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CHAPTER 1

Introduction to Financial Statements


Study Objectives
1. Describe the primary forms of business organization. 2. Identify the users and uses of accounting information. 3. Explain the three principal types of business activity. 4. Describe the content and purpose of each of the financial statements. 5. Explain the meaning of assets, liabilities, and stockholders equity, and state the basic accounting equation. 6. Describe the components that supplement the financial statements in an annual report.

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Chapter Outline
Study Objective 1 - Describe the Primary Forms of Business Organization.
A business may be organized as a sole proprietorship, partnership, or corporation. Sole proprietorship - a business owned by one person Advantages simple to establish owner controlled tax advantages that are more favorable than a corporation Disadvantages proprietor personally liable for all business debts financing may be difficult transfer of ownership may be difficult Partnership - a business owned by two or more people Advantages simple to establish shared control broader skills and resources tax advantages that are more favorable than a corporation Disadvantages partners personally liable for all business debts transfer of ownership may be difficult Corporation - a separate legal entity owned by stockholders Advantages easier to transfer ownership easier to raise funds lower legal liability no personal liability for stockholders Disadvantages unfavorable tax treatment resulting in higher taxes paid by stockholders The emphasis of this text is the corporate form of business.

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Study Objective 2 - Identify the Users and Uses of Accounting Information.


The purpose of financial information is to provide inputs for decision making. Accounting is the information system that identifies, records, and communicates the economic events of an organization to interested users. The users of financial information fall into two groups--internal users and external users. Internal users - users within the organization. Internal users and questions they may ask: Marketing Human Resources Finance Management What price will maximize the company s net income? Can we afford to give employees pay raises this year? Is cash sufficient to pay dividends to stockholders? Which product line is most profitable? What should be eliminated?

External users - users who are outside the organization. External users and questions they may ask: Investors (current and potential) Creditors (suppliers and bankers) IRS, SEC, FTC, labor unions, customers Is the company earning satisfactory income? How does the company compare in size and profitability with competitors? Will the company be able to pay its debts as they come due? Is the company complying with rules and regulations? Is the company properly paying its taxes?

Ethics in financial reporting In 2002, Congress passed the Sarbanes-Oxley Act (SOX) to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals. Effective financial reporting depends on sound ethical behavior. Steps for solving ethical dilemmas: 1. Recognize an ethical situation and the ethical issues involved. 2. Identify and analyze the principal elements in the situation. 3. Identify the alternatives, and weigh the impact of each alternative on various stakeholders.

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Study Objective 3 - Explain the Three Principal Types of Business Activity.


All businesses are involved in three types of activity. The accounting information system keeps track of the results of each of these activities. Financing activities Cash is often obtained from outside sources to start or expand a business. The two primary sources are: Borrowing from creditors which creates a liability bank loan (note payable) debt securities (bonds payable) goods on credit from suppliers (accounts payable) Issuing ownership interests in the corporation to investors (selling stock to shareholders) In addition, financing activities include using cash to pay dividends to stockholders. Investing activities Cash raised through financing activities is used for investing in resources (assets) needed to operate the business (i.e., land, buildings, delivery trucks, equipment, computers, furniture, etc.). Operating activities Once a business has the assets it needs to get started, it begins its operations (the reason it is in business). Operating activities involve revenue and expenses. Revenue is generated from sales or services related assets include accounts receivable, inventory, supplies, prepaid insurance Expenses are incurred in earning revenue related liabilities include accounts payable, wages payable, interest payable, sales taxes payable, income taxes payable

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Study Objective 4 - Describe the Content and Purpose of Each of the Financial Statements.
Accounting information is communicated through four financial statements: Income Statement Reports success or failure of the company's operations during the period. Summarizes all revenue and expenses for period--month, quarter, or year. If revenues exceed expenses, the result is a net income. If expenses exceed revenue, the result is a (net loss). Dividends are payments to the stockholders and are not expenses. Amounts received from issuing stock or obtaining loans are not revenues. Retained Earnings Statement Indicates amount paid out in dividends and amount of net income or net loss for period. Shows changes in the retained earnings balance during period covered by statement. Ending retained earnings represents net income since the inception of the business that has not been paid out as dividends. Balance Sheet Shows relationship between assets and equities at a specific point in time. Equities include liabilities (claims of the creditors) and stockholders equity (claims of the owners). Assets and equities (liabilities and stockholders' equity) must balance. Statement of Cash Flows Provides information about cash receipts and cash payments for the accounting period. Reports the cash effects of a company's operations for a period of time. Shows cash increases and decreases from investing and financing activities. Indicates increase or decrease in cash balance as well as ending cash balance. Interrelationship of Statements Retained earnings statement depends on results of the income statement. Balance sheet and retained earnings statement are interrelated. Statement of cash flows and balance sheet are interrelated.

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Study Objective 5 - Explain the Meaning of Assets, Liabilities, and Stockholders' Equity, and State the Basic Accounting Equation.

Assets - resources owned by the business (things of value)

Liabilities - creditors claims on total assets (obligations or debts of the business)

Stockholders' Equity - ownership claim on total assets

The accounting equation: Assets = Liabilities + Stockholders' Equity

Study Objective 6 - Describe the Components that Supplement the Financial Statements in an Annual Report.
Companies traded on an organized exchange like the New York Stock Exchange or the American Stock Exchange are required to provide shareholders with an annual report which always includes financial statements. In addition, the annual report includes the following information: Management Discussion and Analysis - covers three aspects of a company: 1. Its ability to pay near-term obligations (liquidity) 2. Its ability to fund operations and expansion (capital resources) 3. It results of operations Notes to Financial Statements Clarify information presented in the financial statements Describe accounting policies or explain uncertainties and contingencies Auditor's Report An auditor, a CPA, conducts an independent examination of the company s financial statements. An auditor gives an unqualified opinion if the financial statements present the financial position, results of operations, and cash flows in accordance with generally accepted accounting principles.

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Chapter 1 Review
Describe the three primary forms of business organization and list advantages and disadvantages of each.

Identify the users of accounting information. How do they use this information?

Explain the three types of business activity.

Describe the content and purpose of each of the financial statements.

Define assets, liabilities, and stockholders equity, and state the basic accounting equation.

Describe the components that supplement the financial statements in an annual report.

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CHAPTER 2
A Further Look

at Financial Statements
Study Objectives

1. Identify the sections of a classified balance sheet. 2. Identify and compute ratios for analyzing a company's profitability. 3. Explain the relationship between a retained earnings statement and a statement of stockholders' equity. 4. Identify and compute ratios for analyzing a company's liquidity and solvency using a balance sheet. 5. Use the statement of cash flows to evaluate solvency. 6. Explain the meaning of generally accepted accounting principles.

7. Discuss financial reporting concepts.

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Chapter Outline

Study Objective 1 - Identify the Sections of a Classified Balance Sheet.


In a classified balance sheet, companies often group similar assets and similar liabilities together using standard classifications and sections. This is because items within the groups have similar economic characteristics. The groupings help users determine: (1) whether the company has enough assets to pay its debts and (2) what claims by short-and long-term creditors exist on the company's total assets. A classified balance sheet generally contains the following standard classifications: Current Assets Assets that are expected to be converted to cash or used in the business within a one year or one operating cycle. Examples of current assets: cash, short-term investments (which include shortterm U.S. government securities), receivables (accounts receivable, notes receivable, and interest receivable), inventories, and prepaid expenses (rent, supplies, insurance, and advertising). On the balance sheet, current assets are listed in the order in which they are expected to be converted into cash (order of liquidity).

Long-Term Investments Assets that can be converted into cash, but whose conversion is not expected within one year. These include long-term assets not currently used within business operations (i.e., land, buildings, etc.) and investments in stocks and bonds of other corporations.

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Property, Plant, and Equipment Assets with relatively long useful lives. Assets currently used in operating the business. Examples include land, buildings, machinery, equipment, and furniture and fixtures. Record these assets at cost and depreciate them (except land) over their useful lives. The full purchase price is not expensed in the year of purchase because the assets will be used for more than one accounting period. Depreciation is the practice of allocating the cost of assets to a number of years. Depreciation expense is the amount of the allocation for one accounting period. Accumulated depreciation is the total amount of depreciation that has been expensed since the asset was placed in service. Cost less accumulated depreciation is reported on the balance sheet.

Intangible Assets Noncurrent assets. Assets that have no physical substance. Examples are goodwill, patents, copyrights, and trademarks or trade names. Current Liabilities Obligations that are to be paid within the current year or operating cycle. Common examples are notes payable, accounts payable, wages payable, bank loans payable, interest payable, taxes payable, and current maturities of longterm bank loans payable. Within the current liabilities section, companies usually list notes payable first, followed by accounts payable, and then the remaining items in the order of their magnitude.

Long-Term Liabilities Obligations expected to be paid after one year. Liabilities in this category include bonds payable, mortgage payable, long-term notes payable, lease liabilities, and obligations under employee pension plans. Many companies report long-term debt maturing after one year as a single amount in the balance sheet and show the details of the debt in notes that accompany the financial statements.

Stockholders' Equity Stockholders equity consists of two parts: Common Stock - investments of assets into the business by the stockholders. Retained Earnings - income retained for use in the business.

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Study Objective 2 - Identify and Compute Ratios for Analyzing a Company's Profitability.
Ratio analysis expresses the relationship among selected items of financial statement data. A ratio expresses the mathematical relationship between one quantity and another. The relationship is expressed in terms of 1. Percentage 127% 2. Rate 1.27 times 3. Proportion: 1:27 to 1 Ratios shed light on company performance 1. Intracompany comparisons covers two years for the same company 2. Industry-average comparisons based on average ratios for particular industries 3. Intercompany comparisons based on comparisons with a competitor in the same industry. Evaluating Profitability using the Income Statement Creditors and investors are interested in evaluating profitability. Profitability is frequently used as a test of management's effectiveness. To supplement an evaluation of the income statement, ratio analysis is used. Profitability ratios - measure the income or operating success of a company for a given period of time. Earnings per share is a profitability ratio that measures the net income earned on each share of common stock. is computed by dividing net income by the average number of common shares outstanding during the year. By comparing earnings per share of a single company over time, one can evaluate its relative earnings performance on a per share basis. Comparisons of earnings per share across companies are not meaningful because of the wide variations in numbers of shares of outstanding stock among companies.

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Study Objective 3 - Explain the Relationship Between a Retained Earnings Statement and a Statement of Stockholders' Equity.
Retained Earnings Statement Describes the events that caused changes in the retained earnings account for the period. Add net income to and subtract dividends from the beginning balance of retained earnings to arrive at the ending balance of retained earnings. Statement of Stockholders' Equity Reports all changes in stockholders' equity accounts (i.e., capital stock issued or retired).

Study Objective 4 - Identify and Compute Ratios for Analyzing a Company's Liquidity and Solvency Using a Balance Sheet.
An analysis of the relationship between a company's assets and liabilities can provide users with information about the firm's liquidity and solvency. Liquidity - The ability to pay obligations expected to come due within the next year or operating cycle. Two measures of liquidity include: Working capital Measure of short-term ability to pay obligations Excess of current assets over current liabilities Positive working capital (Current Assets > Current Liabilities) indicates the likelihood for paying liabilities is favorable. Negative working capital (Current Liabilities > Current Assets) indicates that a company might not be able to pay short-term creditors and may be forced into bankruptcy. Current ratio Measure of short-term ability to pay obligations Computed by dividing current assets by current liabilities More dependable indicator of liquidity than working capital Does not take into account the composition of current assets (like slowmoving inventory versus cash) Solvency - The ability of a company to pay interest as it comes due and to repay the balance of debt due at maturity. Solvency ratios include: Debt to Total Assets Ratio Measures the percentage of assets financed by creditors The higher the percentage of debt financing, the riskier the business. Computed by dividing total debt (both current and long-term liabilities) by total assets 1-12

Study Objective 5

Use the Statement of Cash Flows to Evaluate Solvency.

The statement of cash flows provides financial information about the sources and uses of a company's cash. To aid in the analysis of cash, the statement of cash flows reports the cash effect of a company's: Operating activities - Cash inflows and cash outflows associated with the primary operations of the business. Investing activities - Cash outflows from purchasing resources needed in operating the business. Cash inflows from selling these resources. Financing activities - Cash inflows from sources funding the business (i. e. sale of stock, sale of bonds, borrowings, etc.). Cash outflows for repaying debt, paying dividends, or buying shares of the company s stock. Companies generally get cash from two sources: operating activities and financing activities. In the early years of a company s life it typically will not generate enough cash from operating activities to meet its investing needs. Thus, it will issue stock or borrow money. An established company should be able to meet most of its cash needs from operating activities. Cash is needed to purchase property, plant, and equipment throughout the life of the company. Free cash flow is a measurement that provides insight regarding a company s cashgenerating ability. It describes the cash remaining from operations after adjusting for capital expenditures and dividends. It is computed by subtracting capital expenditures and cash dividends from cash provided by operations.

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Study Objective 6 - Explain the Meaning of Generally Accepted Accounting Principles.

Generally Accepted Accounting Principles (GAAP) are accounting guidelines that provide answers to the following questions. How does a company decide on the amount and type of financial information to disclose? What format should a company use? How should a company measure assets, liabilities, revenues, and expenses? The Securities and Exchange Commission (SEC) is a U.S. government agency that oversees U.S. financial markets and accounting standard-setting agencies. The Public Company Accounting oversight Board (PCAOB) determines auditing standards and reviews auditing firms. The primary accounting standard-setting body in the U. S. is the Financial Accounting Standards Board (FASB). The International Accounting Standards Board (IASB) sets standards (IFRS) for many countries outside the U.S. The FASB and IASB are working closely to minimize the differences in accounting standards among various countries. The SEC is working to allow all U.S. companies to switch to IFRS by 2016.

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Study Objective 7

Discuss Financial Reporting Concepts.

To be useful, financial information should possess the following characteristics: relevance, reliability, comparability, and consistency. Relevance - if information has the ability to make a difference in a decision scenario, it is relevant. Accounting information is also relevant to business decisions because it provides a basis for forecasting future earnings and confirms or corrects prior expectations. Financial statements help predict future events and provide feedback about prior expectations about the financial health of the company. In order to be relevant accounting information must be timely. Reliability - information is reliable if it can be depended on. To be reliable information must be: verifiable--free from error and bias, faithful representation--factual, and neutral --cannot be selected, prepared, or presented to favor one set of users over another. Comparability and Consistency Comparability--when different firms use the same accounting principles To make a comparison, companies must disclose the accounting methods used. Consistency--when firms use the same accounting principles and methods from year to year

Assumptions and Principles in Financial Reporting: To develop accounting standards, the FASB relies on the following key assumptions and principles: Monetary Unit Assumption States that only transactions expressed in terms of money are included in accounting records. Economic Entity Assumption Every economic entity can be separately identified and accounted for. Requires economic activities of an entity be kept separate from those of owner and separate from all other economic entities. Time Period Assumption - allows the business to be divided into artificial time periods that are useful for reporting. Going Concern Assumption Assumes business will be in existence for the foreseeable future Assumption allows use of cost (rather than liquidation value) 1-15

Cost Principle - requires assets to be recorded at original cost because that amount is verifiable. Full Disclosure Principle requires that all circumstances and events that would make a difference to financial statement users should be disclosed. Constraints in Accounting Constraints allow a company to modify generally accepted accounting principles without reducing the usefulness of the information content. This ensures that companies apply accounting rules in a reasonable fashion. These constraints are: Materiality - an item is material when its size makes it likely to influence the decision of an investor or a creditor. An item is immaterial if it is too small to have an impact on the decision. The company does not have to follow GAAP for immaterial items.

Conservatism - allows the accountant to choose the accounting method that will be the least likely to overstate assets and income. Many times items in inventory become obsolete or damaged. In this instance, inventory items should be written down to market value if it is lower than cost. A company should not intentionally understate assets or income.

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Chapter 2 Review
Identify sections of a classified balance sheet. Explain the differences between current and long-term assets and liabilities. Identify accounts that fit into each section.

What is measured by profitability ratios? Compute EPS and discuss how it is used to measure profitability.

What is the relationship between a retained earnings statement and a statement of stockholders' equity? Which contains the most information?

Define liquidity and solvency. Identify and compute ratios for analyzing a firm's liquidity and solvency. How are these ratios interpreted?

Use the statement of cash flows to evaluate solvency. Compute free cash flow and describe what it measures.

What are generally accepted accounting principles? Name the U.S. and international standard-setting bodies that establish these principles.

Define and explain the significance of relevance, reliability, comparability, and consistency. Define and explain assumptions and principles that are used in financial reporting. Define and explain constraints in accounting.

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CHAPTER 3

The Accounting Information System


Study Objectives
1. Analyze the effect of business transactions on the basic accounting equation. 2. Explain what an account is and how it helps in the recording process. 3. Define debits and credits and explain how they are used to record business transactions. 4. Identify the basic steps in the recording process. 5. Explain what a journal is and how it helps in the recording process. 6. Explain what a ledger is and how it helps in the recording process. 7. Explain what posting is and how it helps in the recording process. 8. Explain the purposes of a trial balance. 9. Classify cash activities as operating, investing, or financing.

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Chapter Outline
Study Objective 1 - Analyze the Effect of Business Transactions on the Basic Accounting Equation Accounting Information System collects and processes transactions. communicates financial information to decision makers. Factors that shape the Accounting Information System include: nature of the company s business types of transactions company size the volume of data information demands of management and others. Most businesses use computerized accounting systems, sometimes referred to as electronic data processing (EDP) systems. Accounting Transactions economic events that require recording in the financial statements occur when assets, liabilities, or stockholders equity items change as a result of some economic event

Transaction analysis - the process of identifying the specific effects of economic events on the accounting equation A Summary of Three Important Points about Transactions: 1. Each transaction is analyzed in terms of its effect on assets, liabilities, and stockholders equity. 2. The two sides of the equation must always be equal. 3. The cause of each change in stockholders equity must be indicated.

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Study Objective 2 - Explain What an Account is and How it Helps in the Recording Process
Account - an individual accounting record of increases and decreases in a specific asset, liability, or stockholders' equity item. An account consists of three parts: (1) the title of the account, (2) a left or debit side, and (3) a right or a credit side. It is referred to as a T account because the alignment of the parts of the account resembles the letter T.

Study Objective 3 - Define Debits and Credits and Explain How They are Used to Record Business Transactions
The term debit means left, and credit means right. They DO NOT mean increase or decrease. Debit is abbreviated Dr. and credit is abbreviated Cr. The act of entering an amount of the left side of an account is called debiting. Making an entry on the right side is called crediting. When the totals of the two sides are compared, an account will have a debit balance if the left side (dr side) is greater. Conversely, the account will have a credit balance if the right side (cr side) is greater. Double-entry accounting For each transaction, the debits must equal the credits and the accounting equation must be kept in balance. This helps to ensure the accuracy of the recorded amounts and helps to detect errors. Debits increase assets, expenses and dividends. Debits decrease liabilities, common stock and revenues. Credits decrease assets, expenses and dividends. Credits increase liabilities, stockholders equity, and revenues.

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Study Objective 4 - Identify the Basic Steps in the Recording Process


The basic steps in the accounting process are: Analyze each transaction in terms of its effect on the accounts. A source document, such as a sales slip, a check, a bill, or a cash register tape provides evidence of the transaction. Enter the transaction information in the journal. Transfer the journal information to the appropriate accounts in the ledger (book of accounts). Study Objective 5 - Explain What A Journal is and How it Helps in the Recording Process

Transactions are entered in the journal in chronological order before being transferred to the accounts. The journal has a place to record the debit and credit effects on specific accounts for each transaction. Companies may use various types of journals, but every company has the most basic form of journal, a general journal. The journal makes three significant contributions to the recording process: 1. The journal discloses in one place the complete effect of a transaction. 2. The journal provides a chronological record of transactions. 3. The journal helps prevent or locate errors because the debit and credit amounts for each entry can be readily compared. Entering transaction data into the journal is known as journalizing.

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Study Objective 6 - Explain What a Ledger is and How it Helps in the Recording Process
The entire group of accounts maintained by a company is referred to as the ledger. The general ledger contains all of the asset, liability and stockholders' equity accounts. Information in the ledger provides management with the balances in various accounts. Accounts in the general ledger are listed in the chart of accounts, in an order consistent with assets, liabilities, stockholders equity, revenues, and expenses.

Study Objective 7 - Explain What Posting is and How it Helps in the Recording Process
Posting is the process of transferring journal entries to the ledger accounts. Posting accumulates the effects of journal transactions in the individual ledger accounts.

Study Objective 8 - Explain the Purposes of a Trial Balance


A trial balance is a list of accounts and their balances on a specific date. The primary purpose of the trial balance is to prove the mathematical equality of debits and credits after posting. A trial balance uncovers errors in journalizing and posting. is useful in the preparation of financial statements. is limited in that it will balance but not uncover errors when: A transaction is not journalized. A correct journal entry is not posted. A journal entry is posted twice, Incorrect accounts are used in journalizing and posting, or Offsetting errors are made in recording the amount of a transaction.

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Study Objective 9 Financing.

Classify Cash Activities as Operating, Investing, or

Operating activities are the types of activities the company performs to generate profits. These can include cash received or spent to directly support the company s operations, like cash used to pay an accounts payable or cash spent to purchase inventories. Investing activities include the purchase or sale of long-lived assets used in operating the business, or the purchase or sale of investment securities (like stocks and bonds of other companies). Financing activities include borrowing money, issuing shares of stock and paying dividends.

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Chapter 3 Review
What is the basic accounting equation? How do business transactions effect the basic accounting equation?

What is an account and how does it help in the recording process?

Define debit and credit and explain how they are used to record business transactions.

What are the basic steps in the recording process?

What is a journal? How does it help in the recording process?

What is a ledger? How does it help in the recording process?

What is the purpose of posting and how does it help in the recording process?

What is the purpose of a trial balance? If the debits equal the credits in the trial balance, will the financial statements be error-free? Why or why not?

Define cash activities as operating, investing, or financing and give one example of each.

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CHAPTER 4

Accrual Accounting Concepts


Study Objectives
1. Explain the revenue recognition principle and the matching principle. 2. Differentiate between the cash basis and the accrual basis of accounting. 3. Explain why adjusting entries are needed, and identify the major types of adjusting entries. 4. Prepare adjusting entries for deferrals. 5. Prepare adjusting entries for accruals. 6. Describe the nature and purpose of the adjusted trial balance. 7. Explain the purpose of closing entries. 8. Describe the required steps in the accounting cycle. 9. Understand the causes of differences between net income and cash provided by operating activities. 10. Describe the purpose of the basic form of a worksheet.

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Chapter Outline
Study Objective 1 - Explain the Revenue Recognition Principle and the Matching Principle Determining the amount of revenues and expenses to report in a given accounting period can be difficult. Proper reporting requires an understanding of the nature of the company s business. Two principles are used as guidelines: 1. revenue recognition principle 2. matching principle
The revenue recognition principle requires that revenue be recognized in the accounting period in which it is earned. A service company recognizes (records) revenue when the services are performed.

The matching principle requires that efforts (expenses) be matched with accomplishments (revenues). The critical issue is determining when the expense makes its contribution to revenue.

Study Objective 2 - Differentiate Between the Cash Basis and the Accrual Basis of Accounting

With cash basis accounting, revenue is recognized (recorded) when cash is received. Expenses are recognized (recorded) only when cash is paid. Accrual basis accounting requires accountants to adhere to the revenue recognition principle and the matching principle. Cash basis accounting does not satisfy the requirements of Generally Accepted Accounting Principles (GAAP), whereas accrual basis accounting does. Accrual basis accounting provides an objective measurement of net income.

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Study Objective 3 - Explain why Adjusting Entries are Needed, and Identify the Major Types of Adjusting Entries o Adjusting entries are needed to ensure that the revenue recognition and matching principles are followed. o The trial balance may not contain up-to-date and complete data for several reasons: Some events are not recorded daily because it is not efficient to do so. Some costs are not recorded during the accounting period because these costs expire with the passage of time rather than as a result of recurring daily transactions. Some items may be unrecorded. o Adjusting entries are required every time a company prepares financial statements. Every adjusting entry will include one income statement account and one balance sheet account. o Adjusting entries can be classified as either deferrals or accruals. Each of these classes has two subcategories.

Study Objective 4 -

Prepare Adjusting Entries for Deferrals

Deferrals fall into two categories--prepaid expenses and unearned revenues. 1. Prepaid expenses - expenses paid in cash and recorded as assets until they are used or consumed. Prepaid expenses are costs that expire with the passage of time (i. e. rent and insurance) or through use (i. e. supplies). 2. Unearned revenues cash received and recorded as liabilities before the revenue is earned. An adjusting entry for prepaid expenses will result in an increase (a debit) to an expense account and a decrease (a credit) to an asset account. An adjusting entry for unearned revenues will result in a decrease (a debit) to a liability account and an increase (a credit) to a revenue account. An adjusting entry for deferrals (prepaid expenses or unearned revenues) will decrease a balance sheet account and increase an income statement account.

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Study Objective 5 - Prepare Adjusting Entries for Accruals


Accruals fall into two categories--accrued revenues and accrued expenses. Accrued revenues - revenues earned but not yet received in cash or recorded at the statement date. an adjusting entry for accrued revenues will result in an increase (a debit) in an asset account and an increase (a credit) to a revenue account. Accrued expenses - expenses incurred but not yet paid in cash or recorded at the statement date. an adjusting entry for accrued expenses results in an increase (a debit) to an expense account and an increase (a credit) to a liability account. an adjusting entry for accruals (accrued revenues or accrued expenses) increases both a balance sheet and an income statement account.

Summary of basic relationships: Type of Adjustment Accounts Before Adjustment Prepaid expenses Assets overstated Expenses understated Unearned Revenues Liabilities overstated Revenues understated Accrued revenues Assets understated Revenues understated Accrued expenses Expenses understated Liabilities understated

Adjusting Entry Dr. Expenses Cr. Assets Dr. Liabilities Cr. Revenues Dr. Assets Cr. Revenues Dr. Expenses Cr. Liabilities

Study Objective 6 - Describe the Nature and Purpose of the Adjusted Trial Balance The adjusted trial balance is prepared after all adjusting entries have been journalized and posted. The adjusted trial balance shows the balances of all accounts, including those that have been adjusted, at the end of the accounting period. The purpose of the adjusted trial balance is to prove the equality of the total debit balances and total credit balances in the ledger after all adjustments. Financial statements are prepared from the adjusted trial balance.

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Study Objective 7 - Explain the Purpose of Closing Entries


Closing entries transfer net income (or net loss) and dividends to Retained Earnings. This causes the ending balance of Retained Earnings (amount shown on the Balance Sheet) to agree with the balance shown on the Retained Earnings Statement. Close the revenue accounts to the Income Summary account. Close the expense accounts to the Income Summary account. Close the Income Summary account to Retained Earnings. Close Dividends to Retained Earnings. Closing entries produce a zero balance in each temporary account (revenues, expenses, and dividends) These accounts are then ready to accumulate data for the next accounting period. Permanent accounts (assets, liabilities, common stock and retained earnings) are not closed.

After the closing entries have been journalized and posted, a post-closing trial balance is prepared. The post-closing trial balance shows the balances of all of the permanent accounts. The permanent account balances are carried forward to the next accounting period.

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Study Objective 8 - Describe the Required Steps in the Accounting Cycle


Analyze business transactions. Journalize the transactions. Post to ledger accounts. Prepare a trial balance. Journalize and post adjusting entries--deferrals and accruals. Prepare an adjusted trial balance. Prepare financial statements: Income statement Retained earnings statement Balance sheet Journalize and post closing entries. Prepare post-closing trial balance.

Quality of Earnings Earnings management is the planned timing of revenues, expenses, gains, and losses to smooth out bumps in net income. The quality of earnings is greatly affected when a company manages earnings up or down to meet some targeted earnings number. A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of the financial statements. A company with questionable quality of earnings may mislead investors and creditors, who believe they are relying on relevant and reliable information. Companies manage earnings in a variety of ways: Use of one-time items to prop up earnings (i.e. nonrecurring gains) Inflate revenue numbers in the short-run (to the detriment of the long-run) Improper adjusting entries As the result of investor pressure and the Sarbanes-Oxley Act, many companies are trying to improve the quality of their financial reporting.

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Study Objective 9 Understand the Causes of Differences Between Net Income and Cash Provided by Operating Activities
Net income is based on accrual basis accounting and is accomplished through the adjusting entry process. Cash provided by operating activities is determined by comparing cash received from operating activities to cash expenditures from operating activities. Cash provided by operating activities is essentially net income determined under the cash-basis of accounting.

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Chapter 4 Review
What is the revenue recognition principle? What is the matching principle?

What are the differences in the cash basis and the accrual basis of accounting? Which is required by GAAP? Why?

Why are adjusting entries needed? What are the major types of adjusting entries?

Identify types of prepayments and discuss the adjusting entry for each. What happens if the adjusting entry is not made?

Identify types of accruals and discuss the adjusting entry for each. What happens if the adjusting entry is not made? .

Describe the nature and purpose of the adjusted trial balance.

Discuss the purpose of closing entries.

List the required steps in the accounting cycle. Discuss quality of earnings issues.

Discuss the differences between net income and cash provided by operating activities. How do cash-basis and accrual-basis accounting apply?

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CHAPTER 5

Merchandising Operations and the Multiple-Step Income Statement


Study Objectives
1. Identify the differences between a service enterprise and a merchandising company. 2. Explain the recording of purchases under a perpetual inventory system. 3. Explain the recording of sales revenues under a perpetual inventory system. 4. Distinguish between a single-step and a multiple-step income statement. 5. Determine the cost of goods sold under a periodic inventory system. 6. Explain the factors affecting the profitability. 7. Identify a quality of earnings indicator. 8. (Appendix) Explain the recording of purchases and sales of inventory under a periodic inventory system.

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Chapter Outline
Study Objective 1 - Identify the Differences Between a Service Enterprise and a Merchandising Company. In a merchandising company, the primary source of revenues is the sale of merchandise, referred to as sales revenue or sales. Unlike expenses for a service company, expenses for a merchandising company are divided into two categories: Cost of goods sold - the total cost of merchandise sold during the period. Operating expenses - selling and administrative expenses. The operating cycle of a merchandising company ordinarily is longer than that of a service company. The purchase of merchandise inventory and its eventual sale lengthen the cycle. Steps in the operating cycles for a service company and a merchandising company: Service Company Merchandising Company Perform Services Buy Inventory (Cash or Accounts Payable) Bill Customers (Accounts Sell Inventory Receivable) Collect Cash from Accounts Bill Customers (Accounts Receivable Receivable) Collect Cash from Accounts Receivable

Merchandising companies use one of two systems to account for inventory Perpetual Detailed records of the cost of each inventory purchase and sale are maintained and the records continuously show the inventory that should be on hand for every item. Under a perpetual system, a company determines the cost of goods sold each time a sale occurs. For control purposes, companies take a physical inventory count to verify the accuracy of the inventory records. Periodic Detailed records of the goods on hand are not kept throughout the period. A physical inventory is taken at the end of the accounting periods to determine cost of goods on hand as well as cost of goods sold.

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Study Objective 2 - Explain the Recording of Purchases under a Perpetual Inventory System.
The purchase of merchandise for resale is normally recorded by the merchandiser when the goods are received from the seller. Every purchase should be supported by business documents that provide written evidence of the transaction. Every cash purchase should be supported by a canceled check or a cash register receipt indicating the items purchased and the amounts paid. Each credit purchase should be supported by a purchase invoice, which indicates the total purchase price and other relevant information. Cash purchases are recorded by an increase in Merchandise Inventory and a decrease in Cash. Credit purchases are recorded by an increase in Merchandise Inventory and an increase in Accounts Payable. For example, the entry to record the May 4 purchases merchandise inventory by Sauk Stereo from PW Audio Supply, 2/10, n/30 (as shown in the text) is: May 4 Merchandise Inventory Accounts Payable 3,800 3,800

Freight costs are the cost of transporting the goods to the buyer's place of business. If the freight costs are to be paid by the buyer, the costs are considered part of the cost of purchasing inventory. In this instance, Merchandise Inventory is increased and Cash is decreased. For example, if upon delivery of goods on May 6, Sauk Stereo (the buyer pays Haul-It Freight Company $150 for freight charges, the entry on Sauk s books is: May 6 Merchandise Inventory Cash (To record payment of freight on goods purchased) 150 150

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Freight costs incurred by the seller on outgoing merchandise are an operating expense to the seller and labeled freight-out or Delivery Expense. Freight-out is recorded by increasing Freight-out and decreasing Cash. For example, if the freight terms require that the seller pay $150 freight charges, the entry would be: Freight-out 150 Cash 150 (To record payment of freight on goods sold) Goods that are damaged, defective, of inferior quality, or do not meet purchaser specifications may be returned to the seller for credit if the sale was made on credit, or for a cash refund if the purchase was for cash. The transaction described is a purchase return and is recorded by decreasing Accounts Payable and decreasing Merchandise Inventory. Alternatively, the purchaser may choose to keep the goods that are damaged, defective, or of inferior quality provided the seller will grant a discount referred to as a purchase allowance. The credit terms of a purchase on account may allow the buyer to claim a discount if prompt payment is made. A common credit term is 2/10, n/30, which means a 2 percent purchase discount may be taken if the invoice is paid within 10 days of the invoice date. Net amount of the invoice is due within 30 days. When payment is made within the discount period, the amount of Merchandise Inventory decreases. The entry to record a payment would require the purchaser to decrease Accounts Payable, Decrease Cash, and decrease Merchandise Inventory. For example, assume Sauk Stereo pays the balance due of $3,500 on May 14, the last day of the discount period, and takes the $70 discount. The credit terms are 2/10, n/30. May 14 Accounts Payable Cash Merchandise Inventory 3,500 3,430 70

If Sauk Stereo failed to take the discount and instead made full payment of $3,500 on June 3, Sauk would debit Accounts Payable and credit Cash for $3,500. June 3 Accounts Payable Cash 3,500 3,500

Passing up the discount may be viewed as paying interest for use of the money.

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Study Objective 3 - Explain the Recording of Sales Revenues under a Perpetual Inventory System.
Sales revenues are recorded when earned, in accordance with the revenue recognition principle. Typically this occurs when goods are transferred from the seller to the buyer. Sales may be made on credit or for cash. Each sales transaction should be supported by a business document that provides written evidence of the sale. Cash register tapes provide evidence of cash sales. A sales invoice provides written evidence of a credit sale. Cash sales are recorded by increasing Cash and increasing Sales. Credit sales are recorded by increasing Accounts Receivable and increasing Sales. For example, the journal entry that P.W. Audio Supply records on May 4 for the sale to Sauk Stereo is (the merchandise cost to PW is $2,400), terms 2/10, n/30: May 4 Accounts Receivable Sales Cost of Goods Sold Merchandise Inventory 3,800 3,800 2,400 2,400

For internal decision-making purposes, merchandising companies may use more than one sales account.

Sales Returns and Allowances, a contra revenue account to Sales, may be used to record credit for returned goods.

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Two entries are required to record the credit for Sales Returns and Allowances. The first entry is an increase in Sales Returns and Allowances and a decrease in Accounts Receivable. The second entry is an increase in Merchandise Inventory and a decrease in Cost of Goods Sold. For example, the entry that PW Audio Supply records for a return from a customer on May 8 for which the selling price was $300 and the merchandise cost to PW was $140 is: May 8 Sales Returns and Allowances Accounts Receivable Merchandise Inventory Cost of Goods Sold 300 300 140 140

The seller may offer the customer a sales discount for the prompt payment of the balance due. Like a purchase discount, a sales discount, which is based on the invoice price less any returns and allowances, is recorded by increasing cash for the amount received from the customer, decreasing Accounts Receivable for the amount owed by the customer, and increasing Sales Discounts by the amount of the discount. For example, the entry recorded by PW Audio Supply to show the cash receipt on May 14 from Sauk Stereo within the discount period is: May 14 Cash 3,430 Sales Discounts 70 Accounts Receivable (To record collection within 2/10,n/30 discount period from Sauk Stereo)

3,500

Like Sales Returns and Allowances, Sales Discounts is a contra revenue account to sales.

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Study Objective 4 - Distinguish Between a Single-Step and a Multiple-Step Income Statement.


There are two forms of income statements used by companies: Single-step income statement - one step is required in determining net income-subtract total expenses from total revenues. Revenues--includes both operating revenues and nonoperating revenues and gains. Expenses--includes cost of goods sold, operating expenses, as well as nonoperating expenses and losses. Multiple-step income statement Highlights the components of net income. Includes gross profit (which is net sales less cost of goods sold). Distinguishes between operating and non-operating activities. Sales revenues--The income statement for a merchandising concern typically presents gross sales revenues for the period and deducts the contra revenue accounts (sales returns and allowances and sales discounts) to arrive at net sales. Cost of goods sold is the cost of the merchandise sold during the period. Gross profit (also called Gross Margin) is calculated by deducting cost of goods sold from net sales. Gross profit is the merchandising profit of the company. It is not a measure of the overall profit of a company. Operating expenses - are subtracted from gross profit in order to determine income from operations Operating expenses includeSelling expenses--all of the expenses associated with selling the merchandise from the solicitation of the sale until the product is in the hands of the buyer. Administrative expenses--general expenses relating to general operating activities, human resources, accounting, clerical, security, etc. Non-operating activities--unrelated to the company's primary line of operations. Non-operating items are preceded by Income from Operations in the Income Statement. Other revenues and gains--Interest, dividend, rent revenue, and gain from sale of property. Other expenses and losses--Interest expense; casualty losses; loss from sale or abandonment of property, plant, and equipment; and loss from strikes by employees and suppliers

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Study Objective 5 - Determine Cost of Goods Sold under a Periodic Inventory System.
To determine cost of goods sold: Beginning inventory (amount of ending inventory for the previous period) Add: Cost of Goods Purchased, which includes: Purchases Less: Purchases Returns and Allowances Purchases Discounts Add: Freight-in This results in Cost of Goods Available for Sale (total amount that could have been sold during the accounting period) Subtract: Ending inventory (determined by a physical count on the last day of the accounting period) This results in Cost of Goods Sold (subtract this amount from Net Sales to arrive a Gross Profit)

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Study Objective 6 - Explain the Factors Affecting Profitability.


Gross profit rate, calculated by dividing the amount of gross profit by net sales, is generally considered to be more informative than the gross profit amount because it expresses a more meaningful (qualitative) relationship between gross profit and net sales. Profit margin ratio, calculated by dividing net income by net sales, measures the percentage of each dollar of sales that results in net income. The profit margin ratio measures the extent by which selling cover all expenses (including cost of goods sold) and the gross profit rate measures the margin by which selling price exceeds cost of goods sold. A company can improve its profit margin ratio by either increasing its gross profit rate and/or by controlling its operating expenses and other costs. A decline in a company s gross profit may be due to initiatives to sell products with lower markups, increased competition forcing lower selling prices, or higher prices paid to suppliers that cannot be passed along to customers.

Study Objective 7

Identify a Quality of Earnings Indicator.

Earnings have high quality if they provide a full and transparent presentation of how a company performed. The quality of earnings ratio Is an indicator of the quality of earnings Is calculated as net cash provided by operating activities divided by net income. Interpreting the quality of earnings ratio: Measures greater than 1 suggest the company is employing more conservative accounting practices. Measures significantly below 1 may suggest that a company is using more aggressive accounting practices which accelerate income recognition.

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Study Objective 8 (Appendix) Explain the Recording of Purchases and Sales of Inventory Under a Periodic Inventory System.
A key difference between the perpetual inventory system and the periodic inventory system is the point at which the company computes cost of goods sold. Periodic systems require a physical inventory count at the end of the period to determine: (1) the cost of merchandise then on hand and (2) the cost of the goods sold during the period. To record purchases under the periodic system, entries are required for (a) cash and credit purchases, (b) purchase returns and allowances, (c) purchase discounts and (d) freight costs. To record sales under the periodic system, entries are required for (a) cash and credit sales, (b) sales returns and allowances, and (c) sales discounts.

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Chapter 5 Review
1. What are the differences between a service enterprise and a merchandising company?

2. Give a detailed explanation of the recording of purchases under a perpetual inventory system. Use hypothetical figures to illustrate the perpetual inventory system.

3. How are sales revenues recorded under a perpetual inventory system?

4. What are the differences between a single-step and a multiple-step income statement?

5. Calculate cost of goods sold under a periodic inventory system.

6. Explain how the gross profit rate and the profit margin ratio are computed. What does each represent? How can each be improved?

7. How is the quality of earnings ratio calculated? What does this ratio mean if it is significantly less than 1?

8. What is a key difference between a perpetual inventory system and a periodic inventory system?

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CHAPTER 6

Reporting and Analyzing Inventory


Study Objectives
1. Describe the steps in determining inventory quantities. 2. Explain the basis of accounting for inventories and apply the inventory cost flow methods under a periodic inventory system. 3. Explain the financial statement and tax effects of each of the inventory cost flow assumptions. 4. Explain the lower of cost or market basis of accounting for inventories. 5. Compute and interpret the inventory turnover ratio. 6. Describe the LIFO reserve and explain its importance for comparing results of different companies. 7. (Appendix 6A) Apply the inventory cost flow methods to perpetual inventory records. 8. (Appendix 6B) Indicate the effects of inventory errors on the financial statements.

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Chapter Outline

Study Objective 1 - Describe the Steps in Determining Inventory Quantities

In a merchandising company, inventory consists of many different items. These items have two common characteristics: (1) they are owned by the company and (2) they are in a form ready for sale to customers. Only one inventory classification, merchandise inventory, is needed to describe the many different items that make up the total inventory. In a manufacturing company, inventory is usually classified into three categories: Finished goods, Work in process, and Raw materials. Raw materials inventory the basic goods that will be used in production but have not yet been placed into production. Work in process that portion of manufactured inventory that has been placed into the production process but is not yet complete. Finished goods inventory items that are completed and ready for sale. By observing the levels and changes in the levels of these three inventory types, financial statement users can gain insight into management s production plans. No matter whether they are using a periodic or perpetual inventory system, all companies need to determine inventory quantities at the end of the accounting period. If using a perpetual system, companies take a physical inventory at year-end for two purposes: (1) to check the accuracy of their perpetual inventory records and (2) to determine the amount of inventory lost due to wasted raw materials, shoplifting or employee theft. Companies using a period inventory system must take a physical inventory for two different purposes: (1) to determine the inventory on hand at the balance sheet date and (2) to determine the cost of goods sold for the period. Determining inventory quantities involves two steps: (1) taking the physical inventory of goods on hand and (2) determining the ownership of goods. Taking a physical inventory involves actually counting, weighing, or measuring each kind of inventory on hand. To determine ownership of goods, two questions must be answered: (1) Do all of the goods included in the count belong to the company? (2) Does the company own any goods that were not included in the count?

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To arrive at an accurate count, ownership of goods in transit (on board a truck, train, ship, or plane) must be determined. Goods in transit should be included in the inventory of the company that has legal title to the goods. Legal title is determined by the terms of the sale. When the terms are FOB (free on board) shipping point, ownership of the goods passes to the buyer when the public carrier accepts the goods from the seller. When the terms are FOB destination, ownership of the goods remains with the seller until the goods reach the buyer. In some lines of business, it is customary to hold the goods of other parties and try to sell the goods for them for a fee, but without taking ownership of the goods. These are called consigned goods.

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Study Objective 2 - Explain the Basis of Accounting for Inventories and Apply the Inventory Cost Flow Methods under a Periodic Inventory System

After a company has determined the quantity of units of ending inventory, it applies unit costs to the quantities to determine the total cost of the ending inventory and the cost of goods sold.

Determining ending inventory can be complicated if the units on hand for a specific item of inventory have been purchased at different times and at different prices. Therefore, there are a different inventory costing methods available:

Specific identification method identifies the cost of particular units sold and those still remaining in ending inventory. A major disadvantage of this method is that management may be able to manipulate net income. There is no accounting requirement that the cost flow assumption be consistent with the physical movement of the goods. One of the three cost flow assumptions may be used: 1) First-in, First-out (FIFO) method assumes that the earliest goods purchased are the first to be sold. Under FIFO, the cost of the ending inventory is obtained by taking the unit cost of the most recent purchase and working backward until all units of inventory have been costed. FIFO often parallels the actual physical flow of goods. 2) Last-in, First-out (LIFO) method assumes that the last goods purchased are the first to be sold. LIFO seldom coincides with the actual physical flow of inventory. Under LIFO, the cost of the ending inventory is obtained by taking the unit cost the earliest goods available for sale and working forward until all units of inventory have been costed. Beginning inventory is the earliest cost. 3) Average cost method assumes that the goods available for sale are similar in nature and allocates the cost of goods available for sale on the basis of weighted average unit cost incurred. The weighted average unit cost is then applied to the units on hand to determine the cost of the ending inventory.

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Study Objective 3 - Explain the Financial Statement and Tax Effects of Each of the Inventory Cost Flow Assumptions

The reasons companies adopt different inventory cost flow methods are varied, but usually involve on the three following factors: 1) Income statement effects--In periods of increasing prices, FIFO reports the highest net income, LIFO the lowest net income and average cost falls in the middle. In periods of decreasing prices, the opposite is true. FIFO will report the lowest net income, LIFO the highest, with average cost in the middle. To management, higher net income is an advantage: (a) It causes external users to view the company more favorable. (b) Management bonuses, if based on net income, will be higher. Thus, when prices are rising, companies tend to prefer FIFO. In a period of increasing prices, the use of LIFO enables the company to avoid reporting paper or phantom profit. 2) Balance sheet effects--In a period of inflation, the costs allocated to ending inventory, using FIFO, will approximate current costs. Conversely, during a period of increasing prices, the costs allocated the ending inventory using LIFO will be significantly understated. 3) Tax Effects--Both inventory on the balance sheet and net income on the income statement are higher when FIFO is used in a period of inflation. Many companies have switched to LIFO because it yields the lowest net income and therefore, the lowest income tax liability in a period of increasing prices. LIFO Conformity Rule: A tax rule that requires if a company uses LIFO for tax purposes it must also use LIFO for financial reporting purposes. Thus, if a company uses LIFO to reduce its tax bills, it must show the lower net income on its external financial statements.

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Study Objective 4 - Explain the Lower of Cost or Market Basis of Accounting for Inventories

When the value of inventory is lower than its cost, the inventory is written down to its market value by valuing the inventory at the lower of cost or market (LCM) in the period in which the price decline occurs. LCM is an example of conservatism. Under the LCM basis, market is defined as current replacement cost, not selling price. For a merchandising company, market is the cost of purchasing the same goods at the present time from the usual suppliers in the usual quantities.

Study Objective 5 - Compute and Interpret the Inventory Turnover Ratio

Inventory turnover ratio is computed by dividing cost of goods sold by average inventory. The ratio tells how many times the inventory turns over (is sold) during the year. Days in inventory, computed by dividing 365 days by the inventory turnover ratio, indicates the average age of the inventory. High inventory turnover (low days in inventory) indicates the company is tying up little of its funds in inventory (has minimal inventory on hand at any one time). Although minimizing the funds tied up in inventory is efficient, it may lead to lost sales due to inventory shortages. Management should closely monitor the inventory turnover ratio to achieve the best balance between too much and too little inventory.

Study Objective 6- Describe the LIFO Reserve and Explain its Importance for Comparing Results of Different Companies

Accounting standards require firms using LIFO to report the amount by which inventory would be increased (or on occasion decreased) if the firm had instead been using FIFO. This amount is referred to as the LIFO reserve. Reporting the LIFO reserve enables analysts to make adjustments to compare companies that use different cost flow methods.

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Chapter 6 Review
Why do companies need to determine inventory quantities at the end of the accounting period? Explain the steps in determining inventory quantities. Discuss issues involved in determining the ownership of goods. How do the shipping terms (FOB shipping point and FOB destination) affect ownership of goods? Define consigned goods and discuss related ownership issues.

Explain the basis of accounting for inventories and apply the inventory cost flow methods-- FIFO, LIFO, and weighted-average--under a periodic inventory system. Discuss the differences between the physical movement of goods and cost flow assumptions.

Discuss the effects on the income statement and balance sheet and tax effects of each of the inventory cost flow assumptions-- FIFO, LIFO, and weighted-average.

What is the lower of cost or market (LCM) basis of accounting for inventories? Describe the application of LCM.

What is the inventory turnover ratio? How is it computed? How is it used by external users and management?

What is the LIFO reserve? Explain its importance for comparing results of different companies.

In the income statement, if beginning inventory is understated, what effect will it have on cost of goods sold and net income?

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Chapter 7
Fraud, Internal Control, and Cash

Study Objectives

1. Define fraud and internal control. 2. Identify the principles of internal control activities. 3. Explain the applications of internal control principles to cash receipts. 4. Explain the applications of internal control principles to cash disbursements. 5. Prepare a bank reconciliation. 6. Explain the reporting of cash. 7. Discuss the basic principles of cash management. 8. Identify the primary elements of a cash budget. 9. (Appendix) Explain the operation of a petty cash fund.

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Chapter Outline

Study Objective 1

Define Fraud and Internal Control

Fraud is a dishonest act by employee that results in personal benefit to the employee at a cost to the employer Three main factors contribute to fraudulent activity. They are: (1) opportunity, which are usually due to a lack of sufficient controls; (2) financial pressure, which usually is related to too much personal debt or a desire for a better lifestyle; and (3) rationalization, which is justification for why the employee deserves the compensation from fraudulent acts. Sarbanes-Oxley Act of 2002 (SOX) requires all publicly traded U.S. corporations to maintain an adequate system of internal controls. SOX imposes more responsibilities on corporate executives and boards of directors to ensure that companies internal controls are reliable and effective Companies must develop sound principles of control over financial reporting and continually assess that the controls are working. Independent outside auditors must attest to the level of internal controls. Internal control consists of all of the related methods and measures adopted within a business to: Safeguard assets Enhance the reliability of its accounting records Increase efficiency of operations, and Ensure compliance with laws and regulations. There are five primary components of internal control systems: Control environment, or tone at the top. Risk assessment, or identifying and analyzing factors that create risk. Control activities, or policies and procedures to address risk. Information and communication, which allow for both down and up organizational information flow and appropriate external communication. Monitoring, which allow for reporting of significant deficiencies

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Study Objective 2 - Identify the Principles of Internal Control


To safeguard assets and enhance the accuracy and reliability of its accounting records, companies follow internal control principles. The following six internal control principles apply to most enterprises: 1. Establishment of Responsibility An essential characteristic of internal control is the assignment of responsibility to specific individuals. Control is most effective when only one person is responsible for a given task. Establishing responsibility includes the authorization and approval of transactions. 2. Segregation of Duties Segregation of duties is indispensable in a system of internal control. The rationale for segregation of duties is that the work of one employee should, without a duplication of effort, provide a reliable basis for evaluating the work of another employee. There are two common applications of this principle: I. The responsibility for related activities should be assigned to different individuals. Related Activities: When one individual is responsible for all of the related activities, the potential for errors and irregularities is increased. Related purchasing activities should be assigned to different individuals. Related purchasing activities include ordering merchandise, receiving goods, and paying (or authorizing payment) for merchandise. Related sales activities also should be assigned to different individuals. Related sales activities include making a sale, shipping (or delivering) the goods to the customer, and billing the customer. II.The responsibility for record keeping for an asset should be separate from the physical custody of the asset. Separate Record Keeping from Physical Custody The custodian of the asset is not likely to convert the assets to personal use if one employee maintains the record of the assets that should be on hand and a different employee has physical custody of the assets. 3. Documentation Procedures Documents provide evidence that transactions and events have occurred. Documents should be prenumbered and all documents should be accounted for. Source documents for accounting entries should be promptly forwarded to the accounting department to help ensure timely recording of the transaction and event.

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4. Physical Electronic Controls Physical controls relate primarily to the safeguarding of assets. Mechanical and electronic controls safeguard assets and enhance the accuracy and reliability of the accounting records. Use of physical controls is essential. Examples of these controls include: Safes, vaults, and safety deposit boxes for cash and business papers. Locked warehouses and storage cabinets for inventory and records. Computer facilities with pass key access or fingerprint or eyeball scans. Alarms to prevent break-ins. Television monitors and garment sensors to deter theft. Time clocks for recording time worked. 5. Independent Internal Verification Independent internal verification involves the review, comparison, and reconciliation of data prepared by employees. For Maximum benefit: Verification should be made periodically or on a surprise basis. Verification should be done by an employee independent of the personnel responsible for the information. Discrepancies and exceptions should be reported to a management level that can take appropriate corrective action. In large companies, independent internal verification is often assigned to internal auditors. Internal auditors are employees of the company who evaluate on a continuous basis the effectiveness of the company s system of internal control. They periodically review the activities of departments and individuals to determine whether prescribed internal controls are being followed.

6. Human Resource Controls Bonding of employees who handle cash. Rotating employees' duties and requiring employees to take vacations. Conducting thorough background checks, checking on school graduations and verified telephone number of previous employers.

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Limitations of Internal Control Internal control is designed to provide reasonable assurance that assets are properly safeguarded and that the accounting records are reliable. The concept of reasonable assurance rests on the premise that the costs of establishing control procedures should not exceed their expected benefit. The human element is a factor in every system of internal control. A good system can become ineffective as a result of employee fatigue, carelessness, or indifference. Occasionally two or more employees may work together in order to get around prescribed controls (collusion). Collusion can significantly impair the effectiveness of a system of internal control because it eliminates the protection anticipated from segregation of duties. The size of the business may impose limitations on internal control. A small company may find it difficult to apply the principles of segregation of duties and independent internal verification. An important and inexpensive measure any business can take to reduce employee theft and fraud is to conduct thorough background checks. Two tips include: 1. Check to see whether job applicants actually graduated from the schools they list. 2. Never use the telephone numbers for previous employers given on the reference sheet; always look them up yourself.

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Study Objective 3 - Explain the Applications of Internal Control to Cash Receipts


Cash Controls Just as cash is the beginning of a company s operating cycle, it is usually the starting point for a company s system of internal control. Cash is the asset most susceptible to improper diversion and use. Because of the large volume of cash transactions, numerous errors may occur in executing and recording cash transactions. To safeguard cash and ensure the accuracy of the accounting records for cash, effective internal control over cash is imperative. Cash consists of coins, currency (paper money), checks, money orders, and money on hand or on deposit in a bank or similar depository. Cash Receipts Controls: Cash receipts result from cash sales; collections on account from customers; the receipt of interest, rents, and dividends; investments by owners; bank loans; and proceeds from the sale of noncurrent assets. The following internal control principles explained earlier apply to cash receipts transactions as shown: Establishment of responsibility - Only designated personnel (cashiers) are authorized to handle cash receipts. Segregation of duties - Different individuals receive cash, record cash receipts, and hold the cash. Documentation procedures - Use remittance advice (mail receipts), cash register tapes, and deposit slips. Physical controls - Store cash in safes and bank vaults; limit access to storage areas; use cash registers. Independent internal verification - Supervisors count cash receipts daily; treasurer compares total receipts to bank deposits daily. Human resource controls - Bond personnel who handle cash; require vacations; deposit all cash in bank daily. In some instances, the amount deposited at the bank will not agree with the cash recorded in the accounting records based on the cash register tape. When a difference occurs between the actual cash and the amount reported on the cash register tape, the account, Cash Over and Short, is used. Assume for example that the cash register tape indicated sales of $6,956.20 but the amount of cash was only $6,946.10. The cash shortfall of $10.10 would be recorded as follows: Cash Cash Over and Short Sales Revenue 6,946.10 10.10 6,956.20

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Study Objective 4 - Explain the Applications of Internal Control to Cash Disbursements


Cash Disbursement Control Cash is disbursed to pay expenses and liabilities or to purchase assets. Internal control over cash disbursements is more effective when payments are made by check, rather than by cash, except for incidental amounts that are paid out of petty cash. Cash payments are generally made only after specific control procedures have been followed. The paid check provides proof of payment. The principles of internal control apply to cash disbursements as follows: Establishment of responsibility - Only designated personnel (treasurer) are authorized to sign checks. Segregation of duties - Different individuals approve and make payments; check signers do not record disbursements. Documentation procedures - Use prenumbered checks and account for them in sequence; each check must have approved invoice; stamp invoices PAID . Physical controls - Store blank checks in safes with limited access; print check amounts by machine with indelible ink. Independent internal verification - Compare checks to invoices; reconcile bank statement monthly. Human resource controls Bond personnel who handle cash; require employees to take vacations; conduct background checks. Voucher System Controls A voucher system is a network of approvals by authorized individuals, acting independently, to ensure that all disbursements by check are proper A voucher system is effective because: (a) it establishes responsibility for the authorization process; and (b) it keeps track of the documents that back up each transaction. Petty Cash Fund A cash fund used to pay relatively small amounts. Information on the operation of a petty cash fund is provided in the appendix to this chapter.

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Use of a Bank Contributes significantly to good internal control over cash. Minimizes the amount of currency that must be kept on hand. Facilitates the control of cash because a double record is maintained of all bank transactions one by the business and one by the bank. The asset account Cash maintained by the company is the flip-side of the bank s liability account for that company. It should be possible to reconcile these accounts make them agree at any time. Bank statements Each month the company receives a bank statement showing its bank transactions and balances. Some transactions and balances shown include: Checks paid and other debits that reduce the balance in the depositor s account. Deposits and other credits that increase the balance in the depositor s account. The account balance after each day s transactions. Bank statements are prepared from the bank s perspective. Every deposit the bank receives is an increase in the bank s liabilities (an accounts payable) to the depositor. Every check the bank funds or pays for a depositor decreases the bank s liability (an accounts payable) to the depositor.

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Study Objective 5

Prepare a Bank Reconciliation

The bank and the company maintain independent records of the checking account. The two balances are seldom the same because of: Time lags that prevent one of the parties from recording the transaction in the same period. Days elapse between the time a check is written and dated and the date it is paid by the bank. A day may pass between the time receipts are recorded by the company and the time they are recorded by the bank. A time lag may occur when the bank mails a debit or credit memo to the company. Errors by either party in recording transactions. The incidence of errors depends on the effectiveness of internal controls maintained by the company and the bank. Bank errors are infrequent. Reconciliation procedure In reconciling the bank account, it is customary to reconcile the balance per books and balance per bank to their adjusted (correct or true) cash balances. To obtain maximum benefit from a bank reconciliation, the reconciliation should be prepared by an employee who has no other responsibilities related to cash. The reconciliation schedule is divided into two sections balance per bank and balance per books. The following steps should reveal all the reconciling items causing the difference between the two balances: 1. Compare the individual deposits on the bank statement with the deposits in transit from the preceding bank reconciliation and with the deposits per company records or copies of duplicate deposit slips. Deposits recorded by the depositor that have not been recorded by the bank represent deposits in transit and are added to the balance per bank. 2. Compare the paid checks shown on the bank statement or the paid checks returned with the bank statement with (a) checks outstanding from the preceding bank reconciliation and (b) checks issued by the company as recorded in the cash payments journal. Issued checks recorded by the company that have not been paid by the bank represent outstanding checks that are deducted from the balance per bank. 3. Note any errors discovered in the foregoing steps and list them in the appropriate section of the reconciliation schedule. All errors made by the depositor are reconciling items in determining the adjusted cash balance per books. In contrast, all errors made by the bank are reconciling items in determining the adjusted cash balance per bank. 4. Trace bank memoranda to the depositor s records. Any unrecorded memoranda should be listed in the appropriate section of the reconciliation schedule.

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Entries from Bank Reconciliation Each reconciling item used in determining adjusted cash balance per books should be recorded by the depositor. If these items are not journalized and posted, the Cash account will not show the correct balance. Electronic Funds Transfer (EFT) System A new approach developed to transfer funds among parties without the use of paper (deposit tickets, checks, etc.). The approach, called electronic funds transfers (EFT), uses wire, telephone, telegraph, or computer to transfer cash from one location to another.

Study Objective 6

Explain the Reporting of Cash

Cash is recorded in both the balance sheet and the statement of cash flows. The balance sheet shows the amount of cash available at a given point in time. The statement of cash flows shows the sources and uses of cash during a period of time. Cash on hand, cash in banks, and petty cash are often combined and reported simply as cash. Cash is the most liquid asset and listed first in the current assets section of the balance sheet.

Many companies use the designation Cash and cash equivalents in reporting cash. Cash equivalents are short-term, highly liquid investments that are both: (1) Readily convertible to known amounts of cash, and (2) So near their maturity that their market value is relatively insensitive to changes in interest rates. A negative balance in the cash account should be rare. It should be reported among current liabilities. A company may have cash that is not available for general use but rather is restricted for a special purpose. Cash restricted in use should be reported separately on the balance sheet as restricted cash. If the restricted cash is expected to be used within the next year, the amount should be reported as a current asset. When this is not the case the restricted funds should be reported as a noncurrent asset.

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Study Objective 7 - Discuss the Basic Principles of Cash Management Many companies struggle, not because they fail to generate sales, but because they cannot manage their cash. Managing the often-precarious balance created by the ebb and flow of cash during the operating cycle is one of a company s greatest challenges.
Management of cash is the responsibility of the company treasurer. A company can improve its chances of having adequate cash by following five basic principles of cash management: 1. Increase the speed of collection on receivables The more quickly customers pay the more quickly a company can use those funds. Any attempt to force customers to pay earlier must be carefully weighted against the possibility of angering or alienating customers. One common way to encourage customers to pay more quickly is to offer cash discounts for early payment. 2. Keep inventory levels low Maintaining large inventories ties up large amounts of cash, as well as warehouse space. Increasingly, firms are using techniques to reduce the inventory on hand, thus conserving their cash. 3. Delay payment of liabilities A company should use the full payment period, but not stretch payment past the point that could damage its credit rating. 4. Plan the timing of major expenditures In order to increase the likelihood of obtaining outside financing, a company should carefully consider the timing of major expenditures in light of its operating cycle. If at all possible, the expenditure should be made when the company normally has excess cash usually during the off-season. 5. Invest idle cash Cash on hand earns nothing. An important part of the treasurer s job is to ensure that any excess cash is invested, even if it is only overnight. A liquid investment is one with a market in which someone is always willing to buy or sell the investment. A risk-free investment means there is no concern that the party will default on its promise to pay its principal and interest.

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Study Objective 8 - Identify the Primary Elements of a Cash Budget


Cash is vital and planning the company's cash needs is a key business activity. The cash budget shows the anticipated cash flows, over a one- to two-year period. The cash budget contains the following three sections: 1. Cash receipts section includes expected receipts from the company's principal source(s) of revenue, such as cash sales and collections from customers on credit sales. This section also shows anticipated receipts of interest and dividends, and proceeds from planned sales of investments, plant assets, and the company's capital stock. 2. Cash disbursements section shows expected payments for direct materials, direct labor, manufacturing overhead, and selling and administrative expenses. This section also includes projected payments for income taxes, dividends, investments, and plant assets. 3. Financing section shows expected borrowings and the repayment of the borrowed funds and interest. Data in the cash budget must be prepared in sequence because the ending cash balance of one period becomes the beginning cash balance for the next period. Data for preparing the cash budget are obtained from other budgets and from information provided by management. A cash budget contributes to more effective cash management.

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Chapter 7 Review
What are the three factors of the fraud triangle that contribute to fraudulent activity by employees?

Identify the six principles of internal control. Give examples of each principle. Discuss the limitations of internal control.

List six internal controls over cash receipts. Explain the application of each.

List six internal controls over cash disbursements. Explain the application of each.

List the steps in preparing a bank reconciliation. Prepare a bank reconciliation. Prepare the journal entries that result from a bank reconciliation.

In which financial statement(s) is cash reported? Discuss restricted cash and negative cash balances.

Discuss the five basic principles of cash management.

What are the primary elements of a cash budget and what types of items would one find in each of the elements? Be specific in your answer.

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Chapter 8

Reporting and Analyzing Receivables

Study Objectives
1. Identify the different types of receivables. 2. Explain how accounts receivable are recognized in the accounts. 3. Describe the methods used to account for bad debts. 4. Compute the interest on notes receivable. 5. Describe the entries to record the disposition of notes receivable. 6. Explain the statement presentation of receivables. 7. Describe the principles of sound accounts receivable management. 8. Identify ratios to analyze a company's receivables. 9. Describe methods to accelerate the receipt of cash from receivables.

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Chapter Outline

Study Objective 1 - Identify the Different Types of Receivables


The term receivables refers to amounts due from individuals and companies. Receivables are claims that are expected to be collected in cash. Receivables represent one of a company s most liquid assets. Receivables are frequently classified as: Accounts receivable: Are amounts owed by customers on account. Result from the sale of goods and services (often called trade receivables). Are expected to be collected within 30 to 60 days. Are usually the most significant type of claim held by a company. Notes receivable: Represent claims for which formal instruments of credit are issued as evidence of debt. Are credit instruments that normally require payment of interest and extend for time periods of 60-90 days or longer. May result from sale of goods and services (often called trade receivables). Other receivables: Nontrade receivables including interest receivable, loans to company officers, advances to employees, and income taxes refundable. Generally classified and reported as separate items in the balance sheet.

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Study Objective 2 - Explain how Accounts Receivable are Recognized in the Accounts
Two accounting problems associated with accounts receivable are: 1. Recognizing accounts receivable 2. Valuing accounts receivable

Recognizing accounts receivable


Service organizations -- A receivable is recorded when service is provided on account. Debit accounts receivable and credit service revenue Merchandisers A receivable is recorded at the point of sale of merchandise on account. Debit accounts receivable and credit sales Receivable may be reduced by sales discount and/or sales return

Study Objective 3 - Describe the Methods Used to Account for Bad Debts Valuing accounts receivable
Determining the amount of accounts receivable to report is difficult because some receivables will become uncollectible. This creates bad debt expense a normal and necessary risk of doing business on credit.

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Two methods are used in accounting for uncollectible accounts: 1. Direct Write-off Method 2. Allowance Method Direct Write-Off Method When a specific account is determined to be uncollectible, the loss is charged to Bad Debt Expense. For example, assume that Warden Co. writes off M. E. Doran s $200 balance as uncollectible on December 12. The entry is: Dec. 12 Bad Debts Expense 200 Accounts Receivable--M. E. Doran 200 (To record write-off of M. E. Doran account)

Bad debts expense will show only actual losses from uncollectibles. Bad debts expense is often recorded in a period different from that in which the revenue was recorded. Under this method, no attempt is made to: (1) show accounts receivable in the balance sheet at the amount actually expected to be received; and (2) Match bad debts expenses to sales revenue in the income statement. Use of the direct write-off method can reduce the usefulness of both the income statement and balance sheet. Unless bad debt losses are insignificant, the direct write-off method is not acceptable for financial reporting purposes.

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Allowance Method The allowance method of accounting for bad debts involves estimating uncollectible accounts at the end of each period. It provides better matching of expenses and revenues on the income statement and ensures that receivables are stated at their cash (net) realizable value on the balance sheet. Cash (net) realizable value is the net amount of cash expected to be received. It excludes amounts that the company estimates it will not collect. Receivables are therefore reduced by estimated uncollectible amounts on the balance sheet through use of the allowance method. The allowance method is required for financial reporting purposes when bad debts are material. Three essential features of the allowance method are: 1. Uncollectible accounts receivable are estimated and matched against revenues in the same accounting period in which the revenues occurred. 2. Estimated uncollectibles are recorded as an increase to Bad Debts Expense and an increase to Allowance for Doubtful Accounts (a contra asset account) through an adjusting entry at the end of each period. 3. Actual uncollectibles are debited to Allowance for Doubtful Accounts and credited to Accounts Receivable at the time the specific account is written off as uncollectible. Recording Estimated Uncollectibles Allowance for Doubtful Accounts shows the estimated amount of claims on customers that are expected to become uncollectible in the future. The credit balance in the allowance account will absorb the specific write-offs when they occur. Allowance for Doubtful Accounts is not closed at the end of the fiscal year. Bad Debts Expense is reported in the income statement as an operating expense (usually a selling expense). Recording the Write-Off Each write-off should be approved in writing by authorized management personnel. Under the allowance method, every bad debt write-off is debited to the allowance account (not to Bad Debt Expense) and credited to the appropriate Account Receivable. A write-off affects only balance sheet accounts. Cash realizable value in the balance sheet, therefore, remains the same.

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Recovery of an Uncollectible When a customer pays after the account has been written off, two entries are required: (1) The entry made in writing off the account is reversed to reinstate the customer s account. (2) The collection is journalized in the usual manner. The recovery of a bad debt, like the write-off of a bad debt, affects only balance sheet account. In real life, companies must estimate the amount of expected uncollectible accounts if they use the allowance method. Frequently the allowance is estimated as a percentage of the receivables. Management establishes a percentage relationship between the amount of receivables and expected losses from uncollectible accounts. A schedule is prepared in which customer balances are classified by the length of time they have been unpaid. Because of its emphasis on time, this schedule is often called an aging schedule and the analysis of it is often called aging the accounts receivable. After the accounts are arranged by age, the expected bad debt losses are determined by applying percentages, based on past experience, to the totals of each category. The estimated bad debts represent the existing customer claims expected to become uncollectible in the future. This amount represents the required balance in Allowance for Doubtful Accounts at the balance sheet date. Accordingly, the amount of the bad debts adjusting entry is the difference between the required balance and the existing balance in the allowance account. Occasionally the allowance account will have a debit balance prior to adjustment because write-offs during the year have exceeded previous provisions for bad debts. In such a case, the debit balance is added to the required balance when the adjusting entry is made.

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Study Objective 4 - Compute the Interest on Notes Receivable


A promissory note is a written promise to pay a specified amount of money on demand or at a definite time. In a promissory note, the party making the promise to pay is called the maker. The party to whom payment is to be made is called the payee. The payee may be specifically identified by name or may be designated simply as the bearer of the note. Notes receivable give the holder a stronger legal claim to assets than accounts receivable. are frequently accepted from customers who need to extend the payment of an outstanding account receivable, and they are often required from high-risk customers. notes receivable, like accounts receivable, can be readily sold to another party. Promissory notes are negotiable instruments. There are three basic issues in accounting for notes receivable: 1. Recognizing notes receivable. 2. Valuing notes receivable. 3. Disposing of notes receivable. Computing Interest The formula for computing interest is: Face Value of Note (principle) x Annual Interest Rate x Time (in terms of one year) The interest rate specified on the note is an annual rate of interest. The time factor in the computation expresses the fraction of a year that the note is outstanding.

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When the maturity date is stated in days, the time factor is frequently the number of days divided by 360. For example, the maturity date of a 60-day note dated July 17 is determined as follows: Term of note Days in July Date of note Note s days in July Days in August Plus note s days in July Notes days to the end of August Maturity date, September 60 days 31 17 14 31 14 45

45 15

When the due date is stated in terms of months, the time factor is the number of months divided by 12.

Recognizing Notes Receivable To illustrate the basic entry for notes receivable, the text uses Brent Company s $1,000, two-month, 8% promissory note dated May 1. Assume that the note was written to settle an open account. The entry for the receipt of the note by Wilma Company is as follows: May 1 Notes Receivable 1,000 Accounts Receivable Brent Company (To record acceptance of Brent Company note)

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The note receivable is recorded at its face value, the value shown on the face of the note. No interest revenue is reported when the note is accepted because the revenue recognition principle does not recognize revenue until earned. Interest is earned (accrued) as time passes. If a note is exchanged for cash, the entry is a debit to Notes Receivable and a credit to Cash in the amount of the note. Valuing Notes Receivable Like accounts receivable, short-term notes receivable are reported at their cash (net) realizable value. The notes receivable allowance account is Allowance for Doubtful Accounts. The computations and estimations are similar to the ones related to accounts receivable.

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Study Objective 5 - Describe the Entries to Record the Disposition of Notes Receivable
Notes may be held to their maturity date, at which time the face value plus accrued interest is due. In some situations, the maker of the note defaults, and appropriate adjustment must be made. A note is honored when it is paid in full at maturity.

A dishonored note is a note that is not paid in full at maturity. If the lender expects that it will eventually be able to collect, the Notes Receivable account is transferred to an Account Receivable for both the face value of the note and the interest due. If there is no hope of collection, the face value of the note should be written off.

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Study Objective 6 - Explain the Statement Presentation of Receivables


Each of the major types of receivables should be identified in the balance sheet or in the notes to the financial statements. Short-term receivables are reported in the current asset section of the balance sheet below short-term investments. These assets are nearer to cash and are thus more liquid. Both the gross amount of receivables and the allowance for doubtful accounts should be reported. Notes receivable are listed before accounts receivable because notes are more easily converted to cash. Bad Debts Expense is reported under Selling expenses in the operating expense section of the income statement. Interest Revenue is shown under Other Revenues and Gains in the nonoperating section of the income statement. If a company has significant risk of uncollectible accounts or other problems with receivables, it is required to discuss this possibility in the notes to the financial statements.

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Study Objective 7 - Describe the Principles of Sound Accounts Receivable Management


Managing accounts receivable involves five steps: 1. Determine to whom to extend credit. 2. Establish a payment period. 3. Monitor collections. 4. Evaluate the receivables balance. 5. Accelerate cash receipts from receivables when necessary. Determine to whom to extend credit. 1. Risky customers might be required to provide letters of credit or bank guarantees. 2. Particularly risky customers might be required to pay cash on delivery. 3. Ask potential customers for references from banks and suppliers and check the references. 4. Periodically check financial health of continuing customers. Establish a payment period. 1. Determine a required payment period and communicate that policy to customers. 2. Make sure company's payment period is consistent with that of competitors. Monitor collections. 1. Prepare accounts receivable aging schedule at least monthly. 2. Pursue problem accounts with phone calls, letters, and legal action if necessary. 3. Make special arrangements for problem accounts. 4. If a company has significant concentrations of credit risk, it is required to discuss this risk in the notes to its financial statements. 5. A concentration of credit risk is a threat of nonpayment from a single customer or class of customers that could adversely affect the financial health of the company.

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Study Objective 8 - Identify Ratios to Analyze a Company's Receivables


Liquidity is measured by how quickly certain assets can be converted into cash. The ratio used to assess the liquidity of the receivables is the receivables turnover ratio. The ratio measures the number of times, on average, receivables are collected during the period. The receivables turnover ratio is computed by dividing net credit sales (net sales less cash sales) by the average net accounts receivables during the year. A popular variant of the receivables turnover ratio is to convert it into an average collection period in terms of days. This is computed by dividing the receivables turnover ratio into 365 days. The general rule is that the average collection period should not greatly exceed the credit term period (i.e., the time allowed for payment). In some cases, receivables turnover may be misleading. Therefore, it is important to know how a company manages its receivables.

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Study Objective 9 - Describe Methods to Accelerate the Receipt of Cash from Receivables
Two common expressions apply to the collection of receivables: 1. Time is money that is, waiting for the normal collection process costs money. 2. A bird in the hand is worth two in the bush that is, getting the cash now is better than getting it later or not at all. There are three reasons for the sale of receivables. 1. The size of the receivables may cause a company to sell them because it may not want to hold such a large amount of receivables . In recent years, for competitive reasons, sellers (retailers, wholesalers, and manufacturers) often have provided financing to purchasers of their goods. The purpose is to encourage the sale of the company s product by assuring financing to buyers. 2. Receivables may be sold because they may be the only reasonable source of cash. When credit is tight, companies may not be able to borrow money in the usual credit markets or the cost of borrowing may be prohibitive. 3. A final reason for selling receivables is that billing and collection are often time-consuming and costly. As a result, it is often easier for a retailer to sell the receivables to another party that has expertise in billing and collection matters. National credit card sales: Approximately one billion credit cards are recently in use. A common type of credit card is a national credit card such as Visa and MasterCard. Three parties are involved when national credit cards are used in making retail sales: (1) the credit card issuer, who is independent of the retailer, (2) the retailer, and (3) the customer. A retailer s acceptance of a national credit card is another form of selling factoring the receivable by the retailer.

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There are several advantages of credit cards for the retailer: 1. Issuer does credit investigation of customer. 2. Issuer maintains customer accounts. 3. Issuer undertakes collection process and absorbs any losses. 4. Retailer receives cash more quickly from credit card issuer. In exchange for these advantages, the retailer pays the credit card issuer a fee of 2% to 4% of the invoice price for its services. Sales resulting from the use of national credit cards are considered cash sales by the retailer. Upon receipt of credit card sales slips from a retailer, the bank that issued the card immediately adds the amount to the seller s bank balance. To illustrate, Morgan Marie purchases $1,000 of compact discs for her restaurant from Sondgeroth Music Co., and she charges this amount on her Visa First Bank Card. The service fee that First Bank charges Sondgeroth Music is 3 percent. The entry by Sondgeroth Music to record this transaction is: Cash 970 Service Charge Expense 30 Sales (To record Visa credit card sales)

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Sale of receivables to a factor: A common way to accelerate receivables collection is a sale to a factor. A factor is a finance company or a bank that buys receivables from businesses for a fee and then collects the payments directly from the customers. Factoring arrangements vary widely, but typically the factor charges a commission of 1% to 3% of the amount of receivables purchased.

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Chapter 8 Review
Define receivables. What are the different types of receivables? necessary to have them in different categories? Why is it

Explain how accounts receivable are recognized in the accounts. How are accounts receivable valued on the balance sheet?

What are the two methods used to account for bad debts? Which method is required by GAAP if bad debts are material? How is bad debt estimated when using the allowance method? Prepare journal entries for each method. How is an aging schedule prepared? How is it used?

What is a promissory note? What is the formula for computing interest on notes receivable? Discuss the three issues involved in accounting for notes receivable. Prepare journal entries for note transactions.

Describe the entries to record the disposition of notes receivable. journal entries for a dishonored note.

Prepare the

Explain the statement presentation of receivables.

Describe the principles of sound accounts receivable management. What are the five steps in managing accounts receivable?

Identify and compute ratios to analyze a company's receivables. Explain what the ratios measure and what they tell users of financial statements.

What methods are used to accelerate the receipt of cash from receivables? Why do companies pay fees for this service. Prepare journal entries for credit card sales.

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CHAPTER 9

Reporting and Analyzing Long-Lived Assets


Study Objectives
1. Describe how the cost principle applies to plant assets. 2. Explain the concept of depreciation. 3. Compute periodic depreciation using the straight-line method, and contrast its expense pattern with those of other methods. 4. Describe the procedure for revising periodic depreciation. 5. Explain how to account for the disposal of plant assets. 6. Describe methods for evaluating the use of plant assets. 7. Identify the basic issues related to reporting intangible assets. 8. Indicate how long-lived assets are reported in the financial statements. 9. (Appendix) Compute periodic depreciation using the declining-balance method and the units-of-activity method.

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Chapter Outline

Study Objective 1 - Describe how the Cost Principle Applies to Plant Assets
Plant assets are resources that have physical substance (a definite size and shape), are used in the operations of a business, and are not intended for sale to customers. It is important for companies to (1) keep assets in good operating condition, (2) replace worn-out or outdated assets, and (3) expand its productive assets as needed. The cost principle requires that plant assets be recorded at cost. Cost consists of all expenditures necessary to acquire an asset and make it ready for its intended use. If a cost is not included in a plant asset account, then it must be expensed immediately. Such costs are referred to as revenue expenditures. Costs that are not expensed immediately, but are instead included in a plant asset account are referred to as capital expenditures. Cost is measured by the cash paid in a cash transaction or by the cash equivalent price paid when noncash assets are used in payment. The cash equivalent price is equal to the fair market value of the asset given up or the fair market value of the asset received, whichever is more clearly determinable. Once cost is established, it becomes the basis of accounting for the plant asset over its useful life. Land Land is often used as a building site for a manufacturing plant or office. The cost of land includes: (1) The cash purchase price (2) Closing costs such as title and attorney's fees (3) Real estate brokers commissions (4) Accrued property taxes and other liens on the land assumed by the purchaser All necessary costs incurred in making land ready for its intended use increase (debit) the Land account. Land improvements Land improvements are structural additions made to land such as driveways, parking lots, fences, landscaping, and underground sprinklers. The cost of land improvements includes all expenditures necessary to make the improvements ready for their intended use.

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The cost of a new company parking lot includes the amount paid for paving, fencing, and lighting. The total of all these costs would be debited to Land Improvements. Because land improvements have limited useful lives, their costs are expensed (depreciated) over their useful lives. Buildings Buildings are facilities used in operations, such as stores, offices, factories, warehouses, and airplane hangars. All necessary expenditures relating to the purchase or construction of a building are charged to the building account. When a building is purchased, such costs include the purchase price, closing costs (attorney's fees, title insurance, etc.), and real estate broker's commissions. When a new building is constructed, its cost consists of the contract price plus payments made by the owner for architect's fees, building permits, and excavation costs. The inclusion of interest costs in the cost of a constructed building is limited to those incurred during the construction period. Equipment Equipment includes assets used in operations, such as store check-out counters, office furniture, factory machinery, delivery trucks, and airplanes. The cost of equipment consists of the cash purchase price, sales tax, freight charges, and insurance during transit paid by the purchaser, as well as expenditures required in assembling, installing, and testing the unit. Two criteria apply in determining the cost of equipment: (1) The frequency of cost - one time or recurring (2) The benefit period - the life of the asset or one year. To illustrate, assume that Lenard Company purchases a delivery truck at a cash price of $22,000. Related expenditures are for sales taxes $1,320, painting and lettering $500, motor vehicle license $80, and a three-year accident insurance policy $1,600. The cost of the motor vehicle license is treated as an expense, and the cost of an insurance policy is considered a prepaid asset. Thus the entry to record the purchase of the truck and related expenditures is as follows: Delivery Truck License Expense Prepaid Insurance Cash 23,820 80 1,600 25,500

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To Buy or Lease An alternative to purchasing an asset is leasing. In a lease, a party that owns an asset (the lessor) agrees to allow another party (the lessee) to use the asset for an agreed period of time at an agreed price. Some advantages of leasing an asset versus purchasing it are: (1) reduced risk of obsolescence (2) little or no down payment (3) shared tax advantages (4) assets and liabilities are not reported in operating leases. An operating lease is an arrangement allowing one party (the lessee) to use the asset of another party (the lessor) and is accounted for as a rental. Under a capital lease, for the lessee, long-term lease agreements are accounted for in a way that is very similar to purchases. A capital lease is a long-term agreement allowing one party (the lessee) to use another party s asset (the lessor) and is accounted for as a purchase. The lessee shows the leased item as an asset and the obligation owed to the lessor as a liability on the balance sheet. The lessee depreciates the leased asset.

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Study Objective 2 - Explain the Concept of Depreciation


Depreciation is the process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systemic manner. Such cost allocation is designed to properly match expenses with revenues. Depreciation affects the balance sheet through accumulated depreciation, which is reported as a deduction from plant assets. It effects the income statement through depreciation expense. Depreciation is a process of cost allocation, not a process of asset valuation. The book value cost less accumulated depreciation differ significantly from its market value. Depreciation applies to three classes of plant assets: Land improvements Buildings Equipment Land is not a depreciable asset. The revenue-producing ability of a depreciable asset declines during its useful life because of wear and tear. A decline in revenue-producing ability may also occur because of obsolescence the process by which an asset becomes out of date before it physically wears out. Recognizing depreciation for an asset does not result in the accumulation of cash for replacement of the asset. The balance in the Accumulated Depreciation account represents the total amount of the asset's cost that has been charged to expense to date; it is not a cash fund. Factors in computing depreciation: Cost Plant assets are recorded at cost, in accordance with the cost principle. Useful life an estimate of the expected productive life, also called service life, of the asset. Salvage value an estimate of the asset's value at the end of its useful life. of a plant asset may

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Study Objective 3 - Compute Periodic Depreciation Using the Straight-line Method, and Contrast its Expense Pattern with those of Other Methods
Depreciation is generally computed using one of these three methods: 1. Straight-line 2. Declining-balance 3. Units-of-activity Each of these depreciation methods is acceptable under generally accepted accounting principles. Once a method is chosen, it should be applied consistently over the useful life of the asset. Management selects the method it believes best measures an asset s contribution to revenue over its useful life. Straight-line depreciation is the most widely used method of depreciation. Under the straight-line method, an equal amount of depreciation expense is recorded each year of the asset's useful life. To compute the annual depreciation expense under the straight-line method, divide the depreciable cost (the cost of the asset less its salvage value) by the asset's estimated useful life. The annual rate of depreciation is computed by dividing the years in the life of the asset into 100% or 1. Depreciable cost represents the total amount subject to depreciation and is calculated as the cost of the asset less its salvage value. If an asset is purchased during the year rather than on January 1, the annual depreciation is prorated for the proportion of a year it is used.

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The declining-balance method computes periodic depreciation using a declining book value. This method is called an accelerated depreciation method because it results in more depreciation in the early years of an asset's life and less depreciation in the later years of an asset s life than does the straight-line approach. The declining-balance approach can be applied at different rates, which result in varying speeds of depreciation. A common declining-balance rate is double the straight-line rate. This method is often referred to as the double-declining-balance method. Under the units-of-activity method, the life of an asset is expressed in terms of the total units of production or the use expected from the asset. The units-of-activity method is suited to factory machinery and such items as delivery equipment and airplanes. This method is generally not suitable for such assets as buildings or furniture because activity levels are difficult to measure. Under units-of-activity depreciation, the amount of depreciation is proportional to the activity that took place during that period. Depreciation and Income Taxes The IRS allows corporate taxpayers to deduct depreciation expense when computing taxable income. The IRS does not require the taxpayer to use the same depreciation method on the tax return that is used in preparing financial statements. Many large corporations use straight-line depreciation in their financial statements to maximize net income, and at the same time they use a special accelerateddepreciation method on their tax returns to minimize their income taxes. For tax purposes, taxpayers must use on their tax returns either the straight-line method or a special accelerated-depreciation method called the Modified Accelerated Cost Recovery System (MACRS). The choice of depreciation method must be disclosed in a company's financial statements. The disclosure is found in the notes that accompany the statements.

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Study Objective 4 - Describe the Procedure for Revising Periodic Depreciation Revising Periodic Depreciation
The computation of annual depreciation expense is based on estimates. Therefore, management should periodically review depreciation. If wear and tear or obsolescence indicates that annual depreciation is either inadequate or excessive, the company should change the depreciation expense amount.

When a change in an estimate is required, the change is made in current and future years but not to prior periods. Thus, when a change is made (1) there is no correction of previously recorded depreciation expense, and (2) depreciation expense for current and future years is revised. The rational for this treatment is that continual restatement of prior periods would adversely affect the users confidence in financial statements. Significant changes in estimates must be disclosed in the financial statements. Extending an asset's estimated life reduces depreciation and increases net income for the period.

Expenditures During Useful Life


During the useful life of a plant asset, a company may incur costs for ordinary repairs, additions, and improvements. Ordinary repairs - expenditures to maintain the operating efficiency and expected productive life of the asset. Ordinary repairs are usually small in amount and occur frequently throughout the service life. Examples of ordinary repairs include motor tune-ups and oil changes, the painting of buildings, and the replacing of worn-out gears on factory machinery. Ordinary repairs are debited to Repair (or Maintenance) Expense and are immediately charged against revenues. These costs are revenue expenditures. Additions and improvements - costs incurred to increase the operating efficiency, productive capacity, or expected useful life of the plant asset. They are usually material in amount and occur infrequently during the period of ownership. Additions and improvements are debited to the company's investment in productive facilities and generally increase the company s investment in plant assets. Additions and improvements are capital expenditures. Impairment - a permanent decline in the market value of an asset.

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In order that the asset is not overstated on the books, it is written down to its new market value during the year in which the decline in value occurs. In the past some companies delayed recording losses on impairments until a year when the impact on the company's reported results was minimized. The practice of timing the recognition of gains and losses to achieve certain income results is known as earnings management. Immediate recognition of these write-downs is now required.

Study Objective 5 - Explain How to Account for the Disposal of Plant Assets
Whether a plant asset is sold, exchanged, or retired, the company must determine the book value of the plant asset at the time of disposal. Book value is the difference between the cost of the plant asset and the accumulated depreciation to date. If disposal occurs at any time during the year, the depreciation for the fraction of the year to the date of disposal must be recorded. Book value is eliminated by reducing (debiting) Accumulated Depreciation for the total depreciation associated with that asset and reducing (crediting) the asset account for the cost of the asset. In the sale of an asset, the book value of the asset is compared with the proceeds from the sale. If the proceeds exceed the book value a gain on disposal occurs. The gain is reported in the Other revenues and gains section of the income statement.

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To illustrate a gain on sale of plant assets, assume that on July 1, 2010, Wright Company sells office furniture for $16,000 cash. The office furniture originally cost $60,000 and as of January 1, 2010, had accumulated depreciation of $41,000. Depreciation for the first six months of 2010 is $8,000. Then entries to record depreciation expense and update accumulated depreciation to July 1 and to record the sale and the gain on sale is are as follows: July 1 Depreciation Expense 8,000 Accumulated Depreciation Office Furniture 8,000 (To record depreciation expense for the first six months of 2010) Cash Accumulated Depreciation Office Furniture Office Furniture Gain on Disposal (To record sale of office furniture at a gain) 16,000 49,000 60,000 5,000

July 1

Conversely, if proceeds from the sale are less than the book value a loss on disposal occurs. The loss is reported in the Other expenses and losses section of the income statement. The retirement of an asset is recorded by decreasing Accumulated Depreciation for the full amount of depreciation taken over the life of the asset. The asset account is reduced (credited) for the original cost of the asset. The loss is equal to the asset's book value at the time of retirement.

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Study Objective 6 - Describe Methods for Evaluating the Use of Plant Assets
Two measures by which plant assets are evaluated are: 1. Return on assets - an overall measure of profitability. This ratio is computed by dividing net income by average assets. The return on assets ratio indicates the amount of net income generated by each dollar invested in assets. The higher the return on assets, the more profitable the company. 2. Asset turnover ratio indicates how efficiently a company uses its assets that is how many dollars of sales are generated by each dollar invested in assets. This ratio is computed by dividing net sales by average total assets. When comparing two companies in the same industry, the one with the higher asset turnover ratio is operating more efficiently; it is generating more sales per dollar invested in assets. Profit margin ratio revisited from Chapter 5. This ratio is calculated by dividing net income by net sales. It tells how effective a company is in turning its sales into income that is, how much income is provided by each dollar of sales. The return on assets ratio can be computed from the profit margin ratio and the asset turnover ratio. Profit Margin x Asset Turnover = Return on Assets Where: Profit Margin = Net Income Net Sales Asset Turnover = Net Sales Average Total Assets Return on Assets = Net Income Average Total Assets This relationship has important strategic implications for management. If a company wants to increase its return on assets, it can do so in two ways: 1) by increasing the margin it generates from each dollar of goods that it sells (the profit margin ratio), or 2) by increasing the volume of goods that it sells (the asset turnover).

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Study Objective 7 - Identify the Basic Issues Related to Reporting Intangible Assets
Intangible assets are rights, privileges, and competitive advantages that result from ownership of long-lived assets that do not possess physical substance. Well known intangibles are the patents of Microsoft, the franchises of McDonald's, the trade name iPod by Apple, and Nike's trademark "swoosh." Intangible assets are recorded at cost. Intangibles are categorized as having either a limited life or an indefinite life. The cost of intangible assets with indefinite lives should not be amortized. If an intangible has a limited life, its cost should be allocated over its useful life using a process similar to depreciation. The process of allocating the cost of intangibles is referred to as amortization. To record amortization of an intangible asset, Amortization Expense is increased (debited), and the specific intangible asset is decreased (credited). (Unlike depreciation, no contra account, such as Accumulated Amortization, is usually used.) Intangible assets are typically amortized on a straight-line basis. For example, the legal life of a patent is 20 years. Its cost should be amortized over its 20-year life or its useful life, whichever is shorter. In determining useful life, a company should consider obsolescence, inadequacy, and other factors that may cause a patent or other intangible to become economically ineffective before the end of its legal life. Types of intangible assets: Patent - an exclusive right issued by the United States Patent Office that enables the recipient to manufacture, sell, or otherwise control an invention for a period of 20 years from the date of the grant. The initial cost of a patent is the cash or cash equivalent price paid to acquire the patent. Legal costs of protecting a patent in an infringement suit are added to the Patent account and amortized over the remaining life of the patent. Research and development costs are expenditures that may lead to patents, copyrights, new processes, and new products. There are uncertainties in identifying the extent and timing of the future benefit of these expenditures. As a result, research and development costs are usually recorded as an expense when incurred.

Copyrights are granted by the federal government and give the owner the exclusive right to reproduce and sell an artistic or published work. Copyrights extend for the life of the creator plus 70 years. The cost of a copyright consists 1-90

of the cost of acquiring and defending it. The useful life of a copyright generally is significantly shorter than its legal life.

A trademark or trade name is a word, phrase, jingle, or symbol that distinguishes or identifies a particular enterprise or product. Trade names like Wheaties, Monopoly, Sunkist, Kleenex, Coca-Cola, Big Mac, and Jeep create immediate product identification and generally enhance the sale of the product. The creator or original user may obtain exclusive legal right to the trademark or trade name by registering it with the U.S. Patent Office. The registration provides 20 years' protection and may be renewed indefinitely. Because trademarks and trade names have indefinite lives, they are not amortized. If a company purchases the trademark or trade name, the cost is the purchase price. If the company develops the trademark or trade name itself, the cost includes attorney s fees, registration fees, design costs, successful legal defense costs, and other expenditures directly related to securing it. Franchises and Licenses - A franchise is a contractual agreement under which the franchiser grants the franchisee the right to sell certain products, to render specific services, or to use certain trademarks or trade names, usually within a designated geographic area. Another type of franchise, granted by a government body permits the enterprise to use public property in performing its service (i.e. the use of airwaves for radio or TV broadcasting). Such operating rights are referred to as licenses. When costs can be identified with the acquisition of the franchise or license, an intangible asset should be recognized. Annual payments made under a franchise agreement should be recorded as operating expenses in the period in which they are incurred. In the case of a limited life, the cost of a franchise (or license) should be amortized as an operating expense over its useful life. If the life is indefinite or perpetual, the cost is not amortized. Goodwill represents the value of all favorable attributes that relate to a business enterprise, including exceptional management, desirable location, good customer relations, skilled employees, etc. Goodwill is unique: Unlike other assets such as investments, plant assets and even other intangibles, which can be sold individually in the marketplace, goodwill can be identified only with the business as a whole. Goodwill is recorded only when there is an exchange transaction that involves the purchase of an entire business. When an entire business is purchased, goodwill is the excess of cost over the fair market value of the net assets (assets less liabilities) acquired. Goodwill is not amortized because it is considered to have an indefinite life. However, goodwill must be written down if its value is determined to be permanently impaired.

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Study Objective 8 - Indicate how Long-lived Assets are Reported in the Financial Statements
Plant assets are shown in the financial statements under Property, Plant, and Equipment and intangibles are shown separately under Intangible Assets.

Intangibles do not usually use a contra asset account like the contra asset account Accumulated Depreciation used for plant assets. Instead, amortization of these accounts is recorded as a direct decrease (credit) to the asset account.

Either within the balance sheet or in the notes, there should be disclosure of the balances of the major classes of assets (i.e. land, buildings, equipment) and accumulated depreciation by major classes or in total.

In addition, the depreciation and amortization methods used should be described and the amount of depreciation and amortization expense for the period disclosed.

It is also interesting to examine the statement of cash flows to determine the amount of property, plant, and equipment purchased and the cash received from property, plant, and equipment sold in a given year. The cash flows from purchases and dispositions of property, plant, and equipment are shown in the investing activities section of the statement of cash flows.

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Study Objective 9 - Appendix Compute Periodic Depreciation Using the Declining-Balance Method and the Units-of-Activity Method
The declining-balance method produces a decreasing annual depreciation expense over the useful life of the asset. The method is so named because the computation of periodic depreciation is based on a declining book value (cost less accumulated depreciation) of the asset. Annual depreciation expense is computed by multiplying the book value at the beginning of the year by the declining-balance depreciation rate. The depreciation rate remains constant from year to year, but the book value to which the rate is applied declines each year. Book value in the first year is the cost of the asset and in each subsequent year, book value is the difference between cost and accumulated depreciation at the beginning of the year. Unlike other depreciation methods, salvage value is ignored in determining the amount to which the declining-balance rate is applied. Depreciation stops when the asset s book value equals its expected salvage value. The declining-balance method is compatible with the matching principle. The higher depreciation expense in earlier years is matched with the higher benefits received in these years. Conversely, lower depreciation expense is recognized in later years when the asset s contribution to revenue is less. When an asset is purchased during the year, it is necessary to prorate the declining-balance deprecation in the first year on a time basis. For example, if Bill s Pizzas had purchased the delivery equipment on April 1, 2010, depreciation for 2010 would be $3,900 ($13,000 x 40% x 9/12). The book value for computing depreciation in 2011 becomes $9,100 ($13,000 - $3,900), and the 2011 depreciation is $3,640 ($9,100 x 40%). Under the units-of-activity method, useful life is expressed in terms of the total units of production or use expected from the asset. To use this method, the total units of activity for the entire useful life are estimated and that amount is divided into the depreciable cost to determine the depreciation cost per unit. The depreciation cost per unit is then multiplied by the units of activity during the year to give the annual depreciation for that year. When the productivity of the asset varies significantly from one period to another, the units-of-activity method results in the best matching of expenses with revenues. This method is easy to apply when assets are purchased during the year. In such a case, the productivity of the asset for the partial year is used in computing the depreciation.

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Chapter 9 Review
Why are plant assets listed at cost? What costs are included in the cost of plant assets?

What is depreciation?

Compute periodic depreciation using the straight-line method assuming a cost of $10,000, zero salvage value, and a 5-year useful life. Contrast its expense pattern with that of an accelerated method.

When and how do you revise depreciation? Explain the difference between revenue expenditures and capital expenditures.

What are the ways in which plant assets can be disposed? Explain how to account for the disposal of plant assets.

Describe methods for analyzing a company s use of plant assets.

What are intangible assets and how are they reported?

How are long-lived assets reported on the balance sheet?

Explain how the declining balance method is calculated. What kind of assets is the units-of-activity method of depreciated suited for?

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CHAPTER 10

Reporting and Analyzing Liabilities


Study Objectives
1. Explain a current liability and identify the major types of current liabilities. 2. Describe the accounting for notes payable. 3. Explain the accounting for other current liabilities. 4. Identify the types of bonds. 5. Prepare the entries for the issuance of bonds and interest expense. 6. Describe the entries when bonds are redeemed. 7. Identify the requirements for the financial statement presentation and analysis of liabilities.

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Chapter Outline

Study Objective 1 - Explain a Current Liability and Identify the Major Types of Current Liabilities

Liabilities are defined as creditors' claims on total assets and as existing debts and obligations. These claims, debts, and obligations must be settled or paid at some time in the future by the transfer of assets or services. A current liability is a debt that can reasonably be expected to be paid (1) from existing current assets or through the creation of other current liabilities, and (2) within one year or the operating cycle, whichever is longer. Debts that do not meet both of these criteria are classified as long-term liabilities. The different types of current liabilities include notes payable, accounts payable, unearned revenues, and accrued liabilities such as taxes, salaries and wages, and interest.

Study Objective 2 - Describe the Accounting for Notes Payable

Obligations in the form of written notes are recorded as notes payable. Notes payable are often used instead of accounts payable because they give the lender written documentation of the obligation in case legal remedies are needed to collect the debt. usually require the borrower to pay interest and frequently are issued to meet short-term financing needs. are issued for varying periods of time. Notes due for payment within one year of the balance sheet date are generally classified as current liabilities.

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Study Objective 3 - Explain the Accounting for Other Current Liabilities

Sales taxes payable - Sales taxes are expressed as a percentage of the sales price. The seller collects the sales tax from the customer when the sale occurs and remits the tax collected to the state's department of revenue periodically (usually monthly). Most states require that the sales tax collected be rung up separately on the cash register. (Gasoline sales are a major exception.) When sales taxes are not rung up separately on the cash register, total receipts are divided by 100% plus the sales tax percentage to determine sales. Unearned revenues Companies such as magazine publishers and airlines typically receive cash before goods are delivered or services are rendered. The companies account for these unearned revenues as follows: When the advance is received, both Cash and a current liability account identifying the source of the unearned revenue are increased. When the revenue is earned, the unearned revenue account is decreased (debited) and an earned revenue account is increased (credited).

Current maturities of long-term debt - The current portion of a long-term debt should be included in current liabilities. Current maturities of long-term debt are frequently identified in the current liabilities portion of the balance sheet as long-term debt due within one year. It is not necessary to prepare an adjusting entry to recognize the current maturity of long-term debt. Payroll and payroll taxes payable - Every employer incurs liabilities relating to employees' salaries and wages. One is the amount of salaries and wages owed to employees Salaries and Wages Payable. Another is the withholding taxes Federal and State Income Taxes Payable and FICA Taxes Payable, required by law to be withheld from employees' gross pay. Until the withholding taxes are remitted to the government taxing authorities, they are carried as current liabilities. Employers also incur a second type of payroll-related liability. With every payroll, the employer incurs various payroll taxes levied upon the employer. These payroll taxes include the employer s share of Social Security (FICA) taxes and state and federal unemployment taxes.

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Study Objective 4 - Identify the Types of Bonds


Long-term liabilities are obligations that are expected to be paid more than one year in the future and are often in the form of bonds or long-term notes. Bonds are a form of interest-bearing notes payable issued by corporations, universities, and governmental agencies. Bonds, like common stock, are sold in small denominations (usually $1,000 or multiples of $1,000). Secured bonds have specific assets of the issuer pledged as collateral for the bonds. Unsecured bonds are issued against the general credit of the borrower. Convertible bonds can be converted into common stock at the bondholder s option. The conversion often gives bondholders an opportunity to benefit if the market price of the common stock increases substantially. For the issuer, the bonds sell at a higher price and pay a lower rate of interest than comparable debt securities that do not have a conversion option. Callable bonds are subject to retirement at a stated dollar amount prior to maturity at the option of the issuer. Issuing procedures: A bond certificate is issued to the investor to provide evidence of the investor s claim against the company. The face value is the amount of principal due at the maturity date. The maturity date is the date that the final payment is due to the bond holder from the issuing company. The contractual interest rate, often referred to as the stated rate, is the rate used to determine the amount of cash interest the borrower pays and the bond holder receives. The contractual interest rate is generally stated as an annual rate and interest is usually paid semiannually. Determining the Market Value of Bonds The term time value of money is used to indicate the relationship between time and money; in other words, that a dollar received today is worth more than a dollar promised at some time in the future. If someone is going to give you $1 million 20 years from now, you would want to find its equivalent today or its present value.

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The current market value (present value) of a bond is a function of three factors: The dollar amounts to be received in the future. Length of time until the amounts are received. The market rate of interest. The market interest rate is the rate investors demand for loaning funds to the corporation. The process of finding the present value is referred to as discounting the future amounts.

Study Objective 5 Interest Expense

Prepare the Entries for the Issuance of Bonds and

A corporation records bond transactions when it issues or retires (buys back) bonds, and when bondholders convert bonds into common stock. If a bondholder sells a bond to another investor, the issuing firm receives no further money on the transaction, nor is the transaction journalized by the issuing corporation. Accounting for Bond issues - Bonds may be issued at face value, below face value (discount), or above face value (premium). Bond prices, for both new issues and existing bonds, are quoted as a percentage of the face value of the bond. Thus, a $1,000 bond with a quoted price of 97 sells at a price of ($1,000 X 97%) $970. Issuing Bonds at Face Value To illustrate, assume that Devor Corporation issued 100, 5-year, 10%, $1,000 bonds dated January 1, 2010, at 100 (100% of face value). Assume interest is payable annually on January 1. The entry to record the sale is: Jan. 1 Cash 100,000 Bonds Payable (To record sale of bonds at face value)

100,000

The bonds are reported in the long-term liability section of the balance sheet because the maturity date is more than one year away. The adjusting entry to record the accrued interest on December 31 is: Dec. 3l Bond Interest Expense Bond Interest Payable (To accrue bond interest) 10,000 10,000

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Bond interest payable is classified as a current liability because it is scheduled for payment within the next year. The entry to record the payment on January 1: Jan. 1 Bond Interest Payable 10,000 Cash (To record payment of bond interest)

10,000

Discount or Premium on Bonds The contractual or stated interest rate is the rate applied to the face (par) to arrive at the amount of interest paid in a year. The market (effective) interest rate is the rate investors demand for loaning funds to the corporation. Bonds sell at face or par value only when the contractual (stated) interest rate and the market interest rate are the same. However, the market rates change daily. When the contractual and market interest rates differ, bonds sell below or above face value. Issuing Bonds at a Discount If the contractual interest rate is less than the market rate, bonds sell at a discount or at a price less than 100% of face value. Although Discount on Bonds Payable has a debit balance, it is not an asset; it is a contra account, which is deducted from bonds payable on the balance sheet. To illustrate bonds sold at a discount, assume that on January 1, 2010, Candlestick, Inc., sells $100,000, 5-year, 10% bonds at 98 (98% of face value) with interest payable on January 1. The entry to record the issuance is: Jan. 1 Cash 98,000 Discount on Bonds Payable 2,000 Bonds Payable (To record sale of bonds at a discount)

100,000

The $98,000 represents the carrying amount of the bonds. The issuance of bonds below face value causes the total cost of borrowing to differ from the bond interest paid. The difference between the issuance price and the face value of the bonds the discount represents an additional cost of borrowing and should be recorded as bond interest expense over the life of the bond.

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The total cost of borrowing $98,000 for Candlestick, Inc. is $52,000 computed as follows: Annual interest payments ($100,000 x 10% = $10,000; $10,000 x 5) Add: Bond discount ($100,000 - $98,000) Total cost of borrowing

$50,000 2,000 $52,000

To follow the matching principle, bond discount is allocated to expense in each period in which the bonds are outstanding. This is referred to as amortizing the discount. Amortization of the discount increases the amount of interest expense reported each period. As the discount is amortized, its balance will decline and as a consequence, the carrying value of the bonds will increase, until at maturity the carrying value of the bonds equals their face amount. Issuing Bonds at a Premium If the contractual interest rate is greater than the market rate, bonds sell at a premium or at a price greater than 100% of face value. To illustrate bonds sold at a premium, assume the Candlestick, Inc. bonds described before are sold at 102 (102% of face value) rather than 98. The entry to record the sale is: Jan 1 Cash 102,000 Bonds Payable Premium on Bonds Payable (To record sale of bonds at a premium)

100,000 2,000

The premium on bonds payable is added to bonds payable on the balance sheet, as shown below: Long-term liabilities Bonds payable $100,000 Add: Premium on bonds payable 2,000 $102,000 The sale of bonds above face value causes the total cost of borrowings to be less than the bond interest paid because the borrower is not required to pay the bond premium at the maturity date of the bonds. Thus, the premium is considered to be a reduction in the cost of borrowing that reduces bond interest expense over the life of the bonds.

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A bond premium, like a bond discount, is allocated to expense in each period in which the bonds are outstanding. This is referred to as amortizing the premium. Amortization of the premium decreases the amount of interest expense reported each period. That is, the amount of interest expense reported in a period will be less than the contractual amount. As the premium is amortized, its balance will decline and as a consequence, the carrying value of the bonds will decrease, until at maturity the carrying value of the bonds equals their face amount.

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Study Objective 6 - Describe the Entries when Bonds are Redeemed


Bonds are retired when they are purchased (redeemed) by the issuing corporation. Redeeming Bonds at Maturity Regardless of the issue price of bonds, the book value of the bonds at maturity will equal their face value. Assuming that the interest for the last interest period is paid and recorded separately, the interest to record the redemption of the Candlestick bonds at maturity is: Bonds Payable 100,000 Cash (To record redemption of bonds at maturity)

100,000

Redeeming Bonds before Maturity A company may decide to retire bonds before maturity to reduce interest cost and remove debt from its balance sheet. A company should retire debt early only if it has sufficient cash resources. When bonds are retired before maturity, it is necessary to: (1) eliminate the carrying value of the bonds at the redemption date, (2) record the cash paid, and (3) recognize the gain or loss on redemption. The carrying value is the face value of the bonds less unamortized bond discount or plus unamortized bond premium at the redemption date. Assume at the end of the fourth period Candlestick, inc., having sold its bonds at a premium, retires its bonds at 103 after paying the annual interest. The carrying value of the bonds at the redemption date is $100,400. The entry to record the redemption of Candlestick's bonds at the end of the fourth interest period (January 1, 2014) is: Jan. 1 Bonds Payable 100,000 Premium on Bonds Payable 400 Loss on Bond Redemption 2,600 Cash (To record redemption of bonds at 103)

103,000

The loss of $2,600 is the difference between the cash paid of $103,000 and the carrying value, $100,400.

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Study Objective 7 - Identify the Requirements for the Financial Statement Presentation and Analysis of Liabilities
Balance Sheet Presentation Current liabilities are the first category under Liabilities on the balance sheet. Each of the principal types of current liabilities is listed separately within the category. Within the current liabilities section, companies usually list notes payable first, followed by accounts payable. Other items then follow in the order of their magnitude. The current maturities of long-term debt should be reported as current liabilities if they are to be paid from current assets. Long-term liabilities are reported in a separate section of the balance sheet immediately following Current Liabilities. Disclosure of debts is very important. Summary data regarding debts may be presented in the balance sheet with detailed data (such as interest rates, maturity dates, conversion privileges, and assets pledged as collateral) shown in a supporting schedule in the notes. Statement of Cash Flows Presentation Information regarding cash inflows and outflows that resulted from the principal portion of debt transactions is provided in the Financing activities section of the statement of cash flows. Interest expense is reported in the Operating activities section, even though it resulted from debt transactions. Analysis Careful examination of debt obligations helps assess a company s ability to pay its current and long-term obligations. It also helps to determine whether a company can obtain debt financing in order to grow. Liquidity ratios measure the short-term ability of a company to pay its maturing obligations and to meet unexpected needs for cash. A commonly used measure of liquidity is the current ratio (presented in Chapter 2), calculated as current assets divided by current liabilities. In recent years many companies have intentionally reduced their liquid assets (such as cash, accounts receivable, and inventory) because they cost too much to hold. Companies that keep fewer liquid assets on hand must rely on other sources of liquidity. One such source is a bank line of credit a prearranged agreement between a company and a lender that permits the company to borrow up to an agreed-upon amount. Solvency ratios measure the ability of a company to survive over a long period of time. Although at one time there were many U. S. automobile manufacturers, only three U.S. based firms survive today. Many of the others went bankrupt. To 1-104

reduce risks associated with having a large amount of debt during an economic downturn, U.S. automobile manufacturers have taken two precautionary steps. 1. They have built up large balances of cash and cash equivalents to avoid a cash crisis. 2. They have been reluctant to build new plants or hire new workers to meet their production needs. Instead, they have asked existing workers to work overtime, or they outsource work to other companies. One measure of a company solvency is the debt to total assets ratio (Chapter 2), calculated as total liabilities divided by total assets. This ratio indicates the extent to which a company s debt could be repaid by liquidating its assets. Another useful measure is the times interest earned ratio, which provides an indication of a company s ability to meet interest payments as they come due, computed by dividing income before interest expense and income taxes by interest expense. Off-Balance-Sheet Financing A concern for analysts when they evaluate a company s liquidity and solvency is whether that company has properly recorded all of its obligations. The bankruptcy of Enron Corporation, one of the largest bankruptcies in U.S. history, demonstrates how much damage can result when a company does not properly record or disclose all of its obligations. A company s balance sheet may not fully reflect its actual obligations due to offbalance-sheet financing an intentional effort by a company to structure its financing arrangements, in order to avoid showing liabilities on its balance sheet. Two common types of off-balance-sheet financing result from contingencies and lease transactions.

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Contingencies A company s balance sheet may not fully reflect its potential obligations due to contingencies events with uncertain outcomes that represent liabilities. Accounting rules require that companies disclose contingencies in the notes; in some cases they must accrue them as liabilities. A lawsuit is an example of a contingent liability. If the company can determine a reasonable estimate of the expected loss and if it is probable it will lose a lawsuit, the company should accrue for the loss. The loss is recorded by increasing (debiting) a loss account and increasing (crediting) a liability such as Lawsuit Liability. If both conditions are not met, the company discloses the basic facts regarding the suit in the footnotes to its financial statements. Leasing One very common type of off-balance-sheet financing results from lease transactions. In an operating lease the intent is temporary use of the property by the lessee with continued ownership of the property by the lessor. In some cases, the lease contract transfers substantially all of the benefits and risks of ownership to the lessee, so that the lease is in effect, a purchase of the property. This type of lease is called a capital lease. Most lessees do not like to report leases on their balance sheets because the lease liability increases the company's total liabilities. Companies attempt to keep leased assets and lease liabilities off the balance sheet by structuring the lease agreement to avoid meeting the criteria of a capital lease. Critics of off-balance-sheet financing contend that many leases represent unavoidable obligations that meet the definition of a liability, and therefore companies should report them as liabilities on the balance sheet. To reduce these concerns, companies are required to report in a note their operating lease obligations for subsequent years. This allows analysts and other financial statement users to adjust a company s financial statements by adding leased assets and lease liabilities if they feel that this treatment is more appropriate.

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Chapter 10 Review

Explain to someone who knows very little about accounting what a current liability is and illustrate by identifying major types of current liabilities.

Describe the accounting for an interest-bearing note at its inception, at year-end, and at maturity.

How do you account for unearned revenues?

Why are bonds issued? What are the different types of bonds a company or municipality can issue?

Describe the entries for the issuance of bonds issued at a discount.

What entries are necessary when bonds are redeemed?

In what sections of the statement of cash flows would a financial statement user obtain information related to the cash inflows and outflows related to debt transactions?

Define contingencies and discuss the accounting treatment for contingencies. How do leases affect the balance sheet?

Which method of amortization results in a constant amount of amortization and interest expense per period?

Which method of amortization results in a constant percentage rate of interest?

What two components make up each payment on a long-term notes payable? 1-107

CHAPTER 11

Reporting and Analyzing Stockholders Equity


Study Objectives
1. Identify and discuss the major characteristics of a corporation. 2. Record the issuance of common stock. 3. Explain the accounting for the purchase of treasury stock. 4. Differentiate preferred stock from common stock. 5. Prepare the entries for cash dividends and understand the effect of stock dividends and stock splits. 6. Identify the items that affect retained earnings. 7. Prepare a comprehensive stockholders' equity section. 8. Evaluate a corporation's dividend and earnings performance from a stockholder's perspective. 9. (Appendix) Prepare entries for stock dividends.

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Chapter Outline

Study Objective 1 - Identify and Discuss the Major Characteristics of a Corporation


A corporation is: A legal entity. Created by law. Enjoys most of the rights and privileges of a person. May be classified by purpose and by ownership. A corporation may be organized for the purpose of making a profit (such as Nike or General Motors) or it may be a nonprofit charitable, medical, or educational corporation (such as the Salvation Army or the American Cancer Society). Classification by ownership differentiates publicly held or privately held corporations. A publicly held corporation is regularly traded on a national securities market and may have thousands of stockholders. A privately held corporation, often referred to as a closely held corporation, does not offer its stock for sale to the general public and may have only a few stockholders. Characteristics Of A Corporation Several characteristics distinguish corporations from proprietorships and partnerships. Separate legal existence: An entity separate and distinct from owners. Acts under its own name rather than name of stockholders. May buy, own, and sell property; borrow money; and enter into legally binding contracts; may sue or be sued; and pays its own taxes. The acts of owners (stockholders) cannot bind the corporation unless owners are agents of the corporation. Limited liability of stockholders: Creditors ordinarily have recourse only to corporate assets to satisfy their claims. Liability of stockholders is normally limited to investment in corporation. Creditors have no legal claim on personal assets of owners unless fraud has occurred. In the event of bankruptcy of the corporation, stockholders losses are generally limited to the amount of capital they have invested in the corporation. Transferable ownership rights: Ownership is evidenced by shares of capital stock, which are transferable units.

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The transfer of stock is at the discretion of the stockholder; it does not require the approval of either the corporation or other stockholders. Transfer of ownership rights among stockholders has no effect on operating activities of the corporation; nor does if affect the corporation's assets, liabilities and total stockholders' equity. The corporation does not participate in transfer of ownership rights after original sale of capital stock. Ability to acquire capital: It is relatively easy for a corporation to obtain capital through the issuance of stock. Buying stock in a corporation is often attractive to an investor because a stockholder has limited liability and shares of stock are readily transferable. Numerous individuals can become stockholders by investing small amounts of money.

Continuous life: The life of a corporation is stated in its charter. It may be perpetual or limited to a specific number of years. If limited, its period of existence can be extended through renewal of the charter. Since a corporation is a separate legal entity, continuance as a going concern is not affected by withdrawal, death, or incapacity of a stockholder, employee, or officer. Corporation management: Stockholders manage the corporation indirectly through a board of directors, which they elect. The board of directors formulates operating policies and selects officers to execute policy and to perform daily management functions. As a result of the Sarbanes-Oxley Act (SOX), the board is now required to monitor management s actions more closely. The president is the chief executive officer (CEO) and has overall responsibility for managing the business. The chief accounting officer is the controller. The controller s responsibilities include (1) maintaining the accounting records, (2) maintaining an adequate system of internal control and (3) preparing financial statements, tax returns, and internal reports. The treasurer has custody of the corporation s funds and is responsible for maintaining the company s cash position. The organizational structure of a corporation enables a company to hire professional managers to run the business. On the other hand, the separation of ownership and management prevents owners from playing an active role in managing the company, which some owners prefer.

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Government Regulations: A corporation is subject to state and federal regulations. State laws prescribe: the requirements for issuing stock, the distribution of earnings permitted to stockholders, and acceptable methods of retiring stock. Federal securities laws govern: the sale of capital stock to the general public; disclosure of financial affairs to the Securities and Exchange Commission through quarterly and annual reports (if publicly traded) [Additionally, the Sarbanes-Oxley Act (SOX) increased the company s responsibility for the accuracy of these reports.]; and reporting requirements needed for the various securities markets.

Additional Taxes: Corporations, as separate legal entities, must pay federal and state income taxes. Stockholders must pay taxes on cash dividends. Thus, it may be argued that corporate income is taxed twice, once at the corporate level and again at the individual level (double taxation). Advantages of a corporation: Separate legal existence. Limited liability of stockholders. Transferable ownership rights. Ability to acquire capital. Continuous life. Corporation management professional managers. Disadvantages of a corporation: Corporation management separation of ownership and management. Government regulations. Additional taxes.

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Other Forms of Business Organization A variety of hybrid organizational forms forms that combine different attributes of partnerships and corporations now exist. Some examples include: S Corporations, limited partnerships, limited liability partnerships (LLPs), and limited liability corporations (LLCs).

Forming a corporation: A corporation is formed by grant of a state charter. Although a corporation may have operating divisions in a number of states, it is incorporated in only one state. Some states have laws favorable to the corporate form of business organization. (i.e. In the state of Delaware defense tactics against takeovers can be approved by the board of directors without a vote by shareholders.) Upon receipt of its charter, the corporation establishes by-laws. The by-laws establish the internal rules and procedures for conducting the affairs of the corporation. A corporation must obtain a license from each state in which it does business. This license subjects the corporation's operating activities to the general corporation laws of the state. Stockholder rights: Once it is chartered, the corporation sells ownership rights in the form of shares of stock. When a corporation has only one class of stock, it is common stock. Ownership rights are specified in the articles of incorporation or in the by-laws. Proof of stock ownership is evidenced by a printed or engraved form known as a stock certificate. The stock certificate shows the name of the corporation, the stockholder's name, the class and special features of the stock, the number of shares owned, and the signatures of duly authorized corporate officials. Stock certificates are prenumbered to facilitate accountability. Stockholders have the right to: Vote in election of board of directors at annual meeting and vote on actions that require stockholder approval. Share the corporate earnings through receipt of dividends. Keep the same percentage ownership when new shares of stock are issued (preemptive right). Share in assets upon liquidation in proportion to their holdings. This is called a residual claim because owners are paid with assets that remain after all claims have been paid.

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Stock issue considerations: When a corporation decides to issue stock it must answer the following questions: How many shares should be authorized for sale? How should the stock be issued? What value should be assigned to the shares? Authorized stock: The amount of stock a corporation is authorized to sell is indicated in the corporate charter. If all authorized stock is sold, a corporation must obtain consent of the state to amend its charter before issuing additional shares. The authorization of common stock does not result in a formal accounting entry because the event has no immediate effect on either corporate assets or stockholders' equity. Disclosure of the number of shares authorized is required in the stockholders' equity section of the balance sheet. Issuance of stock: A corporation has the option of issuing common stock directly to investors or indirectly through an investment banking firm that specializes in bringing securities to the attention of prospective investors. Direct issue is typical in closely held companies. Indirect issue is customary for publicly held companies. New issues of stock may be offered for sale to the public through various organized U.S. securities exchanges: the New York Stock Exchange, the American Stock Exchange, and 13 regional exchanges. Stock may also be traded on the NASDAQ national market. Par and no-par value stocks: Par value stock is capital stock that has been assigned a value per share in the corporate charter. Years ago, par value was used to determine the legal capital per share that must be retained in the business for the protection of corporate creditors. It is the amount that is not available for withdrawal by stockholders. Because par value has no relationship with market value and in most cases it is an immaterial amount, today many states do not require a par value. No-par value stock is capital stock that has not been assigned a value per share in the corporate charter. It is quite common today. In many states the board of directors is permitted to assign a stated value to the no-par shares, which then becomes the legal capital per share.

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Study Objective 2 - Record the Issuance of Common Stock


The stockholders equity section of a corporation s balance sheet includes paidin (contributed) capital and retained earnings (earned capital). The distinction between paid-in capital and retained earnings is important from a legal and an economic point of view. Paid-in capital is the amount paid in to the corporation by stockholders in exchange for shares of ownership. Retained earnings is earned capital held for future use in the business. The primary objectives in accounting for the issuance of common stock are to (1) identify the specific sources of paid-in capital and (2) maintain the distinction between paid-in capital and retained earnings. The issuance of common stock affects only paid-in capital accounts. When the issuance of common stock for cash is recorded, the par value of the shares is credited to Common Stock, and the portion of the proceeds that is above or below par value is recorded in a separate paid-in capital account. Assume Hydro-Slide, Inc., issues 1,000 shares of $1 par value common stock at par for cash. The entry to record the transaction is: Cash 1,000

Common Stock 1,000 (To record issuance of 1,000 shares of $1 par common stock at par) If Hydro-Slide, Inc., issues an additional 1,000 shares of the $1 par value common stock for cash at $5 per share, the entry is: Cash 5,000

Common Stock 1,000 Paid-in Capital in Excess of Par Value 4,000 (To record issuance of 1,000 shares of common stock in excess of par) The total paid-in capital from these two transactions is $6,000.

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Assuming Hydro-Slide, Inc., has retained earnings of $27,000, the stockholders' equity section of the balance sheet would be: HYDRO-SLIDE, INC. Balance Sheet (partial) Stockholders' equity Paid-in capital Common stock Paid-in capital in excess of par value Total paid-in capital Retained earnings Total stockholders' equity

$2,000 4,000 6,000 27,000 $33,000

If, in the previous example, the stock had been no-par stock with a stated value of $1, the entries would be the same as those for the par stock except the term Par Value would be replaced with Stated Value. If the company issues no-par stock that does not have a stated value, the full amount received is credited to the Common Stock account and there is no need for the Paid-in Capital in Excess of Stated Value account.

Study Objective 3 - Explain the Accounting for the Purchase of Treasury Stock
Treasury stock is a corporation's own stock that has been issued, fully paid for, reacquired by the corporation and held in its treasury for future use. A corporation may acquire treasury stock to meet the following objectives: 1. To reissue the shares to officers and employees under bonus and stock compensation plans. 2. To increase trading of the company's stock in the securities market in the hopes of enhancing its market value by signaling that management believes the stock is underpriced. 3. To have additional shares available for use in the acquisition of other companies. 4. To reduce the number of shares outstanding and thereby increase earnings per share. Treasury stock may be purchased if management is trying to eliminate hostile shareholders by buying them out. The purchase of treasury stock is generally accounted for by the cost method. With the cost method the Treasury Stock is maintained at the cost of the shares purchased. Under the cost method Treasury Stock is increased (debited) by the price paid to reacquire the shares. Treasury Stock decreases by the same amount when the shares are later sold.

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To illustrate, assume on January 1, 2010, the stockholders' equity section for Mead, Inc., has 100,000 shares of $5 par value common stock outstanding (all issued at par value) and Retained Earnings of $200,000. The stockholders' equity section of the balance sheet before purchase of treasury stock is shown as follows: MEAD, INC. Balance Sheet (partial) Stockholders' equity Paid-in capital Common stock, $5 par value, 400,000 shares authorized, 100,000 shares issued and outstanding Retained earnings Total stockholders' equity

$500,000 200,000 $700,000

On February 1, 2010, Mead acquires 4,000 shares of its own stock at $8 per share. The entry is: Feb 1. Treasury Stock 32,000 Cash 32,000 (To record purchase of 4,000 shares of treasury stock at $8 per share) The Treasury Stock account would increase by the cost of the shares purchased ($32,000). The original paid-in capital account, Common Stock, would not be affected because the number of issued shares does not change. Treasury stock is deducted from total paid-in capital and retained earnings in the stockholders' equity section of the balance sheet as follows: MEAD, INC. Balance Sheet (partial) Stockholders' equity Paid-in capital Common stock, $5 par value, 400,000 shares authorized, 100,000 shares issued and 96,000 shares outstanding Retained earnings Total paid-in capital and retained earnings Less: Treasury stock (4,000 shares) Total stockholders' equity

$500,000 200,000 $700,000 32,000 $668,000

Both the number of shares issued (100,000) and the number in the treasury (4,000) are disclosed. The difference is the number of shares of stock outstanding (96,000). The term outstanding stock means the number of shares of issued stock that are being held by stockholders.

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Study Objective 4 - Differentiate Preferred Stock from Common Stock


Preferred stock has contractual provisions that give it preference or priority over common stock. Preferred stockholders have a priority in relation to: (1) dividends and (2) assets in the event of liquidation. Preferred stockholders sometimes do not have voting rights. When a corporation has more than one class of stock, each paid-in capital account title should identify the stock to which it relates. For example, assume Stine Corporation issues 10,000 shares of $10 par value preferred stock for $12 cash per share. The entry to record the issuance is: Cash 120,000

Preferred Stock 100,000 Paid-in Capital in Excess of Par Value Preferred Stock 20,000 (To record issuance of 10,000 shares of $10 par value preferred stock) Preferred stock may have either a par value or no-par value. In the stockholders equity section of the balance sheet, companies show preferred stock first because of its dividend and liquidation preferences over common stock. Dividend Preferences Preferred stockholders have the right to share in the distribution of corporate income before common stockholders. If the dividend rate of preferred stock is $5 per share, common shareholders will not receive any dividends in the current year until preferred stockholders have received $5 per share. The first claim to dividends does not guarantee dividends. Dividends depend on factors such as adequate retained earnings and availability of cash. For preferred stock, the per share dividend amount is stated as a percentage of the stock or as a specified amount. For example, EarthLink specifies a 3% dividend, whereas Nike pays 10 cents per share on its $1 par preferred stock. Cumulative Dividends Preferred stock contracts often contain a cumulative dividend feature. If preferred stock is cumulative, preferred stockholders must be paid both current-year dividends and any unpaid prior-year dividends before common stockholders receive dividends. When preferred stock is cumulative, preferred dividends not declared in a given period are called dividends in arrears. To illustrate dividends in arrears, assume that Scientific Leasing has 5,000 shares of 7%, $100 par value cumulative preferred stock outstanding. The annual dividend is 1-117

$35,000 (5,000 shares x $100 per share X 7%). If dividends are two years in arrears, preferred stockholders are entitled to receive dividends of $105,000 shown below before any distribution may be made to common stockholders. Dividends in arrears ($35,000 x 2 years) Current-year dividends Total preferred dividends $ 70,000 35,000 $105,000

Dividends in arrears are not a liability because no obligation exists until the board of directors declares a dividend. The amount of dividends in arrears should be disclosed in the notes to the financial statements. Liquidation preference Most preferred stocks have a preference on corporate assets if the corporation fails. The preference to assets may be for the par value of the shares or for a specified liquidating value.

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Study Objective 5 - Prepare the Entries for Cash Dividends and Understand the Effect of Stock Dividends and Stock Splits
A dividend is a distribution by a corporation to its stockholders on a pro rata basis. Pro rata means that if you own 10% of the common shares, you will receive 10% of the dividend. Dividends can take four forms: cash, property, scrip (promissory note to pay cash), or stock. Cash dividends, which predominate in practice, and stock dividends, which are declared with some frequency, are both discussed in this chapter. Dividends are generally reported quarterly as a dollar amount per share, although sometimes they are reported on an annual basis. Cash Dividends A cash dividend is a pro rata (or proportional to ownership) distribution of cash to stockholders. For a corporation to pay a cash dividend, it must have the following: 1. Retained earnings. In many states, payment of dividends from legal capital is prohibited. Payment of dividends from paid-in capital in excess of par is legal in some states. Payment of dividends from retained earnings is legal in all states. Companies are frequently constrained by agreements with lenders to pay dividends only from retained earnings. 2. Adequate cash to pay a dividend. 3. Declared dividends. The board of directors has full authority to determine the amount of income to be distributed in the form of dividends and the amount to be retained in the business. Dividends do not accrue, and they are not a liability until they are declared. The amount and timing of a dividend are important issues for management to consider. The payment of a large cash dividend could lead to liquidity problems. A small dividend or a missed dividend may cause unhappiness among stockholders who expect to receive a reasonable cash payment from the company on a periodic basis. In order to remain in business, companies must honor their interest payments to creditors. But the payment of dividends to stockholders is another matter. Entries for cash dividends - Three dates are important in connection with dividends: 1) The declaration date: 1-119

The declaration date is the date the board of directors formally authorizes the cash dividend and announces it to stockholders. The declaration of a cash dividend commits the corporation to a binding legal obligation. An entry is required to recognize the increase in Cash Dividends and the increase in the liability account, Dividends Payable. Assume that on December 1, 2010, the directors of Media General declare a $0.50 per share cash dividend on 100,000 shares of $10 par value common stock. The dividend is $50,000 (100,000 x $0.50), and the entry to record the declaration is: Declaration Date Dec. 1. Retained Earnings (or Cash Dividends Declared) Dividends Payable (To record declaration of cash dividend) 2) The record date: The record date marks the time when ownership of the outstanding shares is determined for dividend purposes. It is important in determining the dividend to be paid to each stockholder but not the total dividend. For Media General, the record date is December 22. No entry is required on the record date. Record Date No entry necessary

50,000 50,000

Dec. 22

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3) The payment date: On the payment date, dividend checks are mailed to the stockholders (as of the record date) and the payment of the dividend is recorded. If January 20 is the payment date for Media General, the entry on that date is: Payment Date Jan. 20 Dividends Payable Cash (To record payment of cash dividend) 50,000 50,000

Note that the payment of the dividend reduces both current assets and current liabilities, but it has no effect on stockholders equity. The cumulative effect of the declaration and payment of a cash dividend on a company s financial statements is to decrease both stockholders equity and total assets. Stock Dividends A stock dividend is a pro rata distribution of the corporation's own stock to stockholders. Whereas a cash dividend is paid in cash, a stock dividend is paid in stock. A stock dividend results in a decrease in retained earnings and an increase in paid-in capital. Unlike a cash dividend, a stock dividend does not decrease total stockholders' equity or total assets. Stock dividends are often issued by companies that do not have adequate cash to issue a cash dividend. To illustrate a stock dividend, assume that you have a 2% ownership interest in Cetus Inc., owning 20 of its 1,000 shares of common stock. In a 10% stock dividend, 100 shares (1,000 x 10%) of stock would be issued. You would receive two shares (2% x 100), but your ownership interest would remain at 2% (22 1,100). You now own more shares of stock, but your ownership interest has not changed. Corporations issue stock dividends for the following reasons: 1. To satisfy stockholders' dividend expectations without spending cash. 2. To increase the marketability of its stock by increasing the number of shares outstanding and thereby decreasing the market price per share. Decreasing the market price of the stock makes it easier for smaller investors to purchase the shares. 3. To emphasize that a portion of stockholders' equity has been permanently reinvested in the business and therefore is unavailable for cash dividends.

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The accounting profession distinguishes between a small stock dividend and a large stock dividend. o A small stock dividend (less than 20%-25% of the corporation's issued stock) is recorded at the fair market value per share. Small stock dividends predominate in practice. o A large stock dividend (greater than 20%-25% of the corporation's issued stock) is recorded at par or stated value per share. Effects of Stock Dividends Stock dividends change the composition of stockholders equity because a portion of retained earnings is transferred to paid-in capital. However total stockholders equity remains the same. Assume Medland Corp. declares a 10% stock dividend on its $10 par common stock when 50,000 shares were outstanding. The market price was $15 per share. Before Dividend Stockholders equity Paid-in capital Common stock, $10 par Paid-in capital in excess of par value Total paid-in capital Retained earnings Total stockholders equity Outstanding shares After Dividend

$500,000 500,000 300,000 $800,000 50,000

$550,000 25,000 575,000 225,000 $800,000 55,000

Total paid-in capital increased by $75,000 and retained earnings decreased by the same amount. Total stockholders equity remains unchanged.

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Stock Splits A stock split is very much like a stock dividend in that it involves the issuance of additional shares of stock to stockholders according to their percentage ownership. However, a stock split results in a reduction in the par or stated value per share. The purpose of stock split is to increase the marketability of the stock by lowering its market value per share, making it easier for the corporation to issue additional shares of stock. In a stock split, the number of shares is increased in the same proportion that the par or stated value per share is decreased. (i.e. in a 2-for-1 split, one share of $10 par value stock is exchanged for two shares of $5 par value stock.) A stock split does not have any effect on total paid-in capital, retained earnings, and total stockholders' equity. With a stock split the number of shares outstanding increases. Assume that instead of issuing a 10% stock dividend Medland splits its 50,000 shares of common stock on a 2-for-1 basis. The effects of Medland's stock dividend are shown as follows: Before Stock Split Stockholders equity Paid-in capital Common stock Paid-in capital in excess of par value Total paid-in capital Retained earnings Total stockholders equity Outstanding shares After Stock Split

$500,000 0 500,000 300,000 $800,000 50,000

$500,000 0 500,000 300,000 $800,000 100,000

Because a stock split does not affect the balances in any stockholders equity accounts, it is not necessary to journalize a stock split. However, a memorandum entry explaining the effect of the split is typically made. Differences between the effects of stock splits and stock dividends are shown: Item Stock Dividend Stock Split Total paid-in capital Increase No change Total retained earnings Decrease No change Total par value (common stock) Increase No change Par value per share No change Decrease

Study Objective 6 - Identify the Items that Affect Retained Earnings

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Retained earnings is net income that is retained in the business. The balance in retained earnings is part of the stockholders' claim on the total assets of the corporation. Retained earnings does not represent a claim on any specific asset. The amount of retained earnings cannot be associated with the balance of any asset account. For example, a $100,000 balance in retained earnings does not mean that there should be $100,000 in cash. In contrast to net income, net losses decrease (are debited to) retained earnings. o Net losses do not decrease (are not debited to) paid-in capital accounts. A debit balance in retained earnings is identified as a deficit and is reported as a deduction in the stockholders' equity section of the balance sheet.

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Retained Earnings Restrictions Although the balance in retained earnings is generally available for dividend declarations, there may be retained earnings restrictions that make a portion of the balance currently unavailable for dividends. o Restrictions may result from one or more of the following causes: legal, contractual, or voluntary. o Retained earnings restrictions are generally disclosed in the notes to the financial statements.

Study Objective 7 - Prepare a Comprehensive Stockholders' Equity Section


In the stockholders' equity section of the balance sheet, paid-in capital and retained earnings are reported, and the specific sources of paid-in capital are identified. Within paid-in capital, two classifications are recognized: 1. Capital stock consists of preferred and common stock. Preferred stock is shown before common because of its preferential rights. Information about the par value, shares authorized, shares issued, and shares outstanding is reported for each class of stock. 2. Additional paid-in capital includes the excess of amounts paid in over par or stated value and paid-in capital from treasury stock. Subclassifications within the stockholders equity sections are seldom presented in published annual reports. o Individual sources of additional paid-in capital are often combined and reported as a single amount as shown in Illustration 11-17. Information regarding cash inflows and outflows during the year that resulted from equity transactions is reported in the Financing Activities section of the statement of cash flows.

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Study Objective 8 - Evaluate a Corporation's Dividend and Earnings Performance from a Stockholder's Perspective
Investors are interested in both a company s dividend record and its earnings performance. Although those two measures are often parallel, that is not always the case. Thus, investors should investigate each one separately. Dividend record - One way that companies reward stock investors for their investment is to pay them dividends. The payout ratio measures the percentage of earnings distributed in the form of cash dividends to common stockholders and is computed by dividing total cash dividends declared to common shareholders by net income. The payout ratios for Nike in 2007 and 2006 are shown in Illustration 11-18. Companies that have high growth rates are characterized by low payout ratios because they reinvest most of their net income in the business. Thus, a low payout ratio is not necessarily bad news. o However, low dividend payments, or a cut in dividend payments, might signal that a company has liquidity or solvency problems and is trying to free up cash by not paying dividends. Thus, investors and analysts should investigate the reason for low dividend payments. Earnings performance - The return on common stockholders' equity is a widely used ratio that measures profitability from the common stockholders viewpoint. This ratio shows how many dollars of net income were earned for each dollar invested by common stockholders. Return on common stockholders' equity is computed by dividing net income available to common stockholders (Net income - Preferred stock dividends) by average common stockholders' equity. The return on common stockholders equity for Nike in 2007 and 2006 are shown in Illustration 11-20. As a company grows larger, it becomes increasingly harder to sustain a high return on common stockholders equity.

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Debt versus equity decisions - To obtain large amounts of long-term capital, corporate managers must decide whether to issue bonds or to sell common stock. Bonds have three primary advantages relative to common stock: Stockholders control is not affected. Bondholders do not have voting rights, so current owners (stockholders) retain full control of the company. Tax savings result. Bond interest is deductible for tax purposes; dividends on stock are not. Return on common stockholders equity may be higher. Although bond interest expense reduces net income, return on common stockholders equity often is higher under bond financing because no additional shares of common stock are issued. The return on common stockholders equity is affected by the return on assets ratio and the amount of leverage a company uses that is, by the company reliance on debt (often measured by the debt to total assets ratio). If a company wants to increase its return on common stockholders equity, it can either increase its return on assets or increase its reliance on debt financing. In general, as long as the return on assets rate exceeds the rate paid on debt, the return on common stockholders equity will be increased by the use of debt. Debt has one major disadvantage, which is reducing solvency. The company locks in fixed payments that must be made in good times and bad. Interest must be paid on a periodic basis, and the principal (face value) of the bonds must be paid at maturity.

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Study Objective 9 - Appendix

Prepare Entries for Stock Dividends

To illustrate the accounting for stock dividends, assume that Medland Corporation has a balance of $300,000 in retained earnings and declares a 10% stock dividend on its 50,000 shares of $10 par value common stock. The current fair market value of its stock is $15 per share. The number of shares to be issued is 5,000 (10% x 50,000), and the total amount to be debited to Retained Earnings is $75,000 (5,000 x $15). The entry to record this transaction at the declaration date is: Stock Dividends Common Stock Dividends Distributable 50,000 Paid-in Capital in Excess of Par Value 25,000 (To record declaration of 10% stock dividend) 75,000

Note that at the declaration date, the account Stock Dividends is increased (debited) for the fair market value of the stock issued: Common Stock Dividends Distributable is increased (credited) for the par value of the dividend shares; and the excess over par is shown as an increase (credit) to an additional paid-in capital account. Common Stock Dividends Distributable is a stockholders equity account; it is not a liability account because assets will not be used to pay the dividend. If a balance sheet is prepared before the dividend shares are issued, the distributable account is reported in paid-in capital as an addition to common stock issued as shown below:

MEDLAND CORPORATION Balance Sheet (partial) Paid-in capital Common stock Common stock dividends distributable

$500,000 50,000

$550,000

When the dividend shares are issued, Common Stock Dividends Distributable is decreased and Common Stock is increased as follows: Common Stock Dividends Distributable 50,000 Common Stock (To record issuance of 5,000 shares in a stock dividend)

50,000

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Chapter 11 Review
Identify the major characteristics of a corporation and classify the characteristic as being advantageous or detrimental to a business.

Describe the accounting treatment for the issuance of stock.

Describe what treasury stock is. State why corporations buy back their own stock, and explain the accounting for the purchase of treasury stock.

Describe how preferred stock is different from common stock.

Describe what is to be done when declaring a dividend and to prepare the entries for cash dividends and stock dividends.

How do net income, net loss, and dividends affect retained earnings?

State the items listed in the stockholders' equity section of the balance sheet.

Use the ratios discussed in this chapter dividend payout ratio and return on common stockholders' equity to evaluate a corporation's dividend and earnings performance from a stockholder's perspective.

What kind of account is Common Stock Dividend Distributable and where is it reported on the financial statements?

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CHAPTER 13 Financial Analysis: The Big Picture


Study Objectives
1. Describe and apply horizontal analysis. 2. Describe and apply vertical analysis. 3. Identify and compute ratios used in analyzing a company s liquidity, solvency, and profitability. 4. Understand the concept of quality of earnings.

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Chapter Outline

Study Objective 1

Describe and Apply Horizontal Analysis

In assessing the financial performance of a company, investors are interested in the core or sustainable earnings of a company. Investors are also interested in making comparisons from period to period. Three types of comparisons have been shown in the text to improve the decision usefulness of financial information: 1. Intracompany basis. Comparisons within a company are often useful to detect changes in financial relationships and significant trends. A comparison of Kellogg's current year's cash amount with the prior year's cash amount shows either an increase or a decrease. Likewise, a comparison of Kellogg's year-end cash amount with the amount of total assets at year-end shows the proportion of total assets in the form of cash. 2. Intercompany basis. Comparisons with other companies provide insight into a company's competitive position. Kellogg's total sales for the year can be compared with the total sales of its competitors such as Quaker Oats and General Mills. 3. Industry averages. Comparisons with industry averages provide information about a company's relative position within the industry. Kellogg's financial data can be compared with the averages for its industry compiled by financial ratings organizations such as Dun & Bradstreet, Moody's, and Standard & Poor's or with information provided on the Internet by organizations such as Yahoo! on its financial site. Three basic tools are used in financial statement analysis to highlight the significance of financial statement data: 1. Horizontal analysis 2. Vertical analysis 3. Ratio analysis Horizontal analysis, also known as trend analysis, is a technique for evaluating a series of financial statement data over a period of time. Its purpose is to determine the increase or decrease that has taken place. The increase or decrease can be expressed as either an amount or a percentage.

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To illustrate horizontal analysis, the most recent net sales figures (in millions) of Kellogg Company are given: 2007 $11,776 2006 $10,907 2005 $10,177 2004 $9,614 2003 $8,812

If we assume that 2003 is the base year, we can measure all percentage increases or decreases from this base-period amount with the following formula: Change Since Base Period = Current-Year Amount - Base-Year Amount Base-Year Amount For example, we can determine that net sales for Kellogg Company increased approximately 9.1% [($9,614 - $8,812) / $8,812] from 2003 to 2004. Alternatively, we can express current-year sales as a percentage of the base period by dividing the current-year amount by the base-year amount: Current Results in Relation to Base Period

Current-Year Amount Base Year Amount

Current-period sales expressed as a percentage of the base-period for each of the five years, assuming 2003 as the base period is: 2007 $11,776 133.64% 2006 $10,907 123.77% 2005 $10,177 115.49% 2004 $9,614 109.10% 2003 $8,812 100%

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The financial statements of Kellogg Company are used to further illustrate horizontal analysis: KELLOGG COMPANY, INC. Condensed Balance Sheets December 31 (In millions) Increase (Decrease) during 2007 Amount Percent $ 290 11.9 174 6.2 219 4.0 $683 6.4

Assets Current Assets Plant assets (net) Other assets Total assets

2007 $2,717 2,990 5,690 $11,397

2006 $2,427 2,816 5,471 $10,714

Liabilities and Stockholders' Equity Current liabilities $4,044 $4,020 Long-term liabilities 4,827 4,625 Total liabilities 8,871 8,645 Stockholders' equity Common stock 493 397 Retained earnings 3,390 2,584 Treasury stock (cost) (1,357) (912) Total stockholders' equity 2,526 2,069 Total liabilities and stockholders' equity $11,397 $10,714

$ 24 202 226 96 806 (445) 457 $683

0.6 4.4 2.6 24.2 31.2 48.8 22.1 6.4

The comparative balance sheet shows a number of changes from 2006 to 2007. Current assets increased $290 million, or 11.9% ($290/$2,427). Property assets (net) decreased $174 million, or 6.2% Other assets increased $219 million or 4.0%. Current liabilities increased $24 million or 0.6% while long-term liabilities decreased $202 million, or 4.4%. Retained earnings increased $806 million, or 31.2%.

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A 2-year comparative income statement of Kellogg Company for 2007 and 2006 is given in condensed format: KELLOGG COMPANY, INC. Condensed Income Statement For the Years Ended December 31 (In millions) Increase (Decrease) during 2007 Amount Percent $869 8.0 515 8.5 354 7.3 252 102 12 (15) 75 (24) $99 8.2 5.8 3.9 (115.4) 5.1 (5.1) 9.9

2007 Net sales $11,776 Cost of goods sold 6,597 Gross profit 5,179 Selling and administrative expenses 3,311 Income from operations 1,868 Interest expense 319 Other income (expense), net (2) Income before income taxes1,547 Income tax expense 444 Net income $1,103

2006 $10,907 6,082 4,825 3,059 1,766 307 13 1,472 468 $1,004

Horizontal analysis of the income statements shows these changes: Net sales increased $869 million, or 8.0% ($869 $10,907). Cost of goods sold increased $515 million, or 8.5% ($515 $6,082). Selling and administrative expenses increased $252 million, or 8.2% ($252 $3,059). Overall, gross profit increased by 7.3% and net income increased by 9.9%. The increase in net income can be attributed to the increase in net sales and a decrease in Income tax expense. When using horizontal analysis, if an item has no value in a base year or preceding year and a value in the next year, no percentage change can be computed. And if a negative amount appears in the base or preceding period and a positive amount exists in the following year, no percentage change can be computed.

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Study Objective 2 - Describe and Apply Vertical Analysis Vertical analysis, also called common-size analysis, is a technique for evaluating financial statement data that expresses each item in a financial statement as a percent of a base amount. On a balance sheet we might say that current assets are 22% of total assets (total assets being the base amount.) On an income statement we might say that selling expenses are 16% of net sales (net sales being the base amount.) Presented below is the comparative balance sheet of Kellogg for 2007 and 2006, analyzed vertically. KELLOGG COMPANY, INC. Condensed Balance Sheets December 31 (In millions) 2007 Percent* 23.8 26.2 50.0 100.0 2006 Amount Percent* $2,427 22.6 2,816 26.3 5,471 51.1 $10,714 100.0

Assets Current Assets Property assets (net) Other assets Total assets

Amount $2,717 2,990 5,690 $11,397

Liabilities and Stockholders' Equity Current liabilities $4,044 Long-term liabilities 4,827 Total liabilities 8,871 Stockholders' equity Common stock 493 Retained earnings 3,390 Treasury stock (cost) (1,357) Total stockholders' equity 2,526 Total liabilities and stockholders' equity $11,397
*Numbers have been rounded to total 100%.

35.5 42.4 77.9 4.3 29.7 (11.9) 22.1 100.0

$4,020 4,625 8,645 397 2,584 (912) 2,069 $10,714

37.5 43.2 80.7 3.7 24.1 (8.5) 19.3 100.0

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In addition to showing the relative size of each category on the balance sheet, vertical analysis may show the percentage change in the individual asset, liability, and stockholders' equity items. Kellogg's current assets increased $290 million from 2006 to 2007 and they increased from 22.6% to 23.8% of total assets. Property assets (net) decreased from 26.3% to 26.2% of total assets. Other assets decreased from 51.1% to 50.0% of total assets. Retained earnings increased by $806 million from 2006 to 2007, and total stockholders equity increased from 19.3% to 22.1% of total liabilities and stockholders equity. This switch to a higher percentage of equity financing has two causes: First, while total liabilities increased by $226 million, the percentage of liabilities declines from 80.7% to 77.9% of total liabilities and stockholders equity. Second, retained earnings increased by $806 million. Thus, the company shifted toward a heavier reliance on equity financing both by using less debt and by increasing the amount of retained earnings. Vertical analysis of the comparative income statements of Kellogg, shown below reveals that: Cost of goods sold as a percentage of net sales increased from 55.8% to 56.0%. Selling and administrative expenses increased from 28.0% to 28.1%. Net income as a percent of net sales increased from 9.1% to 9.4%. The decline in net income as a percentage of sales is due primarily to the decrease in interest expense and income tax expense as a percent of sales. KELLOGG COMPANY, INC. Condensed Income Statement For the Years Ended December 31 (In millions) 2007 Amount $11,776 6,597 5,179 3,311 1,868 319 (2) 1,547 444 $1,103 2006 Amount $10,907 6,082 4,825 3,059 1,766 307 13 1,472 468 $1,004

Net sales Cost of goods sold Goss profit Selling and admin. expenses Income from operations Interest expense Other income (expense), net Income before income taxes Income tax expense Net income *Numbers have been rounded to total 100%.

Percent* 100.0 56.0 44.0 28.1 15.9 2.7 0 13.2 3.8 9.4

Percent* 100.0 55.8 44.2 28.0 16.2 2.8 0 13.4 4.3 9.1

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Vertical analysis enables you to compare companies of different sizes. Shown below is a comparison of the income statements of Kellogg and General Mills: CONDENSED INCOME STATEMENTS For the Year Ended December 31, 2007 (In millions) Kellogg Company, Inc. General Mills, Inc. Amount Percent* Amount Percent* Net sales $11,776 100.0 $12,442 100.0 Cost of goods sold 6,597 56.0 7,955 63.9 Gross profit 5,179 44.0 4,487 36.1 Selling and admin. expenses 3,311 28.1 2,390 19.2 Nonrecurring charges 0 -39 0.3 Income from operations 1,868 15.9 2,058 16.6 Other expense and revenues 765 6.5 914 7.4 (including income taxes) Net income $1,103 9.4 $1,144 9.2
*Numbers have been rounded to total 100%

Although Kellogg's net sales are less than the net sales of General Mills, vertical analysis eliminates the impact of the size difference for the analysis. Kellogg's has a higher gross profit, 44.0%, compared to 36.1% for General Mills, but Kellogg s selling and administrative expenses are 28.1% of net sales, while those of General Mills are 19.2% of net sales. Kellogg's and General Mills report similar percentages for income from operations as a percentage of net sales, 9.4% compared to 9.2%, respectively.

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Study Objective 3 - Identify and Compute Ratios Used in Analyzing a Company's Liquidity, Solvency, and Profitability For analysis of the primary financial statements, ratios can be classified into three types: 1. Liquidity ratios measure the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. 2. Solvency ratios measure the ability of the company to survive over a long period of time. 3. Profitability ratios measure the income or operating success of a company for a given period of time. Study Objective 4 Understand the Concept of Quality of Earnings

A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of financial statements. The issue of quality of earnings has taken on increasing importance because recent accounting scandals suggest that some companies are spending too much time managing their income and not enough time managing their business. Some of the factors affecting quality of earnings include the following: Alternative accounting methods Variations among companies in the application of generally accepted accounting principles may hamper comparability and reduce quality of earnings. For example, one company may use the FIFO method of inventory costing, while another company in the same industry may use LIFO. If inventory is a significant asset to both companies, it is unlikely that their current ratios are comparable. Differences also exist in reporting such items as depreciation, depletion, and amortization. Although these differences in accounting methods might be detected from reading the notes to the financial statements, adjusting the financial data to compensate for the different methods is difficult, if not impossible, in some cases.

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Pro Forma Income Companies whose stock is publicly traded are required to present their income statement following generally accepted accounting principles (GAAP). In recent years, many companies have been also reporting a second measure of income, in addition to their GAAP, called pro forma income. Pro forma income is a measure that usually excludes items that the company thinks are unusual or nonrecurring. There are no rules as to how to prepare pro forma earnings. Companies have a free rein to exclude any items they deem inappropriate for measuring their performance. Many analysts are critical of the practice of using pro forma income because these numbers often make companies look better then they really are. Pro forma numbers might be called EBS, which stands for earnings before bad stuff. Companies, on the other hand, argue that pro forma numbers more clearly indicate sustainable income because unusual and nonrecurring expenses are excluded. Recently, the SEC provided some guidance on how companies should present pro forma information. Everyone seems to agree that pro forma numbers can be useful if they provide insights into determining a company s sustainable income. However, many companies have abused the flexibility that pro forma numbers allow and have used the measure as a way to put their companies in a more favorable light. Improper recognition Because some managers have felt the pressure to continually increase earnings, they have manipulated the earnings numbers to meet these expectations. The most common abuse is the improper recognition of revenue. One practice that companies are using is called channel stuffing. Offering deep discounts on their products to customers, companies encourage their customers to buy early (stuff the channel) rather than later. This lets the company report good earnings in the current period, but it often leads to a disaster in subsequent periods because customers have no need for additional goods. Another practice is the improper capitalization of operating expenses. The classic case is WorldCom, which capitalized over $7 billion of operating expenses to ensure that it would report positive net income.

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Price-Earnings Ratio In order to make a meaningful comparison of market values and earnings across firms, investors calculate the price-earnings (P-E) ratio. The P-E ratio, divides the market price of a share of common stock by earnings per share. The P-E ratio reflects investors assessment of a company s future earnings. Higher P-E ratios are associated with a greater willingness of investors to pay more per share of stock, because they believe the company will have substantial earnings in the future A low price-earnings ratio often signifies that investors think the company s future earnings will not be strong or that it has poor-quality earnings.

Appendix

Comprehensive Illustration of Ratio Analysis

Many ratios used for evaluating the financial health and performance of a company are presented in the text. This appendix provides a comprehensive review of those ratios, discusses some important relationships among them, and focuses on their interpretation. As indicated in the chapter, for analysis of the primary financial statements, ratios can be classified into three types: 1. Liquidity ratios: Measures of the short-term ability of the company to pay its maturing obligations and to meet unexpected needs for cash. 2. Solvency ratios: Measures of the ability of the company to survive over a long period of time. 3. Profitability ratios: Measures of the income or operating success of a company for a given period of time. Go over the information presented in Illustrations 13A-1 through 13A-4. Ratios can provide clues to underlying conditions that may not be apparent from an inspection of the individual components. A single ratio by itself is not very meaningful. The discussion on ratios uses the following comparisons: 1. Intracompany comparisons covering two years for Kellogg Company. 2. Intercompany comparisons using the General Mills, as one of Kellogg's principal competitors. 3. Industry average comparisons based on Reuters.com median ratios for manufacturers of flour and other grain mill products and comparisons with other sources.

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Liquidity ratios measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash. Short-term creditors, such as bankers and suppliers, are particularly interested in assessing liquidity. The measures that can be used to determine the enterprise's short-term debtpaying ability are the current ratio, the current cash debt coverage ratio, the receivables turnover ratio, the average collection period, the inventory turnover ratio, and the average days in inventory. 1. The current ratio expresses the relationship of current assets to current liabilities, computed by dividing current assets by current liabilities. The current ratio is widely used for evaluating a company's liquidity and shortterm debt-paying ability. Review the information in Illustration 13A-5.

2. Current cash debt coverage ratio is the ratio of cash provided by operating activities to average current liabilities. A disadvantage of the current ratio is that it uses year-end balances of current asset and current liability accounts. Those year-end balances may not be representative of the company s current position during most of the year. Because it partially corrects for this problem by using cash provided by operating activities rather than a balance at one point in time, the current cash debt coverage ratio may provide a better representation of liquidity. Review the information in Illustration 13A-6.

3. The receivables turnover ratio measures liquidity by determining how quickly certain assets can be converted to cash. The receivables turnover ratio measures the number of times, on average, receivables are collected during the period. The receivables turnover ratio is computed by dividing net credit sales (net sales less cash sales) by average net receivables during the year. Review the information in Illustration 13A-7.

4. The average collection period is a popular variant of the receivables turnover ratio. The average collection period converts the receivables turnover into an average collection period expressed in days. The ratio is computed by dividing the receivables turnover ratio into 365 days. The general rule is that the collection period should not greatly exceed the credit term period. Review the information in Illustration 13A-8. 5. The inventory turnover ratio measures the number of times on average the inventory is sold during the period. The purpose of this ratio is to measure the liquidity of the inventory. 1-141

The inventory turnover ratio is computed by dividing the cost of goods sold by the average inventory during the period. Review the information in Illustration 13A-9. 6. Days in inventory is a variant of the inventory turnover ratio. The days in inventory measures the average number of days inventory is held. It is computed by dividing the inventory turnover ratio into 365 days. Review the information in Illustration 13A-10. Solvency ratios measure the ability of the enterprise to survive over a long period of time. Long-term creditors and stockholders are interested in a company's long-run solvency, particularly its ability to pay interest as it comes due and to repay the face value of debt at maturity. The debt to total assets ratio, the times interest earned ratio, and the cash debt coverage ratio provide information abut debt-paying ability. In addition free cash flow provides information about the company s solvency and its ability to pay additional dividends or invest in new projects. 7. The debt to total asset ratio measures the percentage of total assets provided by creditors. It is computed by dividing total liabilities (both current and long-term) by total assets. This ratio indicates the degree of financial leveraging and provides some indication of the company's ability to withstand losses without impairing the interests of its creditors. The higher the percentage of debt to total assets, the greater the risk that the company may be unable to meet its maturing obligations. The lower the ratio, the more equity buffer is available to creditors if the company becomes insolvent. Review the information in Illustration 13A-11.

8. The times interest earned ratio, also called interest coverage, indicates the company's ability to meet interest payments as they come due. The ratio is computed by dividing income before interest expense and income taxes by interest expense. Review the information in Illustration 13A-12.

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9. The cash debt coverage ratio is the ratio of cash provided by operating activities to average total liabilities. This ratio is a cash-basis measure of solvency. The cash debt coverage ratio indicates a company's ability to repay its liabilities from cash generated from operating activities without having to liquidate the assets used in its operations. Review the information in Illustration 13A-13. 10. Free cash flow is an indication of a company's solvency and its ability to pay dividends or expand operations. Free cash flow is the amount of excess cash generated after investing in capital expenditures and paying dividends. Review the information in Illustration 13A-14.

Profitability ratios measure the income or operating success of an enterprise for a given period of time. Profitability ratios are important because a company's income or lack of it, affects its ability to obtain debt and equity financing, its liquidity position, and its ability to grow. Profitability is frequently used as the ultimate test of management's operating effectiveness. 11. Return on common stockholders' equity ratio is a widely used measure of profitability from the common stockholder's viewpoint. The ratio shows how many dollars of net income were earned for each dollar invested by the owners. Return on common stockholders' equity ratio is computed by dividing net income minus any preferred stock dividends that is, income available to common stockholders by average common stockholders' equity. Review the information in Illustration 13A-16. 12. The return on assets ratio measures the overall profitability of assets in terms of the income earned on each dollar invested in assets. The return on common stockholders equity ratio is affected by two factors: the return on assets ratio and the degree of leverage. The return on assets ratio is computed by dividing net income by average total assets. Review the information in Illustration 13A-17.

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13. The profit margin ratio, or rate of return on sales, is a measure of the percentage of each dollar of sales that results in net income. The return on assets ratio is affected by two factors, the first of which is the profit margin ratio. The profit margin ratio is computed by dividing net income by net sales for the period. Review the information in Illustration 13A-18. 14. The asset turnover ratio measures how efficiently a company uses its assets to generate sales. The asset turnover ratio is the other factor that affects the return on assets ratio. The ratio is determined by dividing net sales by average total assets for the period. The resulting number shows the dollar sales produced by each dollar invested in assets. Review the information in Illustration 13A-19.

15. The gross profit rate indicates a company's ability to maintain an adequate selling price above its cost of goods sold. The profit margin ratio is strongly influenced by the gross profit rate. The gross profit rate is found by dividing gross profit (net sales less cost of goods sold) by net sales. Review the information in Illustration 13A-21.

16. Earnings per share (EPS) is a measure of the net income earned on each share of common stock. Expressing net income earned on a per share basis provides a useful perspective for determining profitability. Earnings per share is computed by dividing net income by the average number of common shares outstanding during the year. When we use "net income per share" or "earnings per share," it refers to the amount of net income applicable to each share of common stock. Review the information in Illustration 13A-22.

17. The price-earnings (P-E) ratio measures the ratio of the market price of each share of common stock to the earnings per share. The price-earnings ratio is a reflection of investors' assessments of a company's future earnings. The ratio is computed by dividing the market price per share of the stock by earnings per share. Review the information in Illustration 13A-23.

18. The payout ratio measures the percentage of earnings distributed in the form of cash dividends. 1-144

Companies that have high growth rates are characterized by low payout ratios because they reinvest most of their net income in the business. The payout ratio is computed by dividing cash dividends declared on common stock by net income. Review the information in Illustration 13A-24.

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Chapter 13 Review

What is horizontal analysis and how is it used?

What is vertical analysis and how is it used?

Identify the liquidity, solvency, and profitability ratios introduced throughout the text. Describe how the ratios are used in analyzing a firm's liquidity, solvency, and profitability.

Discuss three factors that affect quality of earnings.

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