13-1 Operating Activities Electronic Presentation by Douglas Cloud Pepperdine University Chapter F13

Identify the purpose and major components of the income statement. 2.Explain and apply rules for measuring revenues and receivables and reporting revenue transactions. 3.Describe reporting rules for inventories and cost of goods sold and compare reporting of inventories for merchandising and manufacturing companies. ObjectivesObjectives Once you have completed this chapter, you should be able to: ContinuedContinued

Explain and apply rules for measuring cost of goods sold and inventories and describe the effects of income taxes on the choice of inventory estimation method. 5.Identify routine and nonroutine events that affect a company’s income statement. ObjectivesObjectives

13-41 ObjectiveObjective Identify the purpose and major components of an income statement.

13-5 Basic Operating Activities The income statement reports the results of operating activities for a fiscal period on an accrual basis.

13-6 For the Year Ended December 31, Net sales revenue$3,235,600$686,400 Cost of goods sold (1,954,300) (457,600) Gross profit1,281,300228,800 Selling, general and administrative expenses (1,094,700) (148,300) Operating income186,60080,500 Interest expense (20,400) (4,800) Pretax income166,20075,700 Income taxes (49,860) (22,710) Net income$ 116,340$ 52,990 Earnings per share$ 0.29$ 0.13 The first item on the income statement is net sales revenue. Exhibit 1 Income Statement for Mom’s Cookie Company

13-7 For the Year Ended December 31, Net sales revenue$3,235,600$686,400 Cost of goods sold (1,954,300) (457,600) Gross profit1,281,300228,800 Selling, general and administrative expenses (1,094,700) (148,300) Operating income186,60080,500 Interest expense (20,400) (4,800) Pretax income166,20075,700 Income taxes (49,860) (22,710) Net income$ 116,340$ 52,990 Earnings per share$ 0.29$ 0.13 Cost of goods sold is subtracted from net sales revenue to compute gross profit. Exhibit 1 Income Statement for Mom’s Cookie Company

13-8 For the Year Ended December 31, Net sales revenue$3,235,600$686,400 Cost of goods sold (1,954,300) (457,600) Gross profit1,281,300228,800 Selling, general and administrative expenses (1,094,700) (148,300) Operating income186,60080,500 Interest expense (20,400) (4,800) Pretax income166,20075,700 Income taxes (49,860) (22,710) Net income$ 116,340$ 52,990 Earnings per share$ 0.29$ 0.13 The expenses for marketing and distributing a company’s products and managing its operations are subtracted from gross profit to calculate operating income. Exhibit 1 Income Statement for Mom’s Cookie Company

13-9 For the Year Ended December 31, Net sales revenue$3,235,600$686,400 Cost of goods sold (1,954,300) (457,600) Gross profit1,281,300228,800 Selling, general and administrative expenses (1,094,700) (148,300) Operating income186,60080,500 Interest expense (20,400) (4,800) Pretax income166,20075,700 Income taxes (49,860) (22,710) Net income$ 116,340$ 52,990 Earnings per share$ 0.29$ 0.13 Non-operating expenses or losses, such as Interest Expense, are subtracted from operating income to compute pretax income. Exhibit 1 Income Statement for Mom’s Cookie Company Non-operating income or gains are added, to compute pretax income.

13-10 For the Year Ended December 31, Net sales revenue$3,235,600$686,400 Cost of goods sold (1,954,300) (457,600) Gross profit1,281,300228,800 Selling, general and administrative expenses (1,094,700) (148,300) Operating income186,60080,500 Interest expense (20,400) (4,800) Pretax income166,20075,700 Income taxes (49,860) (22,710) Net income$ 116,340$ 52,990 Earnings per share$ 0.29$ 0.13 Income tax expense is subtracted from pretax income to calculate net income. Exhibit 1 Income Statement for Mom’s Cookie Company

13-11 For the Year Ended December 31, Net sales revenue$3,235,600$686,400 Cost of goods sold (1,954,300) (457,600) Gross profit1,281,300228,800 Selling, general and administrative expenses (1,094,700) (148,300) Operating income186,60080,500 Interest expense (20,400) (4,800) Pretax income166,20075,700 Income taxes (49,860) (22,710) Net income$ 116,340$ 52,990 Earnings per share$ 0.29$ 0.13 Earnings per share is reported on a corporate income statement. Exhibit 1 Income Statement for Mom’s Cookie Company

Explain and apply rules for measuring revenues and receivables and reporting revenue transactions. ObjectiveObjective

13-13 Sales of Goods and Services to Customers Activity Operating Revenues Income Statement Cash Accounts Receivable Cash Accounts Receivable Balance Sheet Cash Received from Customers Statement of Cash Flows Exhibit 2 The Effect of Sales and Services on the Financial Statements

13-14 Revenues and Receivables 1.The selling company has completed most of the activities necessary to produce and sell the goods or services. 2.The selling company has incurred the costs associated with producing and selling the goods or services or can reasonably measure those costs. 3.The selling company can measure objectively the amount of revenue it has earned. 4.The selling company is reasonably sure that it is going to collect cash from the purchaser. Revenue should be recognized when four criteria have been met.

13-15 Recognizing Revenue for Long-Term Contracts Constructo, Inc. contracts to construct a new building for $20 million. The project will take three years. Constructo, Inc. estimates at the end of 2004, the first year of the contract, 20 percent of the work has been completed. For the fiscal period ending in 2004, Constructo, Inc. will recognize revenue of $4 million (20% of $20 million).

13-16 Sales Discounts and Returns Revenues are reported on the income statement net of discounts and expected returns. A discount is a reduction in the normal sales price to encourage customers to buy large quantities of goods (a quantity discount) or to pay their accounts early (a sales discount).

13-17 Sales Discounts and Returns Mom’s Cookie Company sells goods priced at $5,000 to a customer on November 4, 2004, and offers a 2% discount if the customer pays in full within 10 days of the purchase. ASSETS = LIABILITIES + OWNERS’ EQUITY + OWNERS’ EQUITY Date Accounts Cash Other Assets Contributed Capital Retained Earnings 11/4Accounts Rec.5,000 Sales Revenue5,000

13-18 Sales Discounts and Returns If the customer pays within the discount period, the company reduces the revenue by $100 ($5,000 x 2%) and records the discount. ASSETS = LIABILITIES + OWNERS’ EQUITY + OWNERS’ EQUITY Date Accounts Cash Other Assets Contributed Capital Retained Earnings 11/4Cash4,900 Sales Discount–100 Accounts Rec.–5,000

13-19 Sales Discounts and Returns Returns Like sales discounts, sales returns are subtracted from sales revenues in reporting net operating revenues on the income statement.

13-20 Sales Discounts and Returns Textbook Publishing Company sells $5 million of books during fiscal year ASSETS = LIABILITIES + OWNERS’ EQUITY + OWNERS’ EQUITY Date Accounts Cash Other Assets Contributed Capital Retained Earnings 12/31Sales Returns–500,000 Allowance for Returns–500,000 From past experience, the company estimates that $500,000 of its 2004 sales will be returned in 2005.

13-21 Sales Discounts and Returns A major principle of accounting is the matching principle. MATCHING

13-22 Sales Discounts and Returns The matching principle is an effort to match revenues and expenses in the period in which they occur so that revenues, expenses, and net income are not misstated.

13-23 Sales Discounts and Returns Textbook Publishing received a return of $100,000 (sales price) on January 12, 2005, from a credit customer. The goods cost the company $75,000. ASSETS = LIABILITIES + OWNERS’ EQUITY + OWNERS’ EQUITY Date Accounts Cash Other Assets Contributed Capital Retained Earnings 1/12Allowance for Returns100,000 Accounts Rec.–100,000 ContinuedContinued

13-24 Sales Discounts and Returns Textbook Publishing received a return of $100,000 (sales price) on January 12, 2005, from a credit customer. The goods cost the company $75,000. ASSETS = LIABILITIES + OWNERS’ EQUITY + OWNERS’ EQUITY Date Accounts Cash Other Assets Contributed Capital Retained Earnings 1/12Merchandise Inventory75,000 Cost of Goods Sold75,000

13-25 Mom’s Cookie Company has a balance in Allowance for Doubtful Accounts of $1,000 at the end of its 2004 fiscal year before adjustments are made for the year. Management evaluates the company’s credit sales and outstanding receivables and determines that the amount of the allowance account should be $5,000. Uncollectible Accounts

13-26 Since the current allowance balance is $1,000, the allowance account needs to be increased by $4,000. Uncollectible Accounts ASSETS = LIABILITIES + OWNERS’ EQUITY + OWNERS’ EQUITY Date Accounts Cash Other Assets Contributed Capital Retained Earnings 12/31Doubtful Accounts Exp.–4,000 Allowance for Doubtful Accts.–4,000 Doubtful Accounts Expense is a selling expense

13-27 On February 12, 2005, Mom’s Cookie Company determines that $800 owed by Home Goods Company cannot be collected. Uncollectible Accounts ASSETS = LIABILITIES + OWNERS’ EQUITY + OWNERS’ EQUITY Date Accounts Cash Other Assets Contributed Capital Retained Earnings 2/12Accounts Receivable–800 Allowance for Doubtful Accts.800

13-28 Warranty Costs Products under warranty allow the customer to return a defective product for replacement or refund.

13-29 Warranty Costs From sales in March, 2004, Harris Company estimates warranty costs of $12,000 will be incurred in April, May, and June. ASSETS = LIABILITIES + OWNERS’ EQUITY + OWNERS’ EQUITY Date Accounts Cash Other Assets Contributed Capital Retained Earnings 3/31Warranty Expense–12,000 Warranty Obligations12,000

13-30 Warranty Costs On May 15, Harris replaces a faulty motor on an appliance. The cost of the motor is $300 and the cost of labor to install the motor is $100. ASSETS = LIABILITIES + OWNERS’ EQUITY + OWNERS’ EQUITY Date Accounts Cash Other Assets Contributed Capital Retained Earnings 5/15Warranty Obligations–400 Parts Inventory–300 Wages Payable100

Describe reporting rules for inventories and cost of goods sold and compare reporting of inventories for merchandising and manufacturing companies. ObjectiveObjective

13-32 Exhibit 3 The Effect of Inventory Transactions on the Financial Statements

13-33 On May 4, 2004, Mom’s Cookie Company purchased $10,000 of inventory on credit. ASSETS = LIABILITIES + OWNERS’ EQUITY + OWNERS’ EQUITY Date Accounts Cash Other Assets Contributed Capital Retained Earnings 5/4Merchandise Inventory10,000 Accounts Payable10,000 Reporting Inventories and Cost of Goods Sold

13-34 On May 6, Mom’s Cookie Company sold $4,000 of that inventory. ASSETS = LIABILITIES + OWNERS’ EQUITY + OWNERS’ EQUITY Date Accounts Cash Other Assets Contributed Capital Retained Earnings 5/6Cost of Goods Sold–4,000 Merchandise Inventory–4,000 Reporting Inventories and Cost of Goods Sold

13-35 On May 12, Mom’s Cookie Company pays for half of the inventory purchase. ASSETS = LIABILITIES + OWNERS’ EQUITY + OWNERS’ EQUITY Date Accounts Cash Other Assets Contributed Capital Retained Earnings 5/12Accounts Payable–5,000 Cash–5,000 Reporting Inventories and Cost of Goods Sold

13-36 Reporting Inventories and Cost of Goods Sold Purchase discounts for paying for goods and services within the discount period should result in both Inventory and Accounts Payable being reduced.

13-37 Raw Materials Work-in- Process Labor and Overhead Costs Finished Goods Exhibit 4 Components of Manufacturing Inventory Inventories

13-38 Raw materials inventory includes the costs of component parts or ingredients that become part of the product being manufactured. Manufacturing Reporting Inventories and Cost of Goods Sold

13-39 Work-in-process inventory includes the costs of materials, labor, and overhead that have been applied to products that are in the process of being manufactured. Reporting Inventories and Cost of Goods Sold Manufacturing

13-40 Finished goods inventory includes the costs of products that have been completed in the manufacturing process and are available for sale to customers. Reporting Inventories and Cost of Goods Sold Manufacturing

13-41 Exhibit 5 Computation of Manufacturing Inventory Costs

Explain and apply rules for measuring cost of goods sold and inventories and describe the effects of income taxes on the choice of inventory estimation method. ObjectiveObjective

13-43 Measuring Inventory Hydro Company sells and services agricultural irrigation equipment. On March 20, 2004, Hydro purchased 20 pump motors at $200 each. Hydro already had 8 identical motors on hand, for which it had paid $175.

13-44 Measuring Inventory On March 22, 2004, a customer purchased one motor. Should the company record the cost of goods sold for the motor as $175 or as $200?

13-45 $175 per unit Mar. 1 Sold 1 $175 per unit Measuring Inventory First-In, First-Out Method $200 per unit Mar. 20 Using the first-in, first-out method, the cost of the motor sold would be recorded as $175 because $175 is the cost of the oldest item in Hydro’s inventory.

13-46 $175 per unit Mar. 1 Sold 1 Measuring Inventory Last-In, First-Out Method $200 per unit Mar. 20 $200 per unit Using last-in, first-out, Hydro would record the cost of the motor sold on March 22 as $200 because $200 is the cost of the most recent item in Hydro’s inventory.

13-47 Using the weighted-average method, Hydro would record the cost of the motor sold on March 22 as $ $175 per unit = $1,400 Mar. 1 Measuring Inventory Weighted-Average Method $200 per unit =4,000 Mar units$5,400$ per unit $5,400 ÷ 28 units

13-48 Measuring Inventory Mom’s Cookie Company has finished goods inventory of $3,000 at the end of February The inventory includes 150 cases of cookies at a cost of $20 per case. Exhibit 6 (Slide 49) summarizes unit costs and sales for the company for March.

13-49 March 1 Inventory150$20.00$ 3,000 March 8 Batch3, ,900 March 18 Batch3, ,800 March 20Sales5,200 March 28 Batch3, ,700 March 31 Sales3,600 Total Cost of Goods Available for Sale$188,400 March 1 Inventory150$20.00$ 3,000 March 8 Batch3, ,900 March 18 Batch3, ,800 March 20Sales5,200 March 28 Batch3, ,700 March 31 Sales3,600 Total Cost of Goods Available for Sale$188,400 Exhibit 6 Unit Costs and Sales for Mom’s Cookie Company for March

13-50 Measuring Inventory First-In, First-Out Method Perpetual Inventory System Inventory purchased on March 8 and March 18 Beg. Inv. $20.60 per unit Mar. 18 Mar. 8 $20.30 per unit $20.00 per unit

13-51 Measuring Inventory First-In, First-Out Method Perpetual Inventory System $20.00 per unit $20.60 per unit Mar. 8 Mar. 18 $20.30 per unit $20.00 per unit Sold all $20.00 per unit Sold 5,200 units on March 20 Beg. Inv.

13-52 Measuring Inventory First-In, First-Out Method Perpetual Inventory System $20.00 per unit $20.60 per unit Mar. 8 Mar. 18 $20.30 per unit $20.00 per unit Sold all $20.30 per unit Sold 5,200 units on March 20 Beg. Inv.

13-53 Measuring Inventory First-In, First-Out Method Perpetual Inventory System $20.00 per unit $20.60 per unit Mar. 8 Mar. 18 $20.30 per unit $20.00 per unit Sold 2,050 $20.60 per unit Sold 5,200 units on March 20 Beg. Inv.

13-54 Measuring Inventory First-In, First-Out Method Perpetual Inventory System $20.00 per unit $20.60 per unit Mar. 8 Mar. 18 $20.30 per unit $20.00 per unit =$ 0 = 0 =19,570 Ending inventory =$19,570 Beg. Inv.

13-55 Measuring Inventory First-In, First-Out Method Perpetual Inventory System Purchased 3,000 units at $20.90 per unit on March 28 $20.00 per unit $20.60 per unit Mar. 8 Mar. 18 $20.30 per unit Mar. 28 $20.90 per unit $20.00 per unit $20.60 per unit Beg. Inv.

13-56 Measuring Inventory First-In, First-Out Method Perpetual Inventory System Sold 3,600 units on March 31 $20.00 per unit $20.60 per unit Mar. 8 Mar. 18 Mar. 28 $20.30 per unit $20.90 per unit $20.00 per unit Sold 950 $20.60 per $20.60 per unit Beg. Inv.

13-57 Measuring Inventory First-In, First-Out Method Perpetual Inventory System $20.00 per unit $20.60 per unit Mar. 8 Mar. 18 Mar. 28 $20.30 per unit $20.90 per unit $20.00 per unit Sold 2,650 $20.60 per $20.60 per unit $20.90 per unit Sold 3,600 units on March 31 Beg. Inv.

13-58 Measuring Inventory First-In, First-Out Method Perpetual Inventory System $20.00 per unit $20.60 per unit Mar. 8 Mar. 18 Mar. 28 $20.30 per unit $20.90 per unit $20.00 per unit $20.60 per $20.60 per unit =$ 0 = 0 =0=0 Ending inventory =$7,315 =7,315 Beg. Inv.

13-59 Measuring Inventory Last-In, First-Out Method Perpetual Inventory System $20.00 per unit $20.60 per unit Mar. 8 Mar. 18 $20.30 per unit $20.00 per unit Sold all Sold 5,200 units on March 20 $20.60 per unit Beg. Inv.

13-60 Measuring Inventory Last-In, First-Out Method Perpetual Inventory System $20.00 per unit $20.60 per unit Mar. 8 Mar. 18 $20.30 per unit $20.00 per unit Sold 2,200 Sold 5,200 units on March 20 $20.30 per unit Beg. Inv.

13-61 Measuring Inventory Last-In, First-Out Method Perpetual Inventory System $20.00 per unit Beg. Inv. $20.60 per unit Mar. 8 Mar. 18 $20.30 per unit $20.00 per unit $20.30 per unit = $ 3,000 = 16,240 =0=0 Ending inventory =$19,240

13-62 Measuring Inventory Last-In, First-Out Method Perpetual Inventory System $20.00 per unit $20.60 per unit Mar. 8 Mar. 18 $20.30 per unit $20.00 per unit $20.30 per unit Mar. 28 $20.90 per unit Purchased 3,000 units on March 28 Beg. Inv.

13-63 Measuring Inventory Last-In, First-Out Method Perpetual Inventory System $20.00 per unit $20.60 per unit Mar. 8 Mar. 18 $20.30 per unit $20.00 per unit Mar. 28 $20.90 per unit $20.90 per unit Sold 3,600 units on March 31 Sold all Beg. Inv.

13-64 Measuring Inventory Last-In, First-Out Method Perpetual Inventory System $20.00 per unit $20.60 per unit Mar. 8 Mar. 18 $20.30 per unit $20.00 per unit $20.30 per unit Mar. 28 $20.90 per unit Sold 3,600 units on March 31 Sold 600 $20.30 per unit Beg. Inv.

13-65 Measuring Inventory $20.00 per unit $20.60 per unit Mar. 8 Mar. 18 $20.30 per unit $20.00 per unit $20.30 per unit Mar. 28 $20.90 per unit = $3,000 = 4,060 =0=0 Ending inventory =$7,060 =0=0 Beg. Inv. Last-In, First-Out Method Perpetual Inventory System

13-66 Measuring Inventory Average Inventory Method Perpetual Inventory System $20.00 per unit Mar. 8 $20.30 per unit =$ 3,000 =60,900 = 61,800 $125,700 $20.60 per unit Mar. 18 Mar. 20 Average cost $ $125,700 ÷ 6,150 units Beg. Inv.

13-67 Measuring Inventory $20.00 per unit Mar. 20 $ per unit Mar. 20 $20.30 per unit–5,200 $ per unit =$125,700 = 106,283 $ 19,417 Sold 5,200 units on March 20 Mar $ per unit Average Inventory Method Perpetual Inventory System

13-68 Measuring Inventory $20.00 per unit Mar. 20 $ per unit =$19,417 = 62,700 $ 82,117 Purchased 3,000 units on March 28 at $20.90 per unit $20.90 per unit Mar. 28 3,950 $ per unit $82,117 ÷ 3,950 units Average Inventory Method Perpetual Inventory System

13-69 Measuring Inventory $20.00 per unit Mar. 20 $ per unit Sold 3,600 units on March 31 $ per unit Mar $ per unit =$82,117 = 74,841 $ 7,276 Last-In, First-Out Method Perpetual Inventory System

13-70 Measuring Inventory To determine cost of goods sold, we need to recall the amount for cost of goods available for sale, which is $188,400. Click the button next to me to review how this amount was determined.

13-71 Measuring Inventory Regardless of the inventory method used, the cost of goods available for sale is the same amount.

13-72 Measuring Inventory Now, let’s determine the cost of goods sold when using the lifo perpetual inventory method. Cost of goods available for sale$188,400 – Ending inventory 7,060 Cost of goods sold$181,340

13-73 Measuring Inventory How about fifo perpetual? Cost of goods available for sale$188,400 – Ending inventory 7,315 Cost of goods sold$181,085

13-74 Inventory Estimation and Income Taxes The primary reason for the use of LIFO is the tax advantage that LIFO provides to many companies.

13-75 Sales revenues$3,235,600 $3,235,600 Cost of goods sold(1,946,800) (1,954,300) Gross profit1,288,800 1,281,300 Selling, general, and admin. exp.(1,094,700) (1,094,700) Operating income194, ,600 Interest expense (20,400) (20,400) Pretax income173, ,200 Income tax (52,110) (49,860) Net income$ 121,590$ 116,340 For the Year Ended December 31, 2005 FIFO LIFO Exhibit 12 Income Statement for Mom’s Cookie Company Using FIFO and LIFO Inventory Estimation

13-76 Lower of Cost or Market GAAP require companies to compare the cost determined through inventory estimation methods with the current market cost of the inventory on hand at the end of the fiscal year. If current market cost is below the cost resulting from the use of an estimation method such as FIFO or LIFO, the inventory must be written down to the current market costs.

13-77 GAAP require companies to compare the cost determined through inventory estimation methods with the current market cost of the inventory on hand at the end of the fiscal year. Lower of Cost or Market If current market cost is below the cost resulting from the use of an estimation method such as FIFO or LIFO, the inventory must be written down to the current market costs. This requirement is known as the lower of cost or market inventory rule.

13-78 Lower of Cost or Market Tucker Company acquired $500,000 of merchandise on August 18, By December 31, 2004, the end of its fiscal year, it had sold $300,000 of the merchandise. Tucker estimates that the market value of the remaining inventory is $140,000 on December 31, 2004.

13-79 Lower of Cost or Market In keeping with the lower of cost or market rule, Tucker must recognize a $60,000 loss for its inventory at the end of the year. ASSETS = LIABILITIES + OWNERS’ EQUITY + OWNERS’ EQUITY Date Accounts Cash Other Assets Contributed Capital Retained Earnings 12/31Loss on Inventory–60,000 Merchandise Inventory–60,000

Identify routine and nonroutine events that affect a company’s income statement. ObjectiveObjective

13-81 Operating Expenses Most operating expenses other than cost of goods sold are period costs.

13-82 Operating Expenses Yes, period costs are expensed in the fiscal period in which they occur.

13-83 Use of Resources in Operating Activities Activity Income Statement Operating Expenses Balance Sheet Assets Current Assets Liabilities Current Liabilities Assets Current Assets Liabilities Current Liabilities Cash Paid Statement of Cash Flows Exhibit 13 The Effect of Period Costs on the Financial Statements

13-84 Discontinued operations, extraordinary items, and accounting changes may appear on a company’s income statement. Non-recurring Gains and Losses

13-85 Discontinued operations are product lines or major parts of a company from which the company will no longer derive income … Non-recurring Gains and Losses

13-86 …because it has sold or closed the facilities that produced the product line or that included that part of the company. Non-recurring Gains and Losses

13-87 Extraordinary items are gains or losses that are both unusual and infrequent for a particular company. Non-recurring Gains and Losses

13-88 Non-recurring Gains and Losses A cumulative effect of a change in accounting method is a gain or loss associated with changing accounting methods or adopting new accounting standards.

13-89 T HE E ND C HAPTER F13

13-90

13-91 March 1 Inventory150$20.00$ 3,000 March 8 Batch3, ,900 March 18 Batch3, ,800 March 20 Sales5,200 March 28 Batch3, ,700 March 31 Sales3,600 Total Cost of Goods Available for Sale$188,400 March 1 Inventory150$20.00$ 3,000 March 8 Batch3, ,900 March 18 Batch3, ,800 March 20 Sales5,200 March 28 Batch3, ,700 March 31 Sales3,600 Total Cost of Goods Available for Sale$188,400 Exhibit 6 Unit Costs and Sales for Mom’s Cookie Company for March Return to Slide 70