The Financial Statements

The Financial Statements
CHAPTER 1 The Financial Statements © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

ACCOUNTING - THE BASIS OF DECISION MAKING
Accounting is the “language of business” Accounting is the information system that Measures business activities Processes that information into reports Communicates the results to decision makers © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

THE ACCOUNTING SYSTEM: THE FLOW OF INFORMATION
1. People make decisions 2. Business transactions occur 3. Businesses prepare reports to show the results of their operations © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

ACCOUNTING VS. BOOKKEEPING
Bookkeeping is the procedural element of accounting that processes the accounting data © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

DECISION MAKERS WHO USE ACCOUNTING INFORMATION
Individuals Businesses Investors and Creditors Government Regulatory Agencies Taxing Authorities Nonprofit Organizations © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

FINANCIAL ACCOUNTING AND MANAGEMENT ACCOUNTING
Financial accounting provides information to managers and people outside the firm Financial accounting information must meet certain standards of relevance and reliability Management accounting generates confidential information for internal decision makers, e.g., Top executives Department heads © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

ETHICAL CONSIDERATIONS
Ethical standards in accounting are designed to produce accurate information for decision making The result of ethical behavior by accountants is information that people can rely on for decision making © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

TYPES OF BUSINESS ORGANIZATIONS
Proprietorships Have a single owner who is generally the manager Are business entities, but not legal entities Have debt for which the proprietor is personally liable © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Partnerships Join two or more persons together as co-owners Are business entities, but not legal entities Have debt for which each partner is personally liable © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Corporations Are owned by stockholders or shareholders Are business entities and legal entities Are liable for all debts Stockholders have no personal obligation for corporation debts © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

ACCOUNTING PRINCIPLES AND CONCEPTS
Generally accepted accounting principles (GAAP) are The rules that govern how accountants operate Based upon a conceptual framework written by the Financial Accounting Standards Board (FASB) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

The FASB works with the SEC (Securities and Exchange Commission) and the AICPA (American Institute of Certified Public Accountants) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

KEY ACCOUNTING ORGANIZATIONS
Public Sector Law creates the SEC to regulate the stock and bond market in the U.S. Private Sector The FASB determines generally accepted accounting principles Private Sector Accountants apply GAAP through the AICPA GAAP governs accounting information © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

The entity concept States that an organization is an economic entity that keeps its affairs separate from those of the owner(s) The reliability (objective) principle States that accounting records and statements are based on the most reliable data available and documented by objective evidence © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

The cost principle States that acquired assets and services should be recorded at their actual (historical) cost and should maintain that historical cost for as long as they are owned The going-concern concept States that the entity will remain in operation for the foreseeable future © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

The stable-monetary-unit concept States that each dollar has the same purchasing power as any other dollar at any other time © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

THE ACCOUNTING EQUATION
The accounting equation presents the resources of the business and the claims to those resources Economic Resources = Claims to Economic Resources or Assets = Liabilities + Owners’ Equity © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Assets are the economic resources of a business that are expected to be of benefit in the future Claims to assets come from Liabilities Economic obligations - debts payable to outsiders, called creditors Owners’ equity (capital) Assets held by the owners of the business © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

For a corporation, stockholders’ (owners’) equity consists of two main categories Paid-in capital Retained earnings Assets = Liabilities + Stockholders’ Equity or Assets = Liabilities + Paid-in Capital + Retained Earnings © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Paid-in (contributed) capital is The amount invested in the corporation by its owners Comprised basically of common stock © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Retained earnings Is the amount earned by income-producing activities and kept for use in the business Is affected by Revenues - increases in retained earnings from delivering goods or services Expenses - decreases in retained earnings that result from operations © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Net income (net earnings) Total revenues exceed total expenses Net loss Total expenses exceed total revenues Dividends Distributions to stockholders (usually cash) generated by net income © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

COMPONENTS OF RETAINED EARNINGS
Revenues for the Period - Expenses for the Period Start of the Period = End of the Period Beginning Balance of Retained Earnings Net Income (Loss) for the Period Dividends for the Period Ending Balance of Retained Earnings + - - = © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

The owners’ equity of proprietorships and partnerships Makes no distinction between paid-in capital and retained earnings Accounts for the equity of each owner under the single heading of Capital © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

INFORMATION REPORTED ON THE FINANCIAL STATEMENTS
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Question Answer Financial Statement
1. 2. 3. 4. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

INCOME STATEMENT The income statement (statement of earnings) reports the company’s revenues, expenses, and net income or net loss for the period © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

INCOME STATEMENT Revenues are Expenses are
Increases in retained earnings from delivering goods or services to customers or clients Expenses are Decreases in retained earnings that result from operations © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

INCOME STATEMENT Expenses include Cost of goods sold (cost of sales)
The cost of the goods that a company sold to its customers Operating expenses The costs of operating the business © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

INCOME STATEMENT Operating expenses Advertising Depreciation
The cost to promote the company’s products Depreciation The expense of using company-owned buildings, equipment, and furniture Other operating expenses The costs of salaries, utilities, rent, and supplies Interest expense The cost of borrowed money © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

STATEMENT OF RETAINED EARNINGS
The statement of retained earnings reports that portion of net income the company has retained, or kept for use in the business Net income increases retained earnings Dividends paid to stockholders decrease retained earnings © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

STATEMENT OF RETAINED EARNINGS

BALANCE SHEET The balance sheet (statement of financial position) reports the company’s assets, liabilities, and owners’ equity © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

ASSETS Current assets are Current assets include
Those assets which the company expects to convert to cash, sell, or consume during the next 12 months or within the business's normal operating cycle if longer than a year Current assets include Cash Accounts receivable Merchandise inventory Prepaid expenses © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

ASSETS Long-term assets are Long-term assets include
Those assets which the company expects to hold longer then the next 12 months or the business’s normal operating cycle if longer than one year Long-term assets include Property Equipment © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

ASSETS Intangible assets are Other assets are
Those with no physical form Trademarks Patents Other assets are Those with small values which do not fall within any other standard asset category © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

LIABILITIES Current liabilities are Current liabilities include
Debts payable within one year or within the business’s normal operating cycle if longer than a year Current liabilities include Notes payable, short term Accounts payable Accrued expenses payable Income taxes payable © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

LIABILITIES Long-term liabilities are Long-term liabilities include
Debts not payable within one year or within the business’s normal operating cycle if longer than a year Long-term liabilities include Notes payable, long term Bonds payable © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

OWNERS’ EQUITY Owners’ equity
Represents the shareholders’ ownership of the assets of the business Owners’ equity of a corporation consists of Common stock Retained earnings © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

STATEMENT OF CASH FLOWS
The statement of cash flows reports the company’s cash inflows and outflows from operating, investing, and financing activities © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

STATEMENT OF CASH FLOWS
Operating activities Companies operate by buying goods and services, which are sold to customers Investing Activities Companies invest in long-term assets that are used to run the business Financing Activities Companies finance themselves by issuing stock and borrowing money © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

RELATIONSHIPS AMONG THE FINANCIAL STATEMENTS

Processing Accounting Information
CHAPTER 2 Processing Accounting Information © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE ACCOUNT The account is
A detailed record of changes that have occurred in a particular asset, liability, or stockholders’ (owners’) equity item during a period of time Grouped into three categories, according to the accounting equation: Assets Liabilities Owners’ equity Cash © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE ACCOUNT Assets are the economic resources that benefit the business now and in the future The Cash account Shows the cash effects of a business’s transactions Includes money and any medium of exchange that a bank accepts at face value © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE ACCOUNT The Accounts Receivable account
Represents a promise for future receipt The Inventory (Merchandise, Merchandise Inventory) account Is merchandise held for sale to customers The Notes Receivable account Is a written pledge that the customer will pay a fixed amount of money by a certain date © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE ACCOUNT Prepaid expense accounts The Land account
Are expenses paid in advance The Land account Is a record of the cost of land a business owns and uses in its operation The Buildings account Is the cost of a business’s buildings, e.g., office and manufacturing plant © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE ACCOUNT Equipment, Furniture, and Fixtures accounts
Record separate asset accounts for each type of equipment © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE ACCOUNT Liabilities are the debts of the company
The Notes Payable account Includes the amounts that the business must pay on promissory notes The Accounts Payable account Represents the promise to pay off debts arising from credit purchases Accrued Liability accounts Are expenses that have not yet been paid, e.g., Interest Payable, Salary Payable, and Income Taxes Payable © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE ACCOUNT Stockholders’ (Owners’) equity is the owners’ claims to the assets of a corporation A proprietorship uses a single account A partnership uses separate accounts for each owner’s capital balance and withdrawals A corporation uses separate capital accounts for each source of capital © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE ACCOUNT The Common Stock account The Retained Earnings account
Represents the owners’ investment in the corporation The Retained Earnings account Shows the cumulative net income earned by the corporation over its lifetime, minus cumulative net losses and dividends The Dividends account Indicates a decrease in retained earnings when dividends are paid by the corporation © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE ACCOUNT Revenues Expenses
Are reported in a separate account for each increase in stockholders’ equity created by delivering goods or services to customers, e.g., Sales Revenues, Service Revenues, Rent Revenues, Interest Revenues Expenses Are reported in a separate account for each type of expense, e.g., Cost of Sales, Salary Expense, Rent Expense, Advertising Expense, Utilities Expense © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ACCOUNTING FOR BUSINESS TRANSACTIONS
A transaction is any event that both affects the financial position of the business entity and can be reliably recorded © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The owners invest $50,000 of their money to begin the business, and Air & Sea Travel issues common stock to them © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The business buys stationery and other office supplies, agreeing to pay $500 to the office-supply store within 30 days © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Air & Sea Travel pays $2,700 for the following cash expenses: office rent $1,100, employee salary $1,200, and utilities $400 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The owners remodel their home at a cost of $30,000, paying cash from personal funds This event is a transaction of the personal entity, not the business entity No transaction is recorded for Air & Sea Travel © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The table on the next slide summarizes the 11 preceding transactions and provides the data that Air & Sea Travel will use to create its financial statements Data for the statement of cash flows are aligned under the Cash account Income statement data appear as revenues and expenses under Retained Earnings The balance sheet data are composed of the ending balances of the assets, liabilities, and stockholders’ equities The statement of retained earnings, which shows net income (loss) and dividends, can be prepared from the Retained Earnings column © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ANALYSIS OF TRANSACTONS
Income Statement Data Statement of Retained Earnings Data © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

FINANCIAL STATEMENTS OF AIR & SEA TRAVEL, INC.
© 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

DOUBLE-ENTRY ACCOUNTING
The Double-Entry System: Each transaction affects at least two accounts © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Every business transaction involves both a debit and a credit
THE T-ACCOUNT The left side is called the debit side, and the right side is called the credit side Account Title Debit Credit Every business transaction involves both a debit and a credit © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INCREASES AND DECREASES IN THE ACCOUNTS
The type of account determines how increases and decreases are recorded in it: Stockholders’ Equity Accounting Equation Assets = Liabilities + Rules of Debit and Credit Debit Credit Debit Credit Debit Credit - - - + + + © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Assets (debit-balance accounts) are on the opposite side of the equation from liabilities and stockholders’ equity (credit balance accounts) Increases and decreases in assets are recorded in the opposite manner from those in liabilities and stockholders’ equity Liabilities and stockholders’ equity, which are on the same side of the equal sign, are treated in the same way © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Reconsider the first transaction in the Air & Sea Travel illustration. Air & Sea Travel received $50,000 cash and issued common stock Assets = Liabilities Stockholders’ Equity Cash Common Stock Debit for increase, $50,000 Credit for increase, $50,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The second transaction is a $40,000 cash purchase of land Assets = Liabilities Stockholders’ Equity Cash Common Stock Credit for Decrease, 40,000 Bal. 50,000 Bal. 50,000 Land Debit for increase, 40,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Transaction 3 is a $500 purchase of office supplies on account
Assets = Liabilities Stockholders’ Equity Cash Accounts Payable Common Stock Credit for Increase, 500 Bal. 50,000 Bal. 10,000 Office Supplies Debit for increase, 500 Land Bal. 40,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ADDITIONAL STOCKHOLDERS’ EQUITY ACCOUNTS: REVENUES AND EXPENSES
Revenues are increases in stockholders’ equity that result from delivering goods and services to customers Expenses are decreases in stockholders’ equity due to the cost of operating the business © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

+ Common Stock Retained Earnings - Dividends Revenues Expenses The accounting equation can be expanded to include revenues and expenses Liabilities Assets + = Stockholders’ Equity © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Expanded Rules of Debit and Credit
Assets = Liabilities + Common Stock Debit for increase + Credit for Decrease - Debit for Decrease - Credit for Increase + Debit for Decrease - Credit for Increase + Retained Earnings Debit for Decrease - Credit for Increase + Dividends Debit for Increase + Credit for Decrease - Expanded Rules of Debit and Credit Revenues Debit for Decrease - Credit for Increase + Expenses Debit for Increase + Credit for Decrease - © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

RECORDING TRANSACTIONS IN THE JOURNAL
Accountants record transactions first in a journal: a chronological record of an entity’s transactions © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Steps of the journalizing process Identify the transaction from source documents, such as bank deposit slips, sale receipts, and check stubs Specify each account affected by the transaction and classify it by type (asset, liability, stockholders’ equity, revenue, or expense) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Determine whether each account is increased or decreased by the transaction Determine whether to debit or credit the account to record its increase or decrease Enter the transaction in the journal, including a brief explanation for the entry Enter the debit side first and the credit side next © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

A complete journal entry includes The date of the transaction The title of the account debited (placed flush left in the Accounts and Explanations column) The title of the account credited (indented slightly) The dollar amount of the debit (left) The dollar amount of the credit (right) A short explanation of the transaction (not indented) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The first transaction of Air & Sea Travel, Inc. Date Accounts and Explanation Debit Credit Apr. 2 Cash ,000 Common Stock 50,000 Issued common stock to owners. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

COPYING INFORMATION (POSTING) FROM THE JOURNAL TO THE LEDGER
The ledger is a grouping of all accounts with their balances Data must be copied to the appropriate accounts in the ledger - a process called posting © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Many individual asset accounts
Cash All individual accounts combined make up the company’s ledger Many individual asset accounts Accounts Payable Ledger Many individual liability accounts Common Stock Many individual stockholders’ equity accounts © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Journal Entry and Posting to the Ledger
Accounts and Explanation Debit Credit Cash……………………………..50,000 Common Stock…………… ,000 Issued common stock to owners Posting to the Ledger Cash Common Stock 50,000 50,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE FLOW OF ACCOUNTING DATA: PUTTING THEORY INTO PRACTICE
Source Documents Prepared Transaction Analysis Takes Place Transaction Entered in Journal Amounts Posted to Ledger Transaction Occurs © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Issued common stock to owners
Consider again selected transactions of Air & Sea Travel, Inc. - Transaction 1 Transaction analysis Air & Sea Travel, Inc., received $50,000 cash and in turn issued common stock to the owners Cash…………………………..50,000 Common Stock………… ,000 Issued common stock to owners Journal entry Accounting equation Assets = Liabilities + Stockholders’ Equity 50,000 = ,000 Ledger Accounts Cash Common Stock (1) 50,000 (1) 50,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Air & Sea Travel, Inc. - Transaction 2
Transaction analysis The business paid $40,000 for land Land…………………………..40,000 Cash…………………… ,000 Paid cash for land Journal entry Accounting equation Assets = Liabilities + Stockholders’ Equity +40,000 = -40,000 Ledger Accounts Cash Land (1) 50,000 (2) 40,000 (2) 40,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Transaction analysis The business purchased $500 of office supplies on account Office supplies…………………500 Accounts payable……… Purchased office supplies on account Journal entry Accounting equation Assets = Liabilities + Stockholders’ Equity = Ledger Accounts Office supplies Accounts Payable (3) 500 (3) 500 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Transaction analysis The business performed travel service for clients and received cash of $5,500 Cash…………………………..5,500 Service Revenue……… ,500 Performed services for cash Journal entry Stockholders’ Accounting equation Assets = Liabilities Equity Revenues 5, = ,500 Ledger Accounts Cash Service Revenue (1) 50,000 (4) 5,500 (2) 40,000 (4) 5,500 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ACCOUNTS AFTER POSTING
Each account has a balance, denoted as Bal. This amount is the difference between the account’s total debits and total credits Cash (1) 50,000 (4) 5,500 (9) 1,000 (10) 22,000 Bal. 33,300 (2) 40,000 (6) 2,700 (7) (11) 2,100 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE TRIAL BALANCE The trial balance
Is a list of all accounts with their balances Assets first, followed by liabilities and then stockholders’ equity Aids in the preparation of the financial statements by summarizing all the account balances Provides a check on accuracy by showing whether total debits equal total credits © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CORRECTING ACCOUNTING ERRORS
If total debits and total credits on the trial balance are not equal, then accounting errors exist © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Reason(s) behind many of the out-of-balance conditions can be detected by computing the difference between debits and credits on the trial balance and performing one or more of the following actions . . . © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Search the trial balance for a missing account Search the journal for the amount of the difference Divide the difference between total debits and total credits by 2. A debit treated as a credit, or vice versa, doubles the amount of the error Divide the out-of-balance amount by 9. If the result is evenly divisible by 9, the error may be a slide (writing $61 as $610) or a transposition (writing $61 as $16) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CHART OF ACCOUNTS A chart of accounts lists all accounts and account numbers Account numbers usually have two or more digits Assets are often numbered beginning with 1, liabilities with 2, stockholders’ equity with 3, revenues with 4, and expenses with 5 The second, third, and higher digits in an account number indicate the position of the individual account within the category © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BALANCE SHEET ACCOUNTS:
CHART OF ACCOUNTS BALANCE SHEET ACCOUNTS: ASSETS LIABILITIES STOCKHOLDERS’ EQUITY 101 Cash Accounts Payable Common Stock 111 Accounts Receivable Notes Payable Dividends 141 Office Supplies Retained Earnings 151 Office Furniture 191 Land INCOME STATEMENT ACCOUNTS (PART OF STOCKHOLDERS’ EQUITY): Revenues Expenses 401 Service Revenue Rent Expense 502 Salary Expense 503 Utilities Expense © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE NORMAL BALANCE OF AN ACCOUNT
An account’s normal balance is the side of the account - debit or credit - where increases are recorded Assets are called debit-balance accounts Liabilities and stockholders’ equity are called credit-balance accounts © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE NORMAL BALANCE OF AN ACCOUNT
Assets………………………………Debit Liabilities………………………… Credit Stockholders’ Equity - overall … Credit Common stock …………… Credit Retained Earnings ………… Credit Dividends………………………Debit Revenues ……………………… Credit Expenses………………………Debit © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

FOUR-COLUMN ACCOUNT FORMAT
The four-column account format has four amount columns The first pair of columns are for the debit and credit amounts from journal entries The second pair of amount columns are for the account’s balance © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

FOUR-COLUMN ACCOUNT FORMAT
Account: Cash Account No. 101 Balance Jrnl. Date Item Ref Debit Credit Debit Credit 20X1 Apr J , ,000 J , ,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Accrual Accounting and the Financial Statements
CHAPTER 3 Accrual Accounting and the Financial Statements © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

THE BUSINESS CYCLE Businesses pay cash to buy goods and services
Businesses sell goods and services, receiving cash to complete the cycle © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

THE BUSINESS CYCLE 1 Entity has cash 3 Entity has a receivable 2
Purchase of inventory Collection of the receivable 3 Entity has a receivable 2 Entity holds inventory Sale of inventory on account © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

ACCRUAL-BASIS ACCOUNTING VS. CASH-BASIS ACCOUNTING
Accrual accounting Recognizes the impact of a business event as it occurs Revenues are recorded as they are earned Expenses are recorded as they are incurred Is based on a conceptual framework that includes a number of accounting concepts and principles Is required by GAAP © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

THE TIME-PERIOD CONCEPT
Accountants slice time into small segments and prepare financial statements to show progress for specific time periods The most basic accounting period is one year Companies prepare financial statements for interim periods of less than one year © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

THE REVENUE PRINCIPLE The revenue principle tells accountants
When to record revenue with a journal entry Revenue is recorded when it is earned It is earned when the business has delivered a completed good or service to the customer The amount of revenue to record The amount is equal to the cash value of the goods or services transferred to the customer © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Situation 1 - Do Not Record Revenue Situation 2 - Record Revenue
I plan to have you make my travel arrangements March 12 April 2 Air & Sea Travel, Inc. Air & Sea Travel, Inc. photos Disney World No transaction has occurred Situation 1 - Do Not Record Revenue The client has taken a trip arranged by Air & Sea Travel Situation 2 - Record Revenue © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

THE MATCHING PRINCIPLE
Is the basis for recording expenses Directs accountants to Identify all expenses incurred during the accounting period Measure the expenses Match expenses against revenues during the same period © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

The matching principle matches the expense of a period against the revenue earned during the period. To match an expense means to subtract the expense from the revenue in order to measure net income or net loss Revenue Expense Expense Revenue Net income (Net loss) = = Net income or Net loss © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

A natural link (cause and effect) exists between revenues and some types of expenses Sales commissions Cost of goods sold Some expenses are not linked with sales but with a particular time period Rent expense Salary expense © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

UPDATING THE ACCOUNTS FOR THE FINANCIAL STATEMENTS:
The Adjustment Process © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

THE ADJUSTMENT PROCESS
The adjustment process begins with the trial balance The unadjusted trial balance lists the accounts and their balances after the period’s transactions have been recorded © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

These trial balance accounts are incomplete because they omit certain revenue and expense transactions that affect more than one accounting period The accrual basis requires adjustment at the end of the period to produce correct balances for the financial statements © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Consider the Supplies account Supplies is adjusted once a month The amount on the trial balance represents the cost of supplies available for use during the month The supplies on hand at the end of the month must be counted to determine the correct amount to report on the balance sheet © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

The adjustment of Supplies (and Supplies Expense) at the end of the accounting period March 31 April 30 Supplies available for use during April Supplies on hand at April 30 Supplies expense for April = TOTAL COST ASSET = EXPENSE $700 $400 = $300 The adjusting entry updates both the Supplies asset account and the Supplies Expense account © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Accountants make adjusting entries in the journal at the end of the period to enter adjustments into the accounting records Adjusting entries Assign revenues to the period in which they are earned and expenses to the period in which they are incurred Update the asset and liability accounts © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Summary of the Accounting Cycle January 1 December 31 Transactions are recorded all during the period Adjustments are made at the end of the period, but before the financial statements are prepared © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Adjusting entries can be grouped into three basic categories: Deferrals An adjustment of an asset or a liability for which the business paid or received cash in advance Depreciation The systematic allocation of the cost of a plant asset to expense over the asset’s useful life Accruals The recording of an expense or a revenue before paying or receiving cash © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

PREPAID EXPENSES PREPAID RENT
Suppose Air & Sea Travel prepays three months’ rent on April 1, 20X1. If the lease specifies a monthly rental amount of $1,000, the entry to record the payment for three months debits Prepaid Rent as follows: Apr Prepaid Rent (1,000 x 3) ,000 Cash ,000 Paid three months’ rent in advance © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

At April 30, Prepaid Rent is adjusted to remove one month’s expense from the asset account. The adjustment transfers one-third of the asset balance from Prepaid Rent to Rent Expense as follows: Apr Rent Expense (3000 x1/3) ,000 Prepaid Rent ,000 To record rent expense © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

After posting, Prepaid Rent and Rent Expense appear as follows: Prepaid Rent Rent Expense Apr ,000 Apr ,000 Apr ,000 Bal ,000 Bal ,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

PREPAID EXPENSES SUPPLIES
On April 2, Air & Sea Travel paid cash of $700 for office supplies Apr Supplies Cash Paid cash for supplies © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

To measure the business’s supplies expense during April, the owners count the supplies on hand at the end of the month. The count indicates that supplies costing $400 remain. Subtracting the entity’s $400 supplies on hand at the end of April from the cost of supplies available during April ($700) measures supplies expense during the month ($300). © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

The April 30 adjusting entry to update the Supplies account and to record the Supplies Expense for the month is as follows: Apr Supplies Expense ( $700 - $400) Supplies To record supplies expense © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

DEPRECIATION OF PLANT ASSETS
Plant assets are Long-lived tangible assets, such as land, buildings, furniture, machinery, and equipment used in the operations of the business Depreciation is The process of allocating the cost of the decline in value of a plant asset to expense © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

On April 3, Air & Sea Travel purchased furniture on account for $16,500 and made the following entry: Apr Furniture ,500 Accounts Payable ,500 Purchased office furniture on account © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

The straight-line method of depreciation gives an annual depreciation expense of $3,300 $16,000/5 years = $3,300 per year Depreciation for the month of April is $275 $3,300/12 months = $275 per month © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Depreciation expense for April is recorded as follows: Apr Depreciation Expense - Furniture Accumulated Depreciation - Furniture To record depreciation on furniture © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

The Accumulated Depreciation account Shows the cumulative sum of all depreciation expense from the date of acquiring the asset Is a contra asset account An asset account with a normal credit balance A contra account Always has a companion account Always has a normal balance that is opposite that of the companion account © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Accumulated Depreciation
DEPRECIATION OF PLANT ASSETS After posting, the Furniture, Accumulated Depreciation - Furniture, and Depreciation Expense - Furniture accounts appear as follows: Depreciation Expense Furniture Accumulated Depreciation Furniture Furniture Apr ,500 Apr Apr Bal Bal Bal ,500 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Book value is the net amount of a plant asset (cost minus accumulated depreciation) Plant Assets: Furniture $16,500 Less Accumulated Depreciation (275) Book value $16,225 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

ACCRUED EXPENSES An accrued expense is a liability that arises from an expense that the business has incurred but has not yet paid © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

ACCRUED EXPENSES SALARY EXPENSE
Air & Sea Travel pays its employee a monthly salary of $1,900, half on the 15th and half on the last day of the month. During April, the agency paid the employee’s first half-month salary of $950 and made the following entry: Apr Salary Expense Cash To pay salary © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Because April 30, the second payday of the month, falls on a Saturday, the second half-month amount of $950 will be paid on Monday, May 2. At April 30, Air & Sea’s accountant adjusts for additional salary expense and salary payable of $950 by recording an increase in each account as follows: Apr Salary Expense Salary Payable To accrue salary expense © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

After posting, the Salary Payable and Salary Expense accounts appear as follows: Salary Payable Salary Expense Apr Apr Apr Bal Bal ,900 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

ACCRUED REVENUES Guerrero Tours hires Air & Sea Travel on April 15 to perform services on a monthly basis. Guerrero will pay the travel agency $500 monthly, with the first payment on May 15. On April 30, Air & Sea Travel makes the following adjusting entry for half a month’s fee: Apr Accounts Receivable ($500 x 1/2) Service Revenue To accrue service revenue © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

ACCRUED REVENUES Posting this adjusting entry has the following effects on these two accounts: Accounts Receivable Service Revenue 2,250 Apr 7,000 Apr Bal ,500 Bal ,250 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

UNEARNED REVENUES An unearned revenue is an obligation arising from receiving cash in advance of providing a product or a service © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

UNEARNED REVENUES Baldwin Investment Bankers agrees to pay the travel agency $450 monthly. If Air & Sea Travel collects the first amount on April 20, the increases in assets and liabilities are recorded as follows: Apr Cash Unearned Service Revenue Received revenue in advance Unearned Service Revenue is a liability because it represents Air & Sea’s obligation to perform service for the client © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

UNEARNED REVENUES During the last 10 days of the month, the travel agency will earn one-third of the $450. The accountant makes the following adjustment: Apr Unearned Service Revenue (450 x 1/3) Service Revenue To record unearned service revenue that has been earned © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Unearned Service Revenue
UNEARNED REVENUES After posting, the balance of these two accounts appears as follows: Unearned Service Revenue Service Revenue 7,000 Apr Apr Apr Apr Bal Bal ,400 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

PREPAID- AND ACCRUAL- TYPE ADJUSTMENTS

SUMMARY OF THE ADJUSTING PROCESS

THE ADJUSTED TRIAL BALANCE
The adjusted trial balance lists the accounts, along with their adjusted balances Trial Balance © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

PREPARING THE FINANCIAL STATEMENTS FROM THE ADJUSTED TRIAL BALANCE
The April financial statements of Air & Sea Travel can be prepared from the adjusted trial balance © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

ETHICAL ISSUES IN ACCRUAL ACCOUNTING
Ethical issues include “Managing” earnings to meet established goals or budgets Misrepresenting company assets, liabilities, revenues, and expenses to financial statement users © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

CLOSING THE BOOKS Temporary (nominal) accounts are
Revenue, expense, and dividends accounts Closed at the end of the accounting period Permanent (real) accounts are Assets, liabilities, and stockholders’ equity accounts Are not closed at the end of the period because their balances are not used to measure income © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

CLOSING THE BOOKS Closing entries transfer revenue, expense, and dividends balances from their respective accounts to the Retained Earnings account © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

CLOSING THE BOOKS The following are the steps in closing the accounts of a corporation: Debit each revenue account for the amount of its credit balance. Credit Retained Earnings for the sum of the revenues This entry transfers the sum of the revenues to the credit side of Retained Earnings Credit each expense account for the amount of its debit balance. Debit Retained Earnings for the sum of the expenses This entry transfers the sum of the expenses to the debit side of Retained Earnings © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

CLOSING THE BOOKS Credit the Dividends account for the amount of its debit balance. Debit the Retained Earnings account This entry transfers the dividends amount to the debit side of the Retained Earnings account If Air & Sea Travel closes the books at the end of April, the following slides present the complete closing process for the business © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Journalizing Closing Entries  Apr. 30 Service Revenue 7,400
Retained Earnings 7,400  Retained Earnings 4,415 Rent Expense 1,000 Salary Expense 1,900 Supplies Expense Depreciation Expense Utilities Expense Income Tax Expense  30 Retained Earnings 3,200 Dividends 3,200 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Posting Closing Entries:
Rent Expense Service Revenue Adj. 1,000 Bal. 1,000 Clo. 1,000 7,000 Adj Adj Salary Expense 950 Adj Clo, 7,400 Bal. 7,400  Bal. 1,900 Clo. 1,900 Supplies Expense Retained Earnings  Adj. 300 Clo. 4,415 Clo. 3,200 11,250 Clo. 7,400 Bal. 300 Clo Bal 11,035 Depreciation Expense Adj. 275 Dividends Bal. 275 Clo Bal. 3,200 Clo. 3,200 Utilities Expense  Adj. 400 Bal. 400 Clo Adj. = Amount posted from an adjusting entry; Clo. = Amount posted from a closing entry; Bal. = Balance Income Tax Expense Adj. 540 As arrow shows, it is not necessary to make a separate closing entry for each expense. In one closing entry, record one debit to Retained Earnings and a separate credit to each expense account Bal. 540 Clo © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

DETAILED CLASSIFICATION OF ASSETS AND LIABILITIES

Liquidity is a measure of how quickly an item can be converted to cash
Balance sheets list assets and liabilities in the order of their relative liquidity © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

ASSETS Current assets Are assets that are expected to be converted to cash, sold, or consumed during the next 12 months or within the business’s normal operating cycle if longer than a year Include Cash, Accounts Receivable, Notes Receivable, and Prepaid Expenses - merchandising entities include Inventory in current assets © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

ASSETS Long-term assets
Are all assets that are not classified as current assets. They are not held for sale, but rather are used to operate the business Include plant assets (Property, Plant, and Equipment), Land, Buildings, Furniture and Fixtures, and Equipment Include investments in Available-for-Sale Securities, investments in Held-to-Maturity Securities, and Other Assets © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

LIABILITIES Current liabilities
Are debts that are due to be paid within one year or within the entity’s operating cycle if longer than a year Include Accounts Payable, Notes Payable due within one year, Salary Payable, Unearned Revenue, Interest Payable, and Income Tax Payable © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

LIABILITIES Long-term liabilities
Are all liabilities that are not classified as current Include Notes Payable - Long Term © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

DIFFERENT FORMATS FOR THE FINANCIAL STATEMENTS
Balance sheet formats The account format Lists the assets at left and the liabilities and stockholders’ equity at right The report format Lists the assets at the top, followed by the liabilities and stockholders’ equity below © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

DIFFERENT FORMATS FOR THE FINANCIAL STATEMENTS
Income statement formats A single-step income statement Lists all the revenues together under a heading such as Revenues or Revenues and Gains. The expenses appear in a separate category titled Expenses, Costs and Expenses, or Expenses and Losses A multi-step income statement Contains a number of subtotals to highlight important relationships among revenues and expenses © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

MULTI-STEP INCOME STATEMENT
Net sales revenue $150,000 Cost of goods sold ,000 Gross margin ,000 Operating expenses (listed individually) ,000 Income from operations ,000 Other income (expense): Interest revenue $2,000 Interest expense (9,000) Gain on sale of equipment 3, (4,000) Income before tax ,000 Income tax expense ,000 Net income $ 16,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

USE OF ACCOUNTING INFORMATION IN DECISION MAKING
ACCOUNTING RATIOS © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

A rule of thumb: A strong current ratio is 2.00
Total current assets Current ratio = Total current liabilities The current ratio Is the ratio of any entity's current assets to its current liabilities Measures the company’s ability to pay current liabilities with current assets A rule of thumb: A strong current ratio is 2.00 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

A low debt ratio is safer than a high debt ratio
Total liabilities Debt ratio = Total assets The debt ratio Is the ratio of total liabilities to total assets Indicates the proportion of a company’s assets that is financed with debt Measures a business’s ability to pay both current and long-term debts - total liabilities A low debt ratio is safer than a high debt ratio © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison & Horngren

Internal Control and Managing Cash
CHAPTER 4 Internal Control and Managing Cash © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INTERNAL CONTROL Internal control is the organizational plan and all the related measures that an entity adopts to Safeguard assets Encourage adherence to company policies Promote operational efficiency Ensure accurate and reliable accounting records © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INTERNAL CONTROL An effective system of internal control has the following characteristics: Competent, reliable, and ethical personnel Assignment of responsibilities to each employee Proper authorization for deviation from standard policy © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INTERNAL CONTROL Separation of duties
Separation of operations from the accounting function Separation of the custody of assets from accounting for them Separation of the authorization of transactions from the custody of related assets Separation of duties within the accounting function © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INTERNAL CONTROL Internal and external audits
An audit is the examination of the company’s financial statements and the accounting systems, internal controls, and records that produced them An internal auditor is an employee of the business who reports directly to the audit committee An external auditor is an independent auditor hired by a company to audit the financial statements and the factors affecting them © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Organizational Chart of a Corporation
Board of Directors Audit Committee External Auditing Organizational Chart of a Corporation President Senior Vice President Vice President, Production Vice President, Marketing Vice President, Finance and Accounting Other Vice Presidents Treasurer Controller Collections and Credits Cash Management General Accounting Taxes Internal Auditing Investor Relations Banking Relations Budgeting Systems © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INTERNAL CONTROL Documents and records
Business documents and records include Source documents Invoices, purchase orders, receipts, etc. Accounting journals Accounting ledgers Electronic and computer controls Electronic sensors on merchandise Control totals © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INTERNAL CONTROL Other controls Fireproof vaults Burglar alarms
Point of sale terminals Frequent bank deposits Bonded cashiers A bond is an insurance policy that reimburses the company for losses due to employee theft Mandatory vacations Job rotation © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INTERNAL CONTROL The limitations of internal control
A system designed to thwart an individual employee’s fraud can be beaten by collusion between two or more employees to defraud the system A system of internal control that is too complex can hurt efficiency and control © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

USING THE BANK ACCOUNT AS A CONTROL DEVICE
The business should deposit all cash receipts in a bank account and make all cash payments through it. The documents used to control a bank account include the… Signature card Deposit ticket Check Bank statement Bank reconciliation © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Signature Card A card signed by each person authorized to transact business through an account in a bank It protects both the bank and the depositor against forgery © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Deposit ticket A form supplied by the bank which serves as proof of a transaction Check A document instructing the bank to pay the designated person or business a specified amount of money The three parties to a check are The maker The payee The bank © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Check Serial Number Bank Payee Bay Area National Bank California Products Three hundred nineteen and 47/ Dollars Maker © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The bank statement shows the account’s beginning and ending balance and lists the month’s transactions processed by the bank as well as the maker’s canceled checks An electronic funds transfer (EFT) transfers cash by electronic communications EFTs are listed among the deposits and payments on the bank statement © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The bank reconciliation Explains the difference between the firm’s cash balance and the bank statement balance on a certain date Ensures that all cash transactions have been accounted for and that the bank and book records of cash are correct © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Items that cause differences between the bank balance and the book balance are Items recorded by the company but not yet recorded by the bank Deposits in transit - recorded by the company but not by the bank Outstanding checks - issued and recorded by the company, but not yet paid by the bank © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Items recorded by the bank but not yet recorded by the company Bank collections received on behalf of the business Electronic funds transfers paid or received on behalf of the business Service charge assessed by the bank for processing the business’s transactions Interest revenue on checking account © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

NSF (nonsufficient funds) checks received from customers which are worthless and returned to the payee Checks collected, deposited, and returned to the payee by the bank for reasons other than NSF The cost of printed checks Errors by either the company or the bank © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The Paths That Two Checks Take
1 Maker writes check to payee 1 Maker writes check to payee 2 Payee deposits check in bank, which increases payee’s balance 4 Maker’s bank decreases Maker’s balance and sends cancelled check to Maker 3 Payee’s bank sends check to Maker’s bank 4 Maker’s bank account not sufficient to pay the check 2 Payee deposits check in bank, which increases Payee’s balance The Paths That Two Checks Take 3 Payee’s bank sends check to Maker’s bank 5 Maker’s bank returns worthless check to Payee’s bank 7 Payee holds worthless check 6 Payee’s bank decreases payees balance and returns worthless check to payee © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BANK RECONCILIATION ILLUSTRATED
The bank statement for Business Research, Inc., on the next slide indicates that the January 31 bank balance is $5,931.51 © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The detail of Business Research, Inc.’s, cash records is presented on the following slide The company’s Cash account has a balance of $3,294.21 Cash © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Date Item Debit Credit Balance
Ledger: ACCOUNT Cash Date Item Debit Credit Balance 20X1 Jan 1 Balance ,556.12 2 Cash receipt 1, ,668.12 7 Cash receipt ,862.72 31 Cash payments , ,702.58 31 Cash receipt 1, ,294.21 Cash Payments Check No Amount Check No. Amount 332 $3, $286.00 , © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The following reconciling items explain why the two balances differ: The January 31 deposit of $1, does not appear on the bank statement The bank erroneously charged to the account a $100 check (No. 656) written by Business Research Associates © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Five company checks issued late in January and recorded in the journal have not been paid by the bank Check No Date Amount 337 Jan. 27 $286.00 © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The bank received $ by EFT on behalf of Business Research, Inc. The bank collected on behalf of the company a note receivable, $2,114 (including interest of $214) The bank statement shows interest revenue of $28.01 © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Check number 333 for $150 paid to Brown Company on account was recorded as a cash payment of $510 The bank service charge for the month was $14.25 The bank statement shows an NSF check for $52 Business Research pays insurance expense by EFT and has not recorded this $361 payment © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Reconciling items are treated as follows: To the bank balance always Add deposits Subtract outstanding checks Add or subtract corrections of bank errors, as appropriate © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Reconciling items are treated as follows: To the book balance always Add bank collection items, interest revenue, and EFT receipts Subtract service charges, NSF checks, and EFT payments Add or subtract correction of book errors, as appropriate © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

On the basis of the reconciliation, Business Research, Inc., makes the following entries (numbers in parentheses correspond to the reconciling items): Jan. 31 (4) Cash Rent Revenue Receipt of monthly rent © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Jan. 31 (5) Cash ,114.00 Notes Receivable 1,900.00 Interest Receivable Note receivable collected by bank Jan. 31 (6) Cash Interest Revenue Interest earned on bank balance © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Jan. 31 (7) Cash Accounts Payable - Brown Co Correction of check no. 333 Jan. 31 (8) Misc. Expense Cash Bank service charge © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Jan. 31 (9) Accounts Receivable - L. Ross Cash NSF check returned by bank Jan 31. (10) Insurance Expense Cash Payment of monthly insurance © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

OPERATING CYCLE OF A BUSINESS
Cash Collection of Cash Purchases Accounts Receivable Inventory Sales on Account © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

MANAGING CASH Speeding the collection of cash from sales Companies
Sell most of their goods on account Keep a subsidiary accounts receivable ledger with a separate account for each customer Use the accounts receivable ledger to pursue collection from individual customers © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ACCOUNTS RECEIVABLE SUDSIDIARY LEDGER
GENERAL LEDGER Kmart Cash Bal. 1,000 Bal. XX Target Accounts Receivable Bal Bal. 1,800 Toys “R” Us Bal Total 1,800 © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

MANAGING CASH Companies offer sales discounts that motivate customers to pay within a specified period Credit terms of “2/10, n/30” means the customer can Take a 2% discount by paying within ten days of the date of the sale or Pay the full amount within 30 days © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

MANAGING CASH Suppose Fisher-Price makes a $50,000 sale to Toys “R” Us on August 4. If credit terms are 2/10, n/30 and Fisher-Price collects on August 14, Fisher-Price would record the sale and collection with these journal entries: Aug Accounts Receivable - Toys “R” Us 50,000 Sales Revenue 50,000 Sale on account Aug Cash ($50,000 x .98) 49,000 Sales Discount ($50,000 x .02) 1,000 Accounts Receivable - Toys “R” Us 50,000 Collection on account © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

MANAGING CASH Internal control over cash receipts ensures that
All cash receipts are deposited in the bank The company’s cashier combines them with any cash received over the counter and prepares the bank deposit © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INTERNAL CONTROLS OVER CASH RECEIPTS
Element of Internal Control Internal Controls over Cash Receipts Competent, reliable, Companies carefully screen employees for ethical personnel undesirable personality traits. They also spend large sums for training programs. Assignment of Specific employees are designated as cashiers, responsibilities supervisors of cashiers, or accountants for cash receipts. Proper authorization Only designated employees, such as department managers, can grant exceptions for customers, approve check receipts above a certain amount, and allow customers to purchase on credit. Separation of duties Cashiers and mailroom employees who handle cash do not have access to the accounting records. Accountants who record cash receipts have no opportunity to handle cash. © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Internal and external Internal auditors examine company transactions audits for agreement with management policies. External auditors examine the internal controls over cash receipts to determine whether the accounting system produces accurate amounts for revenues, receivables, and other items related to cash receipts. Documents and records Customers receive receipts as transaction records. Bank statements list cash receipts for reconciliation with company records (deposit tickets). Customers who pay by mail include a remittance advice showing the amount of cash they sent to the company. Electronic and computer Cash registers serve as transaction records. Each controls day’s receipts are matched with customer remittance advices and with the day’s deposit ticket from the bank. Other controls Cashiers are bonded. Cash is stored in vaults and banks. Employees are rotated among jobs and are required to take vacations. © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INTERNAL CONTROL OVER CASH PAYMENTS
The Purchasing Process Business Document Prepared by Sent to Purchase request Sales department Purchasing department (requisition) Purchase order Purchasing Outside company that department sells the needed merchandise (supplier or vendor) Invoice (bill) Outside company Accounting department that sells the needed merchandise (supplier or vendor) Receiving report Receiving department Accounting department Disbursement packet Accounting department Officer who signs the check © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INTERNAL CONTROLS OVER CASH PAYMENTS
Element of Internal Control Internal Controls over Cash Payments Competent, reliable, Cash payments are entrusted to high-level ethical personnel employees, with larger amounts paid by the treasurer or assistant treasurer. Assignment of Specific employees approve purchase documents responsibilities for payment. Executives examine approvals, then sign checks. Proper authorization Large expenditures must be authorized by the company owner or board of directors to ensure agreement with organizational goals. Separation of duties Computer operators and other employees who handle checks have no access to the accounting records. Accountants who record cash payments have no opportunity to handle cash. © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Internal and external Internal auditors examine company transactions audits for agreement with management policies. External auditors examine the internal controls over cash payments to determine whether the accounting system produces accurate amounts for expenses, assets, and other items related to cash disbursement . Documents and records Suppliers issue invoices that document the need to pay cash. Bank statements list cash payments (checks and EFT disbursements) for reconciliation with company records. Checks are prenumbered in sequence to account for payments. Electronic, computer, Blank checks are stored in a vault and controlled and other controls by a responsible official with no accounting duties. Machines stamp the amount on a check in indelible ink. Paid invoices are punched to avoid duplicate payment. © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Controlling Petty Cash The petty cash fund is A small amount of cash kept on hand to pay for minor expenses Opened with a particular amount of cash The custodian of the petty cash fund Cashes a check and places the currency and coin in the fund Prepares a petty cash ticket for each petty cash payment © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Petty Cash Ticket Date Mar. 25, 20X4 No. 47 Amount $23.00 For Box of floppy diskettes Debit Office supplies, Acct. No. 145 Received by Fund Custodian © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

In an imprest petty cash system The sum of the cash in the petty cash fund plus the total of the ticket amounts should equal the opening balance at all times The petty cash account keeps its prescribed balance at all times © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

USING A BUDGET TO MANAGE CASH
Is a quantitative expression of a plan that helps managers coordinate the entity’s activities Helps a company manage its cash by expressing the plan for the receipt and payment of cash during a future period © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

To prepare for future cash needs, managers proceed in four steps: Start with the entity’s cash balance at the beginning of the period Add the budgeted cash receipts and subtract the budgeted cash payments Revenue and expense transactions (operating activities from the income statement) © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Asset acquisition and sale transactions (investing activities from the statement of cash flows) Liability and stockholders’ equity transactions (financing activities from the statement of cash flows) The beginning balance plus the expected receipts minus the expected payments equals the expected cash balance at the end of the period © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Compare the expected cash balance to the desired, or budgeted, cash balance at the end of the period Excess cash can be invested Cash balances below the budgeted balance may require additional financing to reach the desired cash balance The following slide shows an example of a cash budget for The Gap, Inc. © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

REPORTING CASH ON THE BALANCE SHEET
Companies usually combine all cash amounts into a single total called “Cash and Cash Equivalents” on the balance sheet Cash equivalents include liquid assets such as Time deposits Certificates of deposit © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

REPORTING CASH ON THE BALANCE SHEET

CORPORATE AND PROFESSIONAL CODES OF ETHICS
Most large companies have a code of ethics designed to encourage ethical and responsible behavior by their employees © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CORPORATE AND PROFESSIONAL CODES OF ETHICS
Accountants have additional incentives to behave ethically Independent accountants must abide by the AICPA Code of Professional Conduct Members of the Institute of Management Accountants are bound by the Standards of Ethical Conduct for Management Accountants © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ETHICAL ISSUES IN ACCOUNTING
To make ethical decisions, people should proceed in six steps: Determine the facts Identify the ethical issues Specify the alternatives Identify the people involved Assess the possible outcomes Make the decision © 2000 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Short-Term Investments
CHAPTER 5 Short-Term Investments and Receivables Note © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

SOME BASIC TERMINOLOGY
Creditor The party to whom money is owed Debt instrument A payable, usually some form of note or bond payable Debtor The party who has a debt © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Equity securities Stock certificates that represent the investor’s ownership of shares of stock in a corporation Maturity The date on which a debt instrument matures or becomes payable © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Securities Notes payable or stock certificates that entitle the owner to the benefits of an investment Term The length of time until a debt instrument matures © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

SHORT-TERM INVESTMENTS (MARKETABLE SECURITIES)
Short-term investments are investments that a company plans to hold for one year or less Short-term investments fall into three categories: Held-to-maturity securities Trading securities Available-for-sale securities © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Held-to-maturity securities are Debt instruments that pay interest Usually held until their maturity dates Reported on the balance sheet at amortized cost Cost plus accrued interest to date © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Short-Term Investment in GE Commercial Paper
SHORT-TERM INVESTMENTS (MARKETABLE SECURITIES) Suppose that on May 1, 2001, Oracle pays $100,000 for General Electric Co. commercial paper that will mature at $100,900 in 90 days. On May 1, 2001, Oracle will record the purchase of the investment in GE commercial paper at $100,000, and Oracle’s Short-Term Investment account will appear as follows: Short-Term Investment in GE Commercial Paper 100,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Short-Term Investment in GE Commercial Paper Interest Revenue
Assuming a May 31 year end, Oracle will accrue 30 days’ interest revenue of $300 that has been earned on the investment [($100,900 - $100,000) x 30/90]. The entries to the Short-Term Investment account and the Interest Revenue account are as follows: Short-Term Investment in GE Commercial Paper Interest Revenue 100,000 300 300 At May 31, Oracle’s amortized cost of its investment in GE commercial paper is $100,300, as shown in the following T-account: Short-Term Investment in GE Commercial Paper 100,000 300 Bal. 100,300 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Trading securities are Purchased as short-term investments Equity or debt securities of another company Accounted for using the market-value method Recorded at cost and later adjusted to current market value for reporting on the balance sheet © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Short-Term Investment in Ford Stock
SHORT-TERM INVESTMENTS (MARKETABLE SECURITIES) Suppose Oracle buys Ford Motor Company stock as a trading investment for $80,000 on May 23, After purchase, Oracle’s Investment account appears as follows: Short-Term Investment in Ford Stock 80,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Short-Term Investment in Ford Stock Unrealized Gain on Investment
SHORT-TERM INVESTMENTS (MARKETABLE SECURITIES) Assume that the Ford stock has increased in value, and at May 31, 2001, Oracle’s investment in Ford stock is worth $90,000--$10,000 more than the purchase price. The year-end adjustment to record market value is as follows: Short-Term Investment in Ford Stock Unrealized Gain on Investment 80,000 10,000 10,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

REPORTING ON THE BALANCE SHEET
Current assets short-term investments: GE commercial paper $100,300 Trading securities: Ford Motor Company stock, at current market value ,000 $190,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

REPORTING ON THE INCOME STATEMENT
Oracle reports its interest revenue, dividend revenue, and gains and losses as Other Revenue (Expense) on its income statement Other Revenue arises from activities other than the company’s main operations Operating income reports on Oracle’s success in its main operations © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

REPORTING ON THE INCOME STATEMENT
The gain or loss on the sale of trading securities is The difference between the sale proceeds and last carrying amount of the investment Reported as Other Revenue (Expense) on the income statement © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Available-for-sale securities are All investment securities not classified as held-to-maturity or trading Long-term investments Reported on the balance sheet at market value © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Accounts and Notes Receivable

The Different Types of Receivables
Receivables are Monetary claims against businesses and individuals Acquired by selling goods and services and by lending money © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Accounts receivable (trade receivables) are Amounts owed to the business by customers Classified as current assets Summarized in the general ledger control account showing the total amounts receivable from all customers Detailed in the subsidiary ledger of accounts receivable with a separate account for each customer © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ACCOUNTS RECEIVABLE SUDSIDIARY LEDGER
GENERAL LEDGER Accounts Receivable Aston Bal. 9,000 Bal. 5,000 Harris Bal. 1,000 Salazar Bal. 3,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

A Note Receivable is A formal promise made by a debtor in writing to pay the creditor a definite sum on a specific future date--the maturity date A current asset if due within one year or less A long-term receivable (investment) if due beyond one year © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INTERNAL CONTROL OVER THE COLLECTION OF RECEIVABLES
An important element of internal control of cash receivables is the separation of cash-handling and cash-accounting duties A bookkeeper should not both handle cash and make the journal entry for its receipt © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ACCOUNTING FOR UNCOLLECTIBLE ACCOUNTS
Selling on credit creates both a benefit and a cost: The benefit - Customers who are unwilling or unable to pay cash immediately may make a purchase on credit, and company revenues and profits rise as sales increase The cost - The company will be unable to collect from some of its credit customers © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Accountants label this cost: Uncollectible-account expense or Doubtful account expense or Bad debt expense There are two methods to account for uncollectible-account expense: The allowance method The direct write-off method © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The Allowance Method The allowance method records collection losses on the basis of estimates instead of waiting to see which customers the business will not collect from © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The Allowance for Uncollectible Accounts (Allowance for Doubtful Accounts) is An estimated amount of the receivables that the business expects not to collect A contra account related to Accounts Receivable © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Subtracting the Allowance for Uncollectibles from Accounts Receivable yields the net amount that the company does expect to collect: Balance Sheet (partial): Accounts Receivable $10,000 Less: Allowance for uncollectible accounts (900) Accounts receivable, net $ 9,100 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Income statement (partial): Uncollectible-account expense $2,000
ACCOUNTING FOR UNCOLLECTIBLE ACCOUNTS The income statement reports Uncollectible-Account Expense among the operating expenses: Income statement (partial): Expenses: Uncollectible-account expense $2,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

METHODS OF ESTIMATING UNCOLLECTIBLES
There are two basic ways to estimate uncollectibles: Percent-of-sales method Aging-of-accounts-receivable method © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Percent of Sales The percent-of-sales method Computes uncollectible-account expense as a percentage of net credit sales Is an income statement approach because it focuses on the amount of expense to be reported on the income statement © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

PERCENT-OF-SALES METHOD
Assume it is December 31, 20X3, and the accounts have these balances before the year-end adjustments: Allowance for Uncollectable Accounts Accounts Receivable 120,000 500 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The credit department estimates that uncollectible-account expense is 1.5% of net credit sales, which were $500,000 for 20X3. The adjusting entry to record bad-debt expense for the year and to update the allowance is 20X3 Dec Uncollectible-Account Expense ($500,000 x 0.015) 7,500 Allowance for Uncollectible Accounts ,500 Recorded expense for the year © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Now the accounts are ready for reporting in the 20X3 financial statements Allowance for Uncollectible Accounts Accounts Receivable 120,000 500 7,500 Bal. 8,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Aging of Accounts Receivable The aging-of-accounts-receivable method Analyzes specific individual accounts receivable according to the length of time they have been receivable Is a balance-sheet approach because it focuses on accounts receivable © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

AGING-OF-ACCOUNTS-RECEIVABLE METHOD
For example, the credit department of Schmidt Builders Supply groups its accounts receivable into 30-day periods © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Schmidt’s total balance of accounts receivable is $112,000. Of this amount the aging schedule indicates that the company will not collect $3,769. Schmidt’s accounts appear as follows before the year-end adjustment: Allowance for Uncollectible Accounts Accounts Receivable 112,000 1,100 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The aging schedule shows that the balance of the allowance account needs to be $3,769. To update the allowance, Schmidt makes this adjusting entry at the end of the period: 20X3 Dec Uncollectible-Account Expense 2,669 Allowance for Uncollectible Accounts ,669 (3, ,100) Recorded expense for the year © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The balance sheet reports the amount that Schmidt expects to collect from customers, $108,231 (112, ,769), as follows: Allowance for Uncollectable Accounts Accounts Receivable 112,000 1,100 Adj ,669 Bal ,769 Net accounts receivable, $108,231 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Combining Percent-of-Sales and Aging Methods For interim statements (monthly or quarterly), companies use the percent-of-sales method because it is easier to apply At the end of the year, these companies use the aging method to ensure that Accounts Receivable is reported at expected realizable value © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Comparing Percent-of-Sales and Aging Methods
Allowance Method Percent-of-Sales Method Aging-of-Accounts-Receivable Method Adjusts Allowance for Uncollectible Accounts Adjusts Allowance for Uncollectible Accounts BY TO Amount of Amount of UNCOLLECTIBLE-ACCOUNT EXPENSE UNCOLLECTIBLE ACCOUNTS RECEIVABLE © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

WRITING OFF UNCOLLECTIBLE ACCOUNTS
Early in 20X4, Schmidt Builders Supply collects on most of its $112,000 accounts receivable as follows: 20X4 Jan. - Mar. Cash 92,000 Accounts Receivable ,000 Collected on account © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Cash increases and Accounts Receivable decreases by the same amount. Total assets are unchanged: Stockholders’ Assets = Liabilities Equity +92, -92,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Suppose Schmidt’s credit department determines that Schmidt cannot collect a total of $1,200 from customers Abbott and Smith. Schmidt’s accountant then writes off Schmidt’s receivables from the two delinquent customers with the following entry: 20X4 Mar Allowance for Uncollectible Accounts 1,200 Accounts Receivable - Abbott Accounts Receivable - Smith Wrote off uncollectible accounts © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The write-off of uncollectible accounts has no effect on total assets or any other account: Stockholders’ Assets = Liabilities Equity +1, -1,200 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Because the write-off entry affects no expense account, it does not affect net income. The write-off has no effect on net receivables either, as shown below: © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The Direct Write-Off Method Under the direct write-off method of accounting for uncollectible receivables The company waits until it decides that a customer’s account receivable is uncollectible The accountant records Uncollectible-Account Expense and writes off the customer’s Account Receivable with a credit © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The Direct Write-Off Method 20X4 Jan Uncollectible-Account Expense 2,000 Accounts Receivable - Jones 2,000 Wrote off bad account © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The Direct Write-Off Method This method is defective for two reasons: Since no Allowance for Uncollectibles is established, assets are overstated on the balance sheet The direct write-off may not match the uncollectible-account expense of each period against the revenue of the period in which the sale was made © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

NOTES RECEIVABLE The two parties to a note are
The creditor who has a note receivable The debtor who has a note payable A promissory note serves as evidence of the debt The principle amount of the note is the amount borrowed by the debtor Interest is revenue for the lender and expense for the borrower © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

For value received, I promise to pay to the order of Continental Bank
PROMISSORY NOTE $1, Aug. 31, 20X2 Amount Date For value received, I promise to pay to the order of Continental Bank Chicago, Illinois One thousand and no/ Dollars on August 31, 20x3 plus interest at the annual rate of 9 percent Interest period starts Principle Payee (Creditor ) Interest period ends on maturity date Principle Interest rate Maker (Debtor) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Aug. 31 Note Receivable - L. Holland 1,000
NOTES RECEIVABLE The term of the note runs from August 31, 20X2, to August 31, 20X3, when Lauren Holland (the maker) promises to pay Continental Bank (the payee) the principal of $1,000 plus 9% interest for the year. After Lauren Holland signs the note Continental Bank gives her $1,000 cash. The bank’s entries follow, assuming a December 31 year end for Continental Bank: 20X2 Aug Note Receivable - L. Holland 1,000 Cash ,000 Made a loan © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

NOTES RECEIVABLE At December 31, Continental Bank must accrue interest revenue for four months (September - December) as follows: Dec Interest Receivable ($1,000 x .09 x 4/12) 30 Interest Revenue Accrued interest revenue © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

NOTES RECEIVABLE When the bank collects the note on August 31, 20X3, the bank’s entry is: 20X3 Aug Cash ,090 Note receivable - L. Holland ,000 Interest Receivable Interest Revenue ($1,000 x .09 x 8/12) Collected note at maturity © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

NOTES RECEIVABLE Some companies sell their merchandise on notes receivable (versus selling on accounts receivable) This arrangement often occurs when The payment term extends beyond the customary accounts receivable period A trade customer’s account receivable is past due © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

NOTES RECEIVABLE Some companies sell their notes receivable to financial institutions, who then collect the notes and earn the interest This practice is called discounting notes receivable because the seller receives a discounted price for the note The seller takes less money to receive immediate cash and shift the credit risk to another party © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Discounted a note receivable
NOTES RECEIVABLE Discounting notes receivable is illustrated with the following entry for discounting a $100,000 note receivable for $96,000: Cash ,000 Interest Expense ,000 Note Receivable ,000 Discounted a note receivable © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

NOTES RECEIVABLE A contingent liability
Is a potential liability that will become an actual liability only if a potential event occurs Is created for the seller when a note receivable is discounted Is reported in the notes to the financial statements of the original payee © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

NOTES RECEIVABLE If the customer
Fails to pay the bank at maturity then the original payee must pay the bank the amount due Pays the bank, then the original payee can forget the note © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

USING ACCOUNTING INFORMATION FOR DECISION MAKING
The acid-test (or quick) ratio is a more stringent measure of the company’s ability to pay current liabilities than the current ratio: Short-term Net current Cash + investments + receivables Acid-test ratio = Total current liabilities Rule of Thumb: The higher the acid-test ratio, the better the business is able to pay its current liabilities © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

USING ACCOUNTING INFORMATION FOR DECISION MAKING
Days’ sales in receivables (average collection period) Indicates how many days it takes to collect the average level of receivables The shorter the collection period, the more quickly the organization can use cash for operations Can be computed in two steps as shown on the following slide © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Days’ Sales in Receivables
Step 1 Net sales One day’s sales = 365 days Step 2 Beginning net Ending net receivables receivables Average net accounts receivable 2 Days’ sales in average accounts receivable = = One day’s sales One day’s sales © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Days Sales in Receivables
Rule of Thumb: Sales on net 30 terms should be collected within approximately 30 days. When there is a discount, such as 2/10 net 30, the collection period may be shorter. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

REPORTING ON THE STATEMENT OF CASH FLOWS
Because investment and receivables transactions affect cash, their effects must also be reported on the statement of cash flows Collections of receivables from customers are cash receipts from operating activities The purchase or sale of an investment is reported as an investing activity The investing in and collection of a note receivable is an investing activity © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Merchandise Inventory, Cost of Goods Sold, and Gross Margin
CHAPTER 6 Merchandise Inventory, Cost of Goods Sold, and Gross Margin © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

MERCHANDISE INVENTORY
A merchandising company’s most important asset is inventory Cost of goods sold or cost of sales is the entity’s major expense © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

TRANSITION FROM SERVICE ENTITIES TO MERCHANDISERS
The following summarized financial statements show how service entities and merchandisers are similar and are different © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

COST PRINCIPLE The cost principle - the cost of any asset is the sum of all the costs incurred to bring the asset to its intended use The intended use of merchandise inventory is readiness for sale Inventory costs include: Purchase price Shipping cost (freight-in) Insurance in transit © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ACCOUNTING FOR INVENTORY
Gross profit (gross margin) is The excess of sales revenue over cost of goods sold So named because operating expenses have not yet been subtracted © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE COST-OF-GOODS-SOLD MODEL
The cost-of-goods-sold model brings together all the inventory data for the entire accounting period: Beginning inventory (balance left over from the preceding period) Purchases of inventory during the current period Ending inventory (balance on hand at the end of the current period) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Beginning inventory (2 units @ $10 each) $ 20
Cost of Goods Sold Cost of goods sold: Beginning inventory (2 $10 each) $ 20 + Purchases of inventory during this period (10 $10 each) = Cost of goods available for sale (12 $10 each) - Ending inventory (3 $10 each) (30) = Cost of goods sold (9 $10 each) $ 90 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE COST-OF-GOODS-SOLD MODEL
The following slide diagrams the cost-of-goods-sold model Beginning inventory and purchases go into goods available for sale Ending inventory and cost of goods sold come out of goods available for sale © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Diagram of the Cost-of-Goods-Sold Model
Cost of goods available for sale $120 Beginning inventory $20 Ending inventory $30 Purchases $100 Cost of goods sold $90 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE AMOUNT OF INVENTORY TO PURCHASE
The amount of inventory to purchase depends on three factors: Budgeted cost of goods sold Budgeted ending inventory Beginning inventory with which you started the period © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE AMOUNT OF INVENTORY TO PURCHASE
A rearrangement of the cost-of-goods-sold formula provides budgeted purchases as follows: 1. Cost of goods sold (based on the budget for the next period) $6,000 2. + Ending inventory (based on the budget for the next period) 1,500 3. = Cost of goods available for sale, as budgeted 7,500 4. - Beginning inventory (actual amount left over from the prior period) (1,200) 5. = Purchases (how much inventory managers need to buy) $6,300 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INVENTORY COSTING METHODS
To compute the cost of goods sold and the cost of inventory on hand, the business’s actual cost must be assigned to each item sold. The four costing methods that GAAP allows are: Specific unit cost Weighted-average cost First-in, first-out (FIFO) cost Last-in, first-out (LIFO) cost © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Specific unit cost (specific identification) Costs inventories at the specific unit cost of the particular unit Is usually used by businesses that deal in high-ticket items Automobiles Jewelry Real estate © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The weighted-average cost method is Based on the weighted-average cost of inventory during the period Computed by dividing the cost of goods available for sale by the number of units available for sale © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Suppose Deckers Outdoor Corporation has 60 units of inventory, such as hiking socks, available for sale during the period. Ending inventory consists of 20 units, and cost of goods sold is based on 40 units. The next slides give the data for computing ending inventory and cost of goods sold using the different inventory costing methods: © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The Weighted-Average Cost Method
Beginning inventory (10 $10 per unit) $100 Purchases: No. 1 (25 $14 per unit) $350 No. 2 (25 $18 per unit) Total purchases Cost of goods available for sale (60 units) Ending inventory (20 $? per unit) ? Cost of goods sold (40 $? per unit) ? Weighted-Average Cost Method Cost of goods available for sale (60 average cost of $15 per unit) $900 Ending inventory (20 $15 per unit) ( 300) Cost of goods sold (40 $15 per unit) $600 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Under the first-in, first-out (FIFO) method The first costs into inventory are the first costs out to cost of goods sold Ending inventory is based on the costs of the latest purchases © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

First-In, First-Out (FIFO) Cost
Beginning inventory (10 $10) per unit) $100 Purchases: No. 1 (25 $14 per unit) $350 No. 2 (25 $18 per unit) Total purchases Cost of goods available for sale (60 units) Ending inventory (20 $? per unit) ? Cost of goods sold (40 $? per unit) ? FIFO Cost Method Cost of goods available for sale (60 units) $900 Ending inventory (cost of the last 20 units available): 20 18 per unit (from purchase No. 2) (360) Cost of goods sold (cost of the first 40 units available): 10 $10 per unit (all of beginning inventory) $100 25 $14 per unit (all of purchase No. 1) 5 $18 per unit (from purchase No. 2) Cost of goods sold $540 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Under the last-in, first-out (LIFO) method The last costs into inventory are the first costs out to cost of goods sold Ending inventory consists of the oldest costs--those of beginning inventory and the earliest purchases of the period © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Last-In, First-Out (LIFO) Cost
Beginning inventory (10 $10) per unit) $100 Purchases: No. 1 (25 $14 per unit) $350 No. 2 (25 $18 per unit) Total purchases Cost of goods available for sale (60 units) Ending inventory (20 $? per unit) ? Cost of goods sold (40 $? Per unit) ? LIFO Cost Method Cost of goods available for sale (60 units) $900 Ending inventory (cost of the first 20 units available): 10 $10 per unit (all of beginning inventory) $100 10 $14 per unit (from purchase No. 1) Ending inventory (240) Cost of goods sold (cost of the last 40 units available): 25 $18 per unit (all of purchase No. 2) $450 15 $14 per unit (from purchase No. 1) Cost of goods sold $660 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

When inventory unit costs are increasing
INCOME EFFECTS When inventory unit costs are increasing FIFO ending inventory is highest because it is priced at the most recent costs, which are the highest LIFO ending inventory is lowest because it is priced at the oldest costs, which are the lowest © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

When inventory unit costs are decreasing
INCOME EFFECTS When inventory unit costs are decreasing FIFO ending inventory is lowest because it is priced at the most recent costs, which are the lowest LIFO ending inventory is highest because it is priced at the oldest costs, which are the highest © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Goods available for sale $900 $900 $900
INCOME EFFECTS Weighted-Average FIFO LIFO Sales revenue $1,000 $1,000 $1,000 Cost of goods sold: Goods available for sale $900 $900 $900 Ending inventory Cost of goods sold Gross profit $ $ $ 400 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INCOME EFFECTS Summary of Income Effects - When inventory unit costs are increasing FIFO Highest ending inventory Lowest cost of goods sold Highest gross profit LIFO Lowest ending inventory Highest cost of goods sold Lowest gross profit Weighted-Average Results fall between the extremes of FIFO and LIFO Summary of Income Effects - When inventory unit costs are decreasing FIFO Lowest ending inventory Highest cost of goods sold Lowest gross profit LIFO Highest ending inventory Lowest cost of goods sold Highest gross profit Weighted-Average Results fall between the extremes of FIFO and LIFO © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE INCOME TAX ADVANTAGE OF LIFO
When prices are rising, applying the LIFO method results in the Lowest taxable income Lowest income taxes © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE INCOME TAX ADVANTAGE OF LIFO
Using the gross profit data from the previous example: Weighted-Average FIFO LIFO Gross profit $460 $340 $400 Operating expenses Income before taxes $200 $ 80 $140 Income tax expense (40%) $ 80 $ 32 $ 56 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

A COMPARISON OF INVENTORY METHODS
LIFO best matches the current value of cost of goods sold with current revenue by assigning to this expense the most recent inventory costs FIFO reports the most current inventory costs on the balance sheet © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Tax payments LIFO results in the lowest tax payments when prices are rising FIFO results in the lowest tax payments when inventory prices are decreasing The weighted-average method produces amounts between the extremes of LIFO and FIFO © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

FIFO produces inventory profits FIFO overstates income by so-called inventory profit during periods of inflation Inventory profit is the difference between gross profit figured on the FIFO basis and gross profit figured on the LIFO basis The replacement cost of inventory is more closely approximated by the cost of goods sold under LIFO than by FIFO © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

LIFO allows managers to manage reported income - up or down LIFO allows managers to manipulate net income When inventory prices are rising rapidly, income and taxes can be lowered by purchasing a large amount of inventory near the end of the year and increasing the cost of goods sold expense Net Income © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

If the business is having a bad year, managers can increase reported income by delaying a large purchase of high-cost inventory until the next period, delaying the increased cost of goods sold until the next period LIFO liquidation Occurs when inventory quantities fall below the level of the previous period Increases reported income and income taxes © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

International perspective LIFO is not allowed in some foreign countries, e.g., Australia and the U. K. Companies that use LIFO must use another accounting method for their inventories in these foreign countries Most countries permit FIFO and weighted-average cost methods © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Higher income or lower taxes? FIFO reports the highest income and results in the highest taxes when prices are rising LIFO reports the highest income and results in the highest taxes when prices are falling Income Taxes © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Which inventory method is better? Different companies have different motives for the inventory method they choose © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Accounting Principles and Their Relevance to Inventories

CONSISTENCY PRINCIPLE
The consistency principle States that businesses should use the same accounting methods and procedures from period to period Makes it possible to compare a company’s financial statements from one period to the next Does not require that a company never change its accounting methods Requires that a company disclose the effect of the change on net income © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

DISCLOSURE PRINCIPLE The disclosure principle
Holds that a company’s financial statements should report enough information for outsiders to make knowledgeable decisions about the company Requires relevant, reliable, and comparable information about a company’s economic affairs Requires the disclosure of the inventory method used © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

MATERIALITY CONCEPT The materiality concept states
That a company must perform proper accounting only for items and transactions that are significant to the business’s financial statements That information is material when its inclusion and correct presentation in the financial statements would cause someone to change a decision because of that information © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ACCOUNTING CONSERVATISM
Conservatism in accounting means Reporting items in the financial statements at amounts that lead to the gloomiest immediate financial results Conservatism guidelines include “Anticipate no gains, but provide for all probable losses” “If in doubt, record an asset at the lowest reasonable amount and a liability at the highest reasonable amount” © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

LOWER-OF-COST-OR-MARKET RULE
The lower-of-cost-or-market (LCM) rule Requires that inventory be reported in the financial statements at whichever is lower--its historical cost or its market value Market value generally means current replacement cost when applied to inventories Replacement cost is the amount the business would have to pay to replace the inventory on hand © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The business must write down the value of its goods if the replacement cost of inventory falls below its historical cost © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Suppose Deckers Outdoor Corporation paid $3,000 for inventory on September 26. By December 31, its value has fallen. The inventory can now be replaced for $2,200. Market value is below cost, and Deckers’ December 31 balance sheet reports this inventory at its LCM value of $2,200. The following slides present the effects of LCM on the balance sheet and the income statement: © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Balance Sheet Current Assets: Cash $ xxx Short-term investments xxx Accounts receivable xxx Inventories, at market (which is lower than $3,000 cost) 2,200 Prepaid expenses xxx Total current assets $x,xxx © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Income Statement Sales revenue $20,000 Cost of goods sold: Beginning inventory (LCM = Cost) $ 2,800 Net purchases ,000 Cost of goods available for sale ,800 Ending inventory Cost = $3,000 Replacement cost (market value) = $2,200 LCM = Market (2,200) Cost of goods sold ,600 Gross profit $ 8,400 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

EFFECTS OF INVENTORY ERRORS
The Period 1 segment on the next slide shows ending inventory is overstated and cost of goods sold is understated, each by $5,000 One period’s ending inventory is the next period’s beginning inventory © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Period Ending Inventory Overstated by $5,000 Period Beginning Inventory Overstated by $5,000 Period 3 Correct Sales revenue $100,000 $100,000 $100,000 Cost of goods sold: Beginning inventory $10,000 $15,000 $10,000 Net purchases 50, , ,000 Goods available for sale 60, , ,000 Ending inventory 15, , ,000 Cost of goods sold , , ,000 Gross profit $ 55,000 $ 45,000 $ 50,000 $100,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Because ending inventory is subtracted in computing cost of goods sold in one period and the same amount is added as beginning inventory to compute next period’s cost of goods sold, the error’s effect cancels out at the end of the second period The overstatement of cost of goods sold in Period 2 counterbalances the understatement in cost of goods sold in Period 1 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Period Period 2 Cost of Gross Profit Cost of Gross Profit Inventory Error Goods Sold and Net Income Goods Sold and Net Income Period 1 Ending Inventory overstated Understated Overstated Overstated Understated Inventory understated Overstated Understated Understated Overstated © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ETHICAL ISSUES IN INVENTORY ACCOUNTING
Managers of companies whose profits do not meet stockholder expectations are sometimes tempted to “cook the books” to increase reported income by Overstating ending inventory, understating cost of goods sold, and overstating net income and retained earnings © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ETHICAL ISSUES IN INVENTORY ACCOUNTING
Assets = Liabilities + Stockholders’ Equity An inventory error has an offsetting effect in the next period The next period’s net income, however, will be lower as a result of this period’s error Creating fictitious sales Excluding goods from ending inventory could imply that the goods had been sold Sales returns, however, would eventually have to be reported = © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ANALYZING FINANCIAL STATEMENTS
Gross Profit Percentage Gross profit = Gross profit percentage Net sales revenue A 36% gross profit means that each dollar of sales generates 36 cents of gross profit and the goods cost the seller 64 cents Rule of Thumb: Compare the company’s gross profit percentage with the industry average or that of another competitor. A small downturn may signal an important drop in net income. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Gross Profit on $1.00 of Sales for Two Merchandisers
$0.20 Gross Profit $0.36 $0.75 Cost of goods sold $0.80 Cost of goods sold $0.64 $0.50 $0.25 Gross Profit on $1.00 of Sales for Two Merchandisers Wal-Mart Deckers Outdoors © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Inventory Turnover Inventory turnover Cost of goods sold Cost of goods sold = = Average inventory Beginning inventory Ending inventory + : 2 Inventory turnover, the ratio of cost of goods sold to average inventory, indicates how rapidly inventory is sold Rule of Thumb: Inventory turnover varies from industry to industry. Compare to industry average. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Rate of Inventory Turnover for Two Companies
Wal-Mart 6.7 times per year 1 2 3 4 5 6 Deckers Outdoor 3.1 times per year 1 2 3 Jan Mar June Sept Dec © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Wal-Mart sells a lot of inventory at a relatively low gross profit with a high turnover Deckers Outdoor, a specialty company, earns a higher gross profit, but cannot sell its merchandise as rapidly as Wal-Mart © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INVENTORY ACCOUNTING SYSTEMS
The two main types of inventory accounting systems are the Periodic inventory system Perpetual inventory system © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Perpetual Inventory System
Keeps a running record of all goods bought and sold Inventory counted once a year Used for all types of goods Periodic Inventory System Does not keep a running record of all goods bought and sold Inventory counted at least once a year Used for inexpensive goods © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INVENTORY ACCOUNTING SYSTEMS
Recording transactions in the perpetual system Inventory purchases are recorded by debiting the Inventory account Sales are recorded by debiting Cash or Accounts Receivable and crediting Sales Revenue Sales also require a debit to Cost of Goods Sold and a credit to Inventory © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Recording Transactions
Perpetual System Recording Transactions 1. Credit purchases of $560,000: Inventory 560,000 Accounts Payable 560,000 Stockholders’ Equity Assets = Liabilities + +560,000 = 560,000 + © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

2. Credit sales of $900,000 (cost $540,000):
Perpetual System Recording Transactions 2. Credit sales of $900,000 (cost $540,000): Accounts Receivable 900,000 Sales Revenue ,000 Stockholders’ Equity Assets = Liabilities + + Revenues +900,000 = + 900,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

2. Credit sales of $900,000 (cost $540,000):
Perpetual System Recording Transactions 2. Credit sales of $900,000 (cost $540,000): Cost of Goods Sold 540,000 Inventory ,000 Stockholders’ Equity Assets = Liabilities + - Expenses - 540,000 = - 540,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

T- Accounts and Financial Statements
Perpetual System T- Accounts and Financial Statements Inventory Cost of Goods Sold 100,000 540,000 540,000 560,000 120,000 Income Statement (partial): Sales revenue $900,000 Cost of goods sold ,000 Gross profit $360,000 Balance Sheet (partial): Current Assets: Cash $ xxx Short-term investments xxx Accounts receivable xxx Inventories ,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Net Amount of Purchases
INVENTORY ACCOUNTING SYSTEMS Net Amount of Purchases Purchase price of the inventory from the seller $600,000 +Transportation cost (freight in) ,000 - Purchase returns for damaged/unsuitable goods (25,000) - Purchase allowances granted by the seller (5,000) - Purchase discounts for early payment (14,000) =Net purchases of inventory $560,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INVENTORY ACCOUNTING SYSTEMS Net Amount of Purchases The cost of the inventory of $560,000 is the net amount of the purchase A purchase discount is a decrease in the cost of purchases earned by making an early payment to the vendor A purchase return is a decrease in the cost of purchases because the buyer returned the goods to the seller © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INVENTORY ACCOUNTING SYSTEMS Net Amount of Purchases A purchase allowance is a decrease in the cost of purchases because the seller granted the buyer a subtraction (an allowance) from the amount owed © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

- Sales Returns & Allowances
INVENTORY ACCOUNTING SYSTEMS Net Sales Net sales are computed exactly as net purchases, except there is no freight-in to account for Net Sales = Sales - Sales Returns & Allowances - Sales Discounts Freight-out is the expense of delivering merchandise to customers and is included in the Delivery Expense account © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INTERNAL CONTROL OVER INVENTORY
Elements of good internal control over inventory include the following: Physically count inventory at least once each year regardless of which inventory accounting system is used Securely store inventory to protect it against theft, damage, and decay © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Allow access to inventory only to personnel who do not have access to the accounting records Keep perpetual inventory records for high-unit-cost merchandise Keep enough inventory on hand to prevent shortage situations that lead to lost sales © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Do not stockpile too much inventory to avoid the expense of tying up money in unneeded items Many manufacturing companies use just-in-time (JIT) inventory systems, which require suppliers to deliver materials just in time to be used in the production process Purchase inventory in economical quantities © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ESTIMATING INVENTORY Sometimes a business must estimate the value of inventory, e.g., when inventory is destroyed by a fire © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The Gross Profit Method = Cost of goods available for sale
ESTIMATING INVENTORY The Gross Profit Method The gross profit method of estimating inventory is based on the cost-of-goods-sold model Beginning inventory + Purchases = Cost of goods available for sale - Ending inventory = Cost of goods sold © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The Gross Profit Method = Cost of goods available for sale
ESTIMATING INVENTORY The Gross Profit Method Rearranging ending inventory and cost of goods sold makes the model useful for estimating ending inventory Beginning inventory + Purchases = Cost of goods available for sale - Cost of goods sold = Ending inventory © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ESTIMATING INVENTORY - Beginning inventory
Cost of goods available for sale Step 1: + Net purchases = Cost of goods available for sale Cost of goods sold - Ending inventory Step 2: = © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The Gross Profit Method
ESTIMATING INVENTORY The Gross Profit Method Suppose a fire destroys a business’s inventory. To collect insurance, the cost of the ending inventory must first be estimated Beginning inventory and net purchases amounts can be taken directly from the accounting records © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ESTIMATING INVENTORY The Gross Profit Method Sales Revenue less Sales Returns and Allowances and Sales Discounts indicate net sales up to the date of the fire The normal gross profit rate is used to estimate cost of goods sold The last step is to subtract cost of goods sold from goods available to estimate ending inventory © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ESTIMATING INVENTORY The Gross Profit Method Beginning inventory $14,000 Purchases ,000 Cost of goods available for sale ,000 Cost of goods sold: Net sales revenue $100,000 Less estimated gross profit of 40% (40,000) Estimated cost of goods sold ,000 Estimated cost of ending inventory $20,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Inventory-related transactions are operating activities The purchase and sale of merchandise set the pace for a company’s operations Payments for inventory and collections from customers are two large operating cash flows © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Deckers Outdoor Corporation Statement of Cash Flows (partial, adapted)
For the Year Ended December 31, 20XX Cash flows from operating activities: Collections from customers $98,029 Payments for inventory (65,960) Payments to other suppliers (40,208) Payments of interest (1,171) Other payments (846) Cash provided (used) by operating activities ($10,156) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

A DETAILED INCOME STATEMENT
Including the treatment of inventories is presented on the following slide © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Plant Assets, Intangible Assets, and Related Expenses
CHAPTER 7 Plant Assets, Intangible Assets, and Related Expenses © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

TYPE OF ASSETS Long-lived assets used in the operation of a business are divided into categories: Plant assets (fixed assets) Are long-lived assets that are tangible Land Buildings Equipment Expensed through depreciation Land is not depreciated © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

TYPE OF ASSETS Intangible assets
Are useful not because of their physical characteristics, but because of the special rights they convey Include Patents Copyrights Trademarks © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Terminology Used in Accounting for Plant Assets and Intangible Assets
Asset Account on the Balance Sheet Related Expense Account on the Income Statement Plant Assets: Land Buildings, Machinery and Equipment, Furniture and Fixtures, and Land Improvements Natural Resources Intangibles None Depreciation Amortization Depletion © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

MEASURING THE COST OF A PLANT ASSET
The cost principle directs a business to carry an asset on the balance sheet at the amount paid for the asset The cost of a plant asset includes The purchase price Applicable taxes Purchase commissions All other amounts paid to acquire the asset and ready it for its intended use © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The cost of land includes The purchase price Brokerage commissions Survey fees Legal fees Back property taxes that the purchaser pays Land grading and clearing, and demolition of any unwanted buildings © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Purchase price of land $300,000
Suppose a business signs a $300,000 note payable to purchase land for a new store site. It pays $10,000 in back property tax, $8,000 in transfer taxes, $5,000 for removal of an old building, a $1,000 survey fee, and $260,000 to pave the parking lot. The cost of the land is Purchase price of land $300,000 Add related costs: Back property tax $10,000 Transfer taxes ,000 Building removal cost 5,000 Survey Fee ,000 Total related costs ,000 Total cost of land $324,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The cost of paving the parking lot, $260,000, is not included in the cost of the land, because the pavement is a land improvement. The entry to record purchase of the land is Land 324,000 Note payable 300,000 Cash ,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The cost of constructing a building includes Architectural fees Building permits Contractors’ charges Payments for material Labor Overhead © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The cost of purchasing an existing building includes The purchase price Brokerage commissions Sales and other taxes Cash or credit expenditures for repairing and renovating the building for its intended purpose © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The cost of machinery and equipment includes The purchase price (less any discounts) Transportation charges Insurance while in transit Sales and other taxes Purchase commissions Installation costs Expenditures for testing the asset before placing it into service © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Land improvements Include the cost of Paving Driveways Signs Fences Sprinkler systems Are recorded in a separate account titled Land Improvements, and depreciated © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The cost of improvements to leased assets Appears on the company’s balance sheet as Leasehold Improvements Is depreciated (amortized) over the term of the lease © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Construction in Progress is An asset, such as a warehouse, that the company is constructing for its own use A plant asset because the company will use the asset in its operations A capital lease is A lease arrangement similar to an installment purchase of the leased asset Reported as an asset © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

An operating lease is An ordinary rental agreement Recorded as Rent Expense Interest cost is capitalized When it is a part of the cost of a self-constructed asset that takes a long time to build © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Assets purchased in a group or “basket” for a lump-sum amount require the identification of cost for each asset The total cost is divided among the assets according to their relative sales (or market) value This allocation technique is called the relative-sales-value method © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

% of Total Market Value Market (Sales) Value Total Market Value
Suppose a combined purchase price of land and building is $2,800,000. The following table presents the market values for the land and building, along with the ratio of each asset’s market value to the total market value: % of Total Market Value Market (Sales) Value Total Market Value Total Cost Cost of Each Asset Asset Land Building Total $ 300,000 2,700,000 $3,000,000  $3,000,000 = 10% 90% 100% x $2,800,000 = $ 280,000 2,520,000 $2,800,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CAPITAL EXPENDITURES VS. REVENUE EXPENDITURES
Capital expenditures increase the asset’s capacity or efficiency or extend its useful life Repair work that generates a capital expenditure is called an extraordinary repair Extraordinary repairs are debited to an asset account © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CAPITAL EXPENDITURES VS. REVENUE EXPENDITURES
Revenue expenditures do not extend the asset’s capacity, but merely maintain it or restore it to working order Ordinary repairs are revenue expenditures Ordinary repairs are debited to an expense account © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Extraordinary repairs
Delivery Truck Expenditures: Capital Expenditure or Revenue Expenditure? Debit Repair and Maintenance Expense for Revenue Expenditures Debit an Asset Account for Capital Expenditures Extraordinary repairs Major engine overhaul Modification of body for new use of truck Addition to storage capacity of truck Ordinary repairs Repair of transmission or other mechanism Oil change, lubrication, etc. Replacement tires, windshield Paint job © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

MEASURING THE DEPRECIATION OF PLANT ASSETS
Depreciation is the allocation of a plant asset’s cost to expense over the period the asset is used The matching principle matches an asset’s expense against the revenue generated over the asset’s life © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Estimated useful life, 20 years $32 million cost
Depreciation and the Matching of Expense with Revenue Annual revenue generated, $9 million minus Annual depreciation expense, $1.6 million* *$32 million/20 yrs. = $1.6 million per year © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Is not a process of valuation Does not mean that the business sets aside cash to replace assets as they wear out Accumulated depreciation does not represent a growing amount of cash © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The causes of depreciation are Physical wear and tear Obsolescence An asset is obsolete when another asset can do the job better or more efficiently © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

To measure depreciation for a plant asset one must know the Cost Estimated useful life The length of service the business expects to get from the asset--an estimate of how long an asset will be useful Useful life may be expressed in years, units of output, miles, or another measure © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Estimated residual value (scrap value) The expected cash value of an asset at the end of its useful life Estimated residual value is not depreciated because the business expects to receive this amount from disposing of the asset © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The four methods for computing depreciation are Straight line Units of production Declining-balance Sum-of-years’-digits © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The following data will be used to illustrate depreciation computations of a Home Depot truck by the three most widely used methods. The sum-of-the-years’-digits method is omitted because so few companies use it. Cost of truck $41,000 Less: Estimated residual value (1,000) Depreciable cost $40,000 Estimated useful life : Years years Units of production 100,000 units (miles) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Straight-line Method Straight-line depreciation per year Cost - Residual value = Useful life, in years = $41,000 - $1,000 5 = $8,000 An equal amount of depreciation is assigned to each year of asset use © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Accumulated depreciation 8,000
MEASURING THE DEPRECIATION OF PLANT ASSETS The entry to record depreciation is Depreciation expense 8,000 Accumulated depreciation 8,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Assume that the truck was purchased on January1, 20X1, and that Home Depot’s fiscal year ends on December 31 A straight-line depreciation schedule is presented on the next slide The final column shows the asset’s book value, the asset’s cost less accumulated depreciation © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Straight-Line Depreciation Schedule for the Home Depot Truck
Depreciation for the Year Asset Book Value Depreciation Rate Depreciable Cost Depreciation Expense Accumulated Depreciation Date Asset Cost X1 $41, $41,000 X $ x $40, = $8, $ 8, ,000 X x , = , , ,000 X x , = , , ,000 X x , = , , ,000 X x , = , , ,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Units-of-Production Method The UOP depreciation equation for the Home Depot truck data in which the units are miles is Units-of-production depreciation per unit of output Cost - Residual value = Useful life, in units of production = $41,000 - $1,000 Home Depot 100,000 miles = $0.40 per mile © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

In the units-of-production (UOP) method Depreciation is assigned to each unit of output Depreciable cost is divided by useful life (in units of production) to determine the per-unit depreciation amount The per-unit depreciation expense is multiplied by the number of units produced each period to compute depreciation © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The truck is expected to be driven 20,000 miles during the first year, 30,000 miles the second, 25,000 during the third, 15,000 during the fourth, and 10,000 during the fifth. The UOP depreciation schedule for this asset is shown below: Depreciation for the Year Asset Book Value Depreciation Per Unit Number of Units Depreciation Expense Accumulated Depreciation Date Asset Cost X1 $41, $41,000 X $ x $20, = $ 8, $ 8, ,000 X x , = , , ,000 X x , = , , ,000 X x , = , , ,000 X x , = , , ,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Double-Declining-Balance Method DDB depreciation rate per year 1 X 2 = Useful life, in years 1 = X 2 5 years = 20% X 2 = 40% © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Double-declining-balance (DDB) depreciation Is an accelerated depreciation method A method that writes off a relatively larger amount of the asset’s cost nearer the start of its useful life than the straight-line method Computes annual depreciation by multiplying the asset’s book value by a constant percentage, which is 2 times the straight-line depreciation rate © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

In the DDB depreciation schedule, the fifth and final year’s depreciation is $4,314 (the $5,314 book value less $1,000 residual value): Depreciation for the Year Asset Book Value Asset Book Value Asset Cost DDB Rate Depreciation Expense Accumulated Depreciation Date X1 $41, $41,000 X x $41,000 = $16, $16, ,600 X x ,600 = , , ,760 X x ,760 = , , ,856 X x ,856 = , , ,314 X ,314* , ,000 *Last-year depreciation is the amount needed to reduce asset book value to the residual value ($5,314 - $1,000 = $4,314). © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The DDB method differs from other methods in two ways: The asset’s residual value is ignored initially; in the first year depreciation is computed on the asset’s full cost Depreciation expense in the final year is whatever amount is needed to reduce the asset’s book value to its residual value © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Accelerated Method Double-Declining-Balance Year Straight-Line
Comparing the Depreciation Methods Accelerated Method Double-Declining-Balance Year Straight-Line Units-of-Production $ 8, $ 8, $16,400 , , ,840 , , ,904 , , ,542 , , ,314 Total $40, $40, $40,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The straight-line method best meets the matching principle for a plant asset that generates revenue evenly over time The units-of-production method best fits those assets that wear out because of physical use rather than obsolescence The accelerated method (DDB) applies best to those assets that generate greater revenue earlier in their useful lives © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

1 2 3 4 5 1 2 3 4 5 1 2 3 4 5 Depreciation Patterns Through Time
Straight-Line Units-of-Production Accelerated (DDB) $ of Annual Depreciation $ of Annual Depreciation $ of Annual Depreciation Time, in years Time, in years Time, in years © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Use of the Depreciation Methods by 600 Companies
*Most of these are probably declining-balance methods because depreciation for income tax purposes is based on the declining-balance concept. Some companies use the same depreciation method for financial statement purposes and for tax purposes. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE RELATIONSHIP BETWEEN DEPRECIATION AND TAXES
Most companies use an accelerated depreciation method for tax purposes because It provides the most depreciation expense as quickly as possible It decreases the tax liability © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Suppose during the first depreciation year of the Home Depot truck example the store’s lumber department has $40,000 in cash sales $300,000 in cash operating expenses An income tax rate of 30 percent The cash flow analysis on the next slide indicates that a higher depreciation expense yields lower income and a lower tax payment © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Cash-Flow Advantage of Accelerated Depreciation
over Straight-line for Income Tax Purposes Income Tax Rate (30%) SL Accelerated Cash revenues $400,000 $400,000 Cash operating expenses , ,000 Cash provided for operations before tax , ,000 Depreciation expense (a noncash expense) , ,400 Income before income tax , ,600 Income tax expense (30%) , ,080 Net income $ 64,400 $ 58,520 Cash-flow analysis $100,000 $100,000 Income tax expense , ,080 Cash provided by operations $ 72, $ 74,920 Extra cash available for investment if DDB is used ($74, ,400) $2,520 Assumed earnings rate on investment of extra cash x 0.10 Cash advantage of using DDB over SL $ 252 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Under the Modified Accelerated Cost Recovery System (MACRS), assets are grouped into one of eight classes identified by asset life: Class Identification by Asset Life (years) Representative Assets Depreciation Method © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

DEPRECIATION FOR PARTIAL YEARS
Since companies purchase plant assets as needed, they must develop policies to compute depreciation for partial years Suppose a calendar-year business purchases a building on April 1 for $500,000 with an estimated life of 20 years and an estimated residual value of $80,000. Assuming the straight-line method, the year’s depreciation for the building is $15,750, computed as follows: $500,000 - $80,000 = $21,000 Full-year depreciation: 20 Partial year depreciation: $21,000 X 9/12 = $15,750 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CHANGING THE USEFUL LIFE OF A DEPRECIABLE ASSET
After an asset is put into use, the business may refine its estimate of the useful life on the basis of experience and new information © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Assume an asset cost of $40,000, an eight-year useful life with no residual value, and the straight-line method The company would record $5,000 depreciation each year ($40,000/8 years) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

After two years, accumulated depreciation reaches $10,000, leaving a remaining depreciable book value of $30,000 ($40,000 - $10,000) Management believes the asset will remain useful for an additional ten years. The company would spread the remaining book value over the asset’s remaining life as follows: © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Accumulated Depreciation 3,000
Asset’s remaining depreciable book value (New) Estimated useful life remaining (New) Annual depreciation  = $30,000  10 years = $3,000 The yearly depreciation entry based on the new estimated useful life is Depreciation Expense 3,000 Accumulated Depreciation 3,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

USING FULLY DEPRECIATED ASSETS
A fully depreciated asset is An asset that has reached the end of its estimated useful life An asset on which no more depreciation is recorded The asset and its depreciation account remain in the ledger with no additional depreciation entries An asset can be used after it is fully depreciated © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

DISPOSAL OF PLANT ASSETS
Before accounting for the disposal of the asset, the business should bring depreciation up to date to measure the asset’s final book value To account for disposal, credit the asset account and debit its related accumulated depreciation account © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Junking a Plant Asset Suppose Wal-Mart store fixtures that cost $4,000 are disposed of in this manner. Accumulated depreciation is $3,000, and book value is therefore $1,000. Disposal of these store fixtures records a loss as follows: Accumulated Depreciation - Store Fixtures ,000 Loss on Disposal of Store Fixtures ,000 Store Fixtures ,000 To dispose of store fixtures © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Selling a Plant Asset Suppose a Home Depot store sells fixtures on September 30, 20X4, for $5,000 cash. The fixtures cost $10,000 when purchased on January 1, 20X1, and have been depreciated on a straight-line basis. Assuming a ten-year useful life, no residual value, and a calendar-year company, partial-year depreciation must be recorded for the asset’s expense from January 1, 20X4, to the sale date. The straight-line depreciation entry at September 30, 20X4, is Sep. 30 Depreciation Expense ($10,000/10 years X 9/12) 750 Accumulated Depreciation - Fixtures 750 To update depreciation © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

After this entry is posted, the Fixtures account and the Accumulated Depreciation - Fixtures account appear as follows. The fixture’s book value is $6,250 ($10,000 - $3,750): Fixtures Accumulated Depreciation - Fixtures Dec. 31, 20X1 1,000 Dec. 31, 20X2 1,000 Dec. 31, 20X3 1,000 Sep. 30, 20X Jan. 1, 20X1 10,000 Balance ,750 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

If the business sells the fixtures for $5,000 cash, the loss on the sale is $1,250, determined as follows: Cash received from sale of the asset $5,000 Book value of asset sold: Cost $10,000 Less accumulated depreciation up to date of sale ( 3,750) 6,250 Gain (loss) on sale of the asset ($1,250) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The entry to record sale of the fixtures for $5,000 cash is Sep Cash 5,000 Accumulated Depreciation - Fixtures 3,750 Loss on Sale of Fixtures 1,250 Fixtures ,000 To sell fixtures © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Accumulated Depreciation - Fixtures 3,750 Gain on Sale of Fixtures 750
DISPOSAL OF PLANT ASSETS If the sale price had been $7,000, the business would have had a gain of $750 (Cash, $7,000 - asset book value, $6,250): Sep Cash 7,000 Accumulated Depreciation - Fixtures 3,750 Fixtures ,000 Gain on Sale of Fixtures To sell fixtures © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

A gain is recorded when an asset is sold for a price greater than the asset’s book value A loss is recorded when the sale price is less than book value Gains increase net income Losses decrease net income © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Trading Plant Assets Businesses often trade in their old plant assets for similar assets that are newer and more efficient In many cases, the business simply transfers the book value of the old asset plus any cash payment into the new asset account © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Assume Mazzio’s Pizzeria’s old delivery car cost $9,000 and has accumulated depreciation of $8,000. If Mazzio’s trades in the old automobile and pays cash of $10,000, the cost of the new delivery car is $11,000 (book value of the old asset, $1,000, plus cash given, $10,000). The pizzeria records the exchange transaction as follows: Delivery Auto (new) 11,000 Accumulated Depreciation (old) 8,000 Delivery Auto (old) ,000 Cash ,000 Traded in old delivery car for new auto © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ACCOUNTING FOR NATURAL RESOURCES AND DEPLETION
Natural resources are assets in the ground (oil) or on top of the ground (timber) Depletion expense is That portion of the cost of natural resources that is used up in a particular period Computed in the same way as units-of-production depreciation © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ACCOUNTING FOR NATURAL RESOURCES AND DEPLETION
Assume an oil lease cost $100,000 and contains an estimated 10,000 barrels of oil. The depletion rate would be $10 per barrel ($100,000/10,000 barrels). If 3,000 barrels are extracted during the year, depletion expense is $30,000 (3,000 barrels x $10 per barrel). The depletion entry for the year is Depletion Expense (3,000 barrels x $10) 30,000 Accumulated Depletion - Oil ,000 Accumulated Depletion is a contra account similar to Accumulated Depreciation © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

THE PLANT ASSET SECTION OF THE BALANCE SHEET
Property, Plant, and Equipment: Land $120,000 Buildings $800,000 Equipment ,000 960,000 Less: Accumulated depreciation (410,000) 550,000 Oil $340,000 Less Accumulated depletion (75,000) 265,000 Total property, plant, and equipment $935,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ACCOUNTING FOR INTANGIBLE ASSETS
Intangible assets are Long-lived assets that are not physical in nature Are recorded at acquisition cost and then systematically written off Amortization is The systematic allocation of an intangible’s cost to expense over its useful life Generally computed on a straight-line basis over a maximum period of 40 years © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Obsolescence often cuts an intangible’s useful life shorter than its legal life Amortization expense for an intangible asset can be written off directly against the asset account rather than held in an accumulated amortization account © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Suppose a company pays $170,000 to acquire a patent on January 1, and the business believes the expected useful life of the patent is only five years. Amortization expense is $34,000 per year ($170,000/5years). The company’s acquisition and amortization entries for this patent are: Jan. 1 Patents ,000 Cash ,000 To acquire a patent Dec 31 Amortization Expense Patents (170,000/5) 34,000 Patents ,000 To amortize the cost of a patent © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Copyrights are exclusive rights to reproduce and sell a book, musical composition, film, or other work of art Copyrights extend 50 years beyond the author’s life Trademarks and trade names (brand names) are distinctive identifications of products or services The cost of a trademark is amortized over its useful life, not to exceed 40 years © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Franchises and licenses are privileges granted by a private business or a government to sell a product or service in accordance with specified conditions The costs of franchises and licenses are amortized over their useful lives rather than over legal lives, not to exceed 40 years © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

A leasehold is a prepayment of rent that a lessee (renter) makes to secure the use of an asset from a lessor (landlord) Goodwill is the excess of the cost of an acquired company over the sum of the market values of its net assets (assets minus liabilities) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Goodwill is Recorded only when it is purchased in the acquisition of another company Is amortized over a period not to exceed 40 years © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Suppose Wal-Mart acquires Mexana Company at a cost of $10 million. The sum of the market values of Mexana’s assets is $9 million, and its liabilities total $1 million. Wal-Mart paid $2 million for goodwill, computed as follows: Purchase price paid for Mexana Company $10 million Sum of the market values of Mexana Company’s assets million Less: Mexana Company’s liabilities ( 1 million) Market value of Mexana Company’s net assets million Excess is called goodwill $2 million © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Wal-Mart’s entry to record the acquisition of Mexana Company would be Assets (Cash, Receivables, Inventories, Plant assets, all at market value) 9,000,000 Goodwill 2,000,000 Liabilities ,000,000 Cash ,000,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The cost of research and development Is one of a company’s most valuable intangible assets Is expensed as it is incurred International accounting Many international companies record goodwill as a decrease in owners’ equity Since goodwill is not amortized, their net income is higher than a U.S. company’s would be in a similar situation © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ETHICAL ISSUES The main ethical issue in accounting for plant assets and intangibles is whether to capitalize or expense a particular cost Companies that want to save on taxes are motivated to expense all the costs they can to decrease taxable income Companies also want financial statements with high net income and high reported amounts for assets © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ETHICAL ISSUES The ethical path is to follow the general guidelines for capitalizing a cost Capitalize all costs that provide a future benefit for the business and expense all other costs © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Plant Assets and Related Expenses
Decision Guidelines Capitalize or expense a cost? Capitalize or expense: Cost associated with a new asset? Cost associated with an existing asset? Interest cost incurred to finance? Which depreciation method to use: For financial reporting? For income tax? General rule: Capitalize all costs that provide future benefits for the business. Expense all costs that provide no future benefit. Capitalize all costs that bring the asset to its intended use. Capitalize only those costs that add to the asset’s usefulness or its useful life. Expense all other costs as maintenance or repairs. Capitalize interest cost only on assets constructed by the business for its own use. Expense all other interest cost. Use the method that best matches depreciation expense against the revenues produced by the asset. Use the method that produces the fastest tax deductions (MACRS). A company can use different depreciation methods for financial reporting and for income tax purposes. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The plant asset transactions that appear on the statement of cash flows are Acquisitions (an investing activity) Sales Depreciation (including amortization and depletion) Is reported in the operating section Decreases net income, but has no effect on cash Is added back to net income in determining cash flow from operations © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Accounting for Current and Long-term Liabilities
CHAPTER 8 Accounting for Current and Long-term Liabilities Debt © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

4. Accrued Salaries and Related Expenses 395
The liability section of The Home Depot balance sheet is presented below: 1. LIABILITIES: 2. Current Liabilities: 3. Accounts Payable $1,586 4. Accrued Salaries and Related Expenses 5. Sales Taxes Payable 6. Other Accrued Liabilities (Accrued Expenses Payable) 7. Income Taxes Payable 8. Current Installments of Long-Term Debt (notes 2 and 5) Total Current Liabilities ,857 10. Long-Term Debt, excluding current installments 1,566 11. Other Long-Term Liabilities 12. Deferred Income Taxes 13. Minority Interest © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CURRENT LIABILITIES Current liabilities
Are obligations due within one year or within the company’s normal operating cycle if it is longer than one year Fall into one of two categories: Liabilities of known amount Liabilities whose amount must be estimated Accounts payable are amounts owed for products or services purchased on account © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CURRENT LIABILITIES Short-term notes payable are notes payable due within one year The following entry records a note payable: 20X1 Sep. 30 Inventory 8,000 Note payable, short-term ,000 Purchase of inventory by issuing a one-year % note © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CURRENT LIABILITIES Dec. 31 Interest Expense (8,000 x .10 x 3/12) 200
At year end, the company must accrue interest expense: Dec Interest Expense (8,000 x .10 x 3/12) 200 Interest Payable Adjusting entry to accrue interest expense at year end © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CURRENT LIABILITIES 20X2 Sep. 30 Note Payable, Short-term 8,000
The following entry records the note’s payment at maturity 20X2 Sep Note Payable, Short-term 8,000 Interest Payable Interest Expense ($8,000 x .10 x 9/12) Cash [$8,000 + ($8,000 x .10)] ,800 The cash payment entry must separate the total interest on the note between The interest expense accrued at the end of the previous period ($200) The current period’s interest expense ($600) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

To record cash sales and the related sales tax
CURRENT LIABILITIES Sales tax payable is a current liability as shown on line 5 Suppose a day’s sales at a Home Depot store totals $200,000. The business collects 5% in sales tax. The store records the day’s sales as follows: Cash ($200,000 x 1.05) 210,000 Sales Revenue ,000 Sales Tax Payable ($200,000 x .05) ,000 To record cash sales and the related sales tax © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CURRENT LIABILITIES The current installment of long-term debt is
The amount of the principal that is payable within one year At the end of the year, a company reclassifies the amount of its long-term debt that must be paid during the upcoming year Reported as a current liability © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CURRENT LIABILITIES An accrued expense (accrued liability) is
An expense that the business has incurred but has not yet paid A liability, thus the term accrued liability © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CURRENT LIABILITIES Home Depot reports several categories of accrued expenses on its balance sheet Accrued Salaries and Related Expenses (line 4) Includes liabilities for salaries, wages, and related payroll expenses at the end of the period Other Accrued Liabilities (line 6) Includes such items as interest payable Income Taxes Payable (line 7) is the amount of taxes still owed at year end © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CURRENT LIABILITIES Payroll (employee compensation) is
A major expense of most businesses Includes Salaries - pay stated at a yearly or monthly rate Wages - pay stated at hourly rates Commissions - a percentage of the sales the employee has made Bonuses - rewards for excellent performance © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CURRENT LIABILITIES Salary expense represents employees’ gross pay and includes several payroll liabilities Salary payable to employees - net (take-home) pay Employee Income Tax Payable - the employees’ income tax that has been withheld from their paychecks © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CURRENT LIABILITIES FICA Tax Payable - the employees’ Social Security tax that has been withheld Includes a liability for Medicare tax Other withholdings authorized by the employee, e.g., union dues © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CURRENT LIABILITIES Accounting for Payroll Expenses and Liabilities Salary Expense (Wage Expense, Commission Expense) 10,000 Employee Income Tax Payable ,200 FICA Tax Payable Employee Union Dues Payable Salary Payable to Employees (take home pay) ,860 To record salary expense © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CURRENT LIABILITIES Unearned revenues indicate that the business has received cash from its customers before it has earned the revenue © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CURRENT LIABILITIES The Dun & Bradstreet (D&B) Corporation provides credit evaluation services to businesses that subscribe to the D&B reports. The liability account is called Unearned Subscription Revenue. Assume that D&B charges a client $150 for a three-year subscription. D&B’s entries would be: 20X1 Jan Cash Unearned Subscription Revenue 150 To receive cash for a three-year subscription 20X1, 20X2, 20X3 Dec. 31 Unearned Subscription Revenue 50 Subscription Revenue ($150/3) To record revenue earned at the end of each year © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Balance Sheet Year 1 Year 2 Year 3 Long-term liabilities:
CURRENT LIABILITIES December 31, Balance Sheet Year 1 Year 2 Year 3 Current liabilities: Unearned subscription revenue $50 $50 -0- Long-term liabilities: Unearned subscription revenue $ Income Statement Revenues: Subscription revenue $50 $50 $50 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CURRENT LIABILITIES THAT MUST BE ESTIMATED
Estimated warranty payable Arises when a company warranties its product Is recorded in the same period that the business recognizes sales revenue Is estimated because the exact amount of warranty expense cannot be known with certainty Warranty © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Estimated Warranty Payable 6,000,000 To accrue warranty expense
CURRENT LIABILITIES THAT MUST BE ESTIMATED Assume that Black & Decker made sales of $200,000,000 subject to product warranties. If Black & Decker estimates that 3% of the products it sells this year will require repair or replacement, the company would estimate warranty expense of $6,000,000 ($200,000,000 x .03) for the period and make the following entry: Warranty Expense ,000,000 Estimated Warranty Payable 6,000,000 To accrue warranty expense © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Assume that defective merchandise totals $5,800,000. Black & Decker will replace it and record the following: Estimated Warranty Payable 5,800,000 Inventory 5,800,000 To replace defective products sold under warranty The company reports Estimated Warranty Payable on the balance sheet under the current-liability caption Accrued liabilities or Accrued expenses payable © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CONTINGENT LIABILITIES
A contingent liability is A potential liability that depends on a future event arising out of past events Subject to the following FASB guidelines for accounting for contingent losses (or expenses) and their related liabilities Record an actual liability if it is probable that the loss (or expense) will occur and the amount can be reasonably estimated © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CONTINGENT LIABILITIES
Report the contingency in a financial statement note if it is reasonably possible that a loss (or expense) will occur There is no need to report a contingent loss that is remote (unlikely to occur) May be reported in a short presentation, after liabilities on the balance sheet, but with no amounts given Usually accompanied by an explanatory note © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Financing Operations With Long-Term Debt

BONDS: AN INTRODUCTION
Bonds payable Are groups of notes payable issued to multiple lenders, called bondholders State the principal The amount that the company has borrowed on the bond certificates Typically are stated in units of $1,000 called face value, maturity value, or par value © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Obligate the issuing company to pay the holder the principal amount at a specific future date called the maturity date Bondholders loan their money to companies for a price: interest on the principal The bond certificate states The interest rate the issuer will pay The dates the interest payments are due © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

When the company pays back the principal The holder returns the certificate The company retires (or cancels) the bond © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

TYPES OF BONDS Term bonds mature at a specified time
Serial bonds mature in installments over a period of time Secured (mortgage) bonds give the bondholder the right to take specified assets of the issuer if the company defaults (fails to pay principal or interest) Debentures are unsecured bonds and are backed only by the good faith of the borrower © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BOND PRICES Bond prices are quoted at a percentage of their maturity value A $1,000 bond quoted at 100 is bought or sold for $1,000, which is 100% of its face value A bond quoted at 101½ has a market price of $1,015 (101.5% of face value, or $1,000 x ) A $1,000 bond quoted at 88 3/8 is priced at $ ($1,000 x ) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Bonds Volume High Low Close Net Change
BOND PRICES The exhibit below contains actual price information for the bonds of Ohio Edison Company, taken from The Wall Street Journal. On this particular day, 12 of Ohio Edison’s 9 1/2%, $1,000 face value bonds maturing in the year 2006 (indicated by 06) were traded. The bonds’ highest price on this day was $795 ($1,000 x 0.795). The lowest price of the day was $785 ($1,000 x 0.785). The closing price (last sale price of the day) was $795, 2 points higher than the closing price of the preceding day. Bonds Volume High Low Close Net Change OhEd 9 1/ / / / © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BOND PRICES A bond issued at a price above its face (par) value is said to be issued at a premium, and a bond issued at a price below face (par) value has a discount As a bond nears maturity, its market price moves toward par value On the maturity date, a bond’s market value exactly equals its par value © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

PRESENT VALUE Money earns income over time, a fact called the time value of money The amount that a person would invest at the present time to receive a greater amount at a future date is called the present value of a future amount © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

PRESENT VALUE The exact present value of any future amount depends on
The amount of the future payment (or receipt) The length of time from the investment to the date when the future amount is to be paid (or received) The interest rate during the period Present value is always less than the future amount © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BOND INTEREST RATES Bonds are sold at market price Market price is
The amount that investors are willing to pay at any given time The bond’s present value equals the present value of two obligations: Principal payment Cash interest payments © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BOND INTEREST RATES The contract (stated) interest rate is
The interest rate that determines the amount of cash interest the borrower pays each year The market (effective) interest rate is The rate that investors demand for loaning their money © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

How the Contract Interest Rate and the Market Interest Rate Interact to Determine the Price of a Bond Payable Issuance Price of Bonds Payable Contract (stated) interest rate on a bond payable Example: (9%) Market interest rate 9% 10% 8% equals implies Par (face, or maturity) value = Par: $1,000 bond issued for $1,000 less than Discount (price below par) Discount: $1,000 bond issued below $1,000  greater than Premium (price above par) Premium: $1,000 bond issued above $1,000  © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Issuing Bonds Payable to Borrow Money

To issue 9%, 5-year bonds at par
ISSUANCE AT PAR Suppose Chrysler Corporation has $50 million in 9% bonds that mature in five years. Chrysler issued these bonds at par on January 1, The issuance entry is 2000 Jan. 1 Cash ,000,000 Bonds Payable ,000,000 To issue 9%, 5-year bonds at par © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ISSUANCE AT PAR Interest payments occur each January 1 and July 1. Chrysler’s entry to record the first semiannual interest payment is 2000 July 1 Interest Expense ($50,000,000 x .09 x 6/12) 2,250,000 Cash ,250,000 To pay semiannual interest © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Dec. 31 Interest Expense ($50,000,000 x .09 x 6/12) 2,250,000
ISSUANCE AT PAR At year end, Chrysler must accrue interest expense and interest payable for six months (July through December), as follows: 2000 Dec Interest Expense ($50,000,000 x .09 x 6/12) 2,250,000 Interest Payable ,250,000 To accrue interest © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

To pay bonds payable at maturity
ISSUANCE AT PAR At maturity, Chrysler will record payment of the bonds as follows: 2005 Jan. 1 Bonds Payable ,000,000 Cash ,000,000 To pay bonds payable at maturity © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ISSUING BONDS PAYABLE BETWEEN INTEREST DATES
Assume that Chrysler issued its 9% bonds payable on February 28, two months after the bonds were dated (January 1, 2000). At issuance, Chrysler Corporation will collect two months of interest from the bondholder and record issuance of the bonds as follows: 2000 Feb. 29 Cash ,750,000 Bonds Payable ,000,000 Interest Payable ($50,000,000 x .09 x 2/12) ,000 To issue 9%, 5-year bonds at par two months after original issue date On June 30, Chrysler will make a semiannual interest payment. Chrysler has interest expense for the four months that the bonds have been outstanding. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ISSUING BONDS PAYABLE AT A DISCOUNT
Suppose Chrysler Corporation issues $100,000 of its 9%, five-year bonds when the market interest rate is 10 percent. Chrysler receives $96,149 at issuance. The entry is 2000 Jan. 1 Cash ,149 Discount of Bonds Payable 3,851 Bonds Payable ,000 To issue 9%, 5-year bonds at a discount © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

After posting, the bond accounts have the following balances: Bonds Payable Discount on Bonds Payable 100,000 3,851 The $3,851 discount represents extra interest expense that Chrysler will recognize little by little over the life of the bond issue © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Chrysler’s balance sheet immediately after issuance of the bonds would report the following: Total current liabilities $ XXX Long-term liabilities: Bonds payable, 9%, due $100,000 Less: Discount on bonds payable (3,851) 96,149 Discount on Bonds Payable is a contra account to Bonds Payable. Subtracting its balance from Bonds Payable yields the carrying amount of the bonds © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

EFFECTIVE-INTEREST METHOD OF DEBT AMORTIZATION
Chrysler Corporation pays interest on its bonds semiannually. Each semiannual interest payment is fixed by the bond contract and remains the same amount over the life of the bonds: Semiannual interest payment = $100,000 x .09 x 6/12 = $4,500 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

EFFECTIVE-INTEREST METHOD OF DEBT AMORTIZATION
The following table uses the effective-interest method of amortization to determine the periodic interest expense and bond carrying amounts For bonds issued at a discount, the interest expense increases as the bonds’ carrying amount increases © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Interest Payment (4 1/2% of Maturity Value)
A B C D E Interest Payment (4 1/2% of Maturity Value) Interest Expense (5% of Preceding Bond Carrying Amount) Bond Carrying Amount ($100,000 -D) Semiannual Interest Date Discount Amortization (B - A) Discount Account Balance (Preceding D-C) Jan. 1, 2000 July 1 Jan. 1, 2001 Jan. 1, 2002 Jan. 1, 2003 Jan. 1, 2004 Jan. 1, 2005 $3,851 3,544 3,221 2,882 2,526 2,152 1,760 1,348 915 416 -0- $ 96,149 96,456 96,779 97,118 97,474 97,848 98,240 98,652 99,085 99,539 100,000 $4,500 4,500 $4,807 4,823 4,839 4,856 4,874 4,892 4,912 4,933 4,954 4,961 $307 323 339 356 374 392 412 433 454 461 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INTEREST EXPENSE ON BONDS ISSUED AT A DISCOUNT
The following exhibit graphs the data from the amortization table The interest expense (Column B) The interest payment (Column A) The amortization of bond discount (Column C) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Amortization of bond discount, $461 $4,807 Interest Expense 4,850
$4,961 $5,000 4,950 Interest expense 4,900 Amortization of bond discount, $461 $4,807 Interest Expense 4,850 4,800 $307 4,500 Interest payment $4,500 4,400 $4,500 Semiannual Interest Periods © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The following graph illustrates the amortization of the bond discount from its beginning balance of $3,851 to its ending balance of $0 These amounts come from column D of the amortization table © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Bond’s maturity value = $100,000 Bond discount = 0 100,000 • • •
$101,000 Bond’s maturity value = $100,000 Bond discount = 0 100,000 • Discount on bonds payable is amortized to $0 • • 99,000 • Bond Carrying Amount • $3,851 Bond carrying amount increases to maturity 98,000 • • • 97,000 • • • 96,000 95,000 Semiannual Interest Periods © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

On July, Chrysler makes the first $4,500 semiannual interest payment and also amortizes (decreases) the bond discount. Chrysler's journal entry is 2000 July 1 Interest Expense 4,807 Discount on Bonds Payable Cash ,500 To pay semiannual interest and amortize bond discount © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

At December 31, 2000, Chrysler accrues interest and amortizes the bond discount for July through December with this entry (amounts from amortization table): 2000 Dec. 31 Interest Expense ,823 Discount on Bonds Payable Interest Payable ,500 To accrue semiannual interest and amortize bond discount © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

At December 31, 2000, Chrysler's bond accounts appear as follows: Bonds Payable Discount on Bonds Payable 100,000 3,851 Bal. 3,221 Bond carrying amount, $96,779 = ($100,000 - $3,221) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ISSUING BONDS PAYABLE AT A PREMIUM
Assume that Chrysler Corporation issues $100,000 of five-year, 9% bonds that pay interest semiannually The market interest rate is 8% and issue price is $104,100 The premium on these bonds is $4,100 The following table shows how to amortize the premium by the effective-interest method © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Interest Payment (4 1/2% of Maturity Value)
A B C D E Interest Payment (4 1/2% of Maturity Value) Interest Expense (4% of Preceding Bond Carrying Amount) Semiannual Interest Date Premium Amortization (A - B) Premium Account Balance (Preceding D-C) Bond Carrying Amount ($100,000 +D) Jan. 1, 2000 July 1 Jan. 1, 2001 Jan. 1, 2002 Jan. 1, 2003 Jan. 1, 2004 Jan. 1, 2005 $4,100 3,764 3,415 3,052 2,674 2,281 1,872 1,447 1.005 545 -0- $104,100 103,764 103,415 103,052 102,674 102,281 101,872 101,447 101,005 100,545 100,000 $4,500 4,500 $4,164 4,151 4,137 4,122 4,107 4,091 4,075 4,058 4,040 3,955 $336 349 363 378 393 409 425 442 460 545 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The entries to record issuance of the bonds and make the first interest payment and amortize the related premium are as follows: 2000 Jan. 1 Cash ,100 Bonds Payable ,000 Premium on Bonds Payable ,100 To issue 9% bonds at a premium 2000 July 1 Interest Expense 4,164 Premium on Bonds Payable Cash ,500 To pay semiannual interest and amortize bond premium © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Immediately after issuing the bonds, Chrysler would report the bonds payable on the balance sheet as follows: Total current liabilities $ XXX Long-term liabilities: Bonds payable $100,000 Premium on bonds payable , ,100 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INTEREST EXPENSE ON BONDS ISSUED AT A PREMIUM
The $4,100 premium on the bonds is a reduction in Chrysler's interest expense over the term of the bond The amount of interest expense each period decreases as the bond carrying amount is amortized downward toward maturity value © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Amortization of bond premium, $545 Interest Expense 4,200
$4,500 $4,500 Interest payment $4,500 4,400 $336 4,300 Amortization of bond premium, $545 Interest Expense 4,200 4,100 $4,164 Interest expense 4,000 $3,955 3,900 Semiannual Interest Periods © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Bond carrying amount decreases to maturity Bond Carrying Amount $4,100
$105,000 104,000 • • 103,000 Bond carrying amount decreases to maturity Bond Carrying Amount $4,100 • 102,000 Premium on bonds payable is amortized to $0 101,000 Bond premium = 0 100,000 • Bond’s maturity value = $100,000 Semiannual Interest Periods © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

STRAIGHT-LINE AMORTIZATION OF BOND DISCOUNT AND BOND PREMIUM
The straight-line amortization method Divides a bond discount (or premium) into equal periodic amounts over the bond’s term The amount of interest expense is the same for each interest period Is allowed by GAAP only when its amounts differ insignificantly from the amounts determined by the effective-interest method © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

EARLY RETIREMENT OF BONDS PAYABLE
The main reason for retiring bonds early is to eliminate interest payments Some bonds are callable The bonds issuer may call, or pay off, the bonds at a specified price whenever the issuer chooses The alternative to calling the bonds is to purchase them in the open market at their current market price © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Air Products and Chemicals, Inc., has $70 million of debenture bonds outstanding with an unamortized discount of $350,000. If the market price of the bonds is 99¼, retiring the bonds results in a gain of $175,000: Par value of bonds being retired $70,000,000 Less: Unamortized discount ,000 Carrying amount of the bonds 69,650,000 Market price ($70,000,000 x ) 69,475,000 Gain on retirement $ ,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The following entry records retirement of the bonds immediately after an interest date: June 30 Bonds Payable ,000,000 Discount on Bonds Payable ,000 Cash ($70,000,000 x ) ,475,000 Extraordinary Gain on Retirement of Bonds Payable ,000 To retire bonds payable before maturity © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The entry removes the bonds payable and the related discount from the accounts and records a gain on retirement GAAP identifies gains and losses on early retirement of debts as extraordinary, and they are reported separately on the income statement, net of tax © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CONVERTIBLE BONDS AND NOTES
Convertible bonds (or notes) may be converted into the issuing company’s common stock at the investor’s option Bond Stock © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Prime Western, Inc., has convertible notes outstanding carried on the books at $12.5 million. The maturity value of the notes is $13 million. If the noteholders convert the notes into 400,000 shares of the company’s $1 par common stock, the entry for this conversion is: May 14 Notes Payable ,000,000 Discount on Notes Payable ,000 Common Stock (400,000 x $1 par) ,000 Paid-in Capital in Excess of Par - Common ,100,000 To record conversion of notes payable © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The carrying amount of the notes ($13,000,000 - $500,000) becomes stockholders’ equity ($400,000 + $12,100,000) The Notes Payable account and its related discount account are zeroed out Common Stock is recorded at its par value Any extra carrying amount of the Notes Payable is credited to Paid-in Capital in Excess of Par - Common © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ADVANTAGES OF FINANCING OPERATION WITH BONDS VS. STOCKS
The money to acquire assets may be financed by the business’s Retained earnings A stock issue A bond issue Each financing strategy has its advantages © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Advantages of Financing Operations By
Issuing Notes or Bonds Payable Issuing Stock Creates no liabilities or interest expense Less risky to the issuing corporation Does not dilute stock ownership or control of the corporation Results in higher earnings per share because interest expense is tax deductible © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Earnings per share (EPS) is the amount of a company’s net income for each share of its common stock It is a standard measure of operating performance for comparing companies of different sizes and from different industries © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Suppose a corporation needs $500,000 for expansion. The company has net income of $300,000 and 100,000 shares of common stock outstanding. Management is considering two financing plans: Plan 1 is to issue $500,000 of 10% bonds payable Plan 2 is to issue 50,000 additional shares of common stock for $500,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The new cash can be invested in operations to earn income of $200,000 before interest and taxes Earning more income on borrowed money than the related interest expense increases the earnings for common stockholders and is called trading on the equity © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The next slide shows the earnings-per-share advantage of borrowing The company’s EPS amount is higher if the company borrows by issuing bonds EPS © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Plan 1 Borrow $500,000 at 10% Plan 2 Issue $500,000 of Common Stock
Net income before expansion $300, $300,000 Project income before interest and income tax $200,000 $200,000 Less interest expense ($500,000 x 0.10) (50,000) Project income before income tax , ,000 Less income tax expense (40%) , (80,000) Project net income , ,000 Total company net income $390, $420,000 Earnings per share after expansion: Plan 1 ($390,000/100,000 shares) $ 3.90 Plan 2 ($420,000/150,000 shares) $ 2.80 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

LEASE LIABILITIES A lease is a rental agreement in which the tenant (lessee) agrees to make rent payments to the property owner (lessor) in exchange for the use of the asset The two types of leases are Operating leases Capital leases © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

OPERATING LEASES Operating leases
Give the lessee the right to use the asset but provide the lessee with no continuing rights to the asset Are accounted for by debiting Rent Expense (or Lease Expense) and crediting Cash for the amount of the lease payment The lessee’s books do not report the leased asset or any lease liability © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CAPITAL LEASES A capital lease is a noncancelable long-term financing obligation that is a form of debt To be classified as a capital lease, a lease agreement must meet any one of the following four criteria: The lease transfers title of the leased asset to the lessee at the end of the lease term © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CAPITAL LEASES The lease contains a bargain purchase option
The lessee can be expected to purchase the leased asset and become its legal owner The lease term is 75% of the estimated useful life of the leased asset The lessee uses up most of the leased asset’s service potential © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CAPITAL LEASES The present value of the lease payments is 90% or more of the market value of the leased asset The lease payments operate as installment payments for the leased asset © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ACCOUNTING FOR A CAPITAL LEASE
The lessee enters the asset into its own accounts and records a lease liability at the beginning of the lease term The lessee capitalizes the asset even though the lessee may never take legal title to the property © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

REPORTING LIABILITIES ON THE BALANCE SHEET
The Home Depot liability section of the balance sheet is presented again on the next slide © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

4. Accrued Salaries and Related Expenses 395
The liability section of The Home Depot balance sheet is presented below: 1. LIABILITIES: 2. Current Liabilities: 3. Accounts Payable $1,586 4. Accrued Salaries and Related Expenses 5. Sales Taxes Payable 6. Other Accrued Liabilities (Accrued Expenses Payable) 7. Income Taxes Payable 8. Current Installments of Long-Term Debt (notes 2 and 5) Total Current Liabilities ,857 10. Long-Term Debt, excluding current installments 1,566 11. Other Long-Term Liabilities 12. Deferred Income Taxes 13. Minority Interest © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

REPORTING LIABILITIES ON THE BALANCE SHEET
Additional categories of long-term liabilities include Deferred income taxes Income taxes that the company can defer and pay later Minority interest Outside stockholders’ interest Other long-term liabilities Includes long-term unearned revenue (deferred credits) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

REPORTING THE FAIR MARKET VALUE OF LONG-TERM DEBT
FASB Statement No. 107 requires companies to report the fair market value of their financial instruments Long-term debts, including notes and bonds payable, are financial instruments © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

PENSION AND POSTRETIREMENT LIABILITIES
A pension is employee compensation that will be received during retirement Companies also provide postretirement benefits, such as medical insurance Companies record pension and retirement benefit expense while employees work for the company © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

At the end of each period, the company compares The fair market value of the assets in the pension plan--cash and investments--with The plan’s accumulated benefit obligation The present value of promised future pension payment to retirees © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

If the accumulated benefit obligation exceeds plan assets, the plan is underfunded, and the company must report the excess liability amount as a long-term pension liability on the balance sheet © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The next slide is an excerpt from The Home Depot’s statement of cash flows The Home Depot finances most of its operations with equity However, it borrowed $246 million by issuing commercial paper (line 3) and paid $8 million on its long-term debt (line 5) Home Depot is able to finance most of its asset purchases with cash generated by operations (line 1) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Statement of Cash Flows For the year ended January 31, 1999
The Home Depot Statement of Cash Flows For the year ended January 31, 1999 In millions Cash Flow from Operating Activities: 1. Net Cash provided by operating activities $ 1,917 Cash Flow from Investing Activities: 2. Net Cash used in investing activities $(2,271) Cash Flow from Financing Activities: Borrowing by issuing commercial paper $ Proceeds from long-term borrowing Payments of long-term debt (8) Proceeds from issuance of common stock Payments of cash dividends (168) Other, net Net cash provided by (used in) financing activities $ 10. Increase (decrease) in cash (110) 11. Cash at beginning of year 12. Cash at end of year $ © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Using the Income Statement and the Statement of Stockholders’ Equity
CHAPTER 11 Net Income Using the Income Statement and the Statement of Stockholders’ Equity © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

QUALITY OF EARNINGS The quality of earnings takes into consideration how net income is generated Income from continuing operations is considered of higher quality than gains from selling off assets because it is a better predictor of future earnings © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CONTINUING OPERATONS In the income statement on slide 6, the topmost section reports income from continuing operations (lines 1-10) This part of the business is expected to continue from period to period Operating income is reported in lines 1-5 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CONTINUING OPERATONS The company restructured operations at a loss of $10,000 (line 6) Restructuring costs include severance pay and moving expense Although the restructuring loss is part of continuing operations, it is highlighted as an “Other” item on the income statement because restructuring falls outside of the main business endeavor © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CONTINUING OPERATONS The gain on the sale of machinery (line 7) is also outside the company’s core business activity Income tax expense (line 9) has been deducted in arriving at income from continuing operations © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Continuing operations
Special items Earnings per share © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CONTINUING OPERATONS Using income from continuing operations in investment analysis Income from continuing operations can be used in estimating the value of Allied Electronics’ common stock by determining the present value of Allied’s stream of future income The investment capitalization rate is used to estimate the value of an investment in the capital stock of another company © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CONTINUING OPERATONS Assume an annual earnings of $54,000 and an interest rate (i) of 12%. The computation of estimated value of a stock is as follows: Estimated annual income in the future Estimated value of Allied Electronics common stock $54,000 = = = $450,000 Investment capitalization rate .12 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CONTINUING OPERATONS The current market value of Allied Stock is
Current market value of the company $513,000 Number of shares of common stock outstanding 108,000 Current market price per share $4.75 = x © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

DECISION In this case, DECISION
The investment decision rule may take this form: DECISION If estimated value of the company Exceeds Current market value of the company Buy the stock Equals Hold the stock Is less than Sell the stock In this case, DECISION Estimated value of the company $450,000 Current market value of the company $513,000 Is less than Sell the stock © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CONTINUING OPERATONS Investors often make their decisions based on the value of a single share of stock: Estimated annual earnings per share Estimated value of one share of common stock = Investment capitalization rate © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CONTINUING OPERATONS To estimate the value of an investment
Most analysts use income from continuing operations Some analysts also use cash flows from operating activities © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Estimated value of Allied Electronics common stock
If Allied Electronics’ income stream is predictable for only 20 years into the future, the value of Allied’s stock would be as follows: Estimated value of Allied Electronics common stock Estimated annual income in the future $54,000 $403,326 Present value of annuity (n=20 periods, i=12%) = x = x 7.469 = Based on this estimate, analysts would believe even more strongly that Allied’s stock is overpriced at $513,000 ($4.75 per share) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

DISCONTINUED OPERATIONS
Most large corporations engage in several lines of business Each identifiable division of a company is called a segment of the business A company may sell a segment of its business generating a gain or loss © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The Discontinued Operations section of the income statement is divided into two components: Operating income (loss) on the segment that is disposed of Gain (loss) on the disposal © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Assuming a tax rate of 40%, Allied Electronics reports this section as follows: Discontinued operations: Operating income, $30,000, less income tax, $12,000 $18,000 Gain on disposal, $5,000, less income tax, $2, , $21,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

EXTRAORDINARY GAINS AND LOSSES
Extraordinary gains and losses (extraordinary items) Are Unusual for the company Infrequent Include Natural disasters (such as earthquakes, floods, and tornadoes) Taking of company assets by a foreign government (expropriation) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Extraordinary items are reported along with their income tax effect. Allied Electronics corporation lost $20,000 of inventory in a flood (line 14 and 15): Extraordinary flood loss $20,000 Less income tax savings ,000 Extraordinary flood loss, net of tax (12,000) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Gains and losses due to employee strikes, the settlement of lawsuits, discontinued operations, and the sale of plant assets are not extraordinary items They are considered normal business occurrences © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CUMULATIVE EFFECT OF A CHANGE IN ACCOUNTING PRINCIPLE
Companies sometimes change from one accounting method to another: From double-declining balance to straight line depreciation From first-in first-out (FIFO) to weighted average cost for inventory © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Companies must report the cumulative effect of the accounting change on net income of prior years in a special section of the income statement after extraordinary items © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Allied Electronics reports the cumulative effect of this accounting change on line 16: Cumulative effect of change in depreciation method $10,000 Less income tax ,000 Cumulative effect of change in depreciation method net of income tax ,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

EARNINGS PER SHARE OF COMMON STOCK
Earnings per share (EPS) Is the amount of a company’s net income per share of its outstanding common stock Is in the final segment of a corporation’s income statement Allows investors to compare earnings for corporations of different sizes and across various industries © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The final section (lines 18-23) of the Allied Electronics income statement shows how the EPS figures are reported: Earnings per share of common stock (20,000 shares outstanding): Income from continuing operations ($54,000/20,000) $2.70 Income from discontinued operations ($21,000/20,000) Income before extraordinary item and cumulative effect of change in depreciation method ($75,000/20,000) $3.75 Extraordinary loss ($12,000/20,000) (0.60) Cumulative effect of change in depreciation method ($6,000/20,000) Net income ($69,000/20,000) $3.45 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Weighted-average shares of common stock outstanding For many corporations, shares outstanding vary from month to month To make EPS as meaningful as possible, corporations divide by the weighted-average number of common shares outstanding during the period © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Assume that Diskette Demo Corporation had these shares of common stock outstanding for the following periods: January through May--240,000 shares June through August--200,000 shares September through December--210,000 shares Number of Common shares Outstanding Weighted-Average Number of Common Shares Outstanding X Fraction of Year = Period during the Year 240,000 200,000 210,000 X 5/12 3/12 4/12 Jan. through May June through Aug. Sept. through Dec. = 100,000 50,000 70,000 Weighted-average number of common shares outstanding during the year 220,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Effect of preferred dividends on earnings per share Holders of preferred stock have first claim on dividends Preferred dividends must be subtracted from income subtotals in the computation of EPS © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

If Allied Electronics Corporation had 10,000 shares of preferred stock outstanding, each with a $1.00 dividend, the annual preferred dividend would be $10,000 (10,000 x $1.00) The $10,000 would be subtracted from each of the different income subtotals, resulting in the following EPS computations: Earnings per share of common stock (20,000 shares outstanding): Income from continuing operations ($54,000-$10,000)/20, $2.20 Income from discontinued operations ($21,000/20,000) Income before extraordinary item and cumulative effect of change in depreciation method ($75,000-$10,000)/20, $3.25 Extraordinary loss ($12,000/20,000) (0.60) Cumulative effect of change in depreciation method ($6,000/20,000) Net income ($69,000-$10,000)/20, $2.95 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Earnings per share dilution Some companies make their preferred stock attractive by offering convertible preferred stock When preferred is converted to common, the EPS is diluted because more common shares are divided into net income EPS EPS © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Corporations with complex capital structures present two sets of EPS figures EPS based on actual outstanding common shares (basic EPS) EPS based on outstanding common shares plus the additional common shares that would arise from conversion of the preferred stock into common (diluted EPS) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

REPORTING COMPREHENSIVE INCOME
Is the company’s change in total stockholders’ equity from all sources other than from the owners of the business Includes net income plus some specific gains and losses © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Unrealized gains or losses on available-for-sale investments
In the statement below, “Other comprehensive income” contains two of these specific gains and losses: Unrealized gains or losses on available-for-sale investments Foreign-currency translation adjustment Revenues $10,000 Expenses (including income tax) ,000 Net income ,000 Other comprehensive income: Unrealized gain on investment $ 650 Less income tax (40%) $390 Foreign-currency translation adjustment (loss) $(900) Less income tax (40%) (540) Other comprehensive income (150) Comprehensive income $ 3,850 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ANALYZING BOTH ACCOUNTING INCOME AND CASH FLOWS
Revenues and expenses are recorded when they occur Net cash flow, however, is based solely on cash receipts and cash payments © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ANALYZING BOTH ACCOUNTING INCOME AND CASH FLOWS
A company may have abundant cash flow but little accounting income The income statement and the statement of cash flows are both needed, along with the balance sheet and statement of stockholders’ equity, for an overall view of the business © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ACCOUNTING FOR INCOME TAXES BY CORPORATIONS
Most corporations have a combined federal and state income tax rate of approximately 40% To account for income tax, the corporation measures for each period Income tax expense An expense on the income statement Income tax payable A liability on the balance sheet © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Income before income tax (from the income statement) Income tax rate =
In general, income tax expense and income tax payable can be computed as follows: Income tax expense Income before income tax (from the income statement) Income tax rate = X Income tax payable Taxable income (from the income tax return filed with the IRS) Income tax rate = X © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The income statement and the income tax return are entirely separate documents The income statement reports the results of operations that we have been working with throughout this course The income tax return is filed with the Internal Revenue Service to determine how much tax the company must pay the government © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

For most companies, income tax expense and income tax payable differs The most important difference between accounting income and taxable income occurs when a corporation uses straight-line depreciation for financial statements and the modified accelerated cost recovery system (MACRS) depreciation on the tax return © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Suppose for 20X2 that IHOP Corp. has
Pretax accounting income of $40 million on the income statement Taxable income of $35 million on the company’s income tax return IHOP will record income tax for 20X2 as follows (dollar amounts in millions and an income tax rate of 40%): 20X2 Dec. 31 Income Tax Expense ($40 x .40) Income Tax Payable ($35 x .40) Deferred Tax Liability Recorded income tax for the year © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Income tax expense is reported on the income statement, and income tax payable and deferred tax liability on the balance sheet, as follows for IHOP Corp. at the end of 20X2: Income statement Income before income tax $ 40 Income tax expense ( 16) Net income $ 24 Balance sheet Current Liabilities: Income tax payable $14 Long-term liabilities * *Assumes the beginning balance of Deferred tax liability was zero. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

PRIOR PERIOD ADJUSTMENTS
Prior period adjustments are corrections to the beginning balance of Retained Earnings for errors of an earlier period © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

June 19 Retained Earnings 10,000 Income Tax Payable 10,000
DeGraff Corporation recorded income tax expense as $30,000 rather than the correct amount of $40,000. This error resulted in understating 20X4 expenses by $10,000 and overstating net income by $10,000. The entry to record this prior period adjustment in 20X5 is 20X5 June 19 Retained Earnings 10,000 Income Tax Payable ,000 Prior period adjustment to correct error in recording income tax expense of 20X4 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

This prior period adjustment would appear on the statement of retained earnings, as follows:
DeGraff Corporation Statement of Retained Earnings Year Ended December 31, 20x5 Retained earnings balance, December 31, 20X4, as originally reported Prior period adjustment--debit to correct error in recording income tax expense of 20X4 Retained earnings balance, December 31, 20X4, as adjusted Net income for 20X5 Dividends for 20X5 Retained earnings balance, December 31, 20X5 $390,000 (10,000) 380,000 114,000 494,000 (41,000) $453,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

RESTRICTIONS ON RETAINED EARNINGS
Dividends and purchases of treasury stock require payments by the corporation to its stockholders Since these outlays decrease the corporation’s assets, a company’s creditors seek to restrict a corporation’s dividend payments and treasury stock purchases Companies usually report their retained earnings restrictions in notes to the financial statements © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ANALYZING THE STATEMENT OF STOCKHOLDERS’ EQUITY
The statement of stockholders’ equity reports the changes in all categories of equity during the period The next exhibit shows the statement of stockholders’ equity for Allied Electronics for 20X2 There is a column for each element of equity, with the far right column reporting total stockholders’ equity © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The statement of stockholders’ equity provides information about the company’s transactions Net income from the income statement (line 3) Details about the company’s issuance of stock (line 2) Declaration of cash dividends (line 4) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Distribution of stock dividends (line 5) Purchase and sale of treasury stock (lines 6-7) Accumulated other comprehensive income: Unrealized gains and losses on available-for-sale investments (line 8) Foreign-currency translation adjustment (line 9) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

RESPONSIBILITY FOR THE FINANCIAL STATEMENTS
Management issues a statement of responsibility along with the company's financial statements to Declare its responsibility for the financial statements Indicate that the financial statements conform to GAAP State that preparation of the financial statements requires the company to make estimates and certain assumptions Statement of Responsibility © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

AUDITOR’S REPORT ON THE FINANCIAL STATEMENTS
Companies engage outside auditors who are certified public accountants to examine their statements The independent auditors Decide whether the company’s financial statements comply with GAAP Issue an audit report © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The audit report typically contains three paragraphs: The first paragraph identifies the audited financial statements The second paragraph describes how the audit was performed, mentioning that generally accepted auditing standards are the benchmark for evaluating the audit’s quality © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The third paragraph states the auditor’s opinion that the financial statements conform to GAAP and that people can rely on them for decision making © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Audit reports usually fall into one of four categories Unqualified (clean) The statements are reliable Qualified The statements are reliable, except for one or more items for which the opinion is said to be qualified © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Adverse The statements are unreliable Disclaimer The auditor was unable to reach a professional opinion The independent audit adds credibility to the financial statements © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Financial Statement Analysis
CHAPTER 13 Financial Statement Analysis © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

FINANCIAL STATEMENT ANALYSIS
The way to compare companies of different sizes is to use standard measures Financial ratios are standard measures that enable analysts to compare companies of different sizes © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

In addition to the financial statements, annual reports contain the following: Notes to the financial statements, including a summary of the accounting methods used Management’s discussion and analysis (MD&A) of the financial results The auditor’s report Comparative financial data for a series of years © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

For example, the graphs in the next exhibit show Bristol-Myers Squibb’s three-year trend of net sales, market value of the company’s stock, and cumulative return to the company’s stockholders © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Representative Financial Data of Bristol-Myers Squibb Company
Net Sales $ Millions Market Value $ Millions Cumulative Return to Shareholders $20,000 15,000 10,000 5,000 $140,000 105,000 70,000 35,000 250% 200 150 100 50 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The objectives of financial statement analysis are to help investors Predict their expected returns (see the previous graph) Assess the risks associated with those returns © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

HORIZONTAL ANALYSIS The study of percentage changes in comparative statements is called horizontal analysis Computing a percentage change in comparative statements requires two steps: Computing the dollar amount of the change from the base period to the later period Dividing the dollar amount of change by the base-period amount © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Horizontal analysis is illustrated for Bristol-Myers Squibb as follows (dollar amounts in millions):
Increase (Decrease) Amount Percent Sales $18,284 $16,701 $1, % Net income 3, , (64) (2.0%) © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Dollar amount of change
The percentage change in Bristol-Myers Squibb’s sales during 1998 is 9.5%, computed as follows: Step 1. Compute the dollar amount of change in sales from 1997 to 1998: 1998 1997 Increase - = $18,284 $16,701 $1,583 Step 2. Divide the dollar amount of change by the base-period amount to compute the percentage change during the later period: Dollar amount of change Percentage Change = Base-year amount $1,583 = = 9.5% $16,701 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

HORIZONTAL ANALYSIS Trend percentages
Are a form of horizontal analysis that examine more than a two- or three-year period Use a selected base year whose amounts are set equal to 100 percent © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

HORIZONTAL ANALYSIS To compute trend percentages, each item for following years is divided by the corresponding amount during the base year Any year $ Trend % = Base year $ © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

HORIZONTAL ANALYSIS Bristol-Myers Squibb Company showed sales, cost of goods sold, and gross profit for the past six years as follows: © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

HORIZONTAL ANALYSIS The base year is 1993
Trend percentages for Net sales are computed by dividing each net sales amount by the 1993 amount of $11,413 Trend percentages for Cost of products sold is computed by dividing by each cost of products sold amount by $3,029 Trend percentages for Gross profit use the base gross profit of $8,383 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

The resulting trend percentages follow:
HORIZONTAL ANALYSIS The resulting trend percentages follow: Sales, cost of products sold, and gross profit have trended upward at almost identical rates throughout the five-year period © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

VERTICAL ANALYSIS Vertical analysis of a financial statement reveals the relationship of each statement item to a specified base, which is the 100% figure Every other item on the financial statement is then reported as a percentage of that base When an income statement is analyzed vertically, net sales is usually the base © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Each income statement item
VERTICAL ANALYSIS Vertical analysis of balance sheet amounts are shown as a percentage of total assets The next exhibit shows the vertical analysis of Bristol-Myers Squibb’s income statement as a percentage of net sales Each income statement item Vertical analysis % = Net Sales © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

COMMON-SIZE STATEMENTS
A common-size statement simplifies the comparison of different companies because their amounts are stated in percentages On a common-size income statement, each item is expressed as a percentage of the net sales amount In the balance sheet, the common size is total assets or the sum of total liabilities and stockholders’ equity © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BRISTOL-MYERS SQUIBB COMPANY Analysis of Current Assets
December 31,1998 and 1997 Percent of Total Assets 1998 1997 Current Assets: Cash and cash equivalents Time deposits and marketable securities Receivables, net Inventories Prepaid expenses Total current assets Long-Term Assets Total Assets 13.8% 1.8 19.6 11.5 7.3 54.0 46.0 100.0% 9.7% 2.3 19.9 12.0 7.8 51.7 48.3 100.0% © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BENCHMARKING Benchmarking is the practice of comparing a company to a standard set by other companies, with a view toward improvement Benchmarking against the industry average Managers, investors, and creditors need to know how one company compares with similar companies © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BENCHMARKING The next exhibit gives the common-size income statement of Bristol-Myers Squibb Company compared with the average for the pharmaceuticals industry Its gross profit percentage is much higher than the industry average Its percentage of net income is significantly higher that the industry average © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Earnings from continuing operation before income tax
BRISTOL-MYERS SQUIBB COMPANY Common-Size Income Statement for Comparison with Industry Average Year Ended December 31, 1998 Bristol-Myers Squibb Industry Average Net sales Cost of products sold Gross profit Operating expenses Earnings from continuing operation before income tax Income tax expense Earnings from continuing operations Special items (discontinued operations, extraordinary gains and losses, and effect of accounting changes) Net earnings 100.0% 26.6 73.4 50.1 23.3 6.1 17.2 17.2% 100.0% 54.7 45.3 36.5 8.8 2.3 6.5 1.4 5.1% © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BENCHMARKING Benchmarking against a key competitor
Common-size statements are also used to compare the company to another specific company The next exhibit presents the common-size income statements of Bristol-Myers Squibb and Procter & Gamble Bristol-Myers Squibb has higher percentages of gross profit, earnings from continuing operations, and net earnings © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BRISTOL-MYERS SQUIBB COMPANY
Common-Size Income Statement for Comparison with Key Competitor Year Ended December 31, 1998 Bristol-Myers Squibb Proctor & Gamble Net sales Cost of products sold Gross profit Operating expenses Earnings from continuing operation before income tax Income tax expense Earnings from continuing operations Special items (discontinued operations, extraordinary gains and losses, and effect of accounting changes) Net earnings 100.0% 26.6 73.4 50.1 23.3 6.1 17.2 17.2% 100.0% 56.7 43.3 27.9 15.4 5.2 10.2 10.2% © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

STATEMENT OF CASH FLOWS IN DECISION MAKING
The cash-flow statement summarizes sources and uses of the entity’s cash flows Internal and external decision makers want to see the majority of cash inflows coming from operating activities WHY? © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

STATEMENT OF CASH FLOWS IN DECISION MAKING
A company cannot stay in business for long if it cannot generate enough cash from operations to cover operating expenses While borrowing and investing activities provide cash for business use, long-term reliance on these activities for sources of cash is not advised © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

USING RATIOS TO MAKE BUSINESS DECISIONS
A ratio expresses the relationship of one number to another The ratios used to make business decisions may be classified as follows: Ratios that measure the company’s ability to pay current liabilities Ratios that measure the company’s ability to sell inventory and collect receivables © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

USING RATIOS TO MAKE BUSINESS DECISIONS
Ratios that measure the company’s ability to pay long-term debt Ratios that measure the company’s profitability Ratios used to analyze the company’s stock as an investment © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

MEASURING A COMPANY’S ABILITY TO PAY CURRENT LIABILITIES
Working capital is defined as follows: Working capital = Current assets - Current liabilities © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

MEASURING A COMPANY’S ABILITY TO PAY CURRENT LIABILITIES
Working capital is widely used to measure a business’s ability to meet its short-term obligations with its current assets The larger the working capital, the better able is the business to pay its debts © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

CURRENT RATIO The current ratio
Is current assets divided by current liabilities Measures the ability of the company to pay current liabilities with current assets The following slides give the comparative income statement and balance sheet of Palisades Furniture, Inc. © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ Current Ratio
The current ratio of Palisades Furniture, Inc., at December 31, 20X3 and 20X2, follow, along with the average for the retail furniture industry: Palisades’ Current Ratio Formula 20X3 20X2 Current assets $262,000 $236,000 Current ratio = = 1.85 = 1.87 Current liabilities $142,000 $126,000 In most industries a current ratio of 2.0 is considered good Industry Average = 1.70 In general, a higher current ratio indicates a stronger financial position © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ACID TEST RATIO The acid-test (or quick) ratio
Indicates whether the entity could pay all its current liabilities if they came due immediately Is computed by dividing cash, short-term investments, and net current receivables (accounts and notes receivable, net of allowances) by current liabilities © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ Acid-Test Ratio
Palisades Furniture’s acid-test ratios for 20X3 and 20X2 are: Palisades’ Acid-Test Ratio Formula 20X3 20X2 Cash + short-term investments + net current receivables Acid-Test ratio = $29,000 + $0 + $114,000 $32,000 + $0 + $85,000 = 1.01 = 0.93 Current liabilities $142,000 $126,000 An acid-test ratio of 0.90 to 1.00 is acceptable in most industries Industry Average = 0.40 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

MEASURING ABILITY TO SELL INVENTORY AND COLLECT RECEIVABLES
Three ratios are presented that measure the company’s ability to sell inventory and collect receivables Inventory turnover Accounts receivable turnover Days’ sales in receivables © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INVENTORY TURNOVER Inventory turnover is
A measure of the number of times a company sells its average level of inventory during a year Computed by dividing the cost of goods sold by the average inventory for the period © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

INVENTORY TURNOVER A high rate of turnover indicates relative ease in selling inventory; a low turnover indicates difficulty in selling In general, companies prefer a high inventory turnover Inventory turnover varies widely with the nature of the business © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ Inventory Turnover
Palisades Furniture’s inventory turnover for 20X3 is: Palisades’ Inventory Turnover Formula Cost of goods sold $513,000 Inventory turnover = = 4.58 Average inventory $112,000 Industry Average = 3.00 Palisades Furniture’s turnover of 4.58 times a year is high for its industry, which has an average turnover of 3.00 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ACCOUNTS RECEIVABLE TURNOVER
Measures a company’s ability to collect cash from credit customers Is computed by dividing net sales by average net accounts receivable The resulting ratio indicates how many times during the year the average level of receivables was turned into cash © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ACCOUNTS RECEIVABLE TURNOVER
In general, the higher the ratio, the more successfully the business collects cash and the better off its operations A receivable turnover that is too high may indicate that credit is too tight, causing the loss of sales to good customers © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ Accounts Receivable Turnover
Palisades’ Furniture’s accounts receivable turnover ratio for 20X3 is computed as follows: Palisades’ Accounts Receivable Turnover Formula Accounts receivable = turnover Net credit sales $858,000 = 8.62 Average net accounts receivable $99,000 Industry Average = 31.3 Palisades’ receivable turnover of 8.62 is much lower than the industry average, possibly because larger stores sell their receivables © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

DAYS’ SALES IN RECEIVABLES
The days’-sales-in-receivables ratio tells How many days’ sales remain in Accounts Receivable Is computed by a two-step process First, divide net sales by 365 days to figure the average sales amount for one day Second, divide this average day’s sales amount into the average net accounts receivable © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ Days’ Sales in Accounts Receivable
Formula Net sales $858,000 1. One day’s sales = = $2,351 365 days 365 days Average net accounts receivable Days’ sales in average accounts = receivable 2. $99,500 = 42 days One days’ sales $2,351 Industry Average = 2 days The day’s sales in receivables for Palisades is higher (worse) than the industry average because the company collects its own receivables © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

MEASURING A COMPANY’S ABILITY TO PAY LONG-TERM DEBT
Two indicators of a business’s ability to pay long-term liabilities are the Debt ratio Times-interest-earned ratio © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

DEBT RATIO The debt ratio tells the proportion of the company’s assets that it has financed with debt The higher the debt ratio, the higher the strain of paying interest each year and the principal amount at maturity The lower the ratio, the lower the business’s future obligations © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ Debt Ratio Formula
Calculation of the debt ratios for Palisades Furniture at the end of 20X3 and 20X2 is as follows: Palisades’ Debt Ratio Formula 20X3 20X2 Total liabilities $431,000 $324,000 Debt ratio = = 0.55 = 0.50 Total assets $787,000 $644,000 The average debt ratio for most companies ranges from Industry Average = 0.64 The company’s debt ratio indicates a fairly low-risk debt compared to the retail furniture industry average © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

TIMES-INTEREST-EARNED RATIO
The times-interest-earned ratio measures the number of times that operating income can cover interest expense A high times-interest-earned ratio indicates ease in paying interest expense A low value suggests difficulty © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ Times-Interest-Earned Ratio
Calculation of Palisades’ times-interest-earned ratio is as follows: Palisades’ Times-Interest-Earned Ratio Formula 20X3 20X2 Income from operations Times-interest-earned ratio = $101,000 $57,000 = 4.21 = 4.07 Interest expense $24,000 $14,000 The norm for U.S. business ranges from for most companies Industry Average = 2.30 The company’s times-interest-earned ratio of around 4.00 is significantly better than the industry average for furniture retailers © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

MEASURING A COMPANY’S PROFITABILITY
There are four rate-of-return measurements that help evaluate a company’s profitability: Rate of return on net sales Rate of return on total assets Rate of return on common stockholders’ equity Earnings per share of common stock © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

RATE OF RETURN ON NET SALES
The rate of return on net sales shows the percentage of each sales dollar earned as net income The higher the rate of return, the more net sales dollars are providing income to the business and the fewer net sales dollars are absorbed by expenses © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ Rate of Return on Sales
The rate-of-return-on-sales ratios for Palisades Furniture are calculated as follows: Palisades’ Rate of Return on Sales Formula 20X3 20X2 Rate of return on sales Net income $48,000 $26,000 = = 0.056 = 0.032 Net Sales $858,000 $803,000 Industry Average = 0.008 The increase in Palisades Furniture’s return on sales identifies the company as more successful than the average furniture store © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

RATE OF RETURN ON TOTAL ASSETS
The rate of return on total assets (return on assets) measures a company’s success in using its assets to earn a profit The sum of interest expense and net income in the numerator is the return to creditors and shareholders who have financed the company’s operations © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ 20X3 Rate of Return on Total Assets
Computation of the return-on-assets ratio for Palisades Furniture is as follows: Palisades’ 20X3 Rate of Return on Total Assets Formula Net income Interest Expense Rate of return on assets + $48,000 + $24,000 = = 0.101 Average total assets $715,000 Industry Average = 0.042 The increase in Palisades Furniture’s return on assets is higher than the industry average © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

RATE OF RETURN ON COMMON STOCKHOLDERS’ EQUITY
Rate of return on stockholders’ equity (return on equity) Shows the relationship between net income and common stockholders’ investment in the company Is calculated by dividing net income available to common stockholders by the average stockholders’ equity during the year © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ 20X3 Rate of Return on Common Stockholders’ Equity
The rate of return on common stockholders’ equity for Palisades Furniture is calculated as follows: Palisades’ 20X3 Rate of Return on Common Stockholders’ Equity Formula Rate of return on common stockholders’ equity Net income Preferred Dividends - $48,000 - $0 0.142 = = Average common stockholders’ equity $338,000 Industry Average = 0.121 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

RATE OF RETURN ON COMMON STOCKHOLDERS’ EQUITY
Palisades’ return on equity (0.142) is higher than its return on assets (0.101). This difference results from borrowing at one rate (8%) and investing the funds to earn a higher rate (14.2%) This practice is called trading on the equity or using financial leverage © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Earnings per share (EPS) is The amount of net income per share of the company’s outstanding common stock Computed by dividing net income available to common stockholders by the number of common shares outstanding during the year © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ Earnings Per Share
Computation of the firm’s EPS for 20X3 and 20X2 follows, assuming the company had 10,000 share of common stock outstanding Palisades’ Earnings Per Share Formula 20X3 20X2 Net income Preferred Dividends Earnings per share of common stock - $48,000 - $0 $26,000 - $0 = = $4.80 = $2.60 Number of shares of common stock outstanding 10,000 10,000 Most companies strive to increase EPS by % annually Palisades Furniture’s EPS increased 85 percent © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ANALYZING A COMPANY’S STOCK AS AN INVESTMENT
Investors purchase stock to earn a return on their investment, which consists of two parts: Gains (or losses) from selling the stock at a price that differs from the investors’ purchase price Dividends, the periodic distributions to stockholders © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

PRICE EARNINGS RATIO The price earnings ratio is the ratio of the market price of a share of common stock to the company’s earnings The higher a stock’s P/E ratio, the higher its downside risk--the risk that the stock’s market price will fall © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Palisades’ Price/Earnings Ratio
Calculations for the P/E ratio of Palisades Furniture, Inc., follow. The market price of its common stock was $50 at the end of 20X3 and $35 at the end of 20X2: Palisades’ Price/Earnings Ratio Formula 20X3 20X2 Market price per share of common stock $50.00 $35.00 P/E ratio = = 10.4 = 13.5 Earnings per share $4.80 $2.60 P/E ratios vary from industry to industry Palisades Furniture’s 20X3 P/E ratio indicates that the company’s stock is selling at 10.4 times earnings © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

DIVIDEND YIELD Dividend yield is the ratio of dividends per share of stock to the stock’s market price per share This ratio measures the percentage of a stock’s market value that is returned annually as dividends © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Dividend Yield on Palisades’ Common Stock
Palisades Furniture paid annual cash dividends of $1.20 per share of common stock in 20X3 and $1.00 in 20X2, and market prices of the company’s common stock were $50 in 20X3 and $35 in 20X2. Calculation of the firm’s dividend yields on common stock is as follows: Dividend Yield on Palisades’ Common Stock Formula 20X3 20X2 Dividend yield on common stock Dividend per share of common stock $1.20 $1.00 = 0.024 $0.029 = = Market price per share of common stock $50.00 $35.00 Dividend yields vary widely, from 5% to 8% for older, established companies, down to the range of 0% to 3% for young growth-oriented companies © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

BOOK VALUE PER SHARE OF COMMON STOCK
Book value per share of common stock is common stockholders’ equity divided by the number of shares of common stock outstanding Some investors rank stock on the basis of the ratio of market price to book value To these investors, the lower the ratio the more attractive the stock © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

Book Value per Share of Palisades’ Common Stock
Calculations of book-value-per-share-of-common-stock ratios follows: Book Value per Share of Palisades’ Common Stock Formula 20X3 20X2 Total stockholders’ equity Book value per share of common stock Preferred equity - $356,000 - $0 $320,000 - $0 = = $35.60 = $32.00 Number of shares of common stock outstanding 10,000 10,000 © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

LIMITATIONS OF FINANCIAL ANALYSIS
Ratios have their limitations Financial analysis may indicate that something is wrong, but it may not identify the specific problem or show how to correct it Managers must evaluate data on all ratios in the light of other information about the company © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

LIMITATIONS OF FINANCIAL ANALYSIS
Ratios should be analyzed over a period of years Any one year, or even any two years, may not be representative of the company’s performance over the long term © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ECONOMIC VALUE ADDED Economic value added (EVA) combines the concepts of accounting income and corporate finance to measure whether the company’s operations have increased stockholder wealth A positive EVA amount indicates An increase in stockholder wealth An attractive stock to investors © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

EVA = Net income + Interest expense - Capital charge
ECONOMIC VALUE ADDED EVA = Net income + Interest expense - Capital charge Where Capital charge Notes payable Loans payable Long-term debt Stockholders’ equity Cost of capital = + + + x © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

ECONOMIC VALUE ADDED The capital charge is the amount that stockholders and lenders charge a company for the use of their money The cost of capital is a weighted average of the returns demanded by the company’s stockholders and lenders The cost of capital varies with the company’s risk © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

EFFICIENT MARKETS, MANAGEMENT ACTION, AND INVESTOR DECISIONS
An efficient capital market is one in which market prices fully reflect all information available to the public Because stocks are priced in full recognition of all publicly accessible data, it can be argued that the stock market is efficient © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

EFFICIENT MARKETS, MANAGEMENT ACTION, AND INVESTOR DECISIONS
This means that managers cannot fool the market with accounting gimmicks For investors, an appropriate strategy seeks to manage risk, diversity, and minimize transaction costs The role of financial statement analysis consists mainly of identifying the risks of various stocks to manage the risk of the overall investment portfolio © 2001 Prentice Hall Business Publishing Financial Accounting, 4/e Harrison and Horngren

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