sales Will I be eligible for a bonus this year F Employees Profit Can my company afford raises Is my job secure The SEC and state securities agencies asks Do the financial information provided to investors accurately reflect G Regulators Operations operations Bank Regulators ask Is the bank engaging only in permitted activities Amount spent H Customers on warranty How dependable is this product How responsive is the service claims department I Competitors How do I compare to my competitor Amount spent on ads Because competitors can gather valuable information about their competitors from the competitors financial statements companies try to provide as general information on their financial statements as possible Business Activities Businesses are involved in three basic types of activities financing activities investing activities operating activities Accounting provides information on these activities Financing Activities Capital is needed during the formation and operation of a business Capital can be provided through debt liabilities andor equity Examples of liabilities or debt include formal borrowings eg Notes Payable as well as the shortterm extension of credit by suppliers eg Accounts Payable employees eg Wages Payable and government eg Taxes Payables Formal debt issued by a corporation Notes Payable or Bonds Payable does not dilute an owner s ownership of the business This is a major advantage of debt The disadvantage of providing capital through debt is that debt has to be paid back often with interest When a corporation wishes to raise capital through issuing capital it can sell stock There are various forms of stock The basic form of corporate stock is common stock The holders of common stock are the residual owners of a corporation The disadvantage of equity financing is that the owner dilutes his or her ownership percentage by issuing new equity The advantage of equity financing is that equity does not have to be returned Shareholders may receive a share of the corporation s profits through the payment of dividends Unlike interest however there is no obligation for a corporation to pay dividends Ethics Perspective As your book notes the failure to provide accurate financial information hurts a number of innocent parties Enron provides one of the most infamous examples of this effect Not only did the failure to accurately report the financial operations hurt Enron investors but it also hurt the entire stock market because it severely shookthe trust that investors had in financial information It is important that accountants and officers of companies to act ethically This is not just a case of morals It should be noted that there are severe consequences for individuals who participate in the distribution of false andor misleading financial information An ethical violation can lead to civil or criminal liability for the violation Officers and accountants can lose their livelihoods over ethical violations They can also be liable for huge financial judgments to shareholders for such violations A serious violation can result in prison sentence We have seen this in the Enron scandal The accountants and management personnel who participated in that distribution face severe financial penalties and prison sentences T ISN T WORTH IT Investing Activities lnvesting involves the acquisition of resources by a business The resources that businesses use in their operations are called assets Assets can be generated by financing transactions For example cash is generated from sales of common stock and bank loans Equipment Property Plant amp Equipment is paid for with available cash and borrowings Assets are also generated by operations For example Accounts Receivables and cash are generated by sales to customers Although your book calls this an investing activity in the context of the Statement of Cash Flows these activities are considered operating activities Operating Activities A business internally generates capital through its operations revenues Examples of revenues include sales revenue service revenue and interest revenue The costs of generating this capital revenues are expenses Examples of these expenses include cost of goods sold the cost of inventory sold selling expenses marketing expenses administrative expenses and interest expense When its revenues exceed its expenses a business has net income When expenses exceed revenues a net loss results There are generally three types of businesses Manufacturing Businesses Merchandising Businesses Service Businesses Communicating With Users of Financial Statements Accounting can be thought of as an information system that provides reports to stakeholders users of financial statements about the economic activities and condition of a business There are four basic financial statements Balance Sheet Income Statement Statement of Retained Earnings Statement of Cash Flows In order for users of financial statements to obtain a fuller picture of the operations of the issuing business comparative financial statements are often provided With comparative financial statements the activities of more than one year are reported with each year s information appearing in a separate column The most recent year is reported on the left Balance Sheet The Balance Sheet is prepared as of a given date It is usually the end of the reporting period Corporations can report their operating results using a calendar year or a fiscal year a 12month period other than a calendar year It reports the financial position of the company as of a given date The Balance Sheet reports the assets liabilities and the net worth of the company These are usually reported at the original cost of the item in question not the fair market value Therefore the Balance Sheet is not claiming to show the current value of the company The Balance Sheet is organized as follows One way to think of a Balance Sheet is that one side reports the resources assets of a business and the other side reports the claims against those resources The claims of the creditors are liabilities and the claims of the investors are equity The resources equal the claims on those resources which leads to the Basic Accounting Equation which is often called the Balance Sheet Equationquot ASSETS LIABILITIES EQUITY The net worth or equity section of a corporate balance sheet is divided into two parts One part is the part that the shareholders contribute to the corporation This is called PaidIn Capital Contributed Capital The second part is the earnings that the corporation earns for itself that it keeps and does not give to its shareholders via dividends These earnings are called Retained Earnings Income Statement The Income Statement reports the results of the companies operations for the reporting period It is dated quotFor Period Ended Datequot For example the latest Income Statement for a calendar year company might be dated quotFor the Year Ended December 31 1998quot The Income Statement gives the revenues expenses and net income of the company for the period in question The selling of capital stock or borrowing of funds does not generate revenues Similarly the paying of dividends is not an expense Income Statement For the Year Ended Revenues XXXX Expenses XXXX Net Income XXXX Most publicly traded corporations report their income using the accrual method Under the accrual method you have revenue when you earn it not when you actually receive it Also you have expenses when you owe them not when you pay them Accountants prefer this because you match the revenues with the expenses that generated them If you used the cash method revenue reported when received and expenses reported when they are paid companies can manipulate their income Statement of Retained Earnings The Statement of Retained Earnings explains the change in the Retained Earnings from last yearto this year It shows Statement of Retained Earnings For the Year Ended Beginning Balance of Retained Earnings XXXXX Plus Net Income for the Year XXXXX Less Dividends for the Year XXXXX Ending Balance of Retained Earnings XXXXX The dividend history of companies is very important to investors The Statement of Retained Earnings provides a summary of that history Statement of Cash Flows The Statement of Cash Flows was introduced around 1986 because people complained that with the accrual method they had difficulty telling whether the company was actually receiving the income that it was accruing The Statement of Cash Flows reports the cash inflows and outflows that the company has from its operations what it does for a living investing purchases and sales of equipment real estate and other assets and financing stock and debt transactions The Statement of Cash Flows explains how cash changed during the year Statement of Cash Flows For the Year Ended Cash Flows From 0 erations Details given Iineliyy line like an Income Statement xxxxx Cash Flows From Investing xxxxx Details given line by line like an Income Statement Cash Flows From Financing xxxxx Details given line by line like an Income Statement Cash Flows For the Year XXXXX Plus Balance of Cash at Beginning of Year XXXXX Balance of Cash at End of Year XXXX Interrelationships of Statements All of the financial statements reports on different aspects of the same operations Some examples The net income reported in the Income Statements is the same net income reported in the Statement of Retained Earnings The change in the retained earnings reported on the Balance Sheet from last year to the current year is explained in the Statement of Retained Earnings The change in the amount of cash reported on the Balance Sheet from last year to the current year is explained in the Statement of Cash Flows Other Comments on Financial Statements At the end of the financial statements you will find the Notes to the Financial Statements These Notes convey a great deal of important information on o The accounting rules and conventions that were followed in preparing the financial statements Additional details about the figures appearing in the financial statements Additional information not appearing in the financial statements eg lines of credit bank covenants amp contingent liabilities The financial statements are accompanied by a letter from the accountants preparing the financial statements The letter describes how the audit of the company was conducted and it states the accountant s opinion on whether the financial reports were prepared in accordance with generally accepted accounting principals GAAP Stakeholders are looking for an unqualified opinion from the CPA Without an unqualified opinion stakeholders cannot have complete confidence that the financial statements give an accurate picture of the company s financial health The financial statements also have a management discussion and analysis section It discussed the company s ability to pay nearterm obligations its ability to fund operations and expansion and its results of operations It analyzes trends in the company s operations and identifies significant events and uncertainties that affect the company s operations These financial statements are the basic financial statements that investors creditors and regulators expect to see for each corporation Generally Accepted Accounting Principles Financial statements are prepared according to Generally Accepted Accounting Principles GAAP GAAP is the set of rules that all accountants try to follow in preparing financial statements The thought is that if everyone follows the same rules then the reader of the financial statements can have more confidence that he or she understands the financial statements using a lesser amount of time than would be the case if the reader had to try to understand the format the corporation is using as well This was not always the case Although the basic accounting rules were developed during the Renaissance by an Italian monk to record the profits of caravans and other business ventures prior to 1933 companies were free to use whatever rules that they wanted in preparing financial statements With the stock market crash of 1929 the federal government wanted to protect investors and creditors The Securities Act of 1933 and The Securities Exchange Act of 1934 require most publicly traded corporations to prepare financial statements in accordance with rules promulgated by the Securities and Exchange Commission SEC The SEC often allows the accounting profession to establish GAAP but if the SEC isn t happy with GAAP then it can require some other reporting rules be followed with governmental filings and reports to shareholders Although it has changed over the years the current group since 1979 that rules on GAAP is the Financial Accounting Standards Board FASB Assumptions and Principles To develop accounting standards the FASB relies on some key assumptions and principles Monetary Unit Assumption This assumption requires that only those things that can be expressed in money are included in the accounting records For example customer satisfaction is important to every business but it is not easily quantified in dollar terms thus it is not reported in the financial statements The monetary unit used is the national currency of the country in which the corporation exists Economic Entity Assumption This is also called the Business Entity or Separate Entity Assumption or Concept Each business must be accounted for as an individual organization Therefore even though you are conducting business as a sole proprietorship not a separate legal entity you still prepare financial statements covering only the business operations You do not include your personal assets and income Time Period Assumption This is also called the Accounting Period Assumption or Concept This assumption states that the life of a business can be divided into artificial time periods eg year or quarters and that useful reports covering those period can be prepared for the business Continuity Assumption This is also called the Going Concern Assumption or Concept Financial statements assume that the company will not be going out of business This influences how financial statements are prepared For example we value inventory at the lower of cost or market The market value of inventory is typically the replacement cost If we assumed that the business was liquidating we would report the inventory at its liquidation value which is probably lower Cost Principle Although there are exceptions most transactions are recorded using historical cost A building is recorded using the purchase price not its fair market value So the Balance Sheet does not purport to reflect the actual value of the company just its book value The cost concept follows from the objectivity concept which requires that accounting records and reports be based upon objective evidence GAAP is also motivated by conservatism Under the conservatism assumptionconcept accountants should value items conservatively Full Disclosure Principle A circumstances and events that would make a difference to stakeholders should be disclosed in either the financial statements or the notes to the financial statements Characteristics of Useful Information To be useful information should possess these qualitative characteristics relevance reliability comparability and consistency Relevance Information is relevant if it will influence investment decisions To be relevant it must also be timely Reliability Information is reliable if it can be depended on It must be verifiable neutral and a faithful representation of what it purports to be Comparability Information is presented so decision makers can recognize similarities differences and trends over different time periods or between different companies The financial statements follow same general rules In order to aid in the comparison each company must disclose the accounting methods used Consistency Accounting procedures and methods once adopted should continue to be used from year to year There are rules for changing accounting procedures that a company uses Materiality Material items must follow GAAP Companies need not follow GAAP for items that are immaterial This is a subjective concept lf an investment or other financial decision would be affected by the size of item in question it is material Conservatism When preparing financial statements a company should choose the accounting method that will be least likely to overate assets and income The Accounting Process Imagine that you want to report on your wealth or financial net worth This could happen because you want to borrow money from a friend and you want to assure them that you can pay back the loan What if you own a house for which you just paid 250000 You could report that you have this house and you have a net worth 250000 Just because you own the house does not mean that you are really worth 250000 For example what if you borrowed the 250000 purchase price from your parents You are not really worth 250000 You have an asset worth 250000 and a liability for 250000 80 you have a zero net worth Imagine that you have no assets or liabilities In other words you have a zero net worth All you have is a credit card with a credit line of 10000 You take the credit card and get a cash advance of 10000 Are you richer than you were before you received the cash advance Sure you have 10000 in cash but you now have a 10000 debt 80 you still have a zero net worth In order to give a full disclosure as to your net worth you have to report your assets liabilities and net worth or in accounting terms quotequityquot A Balance Sheet attempts to provide this disclosure through information regarding a firm s assets liabilities and equity A firm s assets are paid for directly or indirectly with either liabilities or equity As a result of this relationship a firm s assets are equal to its liabilities plus its equity As noted above this relationship is referred to as the balance sheet equation Assets Liabilities and Owner s Equity This relationship is reflected in the Balance Sheet While Balance Sheets can have different formats we will use the format set forth above Under this format the lefthand side of the Balance Sheet assets is equal to the righthand side liabilities and equity Each asset liability and equity item is represented by an account There is a great deal of flexibility in the names given to accounts Each account has two sides just like the Balance Sheet The lefthand side of the account is the debit side of the account The righthand side of the account is the credit side of the account For example one asset account that a firm will have is cash The debits and credits in any account are netted to give the balance in the account at a given time The accounts regarding assets liabilities and equity are summarized in Balance Sheet If an account appears on the lefthand side of the Balance Sheet asset then the account will normally not always have a debit balance If an account appears on the righthand side of the Balance Sheet liabilities and equity then the account will normally have a credit balance With an account that normally has a debit balance eg an asset if you want to increase that account you debit it some more In other words you add to the debit balance If you want to decrease it you credit it In other words you are adding to the side that will be netted against its balance thereby decreasing that balance Similarly if an account normally has a credit balance eg a liability or equity account if you want to increase it you credit it some more and if you want to decrease it you debit it The order in which the accounts appear in the Balance Sheet follows the certain convention Assets are listed by how soon they will be converted into cash Thus cash is the first line of the Balance Sheet Liabilities are listed by how they will be paid Equity accounts are listed by their priority of payment upon liquidation Business transactions are recorded in the accounts The changes to the accounts are summarized in the General Journal For each transaction the General Journal states which accounts are credited and which accounts are debited These General Journal entries take the following form D Name of the Account Debited XXX Cr Name of the Account Credited XXX ILLUSTRATION A ED 0 O U Assume that the firm is a corporation Equity in the corporation is represented by stock There are different types of stock We will only deal with one type here common stock When stock is sold you are increasing the equity in the firm Because cash or other property is given to the corporation the assets eg cash have increased and those assets did not come from debt Thus the net worth or equity is thereby increased Assume 100000 of common stock is sold The equity account here is Common Stock Because cash an asset has increased it is debited Equity is on the righthand side of the balance sheet and it normally has a credit balance In order to increase equity as is the case in this transaction you credit the equity account Common Stock Cash 100000 Cr Common Stock 100000 Purchase of Equipment for 5000 cash Equipment 5000 Cr Cash 5000 Ask yourself what is going on here Your equipment has increased by 5000 Equipment is an asset Assets appear on the lefthand side of the Balance Sheet Therefore to increase the asset you debit the lefthand side of the account Your cash has gone done Cash is an asset Again remember that assets appear on the lefthand side of the Balance Sheet and to decrease an asset you must credit the righthand side of the account Purchase of Equipment in exchange for a promissory note for 10000 Equipment Cr Notes Payable 10000 10000 As was true before you increase the asset of equipment by debiting the left hand side of equipment In this transaction your liabilities are going up Liabilities are on the righthand side of the Balance Sheet To increase a liability you credit the righthand side of the account The liability here is called Promissory Note With a promissory note the debtor does more than merely owing money to the debtor The debtor here executes a formal document in which he or she promises to pay the debt D D Purchase of Supplies for 10000 on credit no formal promissory note is given Supplies 10000 Cr Accounts Payable 10000 Supplies is an asset and it is increasing Because an asset is on the lefthand side of the Balance Sheet debiting the lefthand side of the account increases it In this transaction a different liability is increasing Because Accounts Payable is a liability the account appears on the right hand side of the Balance Sheet Thus to increase the account you must credit the right hand side of the account The liability here is an account payable With an account payable there is no formal document The debtor merely owes the money For example the debtor tells the stationary store to send over letterhead and the store also sends a bill for the amount owed E Purchase of Land and Building for 100000 n C When you pay one price for a bundle of assets you must allocate the purchase price between the assets acquired according to their fair market value Assume that the land is worth 10000 and the building is worth 90000 The 100000 is paid for partly in cash 20000 and partly by delivering a promissory note 80000 Land 10000 Building 90000 Cr Cash 20000 Notes Payable 80000 Here your assets are increasing Assets are normally have a leftsided balance and they are increased through debits Also your liabilities are increasing Liabilities normally have a rightsided balance and they are increased through credits Pay the principal of 6000 on a promissory note Notes Payable 6000 Cr Cash 6000 Here the liability is going down you are paying it off Liabilities appear on the righthand side of the Balance Sheet and therefore to decrease a liability you debit the lefthand side of the account Here the asset of cash is going down To decrease an asset you credit the righthand side of the account Income Statement As noted above a firm s net worth or equity increases from contributions from its owners eg the sale of stock as well as the generation of profits its operations The generation of profits is reflected in certain accounts Inflows to the firm are reflected in revenue accounts and outflows from the firm are reflected in expense accounts Revenues less expenses give you the firm s Net Income Information regarding these accounts is summarized in the Income Statement Revenues increase a firm s equity or net worth Because equity appears on the righthand side of the Balance Sheet it normally has a credit balance You therefore increase an equity account by crediting the righthand side of the account Because revenues increase equity then revenues will normally have a credit righthand side balance Because expenses decrease equity then expense accounts will normally have a debit lefthand balance Illustration Continued G Assume that our firm is a consulting firm and that the firm has earned consulting commissions of 50000 The client has not yet paid these commissions D Accounts Receivable 50000 Cr Consulting Revenue 50000 We did not receive any cash but we still have an asset That asset is the right to collect the money from our client That right is called an Account Receivable and its plural is called Accounts Receivable So two things have happened First our assets have increased Second as a result of our firm s generating revenue the firm is worth more so our equity has increased Accounts Receivable is an asset that has increased thus we debit the account s lefthand side Consulting Revenue is a revenue account and revenues increase equity Thus crediting the righthand side of the revenue account increases it H The firm pays salaries of 20000 D Salary Expense 20000 Cr Cash 20000 Cash has gone down To decrease an asset normally a debit balance account you credit it The firm is worth less This is reflected in the expense account To decrease the equity in the firm normally a credit balance account you debit the expense account The firm uses 3000 of its supplies D Supplies Expense 3000 Cr Supplies 3000 The firm s supplies have gone down Supplies is an asset normally a debit balance account and you decrease it by crediting it The equity in the firm has gone down Equity normally a credit balance account has gone down and you decrease it by debiting the eXpense account J The firm owes one month s rent D Rent Expense 5000 Cr Rent Payable 5000 The firm hasn t paid its rent yet So no asset has gone down yet The firm owes the rent so its liabilities have gone up Liabilities are on the righthand side of the balance sheet and normally have a credit balance To increase liabilities you credit them The firm s equity has gone down Equity normally has a credit balance you decrease it by debiting an eXpense account Trial Balance At the end of the accounting period an accountant will do a trial balance in order to help in locating errors made in the recording process All the accounts with debit balance are totaled and all of the accounts with credit balances are totaled The total debit balances should equal the total credit balances A number of trial balances are conducted during the accounting cycle Closing Entries Finally you have to reflect the revenues and expenses in the equity account First you close the revenue and eXpense accounts to the income summary account Then you close the Income Summary Account to the Retained Earnings Account Illustration Continued K Close out the revenue account D Consulting Revenue 50000 Cr lncome Summary 50000 L Close out the Salaries Expense account D lncomeSummary Cr Salaries Expense M Close out the Supplies Expense account D lncomeSummary Cr Supplies Expense N Close out the Rent Expense account D lncome Summary Cr Rent Expense 0 Close out the Income Summary account D lncomeSummary Cr Retained Earnings GENERAL LEDGER 20000 3000 5000 22000 20000 3000 5000 22000 SUPPLIES BUILDING ACCOUNTS PAYABLE V RENT PAYABLE NOTES PAYABLE Iil r xf hk COMMON STOCK CONSULTING REVENUE SALARY EXPENSE RETAINED EARNINGS INCOME STATEMENT Revenue 50000 Expenses Rent Expense 5000 Supplies Expense 3000 Salary Expense 20000 Total Expenses 28000 Net Income 22000 BALANCE SHEET Assets Liabilities Cash 49000 Accounts Payable 10000 Accounts Receivable 50000 Rent Payable 5000 Supplies 7000 Promissory Note 84000 Equipment 15000 Equity Building 90000 Common Stock 100000 Land 10000 Retained Earnings 22000 Total Assets 221000 Total Liab amp Equity 221000 When the other parts of the equity of a corporation have changed eg common stock besides retained earnings then corporations will use a Statement of Changes in Shareholder Equity rather than a Statement of Retained Earnings STATEMENT OF CHANGES IN SHAREHOLDER EQUITY Common Stock Retained Earnings Beginning Balance 0 0 Sale of Shares of Common Stock 100000 Net Income 22000 Ending Balance 100000 22000 STATEMENT OF CASH FLOWS Cash From Operations Net Income 22000 39 in quot t Iquot 39 39 50000 Increase in Supplies 7000 Increase in Accounts Payable 10000 Increase in Rent Payable 5000 20000 Cash From Investing Purchase Equipment 15000 Purchase Building 90000 Purchase Land 10000 115000 Cash From Financing Issue Promissory Notes 84000 Issue Common Stock 100000 184000 Net Increase in Cash During the Year 49000 Cash Balance at the Beginning of the Year 0 Cash Balance at the End of the Year 49000 Corporations vs Sole Proprietorships amp Partnerships We have focused on the journal entries for a corporation The journal entries used to account for the equity of a sole proprietorship or a partnership are different When capital is given to a sole proprietorship or a partnership the journal entry is similar to the sale of stock by a corporation D Cash 100000 Cr John Smith Capital 100000 When cash is distributed from a sole proprietorship or a partnership to its ownerpartner the journal entry is D John Smith Drawing 5000 Cr Credit 5000 In the case of a corporation distributing funds to its shareholder a similar journal entry exists D Dividends 5000 Cr Cash 5000 Both dividends and the drawing account are temporary nominal accounts that get closed to the equity account that appears on the balance sheet In the case of the sole proprietorship or partnership In the case of a corporation D Retained Earnings 5000 Cr Dividends 5000 Chapter 6 Inventory cost Inciudes everythth that ts patd tn order to get the tnventory ready to seii Inciudes tnvotce prtce iess purchases dtscounts tretght tnsurance tn transtt taxes tarttts tnspectton costs and preparatton costs Two methods of handling inventories the pertodtc tnventory system and the perpetuai tnventory system 4 Periodic inventory system COGS caicuiated at end of year Begtnntng inventory Purchases Goods Avatiabie tor Sate Endtng inventory From Phystcai inventory Cost ot Goods Soid 5 Disadvantages of Periodic Method No tntormatton on theft ors otia e v Everythth not present ts assumed to be soid Uniess phystcai tnventory taken v on t know COGS or inventory Easy system to matntatn Perpetual Inventory System Tracks COGS amp Inventory conttnuousiy Physicai tnventory at end of ertod v Dtscrepanctes attrtbutabie tothett andspotiage 7 Advantage of Perpetual System Gives Information on theit COGS amp Inventory figures always available Disadvantage May be expensive to maintain v With pomsuters amp scanners marginal cost may Have only seen Perpetual System in class so far 8 m a Purchase inventory on credit D Purchases D Merchandiseinventory Cr Accounts Payable Cr Accounts Payable b Transportation Costs on purchases D Freightin D Freightin Cr Accounts Payable Cr Accounts Payable c Purchases Returns and Allowances D Accounts Payable D Accounts Payable Cr Purch RetampAiiow Cr Merch inv Perpetual 9 Periodic Perpetual d Payments on Accounts Payable D Accounts Payable D Accounts Payable Cr Cash Cr Cash e Sale oi Merchandise on Credit D Accounts Receivable D Accounts Receivable Cr Sales Cr ales D CostoiGoodsSoid Cr Merchinv 10 Periodic Perpetual g Return oi MerchandiseSoid D Sales Ret ampAiiow D Sales Ret ampAiiow Cr AR AR D Merchandiseinventory osto oo sSoid i Receipts on Accounts Receivable Cash D Cash i Payment oi Delivery Costs c NR c NR D Freight Out Expense D Freight Out Expense Cr Cash Cr Cash 1 1 12 Beginning Balance oi inventory debit balance Perpetual Inventory System Purchases debit balance Have COGS a ways Purchase Returns ampAiiowances credit balance 39 PeriOdic Inventory SyStem Purchase Discounts credit balance No COGS account Calculate COGS Net all inventory accounts v inventory Accounts closed to income ummary v Net iigure ends up as debit balance in income Summary 7 Just like closing coes account to income Summary iriPeipetuaiSyslerii Freight in debit balance Cost oi Goods Available Ending Balance oi invertory Cost oi Goods Sold 13 INCOME SUMMARY PARTIAL ENTRIES Beg BaIance 01 Inventury Purch FIet ampAII0wances 14 Close Inventory account There were no addrtrons to Inventory durrng year v Thus Inventuryrs begInmng Inventury Purchases PurchaseDrscuunts F htI Ed B I H I mg n n W aanm M W D IncumeSummary 50000 Cr Inventury 50000 Ccst 01 Guuds SuId 15 16 Close temporary inventory accounts D Purchase Drscuunts 30000 Cr Incume Summary 30000 D Incume Summary 10000 Cr FrerghtIn 10000 D Purchase ReturnsampAII0wances 20000 Cr Incume Summary 20000 D Incume Summary 300000 Cr Purchases 300000 17 Physical Inventory end of year Add to Income Summary credrt Add to Inventory account debrt quu prevruust cIused Inventury accuunt v Thrs adds endrng rnventuryhgure 39Invertury nuw reIIects end 01 year Irgure D Inventury 40000 Cr IncumeSummary 40000 INCOME SUMMARY PARTIAL ENTRIES 50000 Beg Inventury Purchases 309000 Frerght In End Inventury Purch FIet amp AIIuw 20000 Purch Drscuunts 33000 40000 19 Beg inventory debit balance 50000 Purchases debit balance 300000 Purch Flet ampAllowances credit balance 20000 Purchase Discounts credit balance 30000 Freight ln debit balance 10000 Cost of Goods Available 310000 Ending Balance of inventory 40000 Cost of Goods Sold 270000 20 Ownership of Goods quotFOB shipping point v Title to goods transfers at seller s place of usiness v Buyer pays shipping costs v Buyer includes goods being shipped in hisher inventory quotFOB destination v Title to goods transfers at the buyer s place of business v Seller pays shipping costs v Seller includes goods being shipped in hisher inventory 21 Consigned Goods Goods transferred physically to another om an 0 P Y v No transfer of title Owner Consignorl Person in Possession Consigneel Consignor includes goods in hisher inventory 22 Inventory Costing Methods Periodic Method When computing COGS amp Inventory v make assumption on which goods are sold Four Methods Assumptions v specific identification v averagecost 39lirstin firstout FlFO v lastin firstout LlFO Calculations done at end of year 23 Assume the following purchases Units Purchased June 1 50 units 1 00 mouth o o E o 24 Assume the following sales Units Sold June 10 70 units 30 210 units 200 units Units in Ending inventory 220 units 25 Specific Identification Method Keep track of which goods sold amp still in inventory 26 You identifvthat these goods were sold v Nlight use Serial Numbers or Labels 50 W15 lt m JUNE 5 BOX 1 10 55 use actual flow of goods 50 units lrum June is 50 x 1 20 60 100 units from June 20 max 1 30 130 80 units from June 25 80 X Wu 112 Cast of Goods Sold 357 28 27 You identifvthat these goods are still on hand 50X 1 00 50 lUOX 1 20 120 70X 1 40 98 50 units from Junef 100 units from June la 70 units from June 25 Cast cl Remaining lnventurv 268 Specific Identification Method Not common Expensive when dealing with high volumes of s Permits companies to manipulate income by choosing to sell highcost or lowcost items Used primarily for highpriced items v E g umputer prucessurs autumubiles expensive c furniture amp iewelry 29 Average Cost Use average cost per unit v For COGS v For lnventury Total cost of goods on hand Number of units 30 Computer average June 50 Units Purchased 500 Average Cost Per Unit units 1 00 units 1 to units 1 20 units 1 30 units 1 A0 units MES500 31 se average to calculate COGS amp Ending Inventory EndrngInventury 220 unrts 125 275 CustuIGuudsSuId 230 unrts 125 350 32 Advantage of Average Cost Method LeveIs out varratrons In cost 33 FirstIn FirstOut Method FIFO Method Assumes trrst goods soId are rst good bought 34 Ending inventory consists of most recent purchases 70 unrtstrumduneEU 70X 130 91 5 quot ts mmmm 5 1 00 50 150 unrtstrumduneES 1sz s1 40 210 50 unrtstrumdunes 50X 110 55 150 unrtstrumdune IUOX 120 180 0mmRamammg wmmy 301 30 unrtstrumduneEO 80X 130 39 Oust uI Guuds SuId 324 35 36 Itlntlation FIFO yreIds hrghest net Income of the tour methods LastIn FirstOut LIFO Method Assumes trrst goods soId are the Iast goods purchased unrts Irum June 25 ISOX 140 210 unrts Irum June 20 IOOX 1 30 130 unItsIrum Juneta 30X 1 20 36 s Oust uI Guuds SuId 376 37 Ending inventory assumed to consist of items from earliest purchases 38 Company using LIFO reports LIFO Reserve Difference between LIFO inventory amp FIFO In t 50 units Irum Junef 50X 1 00 50 V9 0II 50 units Irum June 6 50x 1 r0 55 DiscIosed in notes to financiaI statements I20 units Irum Junefa IEOX 1 20 144 Inventury Using LIFO 249 Cust I Remaining Inventury 249 LIFO RESEIVE 52 Inventury Assuming FIFO 301 39 40 LIFO Reserve AIIows anaIysts to make aIIowances for use 0 LIFO Indicates how much higher Retained Earnings wouId have been had company used FIFO Advantage of LIFO With ianation LIFO best matches current costs thh revenues LIFO gives Iowest net income of four methods v Luwer incume taxes COGS Under FIFO 324 7 Have to 2 same method ioi tax amp iinanciai LIFO Reserve 52 5mm Mmequot COGS Under LIFO 376 41 42 Disadvantage of LIFO With ianation Low income Iooks bad vAnaIysts cumpensateiur LIFO Inventory vaIuation often unreaIistic If inventories shrink cheap inventory costs resuIts in high income tax v CaIIed a LIFO quuidatiun v Retrains cumpanyirum reducing inventury IeveIs when it shuuid fur business reasuns Comparison of Inventory Methods With Infiation v FIFO pruduces a higher net incume v LIFO pruduces a Iuwer net incum v Average cust methud pruduces net incume ere in between LIFO best matches revenues amp current costs FIFO provides most reaIistic inventory vaIue 43 Inventory Costing Methods Perpetual System Which inventory soid determined at time of saie v Nut and D1 year Specific identification method same resuits under both systems vActuai guuds said determine COGS same at end EI1YEaiamp a ime EI1531E FIFOmethod same resuits 39Fiisi units buught determine COGS same at end EI1YEaiamp at time D153 9 44 Average Cost Method You compute average cost after each purchase June 1 50 units 1 00 50 6 50 units 110 55 Units Purchased 100 units 105 Average Oust Per Unit 105100 1 05 COGS for 70 units soid on June 10 is 7350 1 05unit Unsoid units use 105 cost 45 CaicuiatiunJune 10 100 units 105 10500 Saie 10 70 units 105 73 50 Baiance 10 30 units 105 3150 150 units 120 10000 20 100 units 130 13000 25 150 units 140 21000 Units Purchased 430 551 50 nit 1 20 units Average Oust Pei U 551 50430 46 For June 30 sale of 210 units Average cost 120 unit used COGS 210 units X 120 26000 Ending Inventory 220 units x 120 20270 Total COGS is 34230 7350 26880 47 LIFO Use iast units bought be ore sai e June105aie 50 units1ium June 6 50X 1 10 55 20 units1ium June1 20X 1 00 20 Custu1Guuds Said 75 48 Unsold units on June 10 are June 10 Remaining Units 30 units1iumJune1 30X 100 30 Oust D1 Remaining inventuiy 30 49 COGS torJune 30 sale 150 unitstrumduneES ISOX 140 210 60 LII39IIISIIEII39I39iJLII39IEEU IOOX 130 78 Oust uI Gunc s Said 288 Total COGS is 363 75 288 50 Ending Inventory on June 30 30 unitstrum Junet 30X 1 00 30 150 units Irum Juneta ISDX 1 20 180 AU LII39IIIS Irum June 29 40X 1 30 52 Oust uI Remaining Inventury 262 51 Inventory on Balance Sheet Lower of cost or mar et ExampIe of conservatism Market value of inventory Current repIacement cost or Net reaIizabIe vaIue 39LIqLIIdaIIEII39I saIes price Iess seIIing expenses 52 Comparison of cost to marketdone on specific item IeveI mayor category IeveI or totaI inventory IeveI Compare Cost 39FIFO LIFO Specitic ID or Average Market vFIepIacement Vaiue ur Net FIeaIizabIe VaILie 53 Tax rules don permit all of methods described above x m Ies v Tutai inventory cumparisun nut aIIuwed v Can t Lse LIFO With Iuwer uI oust or market 54 What Happens When Your Physical Inventory is Wrong Remember this years ending inventory is next years beginning inventory v Mistake aIIects twu ears What it PhysicaI Inventory is too Low 39YEILI Inrgut to count inventory in one warehouse 55 56 This Year Next Year I I 399 Bai g xxx Two et tects in first year Purch M Income Statement Net Income is too Iow AVaIIabIE XX BaIance Sheet Inventory is too Iow End Inv Too Low gt Beg BaI S Too Low Second year COGS Too High Purch XXX Income Statement Net Income is too high vaiiabie S Too Low l End W m Etiects on net Income over two years ottset Net Income Too Low COGS S Too Low eaCh other out n v Retained Earnings is correct at end ot second year I Net Income Too High 57 58 This Year Next Year What it Physical Inventory is too HighI Beg Bai gxxx vYou counted invertoryintransitwhenyou Purch M WW V9 Avaiiabie sxxx v You counted some inventory tWice End W JED H h gt Big Bay NED H gh COGS Too Low Purch XXX Avaiiabie S Too High i End Inv m Net Income Too High COGS S Too High Net Income Too Low 59 Two et tects in first year Income Statement Net Income is too high BaIance Sheet Inventory is too high Second year Income Statement Net Income is too Iow Etiects on net Income over two years ottset each other out v Retained Earnings is correct at end ot second year 60 Inventory very important Company needs enough inventoryto meet customer mands Doesn t want too much inventory Ties up resources a Inventory can become obsoi le dustInTime system used by many companies Want inventoryto arrive when needed DeII has competitive advantage Keeps reIativer Iow invertoryieveis Meets customer demands quickiy 61 Financial Analysts use two ratios to look at inventory Inventory Turnover Ratio Days In Inventory 62 Inventory Turnover Ratio ndicates number of times on average inventory is soId during the period v Huw manytimes Inventury Tumsuver Cost of Goods Sold Average Inventory 63 Days In Inventory Indicates average number of days between purchase and saIe of inventory How Iong does it take you to seII your inventory Inventory Turnover Ratio 64 My way to remember caicuiation Caicuiate nuw mucn inventury yuu seII in a day Cost of Goods Soid 365 DiVide une day s saies irtu yqu average inventury Ievei Iur the year Average Inventory Inventory Soid in One Day Mathematicaiiytne same as utner appruacn Chapter 5 Merchandising Operations When a service business earns fees they record revenue from the services rendered In the case of the merchandising business you still have the revenue transaction but you also have a second cost transaction because you have produced your revenue from selling an asset The cost or expense generated from the sale of merchandise is called Cost of Goods Sold The Cost of Goods Sold is treated the same as an expense in the journal entries but it can be treated differently in an income statement Often Sales Revenue and Cost of Goods Sold is reported at the top of an income statement and the net difference is labeled Gross Profit or Gross Margin Inventory Systems There are two methods of handling inventories The periodic inventory system and The perpetual inventory system Periodic Inventory System With the periodic inventory system the firm finds out its cost of goods sold at the end of the accounting period Throughout the accounting period the firm keeps track of its purchases To find out what the firm sold the firm takes its beginning inventory adds its purchases for the period This gives the firm all the goods that pass through the firm for the period the goods available for sale The firm then takes a physical inventory This gives the firm what is left at the end of the period The ending inventory is then subtracted from the available goods figure to get the cost of goods sold The periodic inventory system assumes anything not there was sold but the goods could have been stolen The lack of information on the theft or spoilage of goods is a major disadvantage of the periodic system In addition unless a physical inventory is taken the firm does not know what its cost of goods sold is during the period as opposed to the end of the period An advantage of the periodic inventory system is that it is easy to maintain Perpetual Inventory System With the perpetual inventory system the firm keeps track of its cost of goods sold on a continual basis Thus at any given time the firm can estimate its current inventory levels At the end of the period a physical inventory is taken Any discrepancy with the estimated inventory level and the actual inventory level is then attributed to theft and spoilage It used to be very expensive to maintain this type of system but with the use of computers amp scanners this is no longer the case and the perpetual inventory system is increasing in popularity What we have discussed to date is the perpetual inventory system and we will continue to use it in this chapter Recording Purchases of Merchandise When you purchase inventory with cash D Merchandise lnventory 5000 Cr Cash 5000 When you purchase inventory on credit D Merchandise lnventory 5000 Cr Accounts Payable 5000 A cash purchase should be supported with a cancelled check A credit purchase should be supported with an invoice from the supplier Purchase Returns amp Allowances When you return merchandise inventory Purchases Return or get a price reduction on the merchandise Purchases Allowance after they are delivered you write down the price of the Merchandise Inventory to the price actually paid The journal entry in effect reverses in whole return or in part allowance the purchase journal entry A return of entire 5000 purchase D Accounts Payable 5000 Cr Merchandise lnventory 5000 The receipt of a 1 000 purchase allowance on the prior purchase D Accounts Payable 1000 Cr Merchandise lnventory 1 000 Cost of Inventory lnventory cost is defined as the price paid to acquire the inventory and generally includes invoice price less purchases discounts freight insurance in transit taxes tariffs inspection costs and preparation costs It is basically everything that is paid in order to get the inventory ready to sell Transportation Costs The term FOB stands for Free On Board quotFOB shipping pointquot means that the seller transfers title to the goods at the seller s place of business The buyer pays shipping costs For example if you order a car from Ford and the invoice says FOB Detroit then you pay the shipping costs and the car belongs to you as soon as it leaves the factory If something goes wrong during shipment it is your problem The term quotFOB destinationquot means that the seller transfers title to the goods at the buyer s place of business The seller pays shipping costs For example if you order a car from Ford and the invoice says FOB Los Angeles then Ford pays the shipping costs and the car belongs to you when it arrives Transportation Costs on purchases are part of the cost of our inventory These costs are referred to as Freight in or Transportation ln Under the perpetual inventory system you write up the cost of the inventory D Merchandise lnventory 150 Cr Accounts PayableCash 150 Transportation Costs on our sales are an expense They are called Transportation Out or Freight Out D FreightOut 150 Cr Accounts Payable 150 Purchases Discounts When we purchase inventory we are often provided with credit terms that encourage us to pay quickly These are called purchase discounts When we offer these terms to our customers they are called sales discounts A typical purchasesales discount notation credit terms is 210 n30 twoten net thirtyquot This notation says that if the purchaser pays within 10 days then the purchaser may take 2 percent off the price of the goods Otherwise the entire bill is due in 30 days Another example would be 110 EOM This notation says that the purchaser may take a 1 percent discount if he or she pays the invoice during the first 10 days of the next month Otherwise the entire bill is due by the end of the next month lf seller does not wish to offer a discount then the seller indicates when payment is due For example n30 says that the entire amount is due in 30 days The notation n10 EOM says that the invoice amount is due in the first 10 days of the neXt month Usually passing up the purchase discount is thought to be very unwise because the interest cost for delaying the payment for 20 days is very high For example with 220 n30 you are paying 2 for a 20day loan This is an annualized rate of 365 per annum Assume you bought inventory for 3500 and the supplier offered you 210 n30 When you receive the inventory ignore the potential purchase discount D Merchandise lnventory 3500 Cr Accounts Payable 3500 If the payment is made during the discount period you write down the price paid for the Merchandise Inventory to the cash actually paid D Accounts Payable 3500 Cr Cash 3430 Merchandise Inventory 70 If the payment is not made during the discount period D Accounts Payable 3500 Cr Cash 3500 Cash Sales When you make a cash sale you have the following general journal entry reflecting the revenue side of the transaction D Cash 2200 Cr Sales Revenue 2200 The cost side of the transaction is recorded as follows D CostofGoods Sold 1400 Cr Merchandise lnventory 1 400 Sales on Account When a company makes a credit sale the general journal entry is as follows D Accounts Receivable 2200 Cr Sales Revenue 2200 The cost side of the transaction is recorded as noted above Credit Card Sales Companies that allow customers to use a national credit card such as Master Card must follow special accounting procedures Operationally the credit card company reimburses the company for the sale less a service charge eg 2 3 The credit company levies a service charge because it is responsible for establishing credit and collecting the money from the customer There are two ways to handle credit card sales depending on the credit card company Some credit card companies make the vendor wait for payment This isn t done by the major credit card companies This was the way that American Express used to operate The general journal entry looks like a credit sale except that the Account Receivable is from the Credit Card Company not the customer At the time of the sale D Accounts Receivable Credit Card Company 1000 Cr Sales Revenue 1000 At the time payment is received from the credit card company D Cash 970 Credit Card DiscountService Charge Expense 30 Cr Accounts Receivable Credit Card Company 1000 Most major credit card companies make the cash available to the vendor immediately Your book only discusses this situation Because the funds are made available within a few hours there is no need to record an account receivable from the credit card company Instead the transaction is treated as a cash sale with a fee being paid to the credit card company D Cash 970 Credit Card DiscountService Charge Expense 30 Cr Sales Revenue 1000 The Credit Card Discount can be handled as either a selling expense or as a contra revenue which is deducted before getting Net Sales Your book takes the position that the credit card fees are treated as a selling expense Sales Returns and Allowances If a customer returns merchandise that he or she has purchased you want to undo the sale You debit a contrarevenue account Sales Returns amp Allowances that will be deducted from Sales Revenue in order to compute Net Sales This gives management important information about what kind of returns the company is experiencing Undo the sales revenue D Sales Returns and Allowances 300 Cr Accounts Receivable 300 Undo the cost side of the sale D Merchandise lnventory 140 Cr Cost of Goods Sold 140 Sales Discounts If you offer customers a reduction in price if they pay the invoice quickly these discounts are referred to as sales discounts or a cash discount You would use the same credit termsdiscount notation discussed under Purchase Discounts eg 210 n30 The entry at the time of sale D Accounts Receivable 3500 Cr SalesSales Revenue 3500 If the payment is received during the discount period D Cash 3430 Sales Discounts 70 Cr Accounts Receivable 3500 If the payment is not received during the discount period then the general journal entry when the payment is made is D Cash 3500 Cr Accounts Receivable 3500 Sales Discounts are treated as a contra revenue account offsets Revenue in order to get Net Sales Sales Taxes Most states and many cities levy a sales tax on retail transactions and the federal government also charges an excise tax on some products The merchant must collect the taxes from the customer at the time of the sale and record the receipt of cash and the proper tax liabilities The merchant is not paying the tax he or she is collecting it from the customer on behalf of the government D Cash 1 080 Cr Sales 1000 Sales Tax Payable 80 When the sales tax is paid D Sales Tax Payable 80 Cr Cash 80 Trade Discounts A trade discount is when you offer customer a reduction from your regular prices The reduction is not tied to paying the invoice early A good example would be a volume discount For example the price of one unit may be 500 a unit but if the customer buys 10 units then the unit price drops to 400 An After Christmas Salequot is a trade discount The sale is reported at the discounted price the lower price and there is no account for trade discounts Net Sales Net Sales is Sales Revenue reduced by the contrarevenue accounts Sales Revenue 480000 Less Sales Returns and Allowances 12000 Sales Discounts 8000 Credit Card Discounts if treated as a contrarevenue account 6 000 Net Sales 454000 Classified Income Statements In a singlestep income statement the revenues section lists all revenues including other income and the operating costs section lists all expenses including other expenses Many companies however use multiplestep income statement that is more detailed containing several subtractions and subtotals Often corporations present condensed financial statements with only major categories of the financial statement Income Statement For Year Ending December 31 20XX Net Sales 460000 Less Cost of Goods Sold 316 000 Gross MarginProfit 144000 Less Operating Expenses 114 000 Income From Operations 30000 Other Revenue amp Gains 3600 Less Other Expenses amp Losses 2 000 Income Before Income Taxes 31600 Less Income Tax Expense 10 100 Net Income 21 500 Gross MarginProfit Net Sales less Cost of Goods Sold gives you a company s Gross Margin This is also called the Gross Profit This profit or margin gives you the merchandising profit Analysts look at this figure because it gives information about the company s market High gross margins indicate that the sector isn t very competitive The personal computer market in the 1970s amp 1980s was characterized by high gross margins During the 1990s the personal computer market became very competitive and was characterized by shrinking gross margins Operating Expenses Operating Expenses are sales expenses and general amp administrative expenses Unlike Gross Margins which may be viewed as a function of the marketplace Operating Expenses are a direct result of the management of the company How good is the company in controlling its expenses If you subtract the Operating Expenses from the Gross Margin and you have Income From Operations Financial Analysts consider Income From Operations very important because it represents the major operations of the company It is viewed as sustainable and analysts consider it a good indication of future performance Nonoperating Activities Although your book treats Nonoperating Activities as two different items on a classified income statement most companies treat it as one item called Other Revenues and Expenses Nonoperating activities are made up of nonoperating revenues amp gains eg dividends income interest income and gains from sales of assets and nonoperating expenses amp losses eg interest expense and losses from sales of assets After Income From Operations you subtract Other Revenues and Expenses Remainder of Classified Income Statement Income From Operations less Other Revenues and Expenses gives you lncome Before Income Taxes Income Taxes Income Tax Expense or Provision For Income Taxes represent the taxes owed on the income appearing on the financial statement After Income Taxes are deducted you have Net Income Below Net Income a corporation also reports the Net Income earned for each share of common stock Earnings Per Share Example of MultipleStep Income Statement Shafer Auto Parts Corporation Income Statement For the Year Ended December 31 20XX Revenues from Sales 289656 Cost of Goods Sold 181 260 Gross Margin from Sales 108396 Operating Expenses Selling Expenses 54780 General and Administrative Expenses 34 504 Total Operating Expenses 89 284 Income from Operations 19112 Other Revenues and Expenses Interest Income 1400 Less Interest Expense 2 631 Excess of Other Expenses over Other Revenues 1 231 Income Before Income Taxes 17881 Income Taxes 3 381 Net Income M Earnings per share 290 Example of SingleStep Income Statement Shafer Auto Parts Corporation Income Statement For the Year Ended December 31 20XX Revenues Net Sales 289656 Interest Income 1 400 Total Revenues 291056 Costs amp Expenses Cost of Goods Sold 181260 Selling Expenses 54780 General and Administrative Expenses 34504 Interest Expense 2631 Income Tax Expense 1 231 Total Costs and Expenses 276 556 Net Income 14 500 Earnings per share 290 Additional Profitability Ratios Your book notes that there are two additional profitability ratios Gross Profit Rate Gross Margin Percentage Operating Expenses to Sales Ratio Gross Profit Rate This ratio is also called the Gross Margin Percentage As noted above a company s gross margin is an important indicator of the competitiveness of the company s markets Gross Margin is a raw number and financial analyst s prefer a ratio that can be compared to the figures from other years within a company and figures from other companies This ratio is obtained by dividing the Gross Margin by Net Sales Gross ProfitMargin Net Sales Profit Margin Ratio This ratio divides the net income by the Net Sales Net Income Net Sales The ratio allows you to compare the profitability of different firms of different sizes Operating Expenses To Sales Ratio This ratio indicates how well the company s management is able to control its operating expenses Operating Expenses Net Sales Illustration Sportcraft a wholesaler of sporting goods had the following trial balance at December 31 of the current year Sportcraft Trial Balance December 31 20XX Cash Accounts Receivable Inventory January 1 Office Supplies Prepaid Insurance Land Building Less Accumulated DepreciationBuilding Office Equipment Accumulated DepreciationOffice Equipment Accounts Payable Common Stock Dividends Sales Sales Discounts Purchases Purchases Returns and Allowances Transportation In Sales Salaries Expense Transportation Out Advertising Expense Office Salaries Expense The following information is available at December 31 a Office supplies on hand at December 31 are 250 b Prepaid insurance at December 31 is 1500 Debit 6200 28000 45000 800 2100 34000 82000 21300 10000 3500 151000 8200 27600 7800 6100 22300 Credit 16000 5300 19000 161200 252000 2400 c Depreciation for the year is building 2000 office equipment 2400 d Salaries payable but not yet accrued at December 31 are sales salaries 300 office salaries 200 e Inventory at December 31 is 43500 Required Prepare adjusting entries in general journal form Prepare closing entries in general journal form Prepare a classified income statement for the year Prepare a classified balance sheet at December 31 Adjusting Entries D Office Supplies Expense 550 Or Office Supplies on Hand 550 D lnsurance Expense 600 Or Prepaid Insurance 600 D Depreciation ExpenseBuilding 2000 Depreciation ExpenseOffice Equipment 2400 Cr Accumulated DepreciationBuilding 2000 Accumulated DepreciationEquipment 2400 D Sales Salaries Expense 300 Office Salaries Expense 200 Or Salaries Payable 500 Closing entries D lncome Summary 277550 Cr lnventory January 1 45000 Sales Discounts 3500 Purchases 151000 Transportation ln 8200 Sales Salaries 27900 Transportation Out 7800 Advertising Expense 6100 Office Salaries Expense 22500 Office Supplies Expense 550 Insurance Expense 600 Depreciation Expense Building 2000 Depreciation Expense Equipment 2400 D lnventory December 31 43500 Sales 252000 Purchases Returns and Allowances 2400 Cr lncome Summary 297900 Net Income Income Summary 20350 Cr Retained Earnings 20350 Retained Earnings 10000 Cr Dividends 10000 Sportcraft Income Statement For Year Ending December 31 20XX Revenue Sales 252000 Less Sales Discounts 3 5 Net Sales 248500 Cost of Goods Sold Inventory January 1 45000 Add Net Cost of Purchases Purchases 151000 Less Purch Ret amp Allow 2 400 148600 Add Freight In 8 200 Net Cost of Purchases 156 800 Cost of Goods Available for Sale 201800 Less Inventory December 31 43 500 Cost of Goods Sold 158 300 Gross Margin 90200 Operating Expenses Selling Expenses Sales Salaries Expense 27900 Transportation Out 7800 Advertising Expense 6 100 Total Selling Expenses 41800 General and Admin Expenses Office Salaries Expense 22500 Office Supplies Expense 550 Insurance Expense 600 Depreciation ExpenseBuilding 2000 Depreciation ExpenseEquip 2 400 Total Gen and Adm Exp 28 050 Total Operating Expenses 69 850 20 350 Sportcraft Balance Sheet December 31 20XX Assets Current Assets Cash 6200 Accounts Receivable 28000 Inventory 43500 Office Supplies 250 Prepaid Insurance 1 500 Total Current Assets 79450 Longterm Assets Land 34000 Building 82000 Less Accum Depre 18 000 64000 Office Equipment 21300 Less Accum Depre 7 700 13 600 Total Longterm Assets 1 1 1 600 Total Assets 191050 Liabilities amp Shareholders Equity Current Liabilities Accounts Payable 19000 Salaries Payable Total Current Liabilities 19500 Shareholders Equity Common Stock 161200 Retained Earnings 10 350 Total Shareholders Equity 171 550 Total Liabilities amp Shareholders Equity 191050 2 1 Corporations have the following Chapter 1 1 characteristics thatdistinguish them from partnerships 3 4 Separate Legal Existence A corporation is a separate entity from its shareholders A partnership is often treated by the law as a group 0 individuals acting together rather than one en ity Because the corporation is a separate le al entity the owners are not usually liable for the corporation s deb v T Li a sharehulder s liabilitylur a curpurate debt is usuallylimited tn the sharehulder s investment in the curpuratiun vln the case at a partnershipthe partners have unlimited liablity Crediturs may seize all at the partners wealth in urder tn satisfy a partnership debt 5 Transferable Ownership Rights In a partnership a partner may not transfer his or her interest to another vnthout the permission of all of the other partners In a corporation a shareholder may transfer his or her shares to anyone he or she wishes 6 Ability To Acguire Capital American capital markets eg stock e ngesl are geared to raise capital for corporations rather than partnerships It is much easier for corporations to raise capital than it is for partnerships v This is mure cl an advantage at acurpuratiun uier a partnershipthan a characteristic 7 Continuous Life In a partnership if a partner dies the partnership ends and a new partnership must be formed Ont e other hand a corporation s existence is not affected by the death of one or all of its shareholders 8 Corporation Management In a partnership any partner may bind the partnership in agree v This is called mutual agency On the other hand a shareholder has authority to execute a contract on behalf of his or her corporation In a partnership all the partners must vote on any decision On the other hand the shareholders do not participate in the manage of a corporation s affairs v in a curpuratiun the buard ul directurs runs the business thruugh its ullic v This is called centralized management 10 Your book also list two more characteristics of corporations These are not really characteristics but disadvantages of a corporation compared with a partnership 11 Government Regulati s Because a corporation is a separate legal entity corporations have more governmental filings than do partnerships Additional Taxes Because a corporation is a separate legal entity v curpuratiuns have tn pay incume taxes an v sharehulders paytaxes un any dwidends received lr ur ura i u c p tuns v This is called duuble taxatiun Partnerships are treated as a group f individuals conducting business together v each partner pays tax un his ur her share at partnership incume v a later distributiun tuthe partner is taxlree 13 1 4 Forming A Corporation Stockholder Rights In California you form a corporation by filing Thele may be diffelem Ciasses 01510 its articles of incorporation with the Secretary Every corporation must have a class of stock of State referred to as common stoc After it is approved the organizers select the Co mon stockholders elect membe th board of directors who then adopt theb laws Board of Directors which ii el v which are the rules and procedures for conducting ects the officers of the corporation and iii oversees the operations of the c oration m Cmpmat unis 3 W Common stockholders are the residual owners The articles contain among other things the of the corporation types and number of stock that the corporation is authorized to sell 1 5 1 6 Ownership in a corporation is evidenced 39 Issuance fSt k by a document called a stock certificate A corporation may 59 00k dilectil to its which the shareholder receives when he Sharemidm39 or she purchases shares in the corporation v This is called a direct is e The stock certificate states how many shares of stock is owned by the shareholder v This is typical for small corporations e g you form a corporation and purchase all of the shares of stock In the case of large offerings of stock to the public an indirect issue is typically u ed vln an indirect issue the corporation retains investment bankers to sell the corporation s stock to the investment bankers client 18 Par and NoPar Value Stocks Par value is an arbitrary amount assigned to Par value is stated in the articles of incorporation each share of stock that constitutes the legal vame of a share f t Sometimes corporations Simulate par v The common stock is not supposed to be sold value on thequot own initially bythe corporation for less thanthe par This is called stated vaiua value vAlso the parvalue cannot be returned to the shareholders at a later date The corporation commits itself not to issue the stocklessthan the at value Bilmm can my be paid my Di games my my Stated value is handled in a manner similar to value par value 7 Some states allow earnings to be paid out of pard in wpnal inexoess of parvalue With Nopar value stock Common Stoc amount received cm Cl Commnstock 19 issued times the par va as contributed capital called commo be issued vPralarrad Stuck also may have a par ur stated value 20 Legal capital equals the number of shares It l5 the minimum amount that can be reported When only one type of stock l5 issued it l5 Asecond type of stock called preferred stock also ca In California and other states stocks do not need to have a par or stated va They are referred to a nopar stock Your book notes that nopar stock l5 common today N he and Proctor amp Gamble are nopar stocks 21 When par value stock is issued for par value Cash 1 IEIEI Cr Oamnun Stock 1 IEIEI 22 lssue par value common stock for amount in excess of par value o cm ssgaa Cl Commonstock sumo Paid ll Capital ll Excess ol Pailslug woo 24 k or Preferred Stock is credited for the full ssuaa ssuaa lssue stated value common stock for stated value cm 1 000 Cl Commai Stock Maori 25 lssue stated value common stock for amount in excess of stated value D Catt Ct Commonstoc sstaaa k st aaa Patty Ceptlel ttt Ems olSteted Value o aaa 26 Accounting For Treasury Stock A corporatton ts authortzed to sell a gtven number of shares v Thts ts called authuttzed stuck Issued stock the shares sold to stockholders Outstandtng stock Stock that has been tssued to stockholders and has not been bought back bythe corporatton Treasury stock shares bought back and held v lssued but nut uutstandtng 27 Treasury stock is purchased to dtstrtbute to otttcers and employees through stock optton plans to matntatn a favorable market for the company s stock to use tn purchastng other compantes to tncrease earntngs per share and to prevent a hosttle takeover of the company 28 Treasury stock can be held indefinitely reissued or canceled and it has no rights until it is reissued TS does not vote TS does not recetve dtvtdends Treasury stock appears on the balance sheet as the last item in the stockholders39 equity section as a deduction Treasury Stock ts a contraequtty account 29 When treasury stock is purchased Treasury Stock is debited tor the purchase cost D twasvyysnck Comwatt 31000 Ct C h 32000 30 The Treasury Stock may be reissued at cost above cost or below cost Reissued shares of treasury stock at cost cm 32 luau Ct Twury Stack Commu 32000 39 Sale Of onehall 0i Shares 0i treasury Sale of shares of treasury stock at below stock at above cost cost Cash mm D Cash M3000 Cr Treasury soar Camrmn 0000 Perth Caviar Treasury Stock 2000 PedrinCapnel Treasurystack 2000 WW Emquot 5 l Cr Treasury soar common 0000 In no instance should a gain or loss account be established Preferred Stock In addition to common stock a company can 39 A diVidend does 0t haVe to be paid at all also issue preferred stoc because it is not de v usedtu attract investurs by giving them certain preferences aver cummun stuckhulders v Hulders ul preferred stuck are given preference nvercummun sharehulders With noncumulative preferred stock if no when dividends and liquidatingdividendslar d l dividend is paid in one ye n preferred stockholders are never en v ac share at preferred stuck entitles its uwner tn a dullar am e titled to receive that dividend in future years nt ur percentage ul parvalue each year belure cummun stuckhulders receive anything 35 36 With cumulative preferred stock all current The youmai entries reiated to preferred diVidendS P39US any missed diVidendS from stock are similar to those of common stock prior years dividends in arrears must be paid prior to any dividends being paid to common shareholders except that preferred stock is used rather than common stock lssue par value preferred stockfor amount Dividends in arrears should be disclosed in excess of par value either in the balance sheet or as a footnote D cm 5000 Ci PmienaiSioor M 000 PedrinCepnel in Excess oi PaiVaiue 4000 37 Cash Dividends 38 Declaration of a cash dividend to common A dividend is a distribution of assets by a stockholders corporation to its stockholders normally in cash Dividends usually are stated as a specified dollar amount per share of stock and are declared by the board of directors D Dividerm Dec 50000 Ci Dividends Peiwe 50000 Your book also notes that Retained Earnings may be debited instead of Dividends are declared on the M Dividends Declared declaration specifying that the owners of the stock on the date of record will receive the dividends on the date of payment 39 40 No journal entry is made on the date of i record After the date of record stock is Ez rltm Of caSh dw39dends deemed sold exdividend without dividend rights 39 D Dividends Payable Cr Cash 50000 50000 41 42 The temporary account Dividends Stock Dividends DeCIIaredi WIquot be Closed OUt to Retamed Astock dividend is a pro rata distribution of Earnings at the end Of the Year shares of stock to a c oration s stockholders A Stock dividend in mm Eemiigs 550000 Ci DividendsDxlaim 550000 vcunserves cash v tends tn luwer the stuck s market price and valluws fur a nuntaxable distributiun ul additiunal stucktu a curpnratiun s present sharehulders 43 generallournal entry treats it as if capital When stockdividends are declared the the corporation declared a cash dividend and the stockholders turned around and bought stock The result of a stock dividend is the transfer of a portion of retained earnings to contributed 44 Imagine these two hypothetical transactions Declare Cash Dividends D Dividends Declared 5000 Ci C h 5000 Stockholders use money to buy stock C h 5000 Ci CainmnStack 5000 45 If you net these two transactions you get D Stock Divideids 5000 Ci Commai smx 5000 46 If the stock dividend is less than 2025 it is a small stock dividend The dividend is assumed to have little impact on the value of the stoc v so we value the stock diVidend at the currert market value of the sto vll that results in a value greater than par value then the additional amount is credited to Paid in Capital in Excess of Far D Siacanidends cie De red 5000 Cr CammnstacKDistnbmeble Peid39iri Capital in Exoessol Paryeiue M000 4000 47 If the stockdividend is more than 20 25 it is a large stockdividend The dividend is assumed to affect the value of the stock so we Just use the par value of the stock D Stack Dividends Dxlam l 000 Ci CainmnStack Dis1ibut8gtle l 000 48 Stock Dividends is closed out to Retained Earnings A stock dividend does not affect total shareholder equity but it does transfer mounts from Retained Earnings to Contributed Capital D ReteiiiedEemigs 5000 Ci SiockDivdeidsDeclaied 5000 49 50 D Commn Stock Dstnbutable 5000 Ci Commnstook When the stock is actually distributed Stock Splits A stock split is an increase in the number of Unrestricted retained earnings indicate the amount if available that can be distributed to stockholders as divi en s v Restricted retained earnings cannot be Lsed to pay diiidends amount tha other pu v Restriction on retained earnings indicates t e t is to be retained in the business for rposes Corporation may do it on its own because it wants readers to know that it will not be paying dividends because of some policy eg expansion State law may require restrictions on retained earnings when treasury stock is acquired contractual legal or voluntary reasons enders may require this as a condition 0 loan shares of stock outstandin wit a 5000 corresponding decrease in the par or stated value of the stock v For example a alori split on 40000 shares of 30 parialue stock results i etne distribution cit added eddnionalsriares ttnat s a tormerownerot s re nowowns tnreesnaresiand etner ductronotparyalueto The amount for each component of stockholders equity is not affected Qgggtgrandum entry should be made for mined Earnin s d h d d we have mentioned before a corporation s isc oiing the ecrease in par or state ya ue eqth 5 wwded mo two parts as we Est e morease m 5 ares 0 5m v the portion contributed by its shareholders and 0mm m39 others Paidin or Contributed Capital and 39 The urpose of a stock Split is to improve v the portion generated bythe corporation through the stocks marketability by decreasing quot5 Wain Hammad EWWSJ rkwip i tie 39 netiiicome increases its Retained the stocks market rice WW in the above exampie yf the stock was rAwipoiate lOSSOithe paymenlotdirrdends reduoesa H f 180 3 f 1 H wipoiation39s Retained Earnings 5399 m9 0 per 5 are a or 5Fquot e Retained Earnings nonnain riasacr iibalanoe Pmbabll WOUld cause the quotWW Pllce 0 rAdebtt baianoe intne Retained Earnings s wileda decline to approximately 60 per share deficit 9 etamed Eamm s Resmwons Retained earnings may be restricted for Fletained earnings c n be ivided into unrestricted and restricted retained earnings v What we have dealt With so far has been unrestricted retained earnings 9 55 Retained Earnings is not a cash account Restriction of Retained Earnings is Just a transfer notice of the intention not to pay dividends No money is transferred anywhere A restriction on retained earnings will not change total retained earnings rom one account to another to give 56 Sample order of RE section of Balance Stoclmol rs Equity Contr uted capiai reteriedstock mimiistodlt reteriedstocksubsciibed mmnsiocxsunsmbed omimristodltdstiibutable aid Mimi in excess cit par value citalwntributedcaptal n ai Eaminqs Total contributed capitalarid retainedeamings Lesstreasu stock Totalstodmoldeis equity 57 Dividend Payout Ratio The dividend payout ratio measure the percentage of a corporation s earnings that it pays out to its common shareholders39 Total Rash Dwrderids Paid To Oammorisharemlders Net lwame r Preterred Dwrderids 58 Dividend Yield Financial analysts use dividend yield to describe a company s dividend policies in terms similar to interest received Dividend PerShare Cit Common Stock Market Price Per Share Cit Common Stock 59 Return on Common Stockholders g ty This ratio shows how many dollars of net income were earned for each dollar invested by common stockholders Net income 7 Preterred Dividends Average Stockholders Equity Chapter 10 2 Liabilities are classified as current or longterm Current liabilities are are expected to be sa is ie within one year or Within the normal operating cycle whichever is longer Longterm liabilities are expected to be satisfied beyond that period Current liabilities are expected to be satisfied wi current asse s ort rough the incurrence 0 another current liability 3 Shortterm notes payable are evidenced by 4 Thelournal entry to record issuing promissory note in exchange for cash promissory notes that are due within one year of the date of the balance sheet D Cash 5000 Promissory notes usually require the 039 mes Mable all payment of interest 5 6 Thelournal entry to record issuing promissory note to replace Account Payable D Peasant Payabie 55mm Ci Notes Payable 55mm Thelournal entry to record payment of note with interest D Notes Payabie sauce interest Expense 500 Or cash 5500 7 Thelournal entry to record accrued interest expense on note at the end of the fiscal year with no actual payment of the interest is as follows D interest Expense 250 Cr interest Pawbie 8 Thelournal entry to record payment of note with interest at its maturity when some of the interest has been accrued in the previous year is as follows D NoiesPaable 5000 interest Expense 250 interest Pawbie 250 Or cash 5500 9 Most states and many cities levy a sales tax on retail transactions le eral gniernmert alsu charges an excise tax an s inducts The merchant must collect the taxes from the customer at the time of the sale and record the receipt 0 cash and the proper tax lia iities The merchant is the collection agent for the government Thusthe sales taxes are nut an expense ml the rchant 10 Thelournal entry for the sale including the collection of the sales tax is as follows D Cash 109 Cr sales we Sales Taxes Payable 9 11 Payroll liabilities consist of the laborrelated obligations incurred by a siness They relate to two distinct functions payer s Expenses Empluyer pays Sucial Securitytaxes Medicare tax and Line ment xes T ese are all expenses at the empluyer and are relerredtu as payrul a gtlt D Salary 500 Cr 350 9 15 EWPlUYEES 3399 lquEd in Employees Federal lnoameiaxes Payable 50 93121 WW Employees State lnoameTaXes Payable 5 g n aetisaptanasl mimmimgen MWWTW Minnie 5 These amount are not expenses of tne employer WW Wes P313 5 nectmiinsuranse sa Pension Contributions Payable to Charitable Oantribtttion 15 12 The credits are collected from Employees from their salaries ampWaqe Expense tgrcssanamti SalaryPa able 1 3 v The credits represent the Empluyer s cuntributiuns nut Withhulding lrum Empluyees D PayrollTaX Expense grcssamount 90 Or Unemployment insurance Payable 14 guuds ur services in return lur ad a the adva entry is made v Unearned Revenues represent ubligatiuns tn deliver v ce payment When nce payment is received the lulluwmg yuumal Ste D cash as WielS WiWTaXeS WWWable 15 Cr UneamedSubscnptiom 15 Madmre Taxes Payable s v Whenthe service ur product is delivered tn the mm mm Fame 5 custumer the lulluwmg yuumal entry is made Pension Contributions Payable to D Uriearried Subscriptions 15 Or Subscription Revenues s15 15 It a portion of longterm debt is due within the next year and is to be paid from 16 A contingent liability is a potential liability that may or may not become an actual liability They include current assets pending lawsuits the current portion of longterm debt is tax dyspmes classified as a current liability 39 h d b f d discounted notes receivable t a r ya n ng e 5 0 255 as a GHQterm the guarantee of indebtedness of others and I iailure to comply with government regulations 1 7 The two criteria tor recording a contingent liability in the accounts are that occurrence of a liability is probable and the amount can be reasonably estimated 18 Corporations frequently issue longterm bonds or notes to obtain tunds Bonds are publicly traded debts of corporations universities and government entities provides the investors with liquidity Bonds usually are issued in denominations of 1000 or some multiple ot1000 19 Secured bonds give the bondhoiders a ciaim to ce ain assets o the com an on defau Unsecured bonds caiied debenture bonds do not Converitibie bonds can be converted into other securities of the issuer eg stock at a specified rate at the option of the bond hoiders Caiiabie bonds can be repaid eariy at the option of the company Redeemabie bonds can be redeemed eariy at the option of the bond hoiders 20 When bonds are issued company issues bond certificates as evidence of its indebtedness the contract with the bondhoiders is caiied a bond indenture the rights of the bond hoiders are usuaiiy represented by a thirdparty trustee 21 The face vaiue of the bond is the amount that must be paid on the maturity date of the bond The maturity date is the date that the finai payment is due to the investor from the bond issuer the company The contractuai interest rate is the rate that is paid in cash to the bond hoider the stated interest rate Interest on bonds is usuaiiy paid semiannuaiiy 22 The value of a bond is equal to the sum of the present values of the periodic interest payments and the singie payment of principai at maturity 23 Assume that a bond pays interest at a rate of 0 interest compounded semiannuaiiy is being soid Financiai markets require an interest rate of 10 compounded semiannuaiiy The bond has a term of ten years The face vaiue of the bond issue is 100000 The vaiue of the bond is computed as foiiows 24 Evemix months investors wiii receive woo The pieseriivaiue of an annuivoismaa evemix mom dsoaunled at an interest rate of fan compounded Semi annuaiiy s PV wulr Pfirf fifrquot smaa fies f Wt 051 smaaizaiii iizssszgii smaaizaiii 376339 smaaizaiiezsiiasiri smaa i2 45221034 449334334 25 26 Bond prices are expressed as a percentage of face value par value For example when bonds with a face value of 100000 are issued at 97 the pwsemvmm he pral pamem humps PresentValuePrloeoltbe Bond 498408MS3750890 The bond holder wlll reoelve the laee value all the bond anhe WW 7 The euhehl market rate at interest should be used tor the largoan ma illd3 e wmputatlum The rate used lhlhe present value eampulallahs ls relerred to as the dlseauhl rate W p 1 My ohlheBalaneegheellheCamhngValueallleeahdss slaadaalllllaslml 100000 376809 Bonds Payable Wm 90 Less Bond Dlsoalml E arrylng Value When the lace interest rate equals the market interest rate for similar bonds on the issue date the company usually receives face value for the bonds company receives 97000 D W W Cr Bonds Payable 100000 29 30 When the lace interest rate is less than the market interest rate for similar bonds on the issue date the bonds usually sell at a discount They were sold for less than their face value 0 Sh Unamunlzed Bond D ouiml Cr Bonds Payable 100000 The difference between the two is called the carrying value an amountt increases as the discount is amortized and that equals the face value of the bonds at maturity Bonds Payable sledaaa Less Bond Dlsoaunl Z000 E arrylng Value 31 v When the lace interest rate is gie interest rate lui simila 32 At maturity the company makes the atei than the market tollowing journal entry when it pays its i ui39ids untheissue atethe nds bands usually sell at a premium muiethanlace value D BondsPawble siaa aaa D 033 WNW Cr Cash siaaiaaa Cr Bo a Unamonized Bond Premium 33 34 Retire bonds at a loss Retire bonds at a gain D Bonds Payable siaa aaa D Bonds Payable siaa aaa Unamonized Bond Premium tea Unamonized Bond Premium tea LossonRetirememotBonds 600 Or Cash 999000 9 can 5101000 GainonRetirementotBonds i400 35 Liguidity liquidity is the ability of a business to meet its current cash needs a popular ratio used to evaluate a company39s liquidity is the current ratio Current Assets Current Liabilities 36 the ability of a business to meet pay its debts in the longterm is referred to as s g lt m a a pupulai iatiu tn measure suliency is the iatiu ul debt tn tutal assets anuthei pupulai iatiu is the Times interest Earned Flatiu it intimates the abililyol a business to make its interest payments Net lrmme i interest Expensei income Tax Expense interest Earned 37 Strai htLine Amortizatio Under the straightiine method of amortization the amortization e uais the bond discount divide bythe num er of interest payments during the iiie of t e bond Bonds with face vaiue of 1 pay interest at a rate at 8 interest compounded semiannuaiiy have a term at ten years Seii ior 87537 74 e discount is sraa aaa 371537 7114121452 26 38 With straightline amortization every six months you amortize the Bond Discount by 124622620 62311 39 40 I Theiournal entry tor amortization of bond 39 Theiouma39 WWW caSh 39UteieSt discount every six months is as follows payment every six months Is as follows D Band were Expense smog D Bond interest Expense 62311 Cr Cash smug Cr Bond Dsoaum 62311 41 42 When the bonds were issued After six months Bonds Pawbie 51001000 00 Bands Payabie 100900 00 Less Bond Dismum 2 452 25 Less Bond Dwaurrl 11 33915 Carrying Verne s 537 M carrying Vaiue 5 33160 35 43 as the Discount is amortized throughout the bonds lite More is owed astime goes by As you can see the amount owed goes up The effective interest method says that the interest expense should not be the same You owe interest on the unpaid interest the discou t 44 Interest for the first six month period Carrying Value of Bond x Market Interest Rate for Six Months 8753774 x 05 437689 45 The journal entry for the first payment of interest D Bond interest Expense 0407609 Cr Cash 400000 Uiiamonized Bond Disoaum 376 09 46 Balance Sheet after first six months of bond discount amortization Bonds Pa ble 00000 00 Less Bond Disoaunt 1138537 Carrying Value seaiim 47 Interest for the second six month period Carrying Value of Bond x Market Interest Rate for Six Months 8811463 x 05 440573 48 Thelournal entry to make second interest payment D Bond interest Expense 0040570 Cr Cash 00000 00 Unamonized Bond Dsoaum 00573 49 Balance Sheet after second six months of bond discount amortization Bonds Pavabie SiGG GGG 00 Less Bond Dwaunt ii 479 64 carrying Vaiue 53352036 Chapter 9 Plant Assets Plant Assets are also called fixed assets property plant and equipment plant and equipment longterm assets operational assets and longlived assets They are characterized by have a useful life of more than one year used in the operation of the business and are not intended for resale to customers not inventory Plant assets are tangible assets quotTangible assetsquot are assets that you can touch Plant assets include land buildings equipment and natural resources Determining the Cost of Plant Assets Plant assets are recorded at cost historical cost principle The cost of plant assets include the purchase cost freight charges quotfreight inquot insurance while in transit taxes tariffs buying expenses installation costs test runs and other costs involved in the acquisition of the asset These are costs necessary to get the asset ready for use If a cost is not necessary then it is an expense eg vandalism mistakes in installation uninsured theft damage during unpacking and installing and fines for not obtaining proper permits from government agencies When a cost incurred is added to the cost of an asset it is referred to as a capital expenditure When a cost an expense is not capitalized as a cost of an asset but is instead expensed it is referred to as a revenue expenditure When one asset is traded for another asset then the fair market value of the property given for the new asset is treated as the historical cost of the new asset Your book refers to this as the cash equivalent price This is an oversimplification of the actual treatment When a group of longterm assets is purchased for a lump sum a basket purchase the cost should be allocated to the assets acquired in proportion to their appraised values For example if you purchase an existing building the acquisition cost must be allocated between the land building and other assets acquired The cost of an asset constructed includes materials labor and overhead Examples of the Treatment of Acguisition Costs of Assets Land When land is purchased the quotLandquot account is debited for the price paid for the land real estate commissions lawyers fees back taxes assumed these are taxes accrued while the property was owned by the seller but the taxes are paid by the buyer draining clearing landscaping and grading costs assessments for local improvements and the cost less salvage value of razing structures situated on the property Land Improvements Land improvements such as driveways parking lots fences and signs are subject to depreciation and require a separate Land Improvements account Buildings The cost of buildings purchased includes the applicable items described above and the cost of any repairs made in order to make the building usable If a building is construction the construction costs are added to the cost of the building Interest incurred during the construction of a building or other plant asset is included in the cost of the asset capitalized interest This is true even if the loan was not directly used to construct the asset Interest incurred for the purchase of a plant asset is eXpensed when incurred Equipment The cost of equipment includes the price paid sales taxes freight charges and insurance during transit paid by the purchaser It also includes expenditures required in assembling installing and testing the unit Journal Entries For Acguiring Fixed Assets Not in Book The acquisition of plant assets is often financed by issuing stock notes or bonds or through operations When an asset is purchased for cash the general journal entry is as follows D Equipment 5000 Cr Cash 5000 When an asset is purchased for debt the general journal entry is as follows D Equipment cost 5000 Cr Cash down payment 1000 Notes Payable amount borrowed 4000 When an asset is acquired for equity the general journal entry is as follows D Equipment cost 5000 Cr Common Stock par value 1000 APIC cost in excess of par 4000 To Buy or Lease A lease is a contract that allows a business or an individual to use an asset for a specific length of time in return for periodic payments There are two types of leases i operating leases and ii capital leases Capital leases are financing transactions The lessee renter is treated as having acquired the leased property through the use of financing the Capital Lease An operating lease is a lease that does not meet the criteria for Capital Leasesquot There are advantages for leasing plant assets Reduced Risk of Obsolescence The lease may allow the lessee to exchange the leased asset for a more modern one if it becomes outdated Little or No Down Payment In order to purchase an asset the purchaser must usually pay a material portion of the purchase price in cash eg 20 Leases require little or no down payment Shared Tax Advantages With some leases eg operating leases the lessor rather than the lessee receives the depreciation tax deduction The lessee may not need the tax deduction and the lessor is willing to accept lower rental payments in exchange for receiving the tax deduction Assets and Liabilities Not Reported In the case of operating leases the lessee is not treated as the owner of the asset and therefore does not report the assets and the associated liabilities on their balance sheet Journal Entries Relatinq To Leases Not In Book Rental payments under an operating lease are treated as a rent expense for each period the asset is leased D Rent Expense 5000 Cr Cash 5000 Capital leases are not really leases They are financing transactions You are really buying an asset not leasing it Many car leases are in fact financing transactions A capital lease as determined by certain criteria is in substance a sale and should be recorded as an asset to be depreciated and a related liability by the lessee When the capital lease is signed the lessee makes journal entries that record the acquisition of an asset and liability The purchase price and the amount of the liability is the present value of all of the payments under the lease D Equipment Under Capital Lease present value of lease 5000 payments Cr Obligations Under Capital Lease present value of 5000 lease payments At the end of each year the lessee depreciates the leased asset D Depreciation Expense 1000 Cr Accumulated Depreciation Equipment Under Capital 1000 Lease Each payment under the lease is treated as a payment on the debt A portion is treated as interest and a portion is treated as principal D Interest Expense amount paid over present value 200 Obligations Under Capital Lease amount related to present 800 value Cr Cash 1000 Depreciation In dealing with longterm assets the major accounting problem is to determine how much of the asset has benefited the current period 99 expenses and how much should be carried forward as an asset to benefit future periods eg assets This allocation of costs to different accounting periods is called depreciation in the case of plant and equipment property plant and equipment depletion in the case of natural resources and amortization in the case of intangible assets Because land has an unlimited useful life its cost is never converted into an expense The unexpired cost of an asset is called the carrying value also book value and is equal to the cost less accumulated depreciation Equipment cost of asset 10000 Less Acc Depr All Depr to date 4 000 Book Value or Carrying Value 6000 Depreciation as used in accounting refers to the allocation of the cost less the residual value of a plant asset to the periods benefited by the asset It does not refer to the physical deterioration or the decrease in market value of the asset it is a process of allocation not valuation Your book notes that the useful life of an asset is limited by physical depreciation eg as you drive your car it deteriorates and breaks down and functional depreciation eg as your computer gets older it can t handle newer computer programs A plant asset should be depreciated over its estimated useful life in a systematic rational manner Depreciation can be computed once the cost salvage value and estimated useful life have been determined Cost is the cost of the asset calculated in the manner described above Salvage Value is the estimated value at the disposal date it is often referred to as quotresidual valuequot or quotdisposal valuequot Estimated useful life is the period in which the company will use the plant asset It is measured in time or in units Depreciable cost equals the cost less the salvage value It represents the net cost of the asset s use by the For example if a company buys a computer for 1000 and intends to sell it for 100 after it is finished using the computer the company s use of computer costs the company 900 The depreciation expense may not exceed the depreciable cost of the asset The following journal entry is used in connection with depreciation D Depreciation Expense Asset Name 1000 Cr Accumulated Depreciation Asset Name 1000 The most common methods of depreciation are The straightline method based on the passage of time The decliningbalance method an accelerated method and The unitsofactivity method based on units produced miles driven and the like StraightLine Method Under the straightline method the depreciable cost is spread uniformly over the estimated useful life of the asset Depreciation for each year is computed as follows Cost Salvage Value Estimated useful life in years For example if you had an asset with a cost of 10000 a salvage value of 1000 and a useful life of 10 years each year you would take 900 of depreciation 10000 1 00010 DecliningBalance Method Accelerated methods of depreciation result in larger depreciation in the early years of an asset s life Under the decliningbalance method depreciation is computed by multiplying the existing carrying value of the asset by a fixed percentage The doubledecliningbalance method is a form of the declining balance method it uses a fixed percentage that is twice the straightline percentage Under the doubledecliningbalance method the fixed percentage is double the percentage used in the straight line calculation For example if the useful life is 10 years then the straightline depreciation would be 110 10 of the depreciable cost With the double declining balance method you would use twice the straightline rate 20 This percentage is then multiplied against the existing book value of the asset for the year in question Note that the decliningbalance method does not use residual value in figuring the rate Despite this you are not allowed to depreciate the asset below the residual vale In other words depreciation is limited to the amount necessary to bring the carrying value down to the estimated residual value UnitsofActivity Method This is often referred to as the unitsofproduction method or the production method This method is similar to the straightline method Under the straight line method the cost of the asset is spread out evenly over the period in which the asset is used Under the unitsofproduction method the cost is spread evenly over the units produced by the asset Depreciation for each year is computed as follows Cost Salvage Value Estimated units of useful life Units of production method is a good application of the matching principle but can only be used if output over useful life can be estimated with reasonable accuracy Depreciation and Income Taxes The Internal Revenue Code uses the Modified Accelerated Cost Recovery System MACRS which computes depreciation in a manner that is different than the depreciation methods used in financial accounting For example under MACRS set recovery periods are used instead of the actual useful lives of given assets A company is not required to use the same depreciation methods for tax purposes and financial statement purposes Because a company may wish to maximize its profits it will choose to minimize its depreciation expense by using the straightline method On the other hand the same company may wish to minimize its income taxes and therefore will minimize its income by using an accelerated depreciation method Depreciation Disclosure in the Notes A company must disclose the depreciation methods that it employs This disclosure is made in the notes to the financial statements Revising Periodic Depreciation When a company changes an estimate which was used in calculated depreciation expense eg extending the useful life of an asset or changing the residual value of the asset then the company using the remaining book value of the asset recalculates the depreciation expense of the asset leaving previous depreciation unchanged Other Comments on Depreciation Not In Book Besides calculating depreciation on an asset by asset basis assets may be depreciated by grouping them together with other assets with similar traits Depreciation is calculated on the group as a whole When an asset is purchased after the beginning of the year or is discarded before the end of the year depreciation is recorded for only part of the year This is done by computing the year s depreciation and multiplying this figure by the fraction of the year that the asset was in use Expenditures During Useful Life Expenditures relating to plant assets payments or obligations to make future payments are of two types Capital expenditures such as the purchase or expansion of a building benefit several periods and are recorded as the acquisition of assets quotcapitalizedquot Revenue expenditures such as operation and maintenance costs benefit only the current period and are recorded as expenses quotexpensedquot Ordinary repairs are expenditures necessary to maintain an asset in good operating condition they are charged as an expense in the period incurred Your book refers to capital expenditures as additions and improvements They are described as costs that increase the operating efficiency productive capacity or expected useful life of existing plant assets Capital Expenditures Not In Book Capital expenditures on an asset that you already own are usually described as Additions Betterments or Extraordinary Repairs An addition adds a new feature to an existing building An example of an addition would be adding a new room to a building The cost is capitalized and then depreciated expensed over the useful life of the room or the building whichever is shorter A new asset is created by the expenditure A betterment improves a fixed asset s operating efficiency or capacity for its remaining useful life It is added to the cost of the original asset An example would be exchanging the hard drive of a computer for a newer one with more capacity The cost of the new drive is added to the computer s cost and the cost and any accumulated depreciation related to the old hard drive should be removed from the computer s cost Extraordinary repairs are expenditures that either increase an asset s residual value or lengthen its useful life eg a major overhaul of a car engine Extraordinary repairs are recorded by debiting Accumulated Depreciation and crediting Cash This has the effect of increasing the book value of the asset but makes it appear less depreciated The thought is that by making the extraordinary repair you have undone the previous depreciation D Accumulated Depreciation Asset Name 2000 Cr Depreciation Expense Asset Name 2000 If a capital expenditure is recorded mistakenly as a revenue expenditure current period expense is overstated and net income is understated In future periods net income will be overstated since it was all expensed in the first period The opposite effects would be true for a revenue expenditure recorded mistakenly as a capital expenditure Impairments As noted above the historical cost of a plant asset is used in a company s balance sheet The balance sheet is also governed by the principle of conservatism When the market value of an asset falls below the book value of the asset the asset is impaired A company is required to write down the book value of the impaired asset to its fair market value in the year that the decline in value occurs The journal entry to reflect the impairment loss is reflected below D Impairment Loss 10000 Cr Asset Name 10000 Plant Asset Disposals Disposal occurs when the asset is discarded sold or traded in When a business disposes of an asset depreciation is recorded for the period preceding disposal This brings the asset s Accumulated Depreciation account up to the date of disposal When a machine is discarded Accumulated Depreciation Machinery is debited and Machinery is credited for their present balances If the machine is fully depreciated D Accumulated Depreciation Machinery 10000 Cr Machinery 10000 If the machine has not been fully depreciated then Loss on Disposal of Machinery must be debited for the carrying value to balance the entry D Accumulated Depreciation Machinery 7000 Loss on Disposal of Machinery 3000 Cr Machinery 10000 When a machine is sold for cash Accumulated Depreciation Machinery is debited Cash is debited and Machinery is credited If a machine is sold for its book value D Cash 3000 Accumulated Depreciation Machinery 7000 Cr Machinery 10000 If the cash received is less than the carrying value of the machine then Loss on Sale of Machinery would also be debited On the other hand if the cash received is greater than the carrying value then Gain on Sale of Machinery would be credited to balance the entry D Cash 2000 Accumulated Depreciation Machinery 7000 Loss on Sale Machinery 1000 Cr Machinery 10000 Sale of machine at less than carrying value loss recorded D Cash 4000 Accumulated Depreciation Machinery 7000 Cr Machinery 10000 Gain on Sale of Machinery 1000 Sale of machine at more than carrying value Trade Ins Not In Book When an asset is traded in exchanged for a similar one the gain or loss should first be computed as follows Tradein allowance Carrying value of asset traded in Gain loss on tradein For financial reporting purposes both gains and losses should be recognized recorded on the exchange of dissimilar assets Gains should not be recognized on the exchange of similar assets Losses recognized For income tax purposes neither gains nor losses should be recognized on the exchange of similar assets but both should be recognized on the exchange of dissimilar assets When a gain or loss is to be recognized the asset acquired should be debited for its list price cash paid plus tradein allowance a realistic tradein value is assumed The old asset is removed from the books as explained above When a gain or loss is not to be recognized the asset acquired should be debited for the carrying value of the asset traded in plus cash paid this will result in nonrecognition of the gain or loss If you received a new machine worth 15000 in exchange for cash of 9000 and an old machine with a book value of 3000 you would record the new machine at 12000 3000 book value cash of 9000 D MachineryNew 12000 Accumulated Depreciation Machinery Old 7000 Cr MachineryOld 10000 Cash 9000 If a gain was recognized on the above transaction then the new machine would be recorded at its fair market value and a gain of 3000 would be recognized on the receipt of a credit of 6000 for the old machine with the book value of 3000 D MachineryNew 15000 Accumulated Depreciation Machinery Old 7000 Cr MachineryOld 10000 Cash 9000 Gain on Exchange of Machine 3000 Natural Resources Not in Book Natural resources are tangible nonmonetary assets containing valuable substances that may be extracted and sold They are sometimes referred to as quotwasting assetsquot and include standing timber oil and gas fields and mineral deposits Depletion refers to the allocation of a natural resource s cost to accounting periods based on the amount extracted each period Depletion for each year is computed as follows Cost residual value X actual units extracted during period Estimated units to be extracted Units extracted but not sold during the year are recorded as inventory to be charged as an expense in the year sold Tangible assets used with natural resources should be depreciated over the shorter of the life of the tangible asset or the life of the natural resource There are two acceptable methods of accounting for exploration and development of oil and gas reserves Under successful efforts accounting the cost of producing wells is capitalized and depleted while the cost of dry wells is expensed immediately Under the fullcosting method the cost of all wells is capitalized and depleted The following journal entry relates to depletion D Depletion Expense Coal Deposits 1000 Cr Accumulated Depletion Coal Deposits 1000 Analyzing Plant Assets Financial Analysts often use two ratios to evaluate a company s use of its plant assets Return on Assets Ratio and Asset Turnover Ratio Return on Assets Ratio Financial Analysts often look at the profit earned on the company s assets The Return on Assets Ratio is calculated as follows Net Income Average Total Assets Asset Turnover Ratio The Asset Turnover Ratio looks at the productivity of a company s assets rather than their profitability This ratio is calculated as follows Net Sales Average Total Assets Profit Margin Ratio Revisited The Profit Margin and the Asset Turnover Ratio are components of the Return on Assets Profit Margin X Asset Turnover Ratio Return On Assets Net Income Net Sales Net Income Net Sales X Average Total Assets Average Total Assets Net Sales in the Profit Margin and the Asset Turnover Ratio cancel out and leave you with the Return on Assets This relationship demonstrates the fact that if a company wishes to increase its profitability it can either increase its profit margin earn more income on its given revenue or increase its asset turnover ratio make its assets more productive Intangible Assets Intangible assets are longterm assets that have no physical substance they represent certain legal rights and advantages extended to their owner Examples of intangible assets are patents copyrights trademarks goodwill Ieaseholds leasehold improvements franchises licenses brand names formulas and processes An intangible asset should be written off over its useful life through a process called amortization in accordance with the matching principle Assets with an indefinite useful life should not be amortized These assets however still must be written down as impaired assets if their fair market value declines below their book value Rather than using a contra account to reduce the asset being amortized as was the case with Accumulated Depreciation and Accumulated Depletion the intangible asset is reduced by its Amortization expense There is no contra account The journal entry for amortization is as follows D Amortization Expense Patent 1000 Cr Patent 1000 Patents A patent is an exclusive legal right to use an invention for 20 years The cost of a patent should be amortized over the shorter of its useful life or its legal life If a company incurs legal costs in successfully defending its patent these costs are added to the cost of the patent and amortized over its remaining life Research and Development Costs Research and development encompass the development of new products the testing of existing and proposed products and pure research According to GAAP research and development costs normally should be expensed in the period incurred The cost of developing computer software should be treated as research and development up to the point where a product is deemed technologically feasible From that point on software production costs should be capitalized and amortized over their useful lives using the straightline method Copyrights A copyright is an exclusive legal right to publish literary musical and other artistic materials and software For individuals the copyright period is the creator s life plus 50 years The cost of a copyright should be amortized over the shorter of its useful life or its legal life If a company incurs legal costs in successfully defending its copyright these costs are added to the cost of the copyright and amortized over its remaining life Trademarks and Trade Names Trademarks and trade names are the exclusive rights to use registered symbols and names to identify a product or service Trademarks and trade names are registered with the US Patent Office Such registration provides 20 years protection and may be renewed indefinitely as long as the trademark or trade name is in use Because trademarks and trade names have an indefinite life they are not amortized Franchises and Licenses A franchise grants the franchisee the exclusive right to operate a business in a given territory eg a Wendy s A license grants the licensee the right to use property or a process eg formula technique process or design of another person company or government Annual payments on a franchise or license are an operating expense The cost of acquiring a franchise or license should be amortized over its useful life If the useful life is indefinite then there should be no amortization Goodwill Goodwill as the term is used in accounting refers to a company s ability to earn more than is normal for its particular industry or for the amount of its capitalization net assets Goodwill is recorded only when a company is purchased and equals the excess of the purchase cost over the fair market value of the net assets Goodwill is considered to have an indefinite useful life and therefore is not amortized However a company is required to examine whether its Goodwill is impaired on an annual basis Leasehold Not In Book A leasehold is the purchased right to rent property for a long period of time Leasehold improvements are improvements made to leased property that revert to the lessor at the end of the lease They are amortized over the shorter of i the useful life of the improvements or ii the remaining term of the lease Chapter 7 Internal Controls Internal controls consist of all the related methods and measures adopted within a business to Safeguard its assets from employee theft robbery and unauthorized use and Enhance the accuracy and reliability of its accounting records by reducing the risk of errors unintentional mistakes and irregularities intentional mistakes and misrepresentations in the accounting process Internal controls are both preventive and detective Preventive controls are designed to keep thefts from occurring Detective controls are designed to detect thefts once they happen Key internal control principles include Establishment of Responsibility If possible you want one person to be responsible for one task That way if something goes wrong then you know who is responsible and who to blame Segregation of Duties There are different activities that are related to each other Don t let one handle every related activity If different people are working in related areas they may see something that strikes them as odd If one person does everything then it is easy to steal and there is no one to spot another s mistakes For example one person should order goods another should sign for the receipt of goods and a third should pay for the goods If one person handled all of these tasks then he or she could arrange for the company to pay for inventory that was never ordered and received Another example would be that one person should make a sale another should ship the goods and a third should bill the customer If one person did all of these tasks he or she could fail to fully bi customers for shipped goods for kickbacks or for sales to friends Another example would be to separate the job of receiving payments from customers from the job of accounting for the receipts If one person receives and records payments from customers he or she could pocket the receipts while reporting the bills paid to the customers and reporting to the company that payments are not yet received Another example would be to separate the job of making sales from the job of authorizing credit If one person does both jobs he or she might extend credit to inappropriate persons in order to increase his or her sales commissions Record Keeping Separate from Physical Custody The person who has physical custody should not also have the responsibility for accounting for the asset This prevents the custodian from converting the asset for personal use Documentation Procedures Procedures should be established requiring the use of documents Moreover all documents should be prenumbered and accounted for This helps to prevent undocumented transactions from failing to be recorded It also helps to prevent documents from being lost Physical Mechanical and Electronic Controls Physical controls help to safeguard assets For example using safes and locked cash boxes helps to prevent cash from being taken by employees Use of locked warehouses burglar alarms security cameras helps to prevent inventory from being taken Use of passwords on computers helps to prevent unauthorized tampering with company assets and records Use of time clocks helps to prevent employees from coming late and leaving early Independent lnternal Verification The company checks to see whether there are any discrepancies in the records of its employees This is done regularly or on a surprise basis It is done by an employee independent of the person being checked Any discrepancies are reported to the management of the company Bondinq of Employees Who Handle Cash Bonding companies insure a company against losses from theft by employees who handle cash The insurance company screens an employee before insuring them In addition if any loss occurs and insurance company will vigorously prosecute all offenders and trackthem down like bail jumpers in order to deter other potentially dishonest employees Rotating Employees Duties amp Reguiring Vacations The company should insist that every employee take a vacation When someone else does an employee job it is easier to spot discrepancies If an employee is stealing they will never take a vacation for fear that a discrepancy will be spotted For the same reason a company should not let the same person stay in one job for long periods Internal Controls Over Cash Disbursements Cash received from sales in a store are handled by issuing cashier s a given amount to be placed in the cash register the change fund Afterward the amount received from the public is compared to the cash register tape To the extent that any differences exist the amount is charged to Cash Short and Over In the case of a shortfall D Cash 980 Cash Short amp Over 20 Cr Sales Revenue 1000 In the case of too much cash D Cash 1 000 Cr Cash Short amp Over 20 Sales Revenue 980 At the end of the accounting period the Cash Short and Over Account is treated as an expense or miscellaneous revenue account Cash received in the mail from customers is noted on a remittance advice If amounts are stolen it will show up with inconsistencies between cash remittances and amounts credited to customers If the wrong amount is credited to customers the customers should complain As noted above companies should separate those who handle the cash a cashier s department and those who record the cash transactions an accounting department Checks received in the mail are stamped quotFor Deposit Onlyquot this prevents someone other than the payee from depositing the check A voucher system should be used to make payments on liabilities of a company No check is made until a voucher is prepared by the accounting department and approved by an official of the company The check is then issued and given to the creditor of the company Electronic funds transfer EFT systems are used to keep the cost of issuing checks down Petty Cash Fund Sometimes a company has to pay cash for some expenses These expenses involve relatively small amounts To handle these transactions a company sets up a petty cash fund The journal entry is D PettyCash 100 Cr Cash 100 When cash is paid out of this fund the recipient of the petty cash records how much funds were received and for what purpose on a petty cash receipt form Later when the petty cash fund is replenished you treat it as if you paid the expenses recorded on the petty cash receipt forms D Office Supplies 50 Store Supplies 40 Miscellaneous Expense 10 Cr Cash 100 Bank Accounts When you open an account you will complete a signature card This specifies who is allowed to sign checks or withdraw money from the bank account A transaction register or check register lists every check written on the account A business check is often accompanied with a remittance form explaining why the check is being paid For example it will identify that it is paying an invoice dated on a particular date Once a month the bank returns a company s canceled checks with the bank statement The bank statement shows the bank balance at the beginning of the month all additions and deductions during the month and the balance at the end of the month A bank statement s endofmonth balance rarely agrees with the balance in the company s books for that date Thus the accountant must prepare a bank reconciliation to account for this difference and to locate any errors made by the bank or the company The bank reconciliation begins with the balance per books and balance per bank statement figures as of the bank statement date Each figure is adjusted by certain additions and deductions thereby resulting in two adjusted cash balance figures which should agree The balance per books figure is adjusted by information that the bank knew at the bank statement date but that the company did not The balance per bank statement figure is adjusted by information that the company knew at the bank statement date but that the bank did not Examples of adjustments are as follows Outstanding checks are a deduction from the balance per bank statement Deposits in transit are an addition to the balance per bank statement Service charges by the bank appear on the bank statement and are a deduction from the balance per books A customer s nonsufficient funds NSF check is deducted from the balance per books lnterest earned on a checking account is added to the balance per books Miscellaneous charges are deducted from the balance per books miscellaneous credits are added to the balance per books If the bank is collecting promissory notes on behalf of the company a collection of a promissory note would be added to the balance per books After the bank reconciliation has been prepared adjusting entries must be made so that the accounting records will reflect the new information supplied by the bank statement Promissory Note collected by bank D Cash 100 Cr Note Receivable 100 Check returned from bank quotNot Sufficient Fundsquot D Accounts Receivable 100 Cr Cash 100 Service Charge for month D Bank Service Charge Expense 100 Cr Cash 100 lnterest accrued on bank account D Cash 100 Cr lnterestlncome 100 Recorded amount of check received lower than actual amount Book Error Need to reduce Cash and Account Payable by more D Cash 100 Cr Accounts Payable 100 Nature of Cash Cash includes coin currency petty cash checks money orders and money on deposit with banks and similar financial institutions The money on deposit is supposed to be available for unrestricted withdrawal Deposits that are restricted for under 90 days is considered cash Companies frequently have excess cash on hand for short periods of time These may be invested in cash equivalents Cash equivalents are shortterm highly liquid investments that are both Readily convertible to known amounts of cash and 80 near their maturity that their market value is relatively insensitive to changes in interest rates Examples of cash equivalents are Treasury bills commercial paper shortterm corporate notes and money market funds Restricted Cash Cash and cash equivalents do not include cash that is not available for general use but rather is restricted for a special purpose For example landfill companies are often required to maintain a fund of restricted cash to ensure that they will have adequate resources to cover closing and cleanup costs at the end of a landfill site s useful life Restricted cash is reported on a balance sheet as Restricted Cashquot not part of Cash and Cash Equivalentsquot lf restricted cash is expected to be used within the next year the amount should be reported as a current asset If it is not expected to be used within this period then it should be reported as a noncurrent asset Managing and Monitoring Cash A business needs to have enough cash on hand to meet its cash needs on time eg make payments when required It is better if the cash needs are met from the company s operations no cost rather than borrowing interest cost Company treasurers or chief financial officers need to manage their cash receipts and payments effectively The following are basic principles of cash management Increase the speed of collection on receivables eg offer sales discounts lnventory ties up resources Keep inventory levels low eg just in time inventory practices Delay payment of liabilities but don t pass up purchase discounts Plan timing of major expenditures so that you still have adequate cash to meet current needs lnvest idle cash to earn interest Cash Budgeting A company should estimate its future cash receipts and needs in order to help it manage its cash effectively This is accomplished through a cash budget cash budget usually covers a oneyear or twoyear period It shows cash inflows cash outflows and cash from financing when a shortfall is anticipated Cash Budget Beginning Balance of Cash 38000 Add Cash Receipts itemized Collections from customers 168000 Sale of Securities 2 000 Total Cash Receipts 170 000 Total Available Cash 208000 Less Cash Disbursements Materials 23200 Salaries 62000 Cash Selling amp Adm Expenses 94300 Truck Purchase 30000 Income Tax Expense 3 000 Total Cash Disbursements 212 500 Cash Deficiency 4500 Add Financing Borrowings 10 000 Ending Cash Balance 5 500 Chapter 6 Periodic and Perpetual Inventory Systems There are two methods of handling inventories the periodic inventory system and the perpetual inventory system With the periodic inventory system the firm calculates its Cost of Goods Sold at the end of the year The firm takes its beginning inventory and adds its purchases for the period This gives the firm all the goods that pass through the firm for the period the goods available for sale The firm then takes a physical inventory This gives the firm what is left at the end of the period The ending inventory is then subtracted from the available goods figure to get the cost of goods sold Two disadvantages of the periodic method are This method does not give the firm much information on the theft or spoilage of goods Everything not present is assumed to be sold Unless a physical inventory is taken the firm does not know what its cost of goods sold is during the period as opposed to the end of the period An advantage of the periodic method is that it is a easy system to maintain With the perpetual inventory system the firm keeps track of its cost of goods sold on a continual basis Thus at any given time the firm can estimate its current inventory levels At the end of the period a physical inventory is taken Any discrepancy with the estimated inventory level and the actual inventory level is then attributed to theft and spoilage An advantage of the perpetual system is that it provides information about theft and you have a Cost of Goods Sold figure whenever needed A disadvantage of the perpetual system used to be that it was very expensive to maintain this type of system With the use of computers and scanners the marginal cost to implement a perpetual system may be minimal What we have discussed to date is the perpetual inventory system Differences Between Periodic and Perpetual Inventory Systems 9 U 0quot 0 O U Q U 0 Periodic Purchase inventory on credit Purchases Cr Accounts Payable Transportation Costs on purchases Freight In Cr Accounts Payable Accounts Payable Cr Purchases Ret amp Allow Payments on Accounts Payable Accounts Payable Cr Cash Sale of Merchandise on Credit Accounts Receivable Cr Sales 1 Payment of Delivery Costs D g D f Receipts on Accounts Receivable D Freight Out Expense Cr Cash Return of Merchandise Sold Sales Returns and Allowances Cr Accounts Receivable Cash Cr Accounts Receivable D Purchases Returns and Allowances D D D Perpetual Merchandise Inventory Cr Accounts Payable Freight In Cr Accounts Payable Accounts Payable Cr Merchandiselnventory Accounts Payable Cr Cash Accounts Receivable Cr Sales Cost of Goods Sold Cr Merchandiselnventory Freight Out Expense Cr Cash Sales Returns and Allowances Cr Accounts Receivable Merchandise Inventory Cr Cost of Goods Sold Cash Cr Accounts Receivable With the perpetual inventory system you have the Cost of Goods Sold at any given time You just look at the balance of the Cost of Goods Sold account With the periodic inventory system there is no Cost of Goods Sold account Instead you must calculate the Cost of Goods Sold by netting all of the inventory accounts They are all closed to Income Summary and the net amount which results places the Cost of Goods Sold as a debit in the Income Summary account as would have been the case under the perpetual inventory system if you had just closed out the Cost of Goods Sold account Cost of Goods Sold Beginning Balance of Inventory debit balance Purchases debit balance Purchase Returns amp Allowances credit balance Purchase Discounts credit balance Freight In debit balance Cost of Goods Available Ending Balance of Inventory Cost of Goods Sold Income Summary Account INCOME SUMMARY PARTIAL ENTRIES Beginning Balance of I Purchase Returns amp Inventory Allowances Purchases Purchase Discounts Freight In Ending Balance of Inventory Cost of Goods Sold I You close out the Inventory account There were no additions to inventory during the year Thus Inventory is the beginning inventory D Income Summary 50000 Cr Inventory 50000 You then close out all of the temporarynominal accounts D Income Summary Cr Purchases Income Summary Cr FreightIn Purchase Returns amp Allowances Cr Income Summary Purchase Discounts Cr Income Summary 300000 300000 10000 10000 20000 20000 30000 30000 You finally add the current inventory figure from physical inventory at end of year to Income Summary and the Inventory account You previously closed the Inventory account This now adds the ending inventory figure to the Inventory account After this Inventory reflects the end of the year figure D Inventory Cr Income Summary 40000 40000 You now have the correct Cost of Goods figure as a debit balance in the Income Summary If you had used the perpetual system and maintained a Cost of Goods Sold account it would have had a debit balance it is an expense The Cost of Goods Sold account would have been closed and it would have resulted in a debit entry to the Income Summary account INCOME SUMMARY PARTIAL ENTRIES Beginning Balance of 50000 I Purchase Returns 87 20000 Inventory Allow Purchases 300000 I Purchase Discounts 30000 Freight In 10000 I Fndlng Balance of 40000 nventory Cost of Goods Sold 270000 You get the same result if you use the formula Beginning Balance of Inventory debit balance 50000 Purchases debit balance 300000 Purchase Returns amp Allowances credit balance 20000 Purchase Discounts credit balance 30000 Freight In debit balance 10000 Cost of Goods Available 310000 Ending Balance of Inventory 40000 Cost of Goods Sold 270000 Inventory Categories Inventory is often referred to as merchandise inventory by a retailer Manufacturers have three types of inventory raw materials work in process and finished goods When they purchase raw materials it goes into raw materials When the company starts to make the product the materials leave raw materials and get added to work in process In work in process the cost of the materials are combined with the cost of the labor direct labor and the factory overhead Components of Inventory Cost Inventory cost is defined as the price paid to acquire the inventory and generally includes invoice price less purchases discounts freight insurance in transit taxes tariffs inspection costs and preparation costs It is basically everything that is paid in order to get the inventory ready to sell Ownership of Goods The term quotFOB shipping pointquot means that the seller transfers title to the goods at the seller s place of business The buyer pays shipping costs For example if you order a car from Ford and the invoice says FOB Detroit then you pay the shipping costs and the car belongs to you as soon as it leaves the factory The term quotFOB destinationquot means that the seller transfers title to the goods at the buyer s place of business The seller pays shipping costs For example if you order a car from Ford and the invoice says FOB Los Angeles then Ford pays the shipping costs and the car belongs to you when it arrives Merchandise in transit is included in the buyer s inventory if title to the goods has passed eg FOB shipping point Goods in transit shipped FOB destination belong to the seller Sometimes companies enter into a consignment agreement where goods are transferred physically to another company without title transferring Consigned goods belong to the consignor They are not included in the consignee s the company doing the sale not the actual owner inventory Inventory Costing Methods Under the Periodic Method A company must choose an inventory costing method When identical items of merchandise are purchased at different prices during the year it usually is impractical to monitor the actual goods flow and record the corresponding costs Instead the accountant will make an assumption about the cost flow and will use one of the following methods specific identification averagecost firstin firstout FIFO lastin firstout LIFO The alternative methods have different effects on net income income taxes and cash flows The implementation of these methods is effected by whether the company uses the perpetual system or the periodic system We will first discuss the periodic system In the following discussion we will assume that the following purchases of inventory were made during June Units Purchased June 1 50 units 100 6 50 units 110 13 150 units 120 20 100 units 130 25 150 units 140 500 units Units Sold June 10 70 units 30 210 units 280 units Units in Ending Inventory 220 units Specific Identification Under the specific identification method you identify which goods were purchased on which dates eg using serial numbers or labels You then keep track of which goods were sold and which goods are still on hand at the end of the period This method reflects the actual flow of goods Assume that you identify that you sold the following units 50 units from June 6 60 X 110 55 50 units from June 13 50 X 120 60 100 units from June 20 100 X 130 130 80 units from June 25 80 X 140 112 Cost of Goods Sold 357 You identify that you still have these goods in inventory at the end of the year 50 units from June 1 50 X 100 50 100 units from June 13 100 X 120 120 70 units from June 25 70 X 140 Cost of Remaining lnventory 268 This method is not common because it is eXpensive to keep track of which items are sold This is especially true when you sell high volumes of goods This method permits companies to manipulate income by choosing to sell the high or lowcost items The specific identification method is used primarily for highpriced items such as computer processors automobiles eXpensive furniture amp jewelry Average Cost Under the average cost method a weighted average cost per unit is first computed for the goods available for sale during the period This is accomplished by dividing the cost of goods available for sale by the units available for sale June 1 50 units 100 50 6 50 units 110 55 13 150 units 120 180 20 100 units 130 130 25 150 units 140 210 Units Purchased 500 units 625 Average Cost Per Unit 625500 125 Then the average cost per unit is multiplied by the number of units in ending inventory to obtain the cost of ending inventory Ending Inventory Cost of Goods Sold 220 units 125 280 units 125 275 350 This method has the advantage of leveling the effects of variations in cost Cost increases and decreases are IeveIed out A disadvantage of this method is that the most current costs are not used in income determination FirstInI FirstOut Under the firstin firstout FIFO method the cost of the first items purchased is assigned to the first items sold The 280 units sold are assumed to come from the first units 50 units from June 1 60 X 100 50 50 units from June 6 50 X 110 55 150 units from June 13 100 X 120 180 30 units from June 20 80 X 130 39 Cost of Goods Sold 324 Therefore ending inventory consists of the most recent purchases 70 units from June 20 70 X 130 91 150 units from June 25 150 X 140 210 Cost of Remaining Inventory 301 During periods of rising prices FIFO yields the highest net income of the four methods LastInI FirstOut Under the Iastin firstout LIFO method the last items purchased are assumed to be the first items sold The 280 units sold are assumed to be 150 units from June 25 150 X 140 210 100 units from June 20 100 X 130 130 30 units from June 13 30 X 120 36 Cost of Goods Sold 376 Therefore ending inventory is assumed to consist of items from the earliest purchases 50 units from June 1 50 X 100 50 50 units from June 6 50 X 110 55 120 units from June 13 120 X 120 Cost of Remaining Inventory 249 When a company uses LIFO it must report in the notes to its financial statements what its inventory would have been using FIFO The difference between the two numbers is called the LIFO Reserve Inventory Using LIFO 249 LIFO Reserve 52 Inventory Assuming FIFO 301 Reporting LIFO reserve enables financial analysts to make allowances for the use of LIFO when comparing companies The LIFO reserve if positive indicates how much higher retained earnings would have been had the company used FIFO In the prior example the difference in net income would have been equal to the difference in Cost of Goods Sold an eXpense COGS Under FIFO 324 LIFO Reserve 52 COGS Under LIFO 376 An advantage of LIFO is that during periods of rising prices LIFO best matches current merchandise costs with current sales prices This results in the lowest net income of the four methods This is a major advantage when considering taX costs Lower income results in lower income taxes You have to use the same method for financial amp taX purposes The lower net income is also a major disadvantage of LIFO when financial reporting is considered LIFO makes the company look less profitable lower income however most users of financial statements will take this into account when evaluating the company Another disadvantage is that the inventory valuation under LIFO is often unrealistic Also LIFO is not accepted in most other countries A LIFO liquidation occurs when sales have reduced inventories below the levels established in prior years When prices have been rising steadily a LIFO liquidation produces unusually high profits This retrains the company from reducing inventory levels when it may be in the company s best interests to do so Comparison of the Methods During periods of rising prices FIFO produces a higher net income than LIFO and the averagecost method produces net income that is somewhere between those of FIFO and LIFO During periods of falling prices the reverse is true Even though LIFO best follows the matching rule FIFO provides a more upto date ending inventory figure for balance sheet purposes Inventory Methods Under the Perpetual System The pricing of inventories under the perpetual system differs from pricing under the periodic system Under the perpetual system the cost of goods sold is determined at the time of sale and the cost of ending inventory is determined after every inventory transaction The specific identification method produces the same results under the perpetual system as under the periodic system The FIFO method also produces the same results regardless of the system used The first units are always the first units no matter when you do the calculation Average Cost Under the Perpetual System Using the averagecost method in a perpetual system a moving average is computed after each purchase June 1 50 units 100 50 6 50 units 110 55 Units Purchased 100 units 105 Average Cost Per Unit 105100 105 This cost is used for the 70 units sold on June 10 7350 The remaining units will be considered to cost 105 until the next calculation Calculation June 10 100 units 105 10500 Sale 10 70 units 105 7350 Balance 10 30 units 105 3150 13 150 units 120 18000 20 100 units 130 13000 25 150 units 140 21000 Units Purchased 430 units 55150 Average Cost Per Unit 55150430 128 This cost is used when 210 units are sold on June 30 26880 The remaining 220 units in inventory are valued using the 128 cost 28270 The Cost of Goods Sold is 34230 7350 26880 LIFO Under the Perpetual System LIFO produces different figures under the perpetual system because you use the last units purchased before the individual sale June 10 Sale 50 units from June 6 50 X 110 55 20 units from June 1 20 X 100 20 Cost of Goods Sold 75 Remaining inventory is assumed to consist of items from the earliest purchases June 10 Remaining Units 30 units from June 1 30 X 100 30 Cost of Remaining lnventory 30 The most recent goods acquired prior to the June 30 sale is used on that date 150 units from June 25 150 X 140 60 units from June 20 100 X 130 210 78 Cost of Goods Sold 288 The Cost of Goods Sold for the month is 363 75 288 The ending inventory is assumed to consist of items from the earliest purchases that have not been sold previously 30 units from June 1 30 X 100 30 150 units from June 13 150 X 120 180 40 units from June 29 40 X 130 52 Cost of Remaining Inventory 262 Lower of Cost or Market Inventory is carried at the lower of cost or market This is an example of conservatism We do not want unsold obsolete inventory carried at high historical costs The market value of inventory is defined as current replacement cost or net realizable value sales price less selling eXpenses Market value of inventory may fall below its cost because of physical deterioration obsolescence or a decline in price level There are three basic methods for implementing the lower of cost or market comparison You may do it on a specific item level major category level or total inventory level To determine the lower of cost or market First cost is determined by using the FIFO LIFO Specific Identification or Weighted Average methods Second calculate the market value Replacement cost or Net Realizable Value and Third compare cost to market The taX rules do not permit all of the methods described above For example the total inventory comparison is not acceptable for federal income taX purposes Also for taX purposes you may not use lower of cost or market method when using the LIFO method Inventory Errors Cost of goods available is assigned to goods sold and ending inventory Recalling that cost of goods available less ending inventory equals cost of goods sold it can be seen that the higher the cost of ending inventory the lower the cost of goods sold and the higher the gross profit and net income The converse also is true Because the cost of ending inventory is needed to compute the cost of goods sold it affects net income dollar for dollar It is most important to match cost of goods sold with sales so that a proper determination of net income will result This year s ending inventory automatically becomes next year s beginning inventory Because beginning inventory also affects net income dollar for dollar an error in this year s ending inventory results in misstated net income for both this year and next year When ending inventory is understated the Cost of Goods Sold will be too high Because you are subtracting a high number as an expense COGS the net income for the period will be understated This year s ending inventory becomes next year s beginning inventory Thus next year s beginning inventory will be too low This will result in a lower Cost of Goods Sold for the second period Because you are subtracting a COGS figure that is too low the net income in the second year will be overstated The differences in net income for the two years will offset each other This Year Next Year COGS COGS Beg Bal 36 XXX Purch XXX Available XXX End lnv Too Low 9 Beg Bal 36 Too Low Purch XXX COGS Too High Available 36 Too Low End lnv XXX Net Too Low lncome COGS 36 Too Low Net Income Too High When ending inventory is overstated the Cost of Goods Sold will be too low Because you are subtracting a low number for COGS the net income for the period will be overstated This year s ending inventory becomes next year s beginning inventory Thus next year s beginning inventory will be too high This will result in a higher COGS for the second period Because you are subtracting a COGS figure that is too high the net income for the second period will be understated This Year Next Year COGS COGS Beg Bal 36 XXX Purch XXX Available XXX End Inv Too High 9 Beg Bal 36 Too High Purch XXX COGS Too Low Available 36 Too High l End Inv XXX Net Too High Income COGS 5 Too High Net Income Too Low Financial Statement Analysis Financial Analysts pay particular attention to a company s inventory Although a company wants to have enough inventory to meet the demands of its customers it doesn t want to have too much inventory because it ties up resources and the inventory can become obsolete The desire to minimize inventory levels has led to the implementation of a Just InTime operating environment by many companies Under the JustInTime system a company tries to have its inventory arrive just at the time they are needed In determining inventory levels management must balance the cost of handling storing and financing inventories with the cost of lost sales and dissatisfied customers For example Dell is considered to have a competitive advantage over its competitors because it keeps relatively low levels of inventory and still meets the demands of its customers very quickly Two ratios used in this area are Inventory Turnover Ratio Days in Inventory Inventory Turnover Ratio The Inventory Turnover Ratio is used to measure inventory levels and is computed by dividing cost of goods sold by the average inventory It indicates the number of times on average inventory is sold during the period Cost of Goods Sold Average Inventory Days In Inventory This is also called Average Days Inventory On Handquot This ratio indicates the average number of days between the purchase and sale of inventory It is traditionally computed by dividing the number of days in a year by the inventory turnover Inventory Turnover Ratio It is easier for me to remember this formula if I think of it as follows First calculate how much inventory you sell in a day Cost of Goods Sold Now that you have the inventory sold in one day divide that figure into your average inventory level for the year Average Inventory Inventory Sold in One Day Mathematically this is the same formula Estimating Inventory If you use the periodic inventory system then you probably take a physical inventory once a year because it is very expensive When preparing interim financial statements companies usually do not want to go to the expense of conducting a physical inventory Instead the company estimates its inventories based upon its sales figures using two methods retail method and gross margin method As you can see below they are really doing the same thing but they approach it from different angles Both are based on knowing the relationship between product cost and retail values Retail Method of Inventory Valuation The retail method of inventory estimation can be used when there is an overall constant relationship between the cost and the sales price for goods over a period of time To apply the retail method a Goods available for sale is first determined both at cost and at retail Cost Retail Beginning Inventory 40000 55000 Net Purchases includes FreightIn 110000 145000 Goods Available For Sale 150000 200000 b Then calculate the costtoretail ratio In this case it is 75 150000200000 c Sales for the period are subtracted from goods available for sale using retail values to produce ending inventory at retail Retail Value of Goods Available for Sale 200000 Less Sales for Period 160000 Retail Value of Remaining Inventory 40000 d Finally ending inventory at retail is multiplied by the costtoretail ratio to produce an estimate of ending inventory at cost The estimated cost of remaining inventory in this case is 30000 40000 X 75 Gross Margin Method of Inventory Valuation The gross margin method gross profit method of inventory estimation assumes that the percentage of gross profit for a business remains relatively stable from year to year The gross profit method involves three steps First estimate the cost of goods sold by multiplying sales by one minus the gross profit percentage In this case the gross profit percentage is 25 and one minus the gross profit percentage is 75 1 25 Sales 160000 X 1 Gross Profit Percentage X 75 Estimated Cost of Goods Sold 120000 Next use the estimated Cost of Goods Sold in the Calculation of ending inventory Beginning Inventory 40000 Net Purchases at Cost 110000 Goods Available For Sale 150000 Less Estimated COGS 120000 Estimated Ending Inventory 30000
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