The Financial Statements

The Financial Statements
Chapter 1 This chapter addresses The Financial Statements. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 1 Use accounting vocabulary
The first learning objective is to use accounting vocabulary. Use accounting vocabulary Copyright ©2008 Pearson Prentice Hall. All rights reserved

The Language of Business
Accounting is an information system Measures business activities Processes data into reports Communicates results to people and organizations Accounting is used to make decisions Accounting is called the “language of business”. It is an information system that measures business activities, processes data into various reports such as financial statements and budgets . These reports communicate results to people. Accounting is important in decision-making. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Users of Accounting Individuals Taxing Authorities
Investors & Creditors Individuals Taxing Authorities Nonprofit Organizations Who uses accounting information? Individuals who are making financial decisions, such as to rent or buy a home. Investors need accounting information to decide whether to invest in a company. Creditors want to know whether they should lend money to a company. Taxing authorities need accounting information to determine sales, income and other taxes. Nonprofit organizations, such as churches and the Red Cross also need financial information to make decisions. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Financial and Management Accounting
Provides information for external users: Investors Bankers Government agencies MANAGEMENT Provides information for internal users: Managers of the company There are two branches of accounting – financial and management. Financial accounting provides information to external users, such as investors, bankers and government agencies. Conversely, management accounting provides information for internal users, those inside the company, such as managers. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Copyright ©2008 Pearson Prentice Hall. All rights reserved
Ethics in Accounting U.S. companies are required to report relevant and reliable information Recent corporate scandals have emphasized the need for ethical reporting in accounting Companies that sell stock to the public must have an audit by independent accountants Examination of financial records to ensure reliability Accounting information is required to be relevant – important for decision-making – and reliable – verifiable and free from error or bias. Recent accounting scandals, such as Enron and World Com, demonstrate that some companies accounting information was not reliable. An audit by independent accountants is required for companies that sell their stock to the public. Accountants examine the financial records of a company to ensure it is following correct accounting procedure and the accounting system provides reliable results. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Forms of Business Organization
Proprietorship Partnership Limited-Liability Company Corporation Business can form in four different ways – a proprietorship, a partnership, a corporation, or a limited-liability company. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Proprietorship Business has a single owner Legally, business is not separate from owner Owner is personally liable for business debts For accounting, business records are kept separate from personal records A proprietorship is a business with one owner. The owner is personally liable for any business debts. This is because legally there is no distinction between the owner and the business. For accounting purposes, however, the business records are kept separate from the personal records of the owner. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Partnership Two or more owners Each partner is personally liable for business debts Can be risky Partnerships have two or more owners. Like a proprietorship, each partner is personally liable for the business debts. This can be risky as the actions of one partner can impact all the other partners personally. This contributed to a relatively new form of business, called Limited Liability Companies. A limited liability partnership retains the benefits of a partnership, but eliminates some of the risk. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Limited Liability Companies (LLCs)
Owners are called members Members are not personally liable for business debts Reduces owners’ risk Today, many non-corporate businesses form as LLCs In a limited liability company (LLC), the owners are called members. The LLC form of business was created to shield business owners from personal liability. Thus, members of an LLC are not personally responsible for business debts. Their liability is limited to what they invested in the company. Today, most proprietorships and partnerships are formed as LLCs. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Corporations Owners are stockholders Stockholders elect Board of Directors Board sets policy and appoint officers Stockholders not personally liable for corporate debts Formed under state law Pay income taxes Legally distinct from owners A corporation is owned by its stockholders. Each stockholder can vote at annual meetings and elect the members of the Board of Directors. The Board of Directors set company policy and hire the corporate officers. While proprietorships and partnerships outnumber corporations, in terms of financial power, corporations represent the largest companies. A corporation is a separate legal entity. Thus, the stockholders are not liable for corporate debts. They are formed under state law and pay income taxes. Copyright ©2008 Pearson Prentice Hall. All rights reserved

a. What forms of organization will enable the owners of Quality Environmental to limit their risk of loss to the amount they have invested in the business? Corporations and Limited Liability Companies (LLC) Exercise 1-13 examines the different forms of business. Letter (a) highlights that corporations and LLCs have limited liability. Copyright ©2008 Pearson Prentice Hall. All rights reserved

b. What form of business organization will give Beard the most freedom to manage the business as she wishes? ______________________ The owner wouldn’t have to worry about other owners Letter (b) shows one of the benefit of a person running his or her own business. 1-13 Copyright ©2008 Pearson Prentice Hall. All rights reserved

c. What form of organization will give creditors the maximum protection in the event that Quality Environmental fails and cannot pay its debts? Hint: Think about liability and number of owners Answer: Partnership Letter (c) show that from creditor’s perspective having several people personally liable is a benefit. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 2 Learn accounting concepts and principles
Learning objective 2 is to learn accounting concepts and principles. Copyright ©2008 Pearson Prentice Hall. All rights reserved

G A A P GAAP is an acronym for Generally Accepted Accounting Principles U.S. GAAP is formulated by the Financial Accounting Standards Board (FASB) FASB’s Conceptual Framework states that accounting should be: Relevant Reliable Comparable Consistent GAAP stands for Generally Accepted Accounting Principles. In the United States, the standard setting body is the Financial Accounting Standards Board – often called FASB. FASB’s Conceptual Framework states that accounting information should be relevant (makes a difference to a user) and reliable (free from error or bias). In addition, accounting should be comparable (companies in the same industry should use the same accounting rules) and consistent (a company should use the same accounting principles from year-to-year). Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accounting Concepts Entity A business is separate from its owners Reliability Accounting is based on objective evidence Cost Assets are recorded at cost (not fair value) Going-Concern Business will continue indefinitely Monetary Unit Transactions are recorded in a stable currency ($) Some basic concepts underlie accounting practice. The entity concept states that the business is distinct from its owner. Therefore, personal transactions of owners should not be reflected in the business financial records. Reliability means that evidence supports accounting data. The cost principle (also called historical cost) states that assets should be recorded at their original purchase price. While fair values of assets change, historical cost does not. The going-concern concept assumes a business will continue to operate. If this assumption is not true, a different set of accounting rules are used. The basis for ignoring the effect of inflation in the accounting records is based on the assumption that the dollar’s purchasing power is relatively stable. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Concept Violated? Kathy Jones owns a coffee shop. Her personal expenses are included in the accounting records. Entity Using the concepts on the previous slide, which one is not being followed in the above example? The entity concept because Kathy should keep her personal transactions separate from her business records. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Which concept deals with the how assets are valued?
Concept Violated? ABC Company owns land. The purchase price is $50,000. A recent appraisal indicates the land is worth $200,000. ABC shows the land in its financial statements at $200,000. ________________________ Which concept deals with the how assets are valued? Which concept is not being followed here? The cost principle because even though the land is valued at $200,000, it cost the company $50,000. The cost is considered a more reliable number than fair value. 1-19 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 3 Apply the accounting equation to organizations
Learning objective 3 is to apply the accounting equation to organization. Copyright ©2008 Pearson Prentice Hall. All rights reserved

The Accounting Equation
Liabilities Assets = + In accounting, the following is always true: Assets = Liabilities + Equity Owners’ Equity Copyright ©2008 Pearson Prentice Hall. All rights reserved

Assets Economic resources that provide a future benefit Examples: Cash Inventory Equipment Land Buildings Let’s define the elements of the accounting equation Assets are resources the company owns that provide future benefit. Some common assets are: cash, inventory, equipment, land, and building. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Liabilities Outsiders claims to assets Include debts payable to creditors Examples: Accounts payable – liability for goods or services purchased on credit Notes payable – written promise to pay on a certain date (bank loan) Liabilities are outsiders claims to assets. Liabilities include amounts owed to those outside the company – debts. In accounting, many liabilities end with the word “payable”. For example, accounts payable occur when the company buys something on credit. Notes payable are more formal. They are written agreements to pay money at a specific date. For example, a bank loan would be a note payable. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Owners’ Equity Owners’ claim on a business Assets minus liabilities What’s left after debts are paid A corporation’s equity is called stockholders’ equity Owners’ equity equals assets minus liabilities. While liabilities represent creditors claim to the business, equity represents the owner’s claim. In a corporation, the equity is called stockholders’ equity. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accounting Equation Example
Compute the missing amount from each situation on the following slide Remember: Assets = Liabilities + Owners’ Equity Let’s do an example using the accounting equation. On the following slide, figure out the missing piece of the accounting equation. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accounting Equation Example
Assets = Liabilities + Owners’ Equity (a) $50,000 $20,000 (b) $30,000 $10,000 (c) $40,000 $15,000 $70,000 $20,000 Since liabilities plus equity equals assets, add the $50K and $20K to get $70K in assets If assets are $30K, liabilities plus equity also equal $30K. Since we know liabilities are $20K, equity must be $10K. If assets equal $40K and Liabilities equal $15K, equity is the difference - $25K. $25,000 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Shareholders’ Equity Paid-in capital Amounts invested by stockholders Common stock Retained Earnings Amounts earned and kept for use in the company Increased by Revenues Decreased by Expenses Let’s look more closely at Shareholders’ Equity. It consists of two main parts (1) Paid-in capital and (2) Retained Earnings. Paid-in capital represents amounts invested by stockholders – resources invested in the company from outsiders. Retained earnings represents amounts earned and kept by the company (hence the name). Retained earnings is increased by revenues and decreased by expenses. 1-27 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Net Income Revenues Earned by delivering goods or services Expenses Costs of doing business Rent, utilities, insurance Revenues minus expenses equal net income If expense are greater then revenues, a net loss occurs Revenues are generated by providing goods or services. It’s what companies are in business to do. A book store sells books. A dentist cleans teeth. These activities generate revenue. Expenses, on the other hand, are the costs of doing business. Costs such utilities, rent and insurance are common expenses of a business. Revenues minus expenses equals net income – an important number in accounting. If, in the unfortunate case, expenses are greater than revenue, then a net loss is incurred. 1-28 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Dividends Distributions of assets (usually cash) to shareholders Decrease Retained Earnings Do NOT impact net income Shareholders invest in a company and they want something in return. Corporations distribute dividends, usually in the form of cash, to shareholders. Dividends reduce retained earnings. However, they are not an expense. So dividends do not impact net income. 1-29 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Ending Retained Earnings Beginning Retained Earnings
Revenues minus Expenses This diagram shows items that impact retained earnings. A company earns revenue and pays expenses, which results in net income. Net income is added to beginning retained earnings. Dividends are distributions of earnings to shareholders. Dividends are subtracted from retained earnings. plus minus Equals Ending Retained Earnings Beginning Retained Earnings Net Income Dividends 1-30 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 4 Evaluate business operations 1-31
Learning objective 4 is to evaluate business operations. 1-31 Copyright ©2008 Pearson Prentice Hall. All rights reserved

The Financial Statements
Report company’s results to the public Four Statements Income Statement Statement of Retained Earnings Balance Sheet Statement of Cash Flows The financial statements are the vehicle to report accounting information to the public. There are four statements: the income statement, the statement of retained earnings, the balance sheet, and the statement of cash flows. 1-32 Copyright ©2008 Pearson Prentice Hall. All rights reserved

The Income Statement Measures operating performance for the period Reports revenue and expenses and resulting net income (or loss) Also includes gains and losses The income statement show the operating performance for a time period, such as a month, quarter or year. Revenues and expenses are listed on the statement, and net income (or loss) is computed. The income statement also reports any gains or losses. 1-33 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Statement of Retained Earnings
Shows increases and decreases to retained earnings Increase: net income Decrease: dividends The statement of retained earning shows the activity in the retained earnings from the beginning to the end of the period. Net income is added and dividends are subtracted to compute the ending balance. 1-34 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Balance Sheet Measures financial position Reports assets, liabilities and shareholders’ equity Assets and liabilities are categorized Current and Long-term The balance sheet is sometimes called the statement of financial position. It shows the assets, liabilities and equity of the company. It shows that the accounting equation is in balance. To help users read the statement, assets and liabilities are placed into categories – current and long-term. 1-35 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Balance Sheet Categories
Current assets Converted to cash or used within one year Cash, Short-term Investments, Accounts Receivable, Inventory Long-term Property, plant, and equipment Intangible assets Investments Other In general, for accounting current means less than one year. For assets, this means that the item will be used or turned into cash within one year from the balance sheet. Some common current assets are cash, short-term investments, accounts receivable and inventory. Long-term asset are expected to be used in the company for more than one year. Some sub-categories of long-term assets are property, plant & equipment, intangible assets and investments. 1-36 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Current liabilities Due within one year of balance sheet date Accounts payable, salaries payable, taxes payable, short-term borrowings Long-term liabilities Long-term notes payable, mortgage payable Current liabilities are due within one year of balance sheet date and include accounts payable, salaries payable and short-term borrowings. Long-term liabilities have due dates more than one year after balance sheet date. 1-37 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Stockholders’ Equity Paid-in capital Common stock Retained Earnings Stockholders’ Equity has two main parts: Paid-in capital, which includes common stock, and Retained Earnings. 1-38 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Statement of Cash Flows
Shows inflows and outflows of cash by category: Operating activities Investing activities Financing activities The statement of cash flows shows receipts (inflows) and payments (outflows) of cash during the period. The cash flows are put into three categories – operating, investing and financing. 1-39 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Cash Flow Categories Operating Cash generated from day-to-day business activities Related to selling goods and services to customers Investing Cash invested in long-term assets Related to purchasing and selling plant assets and investments Operating activities are those related to the company’s day-to-day operations of generating revenue and paying expenses. Investing represents where a company puts their money for the long-term. Purchasing and selling long-term assets such as buildings, investments are equipment are investing activities. 1-40 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Cash Flow Categories Financing How a company obtains resources to finance business Related to long-term debt and equity (issuing stock) Financing activities are how a company raises money – by borrowing or issuing stock. 1-41 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 5 Use financial statements 1-42
Learning objective 5 is to use financial statements. 1-42 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Relationships of Financial Statements
Net Income (bottom line of Income Statement) flows to Statement of Retained Earnings Ending Retained Earnings flows to Balance Sheet Cash balance from Balance Sheet flows Statement of Cash Flows The four financial statements are inter-related. The net income (or bottom line) of the Income Statement flows to the Statement or Retained Earnings, where it is added the beginning balance of Retained Earnings. The ending balance of Retained Earnings flows to the Balance Sheet in the Stockholders’ Equity Section. The ending cash balance in the balance sheet equals the ending cash as displayed in The Statement of Cash Flows. Financial Statements should be prepared in order since the amount on one statement flows the next 1-43 Copyright ©2008 Pearson Prentice Hall. All rights reserved

RETAINED EARNINGS STATEMENT STATEMENT OF CASH FLOWS
INCOME STATEMENT NET INCOME RETAINED EARNINGS STATEMENT ENDING RETAINED EARNINGS BALANCE SHEET This diagram provides a visual of the inter-relationship of the four financial statements. ENDING CASH STATEMENT OF CASH FLOWS 1-44 Copyright ©2008 Pearson Prentice Hall. All rights reserved

a) Common stock Balance Sheet b) Income tax payable c) Dividends Statement of Retained Earnings d) Income tax expense Income Statement E1-19 provides practice on where items appear on the balance sheet. Common stock is part of equity, which is on the balance sheet Income tax payable is a liability, which goes on the balance sheet. Dividends reduce retained earnings and appear on the Statement of Retained Earnings Income tax expense is an expense used in computing net income and appears on the Income Statement 1-45 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Which statement reports liabilities?
e) Ending balance of Retained Earnings Statement of Retained Earnings AND Balance Sheet f) Total assets g) Long-term debt _____________________ h) Revenue Income Statement Which statement reports liabilities? e) The Statement of Retained Earnings shows the change in the account for the period. The ending balance then flows to the Balance Sheet in the stockholders’ equity section. f) Total assets is the sum of all assets that appears on the Balance Sheet g) Long-term debt is a liability – Balance Sheet h) The Income Statement begins with the revenue earned Copyright ©2008 Pearson Prentice Hall. All rights reserved

i) Cash spent to acquire the building Statement of Cash Flows j) Selling, general and administrative expenses Income Statement k) Adjustment to reconcile net income to cash provided by operating activities Cash paid to purchase long-term assets is shown in the investing section of the Cash Flow Statement j) All expenses appear on the Income Statement k) Operating activities are shown on the Cash Flow Statement 1-47 Copyright ©2008 Pearson Prentice Hall. All rights reserved

l) Ending cash balance Balance Sheet AND Statement of Cash Flows m) Current liabilities Balance Sheet n) Net Income __________________________ AND ____________________________ This number is the bottom line on one statement and is an increase to another l) Ending cash (an asset) is on the Balance Sheet. It is also the last line of the Cash Flow Statement. m) Current liabilities is a Balance Sheet category n) The Income Statement shows the computation of net income, which flows to the Statement of Retained Earnings, where it is an increase. (It also appears in the Cash Flow Statement in the operating section). Copyright ©2008 Pearson Prentice Hall. All rights reserved

Transactions Any event that impacts the financial position of a business Can be measured reliably Two sides: Business gives something Business receives something Accounting records both sides of a transaction Business activity is all about transactions. A transaction is any event that has a financial impact on the business and can be measured reliably. Transactions provide objective information about the financial impact on a company. Every transaction has two sides: ■ You give something, and ■ You receive something In accounting, we always record both sides of a transaction. Copyright ©2008 Pearson Prentice Hall. All rights reserved 51

The Account Record of all changes in a particular asset, liability or equity Remember the accounting equation Assets = Liabilities + Owner’s Equity For each asset, each liability, and each element of stockholders’ equity, we use a record called the account. An account is the record of all the changes in a particular asset, liability, or stockholders’ equity during a period. The account is the basic summary device of accounting. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Common Asset Accounts Cash Bank accounts, cash on hand Accounts Receivable Customer promise to pay for goods or services provided Represents future collection of cash Notes receivable Written promise to pay Bear interest Assets are economic resources that provide a future benefit for a business. Most firms use the following asset accounts: Cash means money and any medium of exchange including bank account balances, paper currency, coins, certificates of deposit, and checks. Accounts Receivable. Companies sells their goods and services and receives a promise for future collection of cash. The Accounts Receivable account holds these amounts. Notes Receivable. A company may receive a note receivable from a customer, who signed the note promising to pay it. A note receivable is similar to an account receivable, but a note receivable is more binding because the customer signed the note. Notes receivable usually specify an interest rate. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Common Asset Accounts Inventory Products held for sale Prepaid expenses Expenses paid for in advance Provide future benefit Includes prepaid rent, prepaid insurance and supplies Land Other accounts include: Inventory. One of most important assets of a company that sells or manufactures products is its inventory – the goods its sells to customers. Other titles for this account include Merchandise and Merchandise Inventory. Prepaid Expenses. A company may pas certain expenses in advance, such as insurance and rent. A prepaid expense is an asset because the payment provides a future benefit for the business. Prepaid Rent, Prepaid Insurance, and Supplies are prepaid expenses. Land. The Land account shows the cost of the land a company uses in its operations. Copyright ©2008 Pearson Prentice Hall. All rights reserved 54

Common Asset Accounts Buildings Equipment Furniture and Fixtures Additional accounts include: Buildings. The costs of a company’s office building, manufacturing plant, and the like appear in the Buildings account. Equipment, Furniture, and Fixtures. Companies can have a separate asset account for each type of equipment, for example, Manufacturing Equipment and Office Equipment. The Furniture and Fixtures account shows the cost of these assets, which are similar to equipment. Copyright ©2008 Pearson Prentice Hall. All rights reserved 55

Common Liability Accounts
Accounts payable Company’s promise to pay for goods or services received Notes payable Signed agreements to pay Include interest Accrued liabilities Expenses that have not been paid Include interest payable and salaries payable Recall that a liability is a debt. A payable is always a liability. The most common types of liabilities include: Accounts Payable. The Accounts Payable account is the direct opposite of Accounts Receivable. A company’s promise to pay a debt arising from a credit purchase of inventory or from a utility bill appears in the Accounts Payable account. Notes Payable. A note payable is the opposite of a note receivable. The Notes Payable account includes the amounts a company must pay because it signed notes promising to pay a future amount. Notes payable, like notes receivable, also carry interest. Accrued Liabilities. An accrued liability is a liability for an expense a company has not yet paid. Interest Payable and Salary Payable are accrued liability accounts for most companies. Income Tax Payable is another accrued liability. Copyright ©2008 Pearson Prentice Hall. All rights reserved 56

Equity Accounts Common stock Shareholders’ investment in the company Retained earnings Earnings kept by the company Cumulative net income minus dividends paid to shareholders Revenues Earned by providing goods or services Expenses Costs of operating a business The owners’ claims to the assets of a corporation are called stockholders’ equity, shareholders’ equity, or simply owners’ equity. Corporate equity accounts include Common Stock, Retained Earnings, and Dividends accounts to record changes in the company’s stockholders’ equity. In a proprietorship, there is a single capital account. For a partnership, each partner has a separate owner equity account. Common Stock. The Common Stock account shows the owners’ investment in the corporation. The corporation receives cash and issues common stock to its stockholders. A company’s common stock is its most basic element of equity. All corporations have common stock. Retained Earnings. The Retained Earnings account shows the cumulative net income earned by a corporation over its lifetime, minus its cumulative net losses and dividends. Dividends. After profitable operations, the board of directors of a corporation may (or may not) declare and pay a cash dividend. Dividends are optional; they are decided by the board of directors. The corporation may keep a separate account titled Dividends, which indicates a decrease in Retained Earnings. Revenues. The increase in stockholders’ equity from delivering goods or services to customers is called revenue. The company uses as many revenue accounts as needed. The Sales Revenue account is often used for revenue earned by selling products. A Service Revenue account is used for the revenue it earns by providing services to customers. For example, a lawyer provides legal services for clients uses a Service Revenue account. A business that loans money to an outsider needs an Interest Revenue account. If the business rents a building to a tenant, the business needs a Rent Revenue account. Expenses. The cost of operating a business is called expense. Expenses decrease stockholders’ equity, the opposite effect of revenues. A business needs a separate account for each type of expense, such as Cost of Goods Sold, Salary Expense, Rent Expense, Advertising Expense, Insurance Expense, Utilities Expense, and Income Tax Expense. Businesses strive to minimize expenses and thereby maximize net income. Copyright ©2008 Pearson Prentice Hall. All rights reserved 57

Transaction Analysis Every transaction has at least two parts The accounting equation always balances before and after each transaction A common transaction for a new business is to issue stock to its owners How would this impact the accounting equation? Each Business transactions impacts at least two accounts. The accounting equation always balances. For example, if one asset increases, either a liability or equity account must increase; or another asset must decrease. Let’s do several examples of transactions and see how they affect the accounting equation. Copyright ©2008 Pearson Prentice Hall. All rights reserved 59

Example Transaction (1)
Three friends decide to start a salon They invest $40,000 to begin the business The business issues common stock to the owners Three friends decide to start a business, a salon that provides hairstyling, manicures and massages. The three friends invest a total of $40,000 cash and receive common stock of the salon. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Type of Equity Transaction
Stockholders’ Equity Type of Equity Transaction + Assets = Liabilities Cash Common stock (1) +$50,000 (1) +$50,000 Issued stock The accounting equation is listed at the top to ensure it always balances. If cash is received by the corporation, assets will increase by $50,000. The other side of the transaction is common stock, which is a stockholders’ equity account. Copyright ©2008 Pearson Prentice Hall. All rights reserved

The salon purchases chairs and massage tables for $12,000 The second transaction of the salon is the purchase of chairs and tables for $12,000 cash. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Stockholders’ Equity = + Assets Liabilities Cash Supplies Equip. Accts Pay Common stock Retained Earnings (1) +$50,000 (1) + $50,000 (2) - $12,000 (2) + $12,000 $38,000 + $12,000 = $50,000 This time two asset accounts are impacted. Any time cash is paid, it decreases. The other asset is equipment; it increases. So, now the company has two assets totaling $50,000 and equity of $50,000. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Example Transactions (3)
The salon purchases hair styling and other supplies on account for $5,000 Next, the salon purchases supplies on account for $ “On account” means the salon will pay later. This is an account payable – a liability. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Stockholders’ Equity = + Assets Liabilities Cash Supplies Equip. Accts Pay Common stock Retained Earnings (1) +$50,000 (1) + $50,000 (2) - $12,000 (2) + $12,000 (3) +$5,000 (3) +$5,000 $38,000 $5,000 $12,000 $5,000 $50,000 In this transaction, an asset increases – supplies – and a liability increases – accounts payable. These amounts are added to the equation. Now the salon has $55,000 of assets and $ of liabilities and equity. $55,000 $55,000 Copyright ©2008 Pearson Prentice Hall. All rights reserved

The salon earns $6,000 from providing services to customers. The business collected cash. Next, the salon actually starts earning revenue. The key phrase is “providing services”. The salon received cash. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Stockholders’ Equity = + Assets Liabilities Cash Supplies Equip. Accts Pay Common stock Retained Earnings (1) +$50,000 (1) + $50,000 (2) - $12,000 (2) + $12,000 (3) +$5,000 (3) +$5,000 (4) +$6,000 (4) +$6,000 Revenue So an assets increase – cash. Revenue is the “other side” of the transaction. Revenue increases retained earnings. So it is shown under Stockholders’ Equity. Again, as the balances as brought down and totaled, you can see that assets equal liabilities plus equity $44,000 $5,000 $12,000 $5,000 $50,000 $6,000 $61,000 $61,000 Copyright ©2008 Pearson Prentice Hall. All rights reserved

The salon paid monthly rent of $4,000 The fifth transaction is the payment of rent. The word “paid” indicates a decrease in cash. Rent is a monthly expense. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Stockholders’ Equity Liabilities = + Assets Cash Supplies Equip. Accts Pay Common stock Retained Earnings (1) +$50,000 (1) + $50,000 (2) - $12,000 (2) + $12,000 (3) +$5,000 (3) +$5,000 (4) +$6,000 (4) +$6,000 Revenue (5) - $4,000 So, cash (an asset) will decrease. Expenses reduce Retained Earnings. Therefore, equity is decreased by $4,000. As always, the accounting equation balances after we total. (5) - $4,000 Expense $40,000 $5,000 $12,000 $5,000 $50,000 $2,000 $57,000 $57,000 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 2 Understand how accounting works
The second objective is to understand how accounting works. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Double-entry Accounting
Each transaction affects at least two accounts As you saw in the salon example, every business transaction affects at least two accounts. This is called double-entry accounting. There are no transactions that only affect one account. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Every transaction has both a debit and a credit
The T-account Account Title Debits on the left side Credits on the right side Every transaction has both a debit and a credit The T-account s a method of recording transactions and keeping track of the dollar amount in particular account. Accounting uses the terms “debit” and “credit” to show the changes to accounts. Debits are always on the left. Credits are on the right. Every transactions has at least one debit and one credit. Debits always equal credits. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Debit and Credit Rules Debit and credit are neutral terms Not good or bad Mean either a decrease or increase depending on the type of account Some students think that debits are good and credits are bad (or vice versa). Remember that they are neutral terms. Debits and credits are increases or decreases depending on the type of account. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Debits and Credits STOCKHOLDERS’ EQUITY = + ASSETS LIABILITIES Debit - Credit + Debit + Credit - Debit - Credit + Debit and credit rules are based on the accounting equation. All assets are increased by debits and decreased by credits. The other side of the equation – liabilities and equity – are the opposite. Credits increase and debits decrease. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Stockholders’ Equity Debit & Credits
Common stock and Retained Earnings are increased by credits Dividends reduce Retained Earnings Dividends are increased by debits Net income increases Retained Earnings Net Income = Revenues minus Expenses Revenues are increased by credits Expenses are increased by debits Since equity accounts have different categories, we need to split it out for purposes of debits and credit rules. The basic equity accounts of “common stock” and “retained earnings” are increased by credits. Since dividends reduce retained earnings, that account is the opposite. It is increased by debits. Net Income increases retained earnings. Net income is computed by subtracting expenses from revenues. Therefore, revenues follow the same debit/credit rules as retained earnings. Revenues are increased by credits. Since expense decrease net income, they are increased by debits. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Debits and Credits Debit to increase Assets Dividends Expenses Credits to increase Liabilities Revenue Common stock Retained earnings It’s important to memorize the debit and credit rules. If you can remember what increases an account, the opposite will be a decrease. Assets, dividends and expenses are increased by debits. Liabilities, Revenue, Common Stock and Retained Earnings are credits. Do NOT proceed until you learn these rules! Copyright ©2008 Pearson Prentice Hall. All rights reserved

Practicing Debits and Credits
Increase cash Debit Increase accounts payable Credit Decrease accounts receivable Increase revenue Let’s practice the debit credit rules. If a company wants to increase cash, what should it do? Cash is an asset. Assets are increased by debits. Account payable is a liability. Liabilities are increased by credits. What type of account is accounts receivable? An asset. If you want to decrease an asset, you credit. Revenues are increased by credits. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Practicing Debits and Credits
Increase rent expense Debit Increase common stock Credit Decrease notes payable Decrease cash __________________________ What type of account is cash? How is it increased? Rent expense is an expense. Expenses are increased by debits. Common stock is part of equity. Therefore, it is increased by a credit. Notes payable is a liability. Since credits increase liabilities, a debit would decrease it. We debited cash when we receive it. So if cash is decreased, we credit. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 3 Record transactions in the journal
The third learning objective is to record transactions in a journal. Copyright ©2008 Pearson Prentice Hall. All rights reserved

The Journal Chronological record of transactions Three steps Identify accounts impacted by transaction Apply debit/credit rules for the increase or decrease in the accounts You should have at least one debit and one credit Record transactions in journal Accountants use a chronological record of transactions called a journal. The journalizing process follows three steps: 1. Specify each account affected by the transaction and classify each account by type (asset, liability, stockholders’ equity, revenue, or expense). 2. Determine whether each account is increased or decreased by the transaction. Use the rules of debit and credit to increase or decrease each account. 3. Record the transaction in the journal, including a brief explanation. The debit side is entered on the left margin, and the credit side is indented to the right. Step 3 is also called “making the journal entry” or “journalizing the transaction.” Copyright ©2008 Pearson Prentice Hall. All rights reserved

Journal entry Write the account debited first and the amount in the left column Write (and indent) the account credited next and the amount in the right column Debits must equal credits When making a journal entry, start by first writing the title of the account that will be debited. The amount is placed in the left column. Next write the title of the account that will be credited. The account credited is indented a bit, so it is not directly under the account debited. The amount of the credit is placed in the right column. Remember, to keep the accounting equation in balance, debits must equal credits. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Apr 1 – Received $25,000 and issued common stock JOURNAL Date Accounts Debit Credit 1-Apr Cash $25,000 Common stock Exercise 2-18 will provide an example of how to prepare journal entries. Let’s prepare journal entries for Double Tree Cellular’s transactions for the month of April. The first transaction involves issuing common stock and cash. The two accounts are cash (an asset) and (common stock (an equity). The company is receiving cash, so it needs to be increased. Assets are increased by debits. The date is written and “cash” is written in the journal. The amount is written in the left-column that is labeled debit. Common stock is increased by credits. Common stock is written on the next line and indented. This helps the reader know that this account is being credited. The amount is placed in the right column labeled credit. Copyright ©2008 Pearson Prentice Hall. All rights reserved

April 2 - Purchased $800 of office supplies on account JOURNAL Date Accounts Debit Credit 2-Apr Supplies $800 Accounts payable Next, the company purchases supplies on account. The two accounts are “supplies” and “accounts payable”. When companies buy items on account, it results in a liability. Supplies is an asset, and it needs to be increased. Debits increase assets. So “supplies” is written first with the amount in the debit column. Liabilities are increased by credits. Therefore, accounts payable is credited. Copyright ©2008 Pearson Prentice Hall. All rights reserved

April 4 - Paid $20,000 cash for land to use as a building site JOURNAL Date Accounts Debit Credit 4-Apr Land $20,000 Cash On April 4, the company paid cash for land. This transaction involves two assets – land and cash. Land is increasing (debit) and cash is decreasing (credit). Copyright ©2008 Pearson Prentice Hall. All rights reserved

April 6 - Performed service for customers and received cash of $2,000 JOURNAL Date Accounts Debit Credit 6-Apr ______ $2,000 __________ “Performed service” indicates revenue was earned. Revenues are recorded with a credit. The debit side would be the cash received. Cash is an assets, and assets are increased by debits. Copyright ©2008 Pearson Prentice Hall. All rights reserved

April 9 Paid $100 on accounts payable JOURNAL Date Accounts Debit Credit 9-Apr Accounts payable $25,000 Cash The company paid part of the accounts payable balance. “Paid” indicates a decrease in cash, which is recorded with a credit. The accounts payable is decreasing, since the company is paying off a portion. To decrease a liability, you debit. Copyright ©2008 Pearson Prentice Hall. All rights reserved

What account is credited when services are performed?
April 17 – Performed services for FedEx on account totaling $1,200 JOURNAL Date Accounts Debit Credit 17-Apr Accounts Receivable $1,200 ________________________ The phrase “performed services” appears again, indicating we need to credit revenue. This time the phrase “on account” is also used. This means the customer will pay later. This is the asset called accounts receivable. We need to increase it, so it is debited. What account is credited when services are performed? Copyright ©2008 Pearson Prentice Hall. All rights reserved

Apr 23 – Collected $900 from FedEx on account JOURNAL Date Accounts Debit Credit 23-Apr Cash $900 Accounts Receivable The customer from six days ago pays part of its bill. “Collected” indicates cash coming in, so we need to increase the asset cash with a debit. Since the customer is paying down its account, accounts receivable needs to be decreased. So it is credited. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Apr 30 – Paid the following expense: salary, $1,000; rent, $500 JOURNAL Date Accounts Debit Credit 30-Apr Salary expense $1,000 Rent expense $500 Cash $1,500 This is an example of a compound transaction. There is more than one debit and one credit. Two expenses are paid. Expenses are increased by debits. So, we write each expense on a separate line, and the amounts of each expense in the left column. Cash is paid for the total. Cash is credited for $1500. Debits still have to equal credits in a compound transactions. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Posting Transferring information from the journal to the ledger The collection of accounts and their balances Transactions are recorded by date in the journal. To determine the dollar amount in an account (balance), the amounts must be transferred from the journal to the ledger. The ledger is the collection of the accounts and their balances/ Copyright ©2008 Pearson Prentice Hall. All rights reserved

Posting JOURNAL Date Accounts Debit Credit 6-Apr Cash $2,000 Service revenue CASH SERVICE REVENUE Here is how posting works. The above entry shows the transaction of $2000 cash received for services provided. To post this entry, the debit to cash is transferred to the debit side of the t-account for cash. The $2000 credited to service revenue is transferred to the credit side of the service revenue T-account. $2,000 $2,000 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Flow of Accounting Data
Transaction occurs Transaction analyzed Accounts identified Debit/Credit rules applied Transaction recorded in the Journal Amounts posted to the Ledger To review, the flow of accounting data follows: Business transactions occur. The transactions are analyzed to identify the accounts affected and whether they should be increased or decreased. Then, the debit/credit rules are applied to increase and/or decrease the accounts. The transactions are recorded in the journal. Finally, the amounts from the journal are posted to the ledger. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Determining Account Balance
After transactions are posted, the amount in each ledger account is computed The debit side and credit side are totaled The difference between the two sides is computed If the debit side is larger, the account has a debit balance If the credit side is larger, the account has a credit balance After transactions are posted to the ledger, the account balance can be determined. The amounts on the debit side of the T-account are added up, as well as, the amounts on the credit side. The difference between the two totals is computed. The larger side is the balance. That is, if the debit total is greater than the credit total, the account balance is on the debit side. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Determining Account Balance
Cash $10,000 $7,000 The credits total to $19,000 $12,000 $15,000 The debits total to $33,000 $ 8,000 Here’s an example to demonstrate how to compute an account balance. First, add the amounts in the left column (debit side). They total to $33,000. Next add the two credit amounts on the right side. They equal $19,000. The difference between $33K and $19K is $14K. The debit side is larger. So cash has a debit balance of $14,000. $14,000 Cash has a debit balance of $14,000 ($33,000 - $19,000) Copyright ©2008 Pearson Prentice Hall. All rights reserved

Trial Balance Lists all accounts with their balance Debit amounts in the left column Credit amounts in the right column Begins with assets, then liabilities and stockholders’ equity The columns are totaled and should equal each other Shows if debits equal credits A trial balance is a listing of all accounts from the ledger and the balances of those accounts. The debit accounts balances are listed in the left column and the credit account balances are listed in the right column. Traditionally, a trial balance begins with the assets, then the liabilities and equity accounts (including revenue and expenses). The two columns are totaled and should equal each others. This demonstrates that debits equal credits. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Correcting Errors Sometimes the trial balance columns don’t equal Steps to find the error: Search for any missing accounts Divide the out-of-balance amount by two This will help find a debit that was listed as a credit, and vice versa Divide the out-of-balance amount by nine Slide – misstating an amount by omitting or adding a zero ($4000 as $400) Transposition – switching figures within a number ($1342 as $1423) Sometimes an error occurs and the trial balance columns don’t equal each other. The first thing a person can do is look for any accounts in the ledger that were omitted from the trial balance. Also, make sure that amounts were posted correctly and in the correct column. If the error still cannot be located, compute the difference between the two columns. Divide this number by two. Look for this amount on the trial balance. Chances are a debit is listed as a credit or vice versa. If you still haven’t found the error, divide the out-of-balance amount by nine. If the result is a whole number (no decimals) look for one of the following two errors: a slide (a missing or extra zero in a balance) or a transposition (switching figures within the balance). Copyright ©2008 Pearson Prentice Hall. All rights reserved

Chart of Accounts Each account is assigned a number Assets usually begin with 1 100s or 1000s Liabilities usually begin with 2 200s and 200s Stockholders’ Equity (Common Stock, Dividends and Retained Earnings) begin with 3 Revenues with a 4 and Expenses with a 5 Companies use a chart of accounts to assign numbers to specific accounts. A standard numbering system is used. Assets begin with a “1”. Depending on the size of the company, 100s or 1000s or even 10,000 is used. For example, cash might be account number 101 or 1010 or Liabilities begin with the number two. For example, accounts payable might be 201 or The pattern continues. Equity accounts begin with the number 3. Revenues begin with a four and expenses with a five. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Normal Balance What increases the account (debit or credit) is the normal balance Assets are increased by debits, so assets have a normal debit balance If the balance is not “normal”, it indicates a negative amount If cash has a credit balance, it means the company has overdrawn its bank account Each account also has a normal balance. If a debit increases the account, the account has a normal debit balance. For example, cash is an asset, assets are increased with debits. Cash has a normal debit balance. Accounts payable, on the other hand, would have a normal credit balance. If an account has a balance opposite of its normal balance, it indicates a negative balance. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Normal Balances DEBITS Assets Dividends Expenses CREDITS Liabilities Retained Earnings Common Stock Revenues Here’s a listing of the account groups and their normal balances. If you memorize these, you will have know what increases each type of account. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 5 Analyze transactions using only T-Accounts
The fifth learning objective is to analyze transactions using only T-Accounts. Copyright ©2008 Pearson Prentice Hall. All rights reserved

T-Accounts A quick informal analysis Helps users of financial information make decisions Sometimes, a business person is out in the field and doesn’t have a journal handy. T-Accounts offer a quick way to determine the impact of certain financial decisions. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Cash $10,000 Feb. 28 Bal. ? Cash Receipts $80,000 Total cash paid $ 5,000 T-Accounts also provide a visual picture of what impacts an account during a period. E2-26 demonstrates this. The beginning and ending balances of certain accounts are provided, along with the description and amount of what increased the account during the month. You can solve for the decrease in the account. If you have three out of four numbers, you can figure out the missing amount. Cash began March with a $10,000 balance and ended March with a $5000 balance. The beginning balance is placed on the left – the debit side – because cash has a normal debit balance. The ending balance is placed after the line, also on the debit side. Cash receipts were $80,000. Receipts increase cash, so that amount is placed on the debit side underneath the beginning balance. So we know that cash began the month with $10,000 was increased by $80,000 and ended the month with $ What was the amount of cash paid out during the month? Mar. 31 Bal. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Cash $10,000 Feb. 28 Bal. ________ Cash Receipts $80,000 Total cash paid Add together the beginning balance and cash receipts. Subtract the ending balance from that amount $ 5,000 Using basic algebra, you can solve for the missing amount. Add together the beginning balance and the receipts to get $90,000. Subtract the ending balance from the $90,000 subtotal to get the amount of cash paid - $85,000. You can check your work by adding $10K + $80K and subtracting $85K. When you do, the correct ending balance of cash is computed. Mar. 31 Bal. Copyright ©2008 Pearson Prentice Hall. All rights reserved

(b) Accounts Receivable $26,000 Feb. 28 Bal. ? Cash collections from customers Sales on account $50,000 $ 24,000 We can use the set up from cash to help solve for the amount “cash collected from customers”. The beginning and ending balance of accounts receivable are provided. Sales on account increase accounts receivable. Cash collections decrease accounts receivable. Mar. 31 Bal. Copyright ©2008 Pearson Prentice Hall. All rights reserved

(b) Accounts Receivable $26,000 Feb. 28 Bal. Cash collections from customers Sales on account $50,000 $52,000 $ 24,000 Add together the beginning balance of AR and add sales on account. The result is $76,000. Subtract the ending balance of $24,000 to determine the cash collections. Mar. 31 Bal. $26,000 + $50,000 = $76,000 $76,000 - $24,000 = $52,000 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Note Payable $13,000 Feb. 28 Bal. Cash paid on note ? $80,000 New Borrowing $ 21,000 Mar. 31 Bal. Now, we need to switch over to the credit side of the T-Account for notes payable, a liability with a normal credit balance. Again, place the beginning and ending amounts in the T-Account. The new borrowing is an increase to notes payable, while cash paid on the note is a decrease. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Note Payable $13,000 Feb. 28 Bal. Cash paid on note $72,000 $80,000 New Borrowing $13,000 + $80,000 = $93,000 $93,000 - $21,000 = $72,000 $ 21,000 Mar. 31 Bal. Add the beginning balance and the new borrowing to get the subtotal of $93,000. Subtract the ending balance to solve for the cash paid on the note. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accrual Accounting & Income
Chapter 3 Chapter 3 addresses Accrual Accounting and Income. Copyright ©2008 Pearson Prentice Hall. All rights reserved 110

Accrual vs. Cash-Basis Accounting
Records business transactions when they occur When sale is made When bill is received Complies with GAAP Presents accurate financial picture CASH Records transactions only when cash is received or paid When customer pays for product or service When bills are paid Only used by very small businesses Omits important info Accrual accounting records the impact of a business transaction as it occurs. When the business performs a service, makes a sale, or incurs an expense, the accountant records the transaction even if it receives or pays no cash. Cash-basis accounting records only cash transactions cash — cash receipts and cash payments. Cash receipts are treated as revenues, and cash payments are handled as expenses. Generally accepted accounting principles (GAAP) require accrual accounting. The business records revenues as the revenues are earned and expenses as the expenses are incurred—not necessarily when cash changes hands. Copyright ©2008 Pearson Prentice Hall. All rights reserved 111

Learning Objective 1 Relate accrual accounting and cash flows
The first learning objective is to relate accrual accounting and cash flows. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accrual Accounting and Cash Flows
Accrual accounting records both cash and non-cash transactions Cash Collecting from customers Paying for expenses Borrowing money Issuing Stock Non-cash Sales on account Purchases on account Using prepaid expenses, such as supplies Accrual accounting is more complex—and more complete—than cash-basis accounting. Accrual accounting records cash transactions, such as: ■ Collecting cash from customers ■ Borrowing money ■ Receiving cash from interest earned ■ Paying off loans ■ Paying salaries, rent, and other expenses ■ Issuing stock Accrual accounting also records noncash transactions, such as: ■ Sales on account ■ Depreciation expense ■ Purchases of inventory on account ■ Usage of prepaid rent, insurance, and supplies ■ Accrual of expenses incurred but not yet paid ■ Earning of revenue when cash was collected in advance Copyright ©2008 Pearson Prentice Hall. All rights reserved

Time-Period Concept Businesses do not stop operations to measure financial transactions Accountants prepare financial statements at regular intervals to measure performance Companies select a twelve-month period for reporting purposes: Calendar year Fiscal year Accountants prepare financial statements for specific periods. The time-period concept ensures that accounting information is reported at regular intervals. The basic accounting period is one year, and virtually all businesses prepare annual financial statements. Over half of large companies use the calendar year from January 1 through December 31. A fiscal year ends on a date other than December 31. Most retailers use a fiscal year that ends on January 31 because the low point in their business activity falls, after Christmas. Companies also prepare financial statements for interim periods of less than a year, such as a month, a quarter (3 months), or a semiannual period (6 months) Copyright ©2008 Pearson Prentice Hall. All rights reserved 114

Learning Objective 2 Apply the revenue and matching principles
The second learning objective is to apply the revenue and matching principles Copyright ©2008 Pearson Prentice Hall. All rights reserved 115

The Revenue Principle Revenue is recorded when earned When product or service is delivered to customer Cash may come before, at the same time, or after delivery Revenue is recorded at the cash value of goods or services provided When should you record revenue? After it has been earned—and not before. In most cases, revenue is earned when the business has delivered a good or service to a customer. It has done everything required to earn the revenue by transferring the good or service to the customer. When the company is paid for the revenue varies. Sometimes customers pay before the product or service is provided. Other times, customers pay after the product or services is provided (accounts receivable). Regardless of the timing of the cash receipt, revenue should be recognized when earned. Copyright ©2008 Pearson Prentice Hall. All rights reserved 116

The Matching Principle
Expenses are incurred to help produce revenue Expenses should be recorded in the time period in which they are incurred Expenses should be matched to the revenues they help produce The matching principle is the basis for recording expenses. Expenses are the costs of assets used up, and of liabilities created, in the earning of revenue. While expenses have no future benefit to the company, they are necessary costs of running a business and help generate revenue. The matching principle includes two steps: 1. Identify all the expenses incurred during the accounting period. 2. Measure the expenses, and match expenses against the revenues earned. To match expenses against revenues means to subtract expenses from revenues to compute net income or net loss. EXPENSES REVENUES Copyright ©2008 Pearson Prentice Hall. All rights reserved 117

Expenses May be paid in cash Paying monthly rent May arise from using up an asset Using supplies previously purchased May arise from creating a liability Receive a bill from a supplier Some expenses are paid in cash, such as paying monthly rent. Other expenses arise from using up an asset such as supplies. Still other expenses occur when a company creates a liability. For example, a company uses electricity continuously. When the company receives the bill from the electric company, it records the expense and a liability. Copyright ©2008 Pearson Prentice Hall. All rights reserved 118

The Adjustment Process
At the end of the period, a business prepares financial statements Ensures that: All revenue that has been earned has been recorded All expenses that have been incurred are matched to revenues Asset and liability accounts are up-to-date At the end of an accounting period (month, quarter or year), a company prepares financial statements. Adjustments are made to several account to make sure that all revenue earned has been recorded. Also, all expenses that have been incurred must be recorded and matched to revenues. Further, certain asset and liability accounts must be adjusted so their balances are up-to-date. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Categories of Adjusting Entries
Deferrals Depreciation Accruals Adjusting entries fall into three major categories – deferrals, depreciation and accruals. 3-121 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Deferrals Cash has already been received or paid Related expense or revenue has not yet been recorded Prepaid expenses Company has paid for expense in advance Adjustment needed to record amount used Unearned revenues Customer pays in advance for good or service Adjustment needed to record amount of revenue earned Deferrals are transactions where the cash has already been received or paid. However, the related expense or revenue has not yet been recorded. Prepaid expenses are when a company pays in advance for an expense, such as rent or insurance. When the cash was paid, a prepaid asset account was debited. At the end of the period, an adjustment is need to record the amount of the prepaid asset that has expired or been used. Conversely, unearned revenues occur when a customer prepays for a good or service. When the cash was received, an unearned revenue (a liability) account was credited. At the end of the period, an adjustment is need to record the amount of revenue earned. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Prepaid Expenses Expenses paid in advance Include prepaid rent and supplies Asset is recorded when purchased Adjustment needed to record amount used Let’s look closer at prepaid expenses. Some common accounts are “prepaid rent” and “supplies”. When these items are paid for and asset is recorded. An adjustment is needed at the end of the period to reflect the amount used or expired. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Prepaid Rent Example Suppose on April 1 on a company paid $12,000 for one year’s rent in advance JOURNAL Date Accounts Debit Credit 1-Apr Prepaid rent $12,000 Cash Let’s say a company paid $12,000 for one year’s rent in advance on April 1. The entry on April 1 to record this transaction would include a debit to “prepaid rent”, an asset. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Prepaid Rent Example Now, it’s December 31, the company’s year-end The amount of rent that has expired must be recorded This amount is recorded as rent expense Prepaid rent (asset) needs to be reduced so it reflects the amount of rent remaining On December 31, the company’s year-end, an adjustment is need to record the amount of rent that has expired. This amount will be recorded as rent expense. In addition, the prepaid rent account needs to be reduced so its balance reflects the amount of rent remaining. Copyright ©2008 Pearson Prentice Hall. All rights reserved

$12,000 Prepaid Rent $9,000 $3,000 December 31 April 1, following year April 1, current year April 1 to December 31 = 9 months 3 out of 12 months of rent remains The line on this diagram represents the twelve-month period that the prepaid rent covers. December 31 falls nine months after the $12,000 of prepaid rent was recorded. Therefore, 9 months of the prepaid rent account has expired. 9/12 of $12,000 is $9,000. This amount will be recorded as rent expense. Three months of prepaid rent remains - January through March of the next year. After adjustment, prepaid rent should equal three months or $3,000. 9 out of 12 months of rent has expired 3/12 x $12,000 = $3,000 9/12 x $12,000 = $9,000 3-126 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Prepaid Rent Example Dec 31 – Adjust Prepaid Rent account for amount expired JOURNAL Date Accounts Debit Credit 12-31 Rent Expense $9,000 Prepaid Rent The adjusting entry needed has a debit to rent expense and a credit to prepaid rent for $9,000. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Prepaid Rent Rent Expense Apr 1 $12,000 Dec $9,000 Dec $9,000 Represents amount expired $3,000 Represents amount remaining End-of-year balance T-Accounts show the result of the adjusting entry. Originally, when the company paid for the rent, prepaid rent was debited for $12,000. When this adjusting entry is posted, $9,000 is recorded in rent expense and prepaid rent is decreased by the same amount. The ending balances show that rent expense equals the amount of rent expired (April 1 – December 31) and that prepaid rent equals the amount remaining – $3,000 – for the first three months of the next calendar year. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Supplies Example Suppose a company purchased $3,200 of supplies during the year The asset “supplies” was debited for each purchase At the end of the year, a physical count reveals $500 of supplies on hand Supplies is another common type of prepaid expense. The supplies account, an asset, is debited each time a company buys supplies. However, companies usually do not make entries to record each time a supply is used. Instead, a physical count of supplies is taken at year end. In the example above, a company purchased $3,200 of supplies during the year. At the end of the year, $500 of supplies remained. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Supplies Example Supplies $3,200 $500 Balance per ledger
What amount of supplies was used? Balance per ledger Balance per physical count $500 One of the purposes of adjusting entry is to ensure that asset accounts are reported at their proper balances. The supplies account should equal the actual amount of supplies on hand. Before adjustment, the supplies account has $3,200 in it. The correct balance is $500. We can “back into” the amount of supplies used by subtracting the amount on hand ($500) from the amount in the accounting records ($3,200). The company used $1,700 of supplies. Subtract the balance per count from the balance per ledger Copyright ©2008 Pearson Prentice Hall. All rights reserved

Supplies Example Dec 31 – Adjust Supplies account for amount used JOURNAL Date Accounts Debit Credit 12-31 Supplies Expense $1,700 Supplies The adjusting entry need has a debit to supplies expense and a credit to supplies for $1,700. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Supplies Supplies Expense $3,200 Dec 31 $1,700 Dec $1,700 Represents amount used $500 Represents amount on hand End-of-year balance T-Accounts show the impact of the adjusting entry. After it’s posted, supplies expense equals the amount of supplies used during the year and supplies (asset) equals the amount of supplies on hand at the end of the year. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Depreciation of Plant Assets
Allocation of plant assets cost over their useful lives Results in a debit to an expense Depreciation Expense Corresponding credit Accumulated Depreciation Most companies own plant asset, such as buildings, furniture, equipment and vehicles. The cost of these plant assets is allocated over their useful lives to expense. This process is called depreciation. To record depreciation, depreciation expense is debited and accumulated depreciation is credited. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accumulated Depreciation
Account that shows the sum of depreciation expense of the plant asset Contra-asset Always has a companion account Normal credit balance Accumulated depreciation represents the cumulative total of depreciation expense recoded. It is a contra-asset. Contra-asset accounts never “stand alone”. They are always paired with a companion account. The contra account is subtracted from its companion account. Therefore, its normal balance is opposite of the companion account. So, accumulated depreciation has a normal credit balance. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Depreciation Example A company purchases equipment for $50,000 The estimated useful life of the equipment is five years The simplest way to compute depreciation is to divide the asset’s cost by its estimated life. This is called straight-line depreciation. For example, let’s say a company purchases equipment for $50,000 and assigns it a useful life of five years. Annual depreciation expense would be $5,000 – the $50,000 cost of the equipment divided by the five year life. $5,000 annual depreciation 50,000/5 years = Copyright ©2008 Pearson Prentice Hall. All rights reserved

Depreciation Example Dec 31 – Adjusting entry to record depreciation of equipment JOURNAL Date Accounts Debit Credit 12-31 Depreciation Expense $5,000 Accumulated Depreciation The adjusting entry to record depreciation of the equipment would include a debit to depreciation expense and a credit to accumulated depreciation of $5,000. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Depreciation – Balance Sheet
Plant assets: Equipment $50,000 Less: Accum. Depr. (5,000) $45,000 On the balance sheet, accumulated depreciation would be listed below the equipment as a reduction. The $5,000 accumulated depreciation balance is subtracted from the $50,000 cost. The result is net equipment of $45,000. Each year the accumulated depreciation account would increase by $5,000 until the net amount of equipment would be zero. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accrued Expenses Expense incurred before cash is paid Result in a liability Common accrued expenses: Salaries Interest Taxes Another type of adjusting entry is accrued expenses. These occur when an expense is incurred before it is paid. Contrast this to prepaid expenses, when the company pays an expense before it is incurred. Accrued expense result in a liability – a payable account. Some common accrued expense are salaries, interest and taxes. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accrued Salary Expense Example
A company pays its employees a weekly salary each Friday Salaries for each week total $10,000 December 31, the company’s year-end, falls on a Wednesday An example of accrued salaries will show how the adjustment works. Let’ say a company pays its employees each Friday and weekly salaries total $10,000. This year, December 31 falls on a Wednesday. Pay day won’t occur until Friday, which would be in the next calendar year. Copyright ©2008 Pearson Prentice Hall. All rights reserved

$10,000 Salaries $6,000 $4,000 Friday, January 2 pay day Monday, December 29 Wednesday, December 31 year end Monday through Wednesday = 3 days The line above represents the five-day work week. The $10,000 of salaries needs to be allocated between the current year and the upcoming year. A vertical line is drawn on December 31. For accounting purposes, everything stops on this day. All expenses incurred before “the line” must be recorded. Three out of the five days of salaries expense needs to be recorded. This amounts to $6,000. 3 out of 5 days of salaries expense has been incurred 3/5 x $10,000 = $6,000 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Dec 31 – Record accrued salary expense JOURNAL Date Accounts Debit Credit 12-31 Salary expense $6,000 Salary payable The adjusting entry to record the accrued salaries has a debit to salary expense and a credit to salary payable. The company owes employees for the work they have provided. On January 2, pay day, the company will satisfy this liability. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accrued Revenues Companies often earn revenue before cash is received Results in an accrued revenue Receivable recorded Companies also have accrued revenues. Like accrued expenses, the cash portion of the transactions has not yet occurred. With accrued revenues, the company has earned the revenue, but has not yet received the cash. Therefore, an adjustment is needed to record the revenue earned and the future collection of cash – a receivable. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accrued Revenue Example
A company performed services for customers during the last week of the year totaling $5,000 The revenue has not yet been recorded because the customers won’t be billed until January An example will demonstrate how to account for accrued revenues. A company performed services for customers during the last week of the year. The amount of revenue earned was $5,000. Since the clients won’t be billed until the following year, no revenue has yet been recorded. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Dec 31 – Record accrued revenue JOURNAL Date Accounts Debit Credit 12-31 Accounts Receivable $5,000 Service Revenue To record the accrued revenue, an adjusting entry is prepared debiting accounts receivable and crediting service revenue. Note that this is the same entry that is made during the year to record revenue on account. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Unearned Revenues Recorded as a liability when company receives payment Company owes customer product or service Revenue is not recorded until earned When company provides product or service An adjusting entry is made to transfer amount from unearned revenue to revenue While accrued revenues record revenue earned but not yet received, unearned revenues are when the company receives cash before the revenue has been earned. When the company receives cash, a liability is recorded – called unearned revenue. This liability is different than many payables. The company does not owe money, it owes a product or service to the customer who prepaid. At the end of the period, an adjustment is necessary to record the amount of revenue that has been earned. The amount earned is transferred from the unearned revenue account to a revenue account. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Unearned Revenue Example
On November 1, a company receives a customer payment of $18,000 for services to be performed during the next three months An example will show how to account for unearned revenues. On November 1 a company received $18,000 from a customer for services to be performed for the next three months. In other words, the customer prepaid for the service. The cash came before the revenue. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Nov 1 – Record advance payment received by customer JOURNAL Date Accounts Debit Credit 11-1 Cash $18,000 Unearned revenue On November 1, the company would debit cash to record the prepayment. The credit would be to unearned revenue – a liability. Copyright ©2008 Pearson Prentice Hall. All rights reserved

$18,000 $12,000 $6,000 December 31 January 31, following year November 1, current year November 1 to December 31 = 3 months 1 out of 3 months remains unearned The line above represents the three months for which the customer paid in advance. December 31 falls two months after the receipt of cash. Therefore, two out of three months of the unearned revenue is now earned. Two-thirds of 18,000 equals $12,000. $6,000 of the payment remains unearned. 2 out of 3 months of revenue has been earned 1/3 x $18,000 = $6,000 2/3 x $18,000 = $12,000 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Dec 31 – Record portion of unearned revenue that has been earned JOURNAL Date Accounts Debit Credit 12-31 Unearned revenue $12,000 Service revenue The adjusting entry to record the portion earned would debit unearned revenue for $12,000. This reduces the liability. The credit is to service revenue. Until this point, no revenue had been recorded. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Unearned Revenue Service Revenue Dec $12,000 Nov 1 $18,000 Dec $12,000 Represents amount earned $6,000 Represents amount unearned End-of-year balance T-accounts illustrate how the adjustment impacted the accounts. On November 1, $18,000 was credited to the liability account unearned revenue. There was no amount in service revenue related to this receipt. After the adjustment is posted, service revenue has a balance of $12,000 representing the two month of revenue earned. Unearned revenue has an ending balance of $6000, representing the portion still unearned at December 31. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Summary of Adjusting Entries
Purpose of adjusting entries Measure income Update balance sheet Each adjusting entry affects One income statement account Revenue or Expense One balance sheet account Asset or liability You have learned about three categories (deferrals, accruals and depreciation) and five types (prepaid expense, depreciation, accrued expenses, accrued revenues and unearned revenues) of adjusting entries. Recall that the purpose of adjusting entries is to measure income (both revenue and expenses) and update the balance sheet accounts. Note that each type of adjusting entry impacts an income statement account (either a revenue or an expense) and a balance sheet account (either an asset or a liability). Also, note that the “cash” account is never used in an adjusting entry. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Adjusted Trial Balance
Trial balance prepared after adjusting entries are made and posted These amounts are used to prepare the financial statements: Income Statement Statement of Retained Earnings Balance Sheet An adjusted trial balance is, as its name implies, a trial balance prepared after adjusting entries are prepared and posted. The account balances on the adjusted trial balance are the amounts used to prepare the financial statements. The financial statements include the income statement, the statement of retained earnings and the balance sheet. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 4 Prepare the financial statements
The fourth learning objective is to prepare the financial statements. Prepare the financial statements Copyright ©2008 Pearson Prentice Hall. All rights reserved

Income Statement Reports net income or loss Revenues minus expenses Net income flows to Retained Earnings Statement The first financial statement prepared in the income statement, which shows the net income or loss earned by the company. Net income is computed by subtracting revenues from expenses. The amount of net income flows to the Statement of Retained Earnings. Therefore, a company should prepare the income statement before the retained earnings statement. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Statement of Retained Earnings
Shows changes to the Retained Earnings account Net Income is added to beginning balance Dividends are subtracted Ending Retained Earnings flows to the Balance Sheet The second statement prepared is the Statement of Retained Earnings. This report shows the changes to the retained earnings account. It starts with the beginning balance, net income (from the Income Statement) is added and dividends are subtracted to determine the ending balance in retained earnings. The ending balance flows to the Balance Sheet in the Stockholders’ Equity section. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Balance Sheet Reports assets, liabilities and equity Shows that the accounting equation is in balance The third financial statement prepared is the balance sheet. This report lists the asset, liability and equity accounts of a company. It demonstrates that the accounting equation is in balance. Copyright ©2008 Pearson Prentice Hall. All rights reserved

RETAINED EARNINGS STATEMENT
INCOME STATEMENT NET INCOME RETAINED EARNINGS STATEMENT ENDING RETAINED EARNINGS The order in which the statements are prepared is important. Net Income from the Income Statement flows to the Retained Earnings Statement. The ending balance of the Retained Earnings Statement flows to the Balance Sheet. BALANCE SHEET Copyright ©2008 Pearson Prentice Hall. All rights reserved

Closing the Books Done after financial statements are prepared Set temporary accounts to zero Transfers balances to retained earnings account Journalizes activity in Statement of Retained Earnings The final step in the accounting cycle is to close the books. This is done after financial statements are prepared. Closing entries “zero out” temporary accounts and transfer their balances to retained earnings. Closing entries mirror the Retained Earnings Statement. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Temporary and Permanent Accounts
Revenues, Expenses and Dividends Closed Balances represent a period of time Permanent Asset, liability and equity accounts Not closed Ending balance of one period carries over to following period Temporary accounts are revenue, expenses and dividends. These accounts are closed at the end of the year and begin the following year with a zero balance. Their balances represent a period of time. For example, the service revenue account shows the amount of revenue earned for the year. Permanent accounts are the asset, liability and equity accounts. These accounts are not closed. Their year-end balances carry forward to the next year. If a company has cash of $10,000 at the end of one year, it begins the next year with $10,000. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Closing Entries Debit each Revenue account for the amount in its credit balance Retained earnings is credited Credit each Expense account for the amount in its debit balance Retained earnings is debited Credit Dividends for the amount in its debit balance R E D There are three closing entries. First, each revenue account is debited for its balance. Retained Earnings is credited, which increases the account. Second, each expense account is credited for its balance. Retained earnings is debited, which decreases it. Now, Retained Earnings has been increased by revenues and decreased by expenses. Revenues minus expenses equals net income. Net income has been added to Retained Earnings, just like in the Statement of Retained Earnings. The third closing entry credits the Dividends account and debits Retained Earnings. This zeros out Dividends and decreases retained earnings. This mirrors the R.E. Statement where dividends is subtracted. The acronym RED can help you remember the closing entries. R for revenues, E for expenses and D for Dividends. Note, Retained Earnings is a permanent account and is not closed. It is, however, increased and decreased by the closing entries. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Dec 31 – Close Revenues JOURNAL Date Accounts Debit Credit 12-31 Service Revenue $23,600 Other revenue 600 Retained earnings $24,200 E3-29 demonstrates the closing process. Above is the entry to close the two revenue accounts. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Which account would be debited? Total the expenses for the amount
Dec 31 – Close expenses JOURNAL Date Accounts Debit Credit 31-Dec ________________________ _________ Cost of services sold $11,600 Selling, general & admin exp $6,900 Depreciation expense $4,100 Income tax expense $500 Each expense account is credited for its balance and retained earnings is debited for the total. At this point, retained earnings has been increased by the amount of net income earned by the company. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Dec 31 – Close Dividends JOURNAL Date Accounts Debit Credit 12-31 Retained earnings $400 Dividends The last closing entry zeros out the dividends account. Retained earnings is debited and Dividends is credited for the amount of Dividends (not the retained earnings balance). Copyright ©2008 Pearson Prentice Hall. All rights reserved

Retained earnings $1,900 Balance X1 Expenses $23,100 $400 $24,200 Revenues Dividends $2,600 Balance X2 Determine net income. Remember revenues minus expenses A T-account is a good way to determine the ending balance of retained earnings. The beginning balance comes from the amount provided in the text. The first closing entry increases the account by the amount of revenue. The second closing entry decreases it by the amount of expenses. The third closing entry decrease it by the amount of dividends. The result is an ending balance of $2,600. Remember, retained earnings isn’t closed. It is used in the closing process, but not closed. Net income equals the revenues minus the expenses. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Classifying Assets & Liabilities
Current and long-term classifications are based on liquidity How quickly item is converted to in cash Current assets will be converted to cash, sold or used during the next year Long-term assets include plant assets Current liabilities must be paid in the next 12 months Long-term liabilities have due dates more than one year from balance sheet date Balance sheet accounts are often classified. The classification is based on length of time. One year is a guideline in this process. Assets are often listed in order of liquidity – how quickly an item turns to cash. Current assets are those that will be converted to cash, sold or used within one year. Long-term assets are all those that don’t meet the criteria for current. A common category of long-term assets is plant assets. Liabilities are also split into to current and long-term. Again one year is the guideline. Those liabilities that must be paid (or satisfied) within one year are current. Those that are due more than one year from balance sheet date are long-term. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Classified Balance Sheet
Places assets into meaningful categories Categories: Current assets Long-term investments Property, plant and equipment Intangible assets Other assets The classified balance uses these categories. In addition to current assets, companies have sections for long-term investments; property, plant and equipment; intangible assets and other assets. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Balance Sheet Formats Report format Assets at the top Followed by liabilities and stockholders’ equity Account format Assets on the left Liabilities and stockholders’ equity on the right The balance sheet can be prepared in one of two formats. The report format lists assets at the top, followed by liabilities and equity. The account format shows assets on the left and liabilities and equity on the right. Either format is acceptable. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Income Statement Formats
Single-step All revenues and gains grouped together All expenses and losses grouped together Multi-step Includes useful subtotals Gross profit Net revenues minus cost of goods sold Income from operations Net income The income statement also has two formats. The single step lumps all revenues and gains together and all expenses and losses. The multi-step income statement incorporates categories and subtotals. Cost of goods sold is subtracted from net revenues to determine gross profit. Gross profit minus operating expenses equals income from operations. Other expenses and revenues are subtracted to determine net income. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 6 Use two new ratios to evaluate a business
The sixth learning objective is to use two new ratios to evaluate a business. Use two new ratios to evaluate a business Copyright ©2008 Pearson Prentice Hall. All rights reserved

Current ratio Measure company’s ability to pay current liabilities with current assets Rule of thumb: Strong current ratio is 1.50 The current ratio is computed by dividing current assets by current liabilities. It measures a company’s ability to pay current liabilities. A rule of thumb is that a current ratio should be 1.5 or higher. Current assets Current liabilities Copyright ©2008 Pearson Prentice Hall. All rights reserved

Debt Ratio Proportion of assets that is financed with debt High debt ratio indicates more risk Total liabilities Total assets The debt ratio is computed by dividing total liabilities by total assets. Note, totals are used, not just current. This ratio shows the proportion of assets that is financed by debt. The higher the debt ratio, the riskier the company. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Current ratio: Current assets = Cash + Accounts Receivable + Inventories + Other current assets $900 + $27,700 + $33,000 = $4,800 = $66,400 Total Current liabilities = $53,600 S3-14 demonstrates how to compute these two ratios. First, pick out the assets that are current. These are cash, accounts receivable, inventories and other current assets. These total to $66,400. Total current liabilities is given as $53,600. Divide the current assets by current liabilities to get a current ratio of This means the company has approximately one-and-one-quarter as many current assets as current liabilities. Current ratio = 66,400 / 53,600 Current ratio = ______ Copyright ©2008 Pearson Prentice Hall. All rights reserved

Debt ratio: Total liabilities = Current liabilities + Long-term liabilities $53,600 + $13,500 = $67,100 Total assets = Current assets + Property & Equipment, net + Other assets For the debt ratio, compute total liabilities. This equals the current liabilities plus the long-term - $67,100. Total assets are the current assets computed for the current ratio, plus property & equipment, net and other assets. These amount to $97,900. This gives us a debt ratio of .69. $66,400 + $7,200 + $24,300 = 97,900 Debt ratio = $67,100 / $97,900 Debt ratio = .69 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Internal Control & Cash
Chapter 4 Chapter 4 addresses Internal Control and Cash. Copyright ©2008 Pearson Prentice Hall. All rights reserved 176

Internal Control - Objectives
Safeguard assets Encourage employees to follow company policy Promote operational efficiency Ensure accurate, reliable accounting records Comply with legal requirements A key responsibility of a manager is to control the operations of the business. Owners and top executives set company goals, they hire managers to lead the way, and employees carry out the plan. Internal control is the organizational plan and all the related measures designed to accomplish 5 objectives: Safeguard assets. A company must protects its assets; otherwise it’s throwing away resources. Cash, especially, should be protected. Encourage employees to follow company policy. Everyone in an organization—managers and employees—needs to work toward the same goal. It’s also important for managers to develop policies so that the company treats customers and employees fairly. This will make it more likely employees will respect company assets. 3. Promote operational efficiency. A well-run company performs tasks in an efficient manner. Elimination of waste can increase profits. 4. Ensure accurate, reliable accounting records. Good records are essential. Without reliable records, it is difficult to tell which part of the business is profitable and which part needs improvement. A company could be losing money on a product it sells—unless it keeps good records for the cost of products. 5. Comply with legal requirements. Companies, like people, are subject to the law. When companies disobey the law, they must pay fines or alter their business, or, in extreme cases, their top executives go to prison. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Sarbanes-Oxley Act (SOX)
Accounting scandals shook the public’s confidence in the accounting profession Enron and WorldCom overstated profits Auditors Arthur Anderson went out of business In response, Congress passed SOX Established new provisions for how large corporations are audited The Enron and WorldCom accounting scandals shook the public’s confidence in the accounting profession. Enron overstated profits and went out of business, leaving its employees with nothing. WorldCom (now MCI) reported expenses as assets and overstated both profits and assets. The company only recently emerged from bankruptcy. Sadly, the same accounting firm, Arthur Andersen, had audited both companies’ financial statements. Arthur Andersen then closed its doors. To address public concern, Congress passed the Sarbanes-Oxley Act, abbreviated as SOX. SOX revamped corporate governance in the United States and affected the accounting profession. Here are some of the SOX provisions: 1. Public companies must issue an internal control report, and the outside auditor must evaluate the client’s internal controls. 2. A new body, the Public Company Accounting Oversight Board, oversees the auditors of public companies. 3. An accounting firm may not both audit a public client and also provide certain consulting services for the same client. 4. Stiff penalties await violators—25 years in prison for securities fraud; 20 years for an executive making false sworn statements. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 1 Set up an internal control system
The first learning objective is to set up an internal control system. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Monitoring of Controls
Control Environment Tone set “at the top” Top management should set good example for employees Risk assessment Identify risks in the business environment Control Procedures Ensure goals are achieved Monitoring of Controls Auditors make sure controls are working Internal control can be broken down into 5 components: 1) Control Environment: The control environment is the “tone at the top” of the business. It starts with the owner and the top managers. They must behave honorably to set a good example for company employees. The owner must demonstrate the importance of internal controls if he or she expects the employees to take the controls seriously. 2) Risk Assessment: A company must identify its risks. The risks vary depending on the industry a company is in. All companies face the risk of bankruptcy. Companies facing difficulties are tempted to falsify the financial statements to make themselves look better than they really are. 3) Control Procedures: These are the procedures designed to ensure that the business’s goals are achieved. Examples include assigning responsibilities, separating duties, and using security devices to protect inventory from theft. 4) Monitoring of Controls: Companies hire auditors to monitor their controls. Internal auditors monitor company controls to safeguard the company’s assets, and external auditors monitor the controls to ensure that the accounting records are accurate. 5) Information System: The owner of a business needs accurate information to keep track of assets and measure profits and losses. Information System Provides accurate information to keep track of assets and measure income Copyright ©2008 Pearson Prentice Hall. All rights reserved

Internal Control Procedures
Competent, reliable and ethical employees Staff should be trained and fairly rewarded for its work Assignment of Responsibilities Job descriptions should be clear Separation of Duties Operations from accounting Custody of assets from accounting There are several internal control procedures. The first being that employees should be competent, reliable, and ethical. Paying good salaries will attract high-quality employees. They also must be trained to do the job, supervised and rewarded fairly. This will build a competent staff. Second, a company should have clear assignment of responsibilities. In a business with good internal controls, no important duty is overlooked. Each employee has certain responsibilities. The third and essential internal control procedure is separation of duties. Management should divide related duties between two or more people. Separation of duties limits fraud and promotes the accuracy of the accounting records. Separation of duties can be divided into two parts: 1. Separate operations from accounting. Accounting should be completely separate from the operating departments, such as production and sales. This would help sales figures to stay accurate. 2. Separate the custody of assets from accounting. Accountants must not handle cash, and cashiers must not have access to the accounting records. If one employee has both cash-handling and accounting duties, that person can steal cash and conceal the theft. cash. Neither person should have both jobs. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Internal Control Procedures
Audits Internal or External Documents Electronic Devices Other controls Fireproof vaults for important documents Bonds on employees who handle cash Mandatory vacations and job rotation To validate their accounting records, most companies have an audit. An audit is an examination of the company’s financial statements and accounting system. To evaluate the system, auditors examine the internal controls. Audits can be internal or external. Internal auditors are employees of the business. They ensure that employees are following company policies and operations are running efficiently. Internal auditors also determine whether the company is following legal requirements. External auditors are completely independent of the business. They are hired to determine that the company’s financial statements agree with generally accepted accounting principles. Auditors examine the client’s financial statements and the underlying transactions in order to form a professional opinion of the financial statements. Documents provide the details of business transactions. Documents include invoices and sales orders. Documents should be pre-numbered to prevent theft and inefficiency. A gap in the numbered sequence draws attention. However, many accounting systems are relying less on documents and more on digital storage devices. For example, large retailers control inventory by attaching an electronic sensor to merchandise. The cashier removes the sensor. If a customer tries to leave the store with the sensor attached, an alarm sounds. Companies also use bar codes on the merchandise to ring up customers. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Internal Controls for E-Commerce
Risks of online business Stolen credit cards Computer viruses Phishing Security measures Encryption Firewalls E-commerce creates its own risks. Hackers may gain access to confidential information such as account numbers and passwords. E-commerce pitfalls include: ■ Stolen credit-card numbers ■ Computer viruses - malicious programs that (a) enters program code without consent and (b) performs destructive actions in the victim’s computer files or programs. ■ Phishing expeditions - Thieves create bogus Web sites that attract lots of visitors, and the thieves obtain account numbers and passwords from unsuspecting people. The thieves then use the data for illicit purposes. To address the risks posed by e-commerce, companies have devised a number of security measures, including encryption and firewalls. Encryption rearranges messages by a mathematical process. The encrypted message can’t be read by those who don’t know the code. Firewalls limit access into a local network. Members can access the network, but nonmembers can’t. Usually several firewalls are built into the system. PINs and passwords are part of firewalls. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Limitations of Internal Control
Collusion Two people working together can circumvent system Cost Company must weigh the benefits of controls with the cost Unfortunately, most internal controls can be overcome. Collusion—two or more people working together—can beat internal controls. In addition, the stricter the internal control system, the more it costs. A complex system of internal control can strangle the business with red tape. Internal controls must be judged in light of their costs and benefits. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Bank Account as Control
Keeping cash in a bank account safeguards the asset Bank account documents provide controls Signature card Deposit tickets Checks Bank Statements Electronic Funds Transfer (EFT) Cash is the most liquid asset because it’s the medium of exchange. Cash is easy to conceal and relatively easy to steal. As a result, most businesses create specific controls for cash. Keeping cash in a bank account helps control cash because banks have established practices for safeguarding customers’ money. The documents used to control a bank account include the: 1. Signature card: Banks require each person authorized to sign on an account to provide a signature card. This protects against forgery. 2. Deposit ticket: Banks supply standard forms such as deposit tickets. The customer fills in the amount of each deposit. As proof of the transaction, the customer keeps a deposit receipt. 3. Check: To pay cash, the depositor can write a check, which tells the bank to pay the designated party a specified amount. 4.Bank statement: Banks send monthly statements to customers that reports what the bank did with the customer’s cash. The statement shows the account’s beginning and ending balances, cash receipts, and payments. Included with the statement are copies of canceled checks (or the actual paid checks). 5. Electronic funds transfer (EFT): EFT moves cash by electronic communication. It is cheaper to pay without having to mail a check, so many business pay their loans and expenses using EFT. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 2 The second learning objective is to apply the revenue and matching principles. Prepare and use a bank reconciliation as a control device Copyright ©2008 Pearson Prentice Hall. All rights reserved 186

Bank Reconciliation Process to update cash account Book Balance
Cash account in General Ledger Bank Balance Cash amount according to bank statement Another effective control on cash is the preparation of a bank reconciliation. This process involves explaining the differences between the book balance of cash and bank balance of cash. These amounts don’t equal each other because of timing differences between when the company records items and when the bank records them. Amounts don’t equal due to time lags in recording transactions Copyright ©2008 Pearson Prentice Hall. All rights reserved

Preparing a Bank Reconciliation
Bank balance Book balance Add: Deposits in transit Add: Bank collections & Interest revenue Subtract: Outstanding checks Subtract: EFT payments, service charges, NSF checks There are two “sides” to a bank reconciliation – the bank side and the book side. 1. Items to show on the Bank side of the bank reconciliation: Deposits in transit (outstanding deposits): The company has recorded these deposits, but the bank has not. For example, on the bank statement date, a deposit was made late in the day. The company has recorded this, but the bank has not. Outstanding checks. The company has written and recorded these checks, but the checks have not cleared - the bank has not yet paid them. c. Bank errors. Occasionally, the bank may make an error by posting a deposit or check to another account. Depending on the error, these items are subtracted or added. 2. Items to show on the Book side of the bank reconciliation: a. Bank collections: Bank collections are cash receipts that the bank has recorded for your account. But you haven’t recorded the cash receipt yet. Many businesses have their customers pay directly to their bank. This is called a lock-box system and reduces theft. An example is a bank’s collecting an account or note receivable for the company. b. Interest revenue. A company can earn interest on its account. c. Electronic funds transfers (EFT): The company may set up automatic payments for certain bills. d. Service charges: This cash payment is the bank’s fee for processing transactions and for check printing . e. Nonsufficient funds (NSF) check: Sometimes companies will receive checks that “bounce”. The company records this as a cash receipt, but the bank does not. f. Book errors. Companies may make errors in recording amounts of checks or deposits. For example, a check for $476 may get recorded as $467. Add or Subtract: Bank errors Add or Subtract: Book errors Equals: Adjusted Cash Balance Equals: Adjusted Cash Balance Copyright ©2008 Pearson Prentice Hall. All rights reserved

Bank Balance, May 31 $595 Plus: deposit in transit $1,788 Less: outstanding checks ($603) Adjusted Cash Balance $1,780 Example E4-20 shows the development of an adjusted cash balance. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Subtract the actual amount of the deposit from the amount recorded
Book Balance, May 31 $1,882 Plus: Rent collection $300 Less: Service charge ($12) Less: NSF checks ($120) Less: Printed checks ($9) Less: Error _____________ Adjusted Cash Balance $1,780 What would be the amount of the error? Now, we show how to account for errors. Subtract the actual amount of the deposit from the amount recorded Copyright ©2008 Pearson Prentice Hall. All rights reserved

Entries from Reconciliation
All items on the book side require a journal entry All items added will result in a debit to cash All items subtracted will result in a credit to cash After entries are posted Cash Balance in Ledger = Adjusted Cash Balance on Reconciliation The bank reconciliation is an accountant’s tool separate from the journals and ledgers. It does not account for transactions in the journal. To get the transactions into the accounts, journal entries must be prepared and post to the ledger. All items on the Book side of the bank reconciliation require journal entries. After these entries are prepared and posted, the cash account balance will equal the adjusted cash balance on the reconciliation. Copyright ©2008 Pearson Prentice Hall. All rights reserved

JOURNAL Date Accounts Debit Credit 31-May Cash $300 Rent revenue Miscellaneous Expense $21 Cash ($9 +$12) Exercise E4-21 shows the journal entry process. Copyright ©2008 Pearson Prentice Hall. All rights reserved

What account is debited for NSF checks?
JOURNAL Date Accounts Debit Credit 31-May _____________________ $120 Cash Salary Expense $261 What account is debited for NSF checks? Exercise E4-21 continues to show additional journal entries. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 3 The third learning objective is to apply internal controls to cash receipts and cash payments. Apply internal controls to cash receipts and cash payments Copyright ©2008 Pearson Prentice Hall. All rights reserved 194

Internal Control over Cash Receipts
Over the counter Cash register record transactions Receipts issued to customer Manager compares cash in drawer to cash register record Receipts deposited at least daily By mail Checks and remittance advice separated Checks sent to treasurer for deposit Remittance advice sent to accounting to record Bank deposit slip compared with debit to cash Cash requires some specific internal controls because cash is relatively easy to steal and it’s easy to convert to other forms of wealth. Moreover, all transactions ultimately affect cash. All cash receipts should be deposited for safekeeping in the bank—quickly. Companies receive cash over the counter and through the mail. Each source of cash has its own security measures. Cash Receipts over the Counter: The cash register provides control over the cash receipts. Companies issue a receipt to ensure that each sale is recorded. The cash drawer opens when the clerk enters a transaction, and the machine records it .At the end of the day, a manager proves the cash by comparing the cash in the drawer against the machine’s record of sales. This step helps prevent theft by the clerk. At the end of the day—or several times a day if business is brisk—the cashier deposits the cash in the bank. The machine tape then goes to the accounting department for the journal entry to record sales revenue. These measures, coupled with oversight by a manager, discourage theft. Cash receipts by mail: Many companies receive cash by mail. All incoming mail is opened by a mailroom employee. The mailroom then sends all customer checks to the treasurer, who has the cashier deposit the money in the bank. The remittance advices go to the accounting department for journal entries to Cash and customer accounts. As a final step, the controller compares the bank deposit amount from the treasurer to the Debit to Cash from the accounting department. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Internal Control Over Cash Payments
Payment by check Provides record of payment Must be signed by authorized official Official should study evidence supporting payment Payment by check is an important internal control in three ways. First, the check provides a record of the payment. Second, the check must be signed by an authorized official. Third, before signing the check, the official should study the evidence supporting the payment. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Documents Used to Control Purchases
Purchase order Prepared by purchasing company to place order Invoice Prepared by selling company to list items sent and to request payment Receiving report Prepared by purchasing company to show that goods were received Documents used in the purchase process also provide internal control. When a company orders goods, it prepares a purchase order, which lists the items it is ordering. When the purchase order is received, the company selling the products prepares an invoice, which lists the items it is shipping, along with the price. The invoice serves as a bill to the company purchasing the items. When the goods are received by the purchasing company, a receiving report is prepared listing the items and the quantities received. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Payment packet Documents should agree before payment is made Receiving Report Invoice Purchase Order These three documents make up a payment packet. Before the company purchasing the goods pays for the items, the three documents should be compared to make sure that the items that were ordered were received. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Separation of Duties Responsibilities should be split: Purchasing goods Receiving goods Approving and paying for goods For good internal control, the purchasing agent should neither receive the goods nor approve the payment. If these duties aren’t separated, a purchasing agent can buy goods and have them shipped to his or her home. Or a purchasing agent can spend too much on purchases, approve the payment, and split the excess with the supplier. To avoid these problems, companies split the following duties among different employees: purchasing goods, receiving goods and approving and paying for goods. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Petty Cash Small amount of cash kept on hand for incidental purchases Fund is established at a set amount Custodian of fund prepares ticket that lists each item purchased Tickets plus remaining cash should equal fund balance Sometimes, going through the approval process for check writing doesn’t make sense. For example, expenditures for executive’s taxi fare, postage or delivery of a package across town need to paid immediately. Therefore, companies keep a petty cash fund on hand to pay such minor amounts. The petty cash fund is opened with a particular amount of cash. A check for that amount is then issued to Petty Cash. The custodian of the petty cash fund cashes the check and places the money in the fund, which may be a cash box or other device .For each petty cash payment, the custodian prepares a petty cash ticket to list the item purchased. 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 original balance at all times. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 4 Use a budget to manage your cash
The fourth learning objective is to use a budget to manage your cash. Use a budget to manage your cash Copyright ©2008 Pearson Prentice Hall. All rights reserved

Budget Financial plan that helps coordinate business activities A cash budget helps a company manage cash by planning receipts and payments Managers control operations with a budget. A budget is a financial plan that helps coordinate business activities. Cash is budgeted most often. Companies need to plan for events such as purchasing new plant assets or making other investments. Will operations generate enough cash or will the company need to borrow funds for investments? A cash budget helps a company or an individual manage cash by planning receipts and payments during a future period. The company must determine how much cash it will need and then decide whether or not operations will bring in the needed cash. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Compare ending balance to minimum needed
CASH BUDGET Beginning cash balance Plus: Budgeted Cash Receipts Minus: Budgeted Cash payments Equals: Expected ending cash balance A cash budget is prepare as follows: 1. Start with the entity’s cash balance at the beginning of the period. This is the amount left over from the preceding period. 2. Add the budgeted cash receipts and subtract the budgeted cash payments. 3. The beginning balance plus receipts and minus payments equals the expected cash balance at the end of the period. 4. Compare the ending cash balance to the budgeted cash balance at the end of the period. Managers know the minimum amount of cash they need (the budgeted balance). If the budget shows excess cash, they can invest the excess. But if the expected cash balance falls below the budgeted balance, the company will need to obtain additional financing. The company may need to borrow the shortfall amount. The budget is a valuable tool for helping the company plan for the future. Compare ending balance to minimum needed If excess, invest If shortfall, borrow Copyright ©2008 Pearson Prentice Hall. All rights reserved

Cash Budget 20X8 Beginning cash balance $81 Budgeted cash receipts: Cash collections from customers $11,284 Sale of equipment 115 $11,399 E4-24 displays a cash budget. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Budgeted cash payments: Costs of services and products $6,166 Operating expenses 2,543 Purchase of new equipment 1,825 Debt payments 597 Dividend payment 338 $11,469 Expected cash balance $11 E4-24 shows the resulting expected cash balance. Copyright ©2008 Pearson Prentice Hall. All rights reserved

What amount of borrowing would get the company to its minimum?
Expected Cash Balance = $11 Company’s Minimum Cash Balance = $75 What amount of borrowing would get the company to its minimum? So, if the expected cash balance is $11 and the company’s minimum cash balance is $75, the company will have to borrow $64. Expected Borrowing = ________ Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 5 Make ethical business judgments
The fifth learning objective is to make ethical business judgments. Make ethical business judgments Copyright ©2008 Pearson Prentice Hall. All rights reserved

Codes of Ethics Most companies have a code of ethics Owners and managers must set an ethical tone as well The accounting profession is expected to maintain higher standards AICPA Code of Professional Conduct Standards of Ethical Conduct for Management Accountants Most companies have a code of ethics to encourage employees to behave ethically. But codes of ethics are not enough by themselves. Owners and managers must set a high ethical tone. The owner must make it clear that the company will not tolerate unethical conduct. As professionals, accountants are expected to maintain higher standards than society in general. Their ability to do business depends entirely on their reputation. Most independent accountants are members of the American Institute of Certified Public Accountants and must abide by the AICPA Code of Professional Conduct. Accountants who are members of the Institute of Management Accountants are bound by the Standards of Ethical Conduct for Management Accountants. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Ethical Issues in Accounting
Pressure often exists for managers to reach earnings or stock price goals Earnings can be manipulated by Understating expenses Overstating revenues Use Framework for Making Ethical Judgments Because financial results are important to owners of a company, pressure often exists for managers to meet earnings expectations. Stock prices react to reporting earnings of a company. Earnings can be manipulated by understating expenses or overstating revenues. Accountants must be aware of this pressure and use the framework for making ethical judgments when faced with difficult situations. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Framework for Ethical Judgments
Identify the ethical issue Specify the alternatives Assess the possible outcomes Make the decision In order to make ethical judgments, we must identify the issue; specify the alternatives; assess the outcomes and make a decision. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Short-Term Investments & Receivables
Chapter 5 Chapter 5 covers short-term investments and receivables. Copyright ©2008 Pearson Prentice Hall. All rights reserved 212

Learning Objective 1 Account for short-term investments
Learning Objective 1 accounts for short-term investments. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accounting for Short-Term Investments
Also called marketable securities Held for one year or less Most liquid asset other than cash Placed into three categories: Short-term investments are also called marketable securities. These are investments that a company plans to hold for one year or less. They allow the company to invest cash for a short period of time and earn a return until the cash is needed. Short-term investments are the next-most-liquid asset after cash. This is why companies report short-term investments immediately after cash and before receivables on the balance sheet. A short-term investment falls into one of three categories: (1) trading investments (2) available-for-sale investments (covered in chapter 10) (3) held-to-maturity investments. Trading Investments Available-for-Sale Held-to-Maturity Copyright ©2008 Pearson Prentice Hall. All rights reserved

Selling price > cost = Gain
Trading Investments Held for short time and then sold Gain or loss recorded Dividend revenue may also be received At year-end, trading investments are adjusted to equal their market value Results in an unrealized gain or loss Selling price > cost = Gain Selling price < cost = Loss The purpose of owning a trading investment is to hold it for a short time and then sell it for more than its cost. Trading investments can be the stock of another company. Suppose a company purchases stock, intending to sell the stock within a few months. If the market value of the stock increases, the company will have a gain; if the stock price drops, the company will have a loss. The company may also receive dividend revenue from its investment. At the company’s year end, any trading investments are adjusted to equal their market values. The difference between an investment’s market value and cost is an unrealized gain or loss. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Unrealized Gains & Losses
Difference between market price and cost of investment at year-end Unrealized – investment has not been sold Market price > cost = Unrealized gain Market price < cost = Unrealized loss Unrealized gains and losses are recorded on trading investments. At year end, the market value of the investments is compared to their cost. If the market value is greater than cost, an unrealized gain is recorded and the investment account is increased to equal its market value. If the market value is less than cost, an unrealized loss results, and the investment account is decreased to equal market value. The term “unrealized” is used because the company still holds the investment – it has not been sold. These gains and loss amounts will more than likely change as market values fluctuate on investments. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Realized vs. Unrealized
Investment sold to third party Gain or loss = difference between selling price and cost Word “realized” usually dropped from title Unrealized Company still owns investment Gain or loss = difference between market value and cost Word “unrealized” is kept in account title It is important to distinguish between an realized gain or loss and an unrealized gain or loss. Realized means that the investment has been sold. The company no longer has possession of it. A gain or loss is recorded for the amount that the selling price exceeded the cost (or vice versa). The word “realized” is seldom used in the account title. Instead, the accounts are just called “gain” or “loss”. Unrealized gains and losses are recorded when the company still owns the investment. It is called unrealized because it has not been sold – no cash has been received. The unrealized loss is the difference between the end-of-period market value and the cost of the investment. It is important to label these as “unrealized” to distinguish them from gains or losses from sales. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Entries to Adjust to Market
JOURNAL Date Accounts Debit Credit Short-term investments $$$ Unrealized gain on investments Adjusted investment to market value (when greater than cost) Unrealized loss on investments Adjusted investment to market value (when less than cost) The entries to adjust trading investments to market are above. Unrealized gain is a credit balance, just like other revenues and gains. By debiting short-term investments, the account is increased to equal market value. If an unrealized loss occurs, the loss account is debited and short-term investments is credited to reduce it to its market value. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Reporting on Financial Statements
Balance Sheet Trading Investment Reported at current market value Listed directly under “cash” in the current asset section Income Statement Gains and losses From sales of investments Investment revenue From dividends or interest earned Unrealized gain or loss From entry to adjust to market value On the balance sheet, trading investments at their current market value. They appear on the balance sheet in the current asset section immediately after cash because short-term investments are almost as liquid as cash. On the income statement, there can be up to three accounts related to trading investments. If trading investments are sold during the period, a gain or loss will be incurred. Investments also can earn interest revenue and dividend revenue. If the company has any trading investment at the end of the period, the entry to adjust to market will result in an unrealized gain or loss. For trading investments these three items are reported on the income statement as Other revenue, gains, and (losses) section. Copyright ©2008 Pearson Prentice Hall. All rights reserved

JOURNAL Date Accounts Debit Credit Nov 6 Trading investment $35,000 Cash Nov 27 $850 Dividend revenue Exercise 5-18 shows the journal entries for trading investments and cash. Copyright ©2008 Pearson Prentice Hall. All rights reserved

E5-18 12-31 Unrealized loss _______ Trading Investments ________
JOURNAL Date Accounts Debit Credit 12-31 Unrealized loss _______ Trading Investments ________ What would be the amount of the unrealized loss? Exercise 5-18 continues the display of journal entries to address unrealized losses. Compute the difference between the cost and market value. Copyright ©2008 Pearson Prentice Hall. All rights reserved

JOURNAL Date Accounts Debit Credit 1-11 Cash $36,000 Trading Investments $33,000 Gain on sale of investments $3,000 Exercise 5-18 shows continues the display of journal entries to show how to account for a gain in the sale of investments. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Receivables Monetary claims against others Third most liquid asset Accounts Receivable Amounts owed by customers for selling goods or services Notes Receivable Lending money to outsiders More formal than accounts receivable Receivables are the third most liquid asset—after cash and short-term investments. They are monetary claims against others. The two major types of receivables are accounts receivable and notes receivable. A business’ accounts receivable are the amounts collectible from customers from the sale of goods and services. Accounts receivable, which are current assets, are sometimes called trade receivables or merely receivables. Notes receivable are more formal contracts than accounts receivable. For a note, the borrower signs a written promise to pay the lender a definite sum at the maturity date. This is why notes are also called promissory notes. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 2 Apply internal controls to receivables
Learning Objective 2 shows how to apply internal controls to receivables. Copyright ©2008 Pearson Prentice Hall. All rights reserved 224

Internal Control over Cash Collections on Account
Separate cash-handling from cash-accounting duties Cash-handling One person receives customer checks and makes deposits Cash-accounting Another person makes entries to customer accounts Businesses that sell on credit receive most of their cash receipts on account. Internal control over collections on account is important. An important element of internal control deserves emphasis here—the separation of cash-handling and cash-accounting duties. One person, usually a supervisor and not the bookkeeper, should open incoming mail and make the daily bank deposit. The bookkeeper should not be allowed to handle cash. Only the remittance advices would be forwarded to the bookkeeper to credit customer accounts. Removing cash handling from the bookkeeper and keeping the accounts away from the supervisor separates duties and strengthens internal control. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accounting for Uncollectible Receivables
Extending credit to customers bears some risk Risk: Some customers do not pay the amount owed Cost: Uncollectible accounts Extending credit to customers can have the benefit of increased sales. Customers who do not have cash immediately available can use credit. Unfortunately, some customers don’t pay their debts. Companies need to have a way to account for uncollectible accounts. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 3 Use the allowance method for uncollectible receivables Learning Objective 3 shows how to use the allowance method for uncollectible receivables. Copyright ©2008 Pearson Prentice Hall. All rights reserved 227

A contra-asset is always paired with an asset and reduces
Allowance Method Amount of uncollectible accounts is estimated An expense is recorded as part of the adjusting process A contra-asset is recorded that reduces accounts receivable on the balance sheet The best way to measure bad debts is by the allowance method. This method records collection losses based on estimates based upon the company’s collection experience. Companies don’t wait to see which customers will not pay. Instead, they record the estimated amount as Uncollectible-Account Expense and also sets up Allowance for Uncollectible Accounts. Other titles for this account are Allowance for Doubtful Accounts and Allowance for Bad Debts. This is a contra account to Accounts Receivable. The allowance shows the amount of the receivables the business expects not to collect. Previously, the Accumulated Depreciation account was explained. This contra-account shows the amount of a plant asset’s cost that has been expensed—the portion of the asset that’s no longer a benefit to the company. Allowance for Uncollectible Receivables serves a similar purpose for Accounts Receivable. The allowance shows how much of the receivable has been expensed. A contra-asset is always paired with an asset and reduces its balance Copyright ©2008 Pearson Prentice Hall. All rights reserved

Entry to Record Uncollectible accounts
JOURNAL Date Accounts Debit Credit Uncollectible accounts expense Allowance for uncollectible accounts Goes on the Income Statement The entry to record uncollectible accounts has a debit to “uncollectible accounts expense”, which will appear on the income statement. The credit is to “allowance for uncollectible accounts” which will appear on the balance sheet directly beneath the accounts receivable. It is subtracted from accounts receivable to show net receivables. Goes on the Balance Sheet netted with accounts receivable Copyright ©2008 Pearson Prentice Hall. All rights reserved

Balance Sheet Current assets: Accounts receivable $$,$$$ Less: Allowance for Uncollectible Accounts ( $,$$$) Accounts receivable, net OR On the Balance Sheet, accounts receivable appear in the current assets section, usually right after short-term investments. On a detailed balance sheet, accounts receivable is shown, as well as the allowance for uncollectible accounts. The allowance is subtracted to determine net accounts receivable. On a condensed balance sheet, just the net amount is shown. Accounts receivable, net $$,$$$ Copyright ©2008 Pearson Prentice Hall. All rights reserved

Methods to Estimate Uncollectibles
Percent-of-sales Expense is estimated based on credit sales Income Statement approach Aging-of-receivables Accounts receivable analyzed based on how long outstanding Balance Sheet approach The best way to estimate uncollectibles uses the company’s history of collections from customers. There are two basic ways to estimate uncollectibles: (1) Percent-of-sales-method (2) Aging-of-receivables method. The percent-of-sales method computes uncollectible-account expense as a percent of revenue. This method takes an income statement approach because it focuses on the amount of expense to be reported on the income statement. The other popular method for estimating uncollectibles is called aging-of-receivable. This method is a balance-sheet approach because it focuses on accounts receivable. In the aging method, individual receivables from specific customers are analyzed based on how long they have been outstanding. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Age of Accounts Days Days Days Over 90 Days $ ,000 $ ,000 $ ,000 $ ,000 0.5% 1% 60% 40% $ $ $ ,000 $ ,000 Exercise 5-23 shows the aging of accounts. $37,150 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Adjustment needed = Aging schedule - Balance
$37,150 Balance in Allowance $7,400 Adjustment needed JOURNAL Date Accounts Debit Credit 12-31 Uncollectible accounts expense _______ Allowance for uncollectible accounts ______ Exercise 5-23 shows the journal entry for uncollectible accounts. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Allowance for Uncollectible Accounts
Balance before adjustment $7,400 Adjusting entry $29,750 Balance per aging schedule $37,150 Exercise 5-23 shows the T-account that displays the allowance for uncollectible account entries. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Uncollectible Accounts Methods
Percent-of-Sales Aging-of-Receivables Adjust Allowance for Uncollectible Accounts Adjust Allowance for Uncollectible Accounts BY TO Comparing the two methods will help highlight their differences. The percent-of-sales method computes uncollectible accounts expense without regard to the balance in the allowance for uncollectible accounts. The aging method, on the other hand, focuses on the amount of receivables that are not likely to be collected. Then, adjusts the allowance to equal that amount. The Amount of UNCOLLECTIBLE ACCOUNT EXPENSE The Amount of UNCOLLECTIBLE ACCOUNTS RECEIVABLE Copyright ©2008 Pearson Prentice Hall. All rights reserved

Writing Off a Specific Account
The allowance is used to absorb specific accounts that are determined to uncollectible When it’s determined a customer cannot pay, the following entry is made: JOURNAL Date Accounts Debit Credit Allowance for uncollectible accounts $$$$ Accounts receivable When management decides that a specific accounts receivable is uncollectible, the account is “written off”. The purpose of the Allowance for Uncollectible Accounts is to absorb these write offs. The Allowance is adjusted at the end of one year, so it can be used the following year for actual accounts receivable that are uncollectible. The entry to record the write off has a debit to the Allowance and a credit to the customer’s accounts receivable. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Direct Write-Off Method
Less preferable than allowance method Does not match expenses with revenues Accounts Receivable overstated Uncollectible Accounts Expense used for write offs No Allowance for Uncollectible Accounts There is another, less preferable, way to account for uncollectible receivables. Under the direct write-off method, the company waits until a specific customer’s receivable proves uncollectible. Then the accountant writes off the customer’s account and records Uncollectible-Account Expense. The direct write-off method uses no allowance for uncollectibles. As a result, receivables are always reported at their full amount, which is more than the business expects to collect. Assets on the balance sheet are overstated. Also, The direct write-off method causes a poor matching of uncollectible-account expense against revenue. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accounts Receivable Sales on account Payments on account Uncollectible accounts written off Activity in accounts receivable during the year is illustrated in this t-account. Sales on account increase the account and customer payments on account decrease it. When a specific account is determined to be uncollectible, accounts receivable is decreased. Copyright ©2008 Pearson Prentice Hall. All rights reserved

What is the normal balance of the Allowance?
Allowance for Uncollectible Accounts Uncollectible accounts written off Uncollectible account adjustment What is the normal balance of the Allowance? The allowance for uncollectible accounts has a normal credit balance. It is increased with the entry to record uncollectible accounts expense and decreased when specific accounts are written off. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 4 Account for notes receivable
Learning Objective 4 shows how to account for notes receivable. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Notes Receivable Terms
Creditor Debtor Interest Maturity Date Maturity Value Principal Term Party to whom money is owed; lender Party that owes money; borrower Cost of borrowing money; percent Date debtor must pay the note Sum of principal and interest on note Notes Receivable terminology includes: Creditor: The party to whom money is owed. The creditor is also referred to as the lender. Debtor: The party that borrowed and owes money on the note. The debtor is also called the maker of the note or the borrower. Interest: Interest is the cost of borrowing money. The interest is started in an annual percentage rate. Maturity date: The date on which the debtor must pay the note. Maturity value: The sum of principal and interest of the note. Principal: The amount of money borrowed by the debtor. Term: The length of time for which the note was signed by the debtor Amount borrowed by debtor Length of time money is borrowed Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accounting for Notes Receivable
To record the receipt of a note receivable, the following entry is made: JOURNAL Date Accounts Debit Credit Notes Receivable $$,$$$ Cash When a company issues a note receivable, the account is debited and cash is credited. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Interest needs to be accrued on any note receivable outstanding at year end: JOURNAL Date Accounts Debit Credit Interest receivable $$,$$$ Interest revenue If there are notes receivable outstanding at year-end, an adjusting entry is made to record the interest accrued on the note. Interest receivable (current asset) is debited and interest revenue is credited. The amount of interest is computed by multiplying the principal by the interest rate by the time the note has been outstanding. The days are counted from the date the note was issued until the end of the year. Time = date note is signed to end-of-year Interest is computed by the formula: Principal x rate x time Copyright ©2008 Pearson Prentice Hall. All rights reserved

When payment is received on note, the following entry is made JOURNAL Date Accounts Debit Credit Cash Notes Receivable Interest receivable Interest revenue For maturity value For principal When payment is received on the note, cash is debited for the maturity value – principal plus interest. Notes receivable is credited for the principal – the same amount that was debited in the original entry. Interest receivable is credited for the amount it was debited for in the adjusting entry. Interest revenue is computed from the beginning of the year to the date of payment. Zeroes out adjustment For remaining interest earned Copyright ©2008 Pearson Prentice Hall. All rights reserved

Credit and Bank Card Sales
Credit Cards American Express and Discover Bank Cards VISA and MasterCard Both charge the retailer a fee The merchant sells merchandise and lets the customer pay with a credit card, such as Discover or American Express, or with a bankcard, such as VISA or MasterCard. This strategy may dramatically increase sales, but the added revenue comes at a cost. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 5 Use two new ratios to evaluate a business
Learning Objective 5 shows how to use two new ratios to evaluate a business. Use two new ratios to evaluate a business Copyright ©2008 Pearson Prentice Hall. All rights reserved

Days’ Sales in Receivables
How long it takes a company to collect its average amount of receivable Compute one day’s sales Days’ sales in receivables Net Sales 365 Days After a business makes a credit sale, the next step is collecting the receivable. Days’ sales in receivables, also called the collection period, tells a company how long it takes to collect its average level of receivables. Shorter is better because cash is coming in quickly. The longer the collection period, the less cash is available to pay bills and expand. Days’ sales in receivables can be computed in 2 logical steps. First, compute one day’s sales (or total revenues). Then divide one day’s sales into average receivables for the period. Average receivables One Day’s Sales Copyright ©2008 Pearson Prentice Hall. All rights reserved

Acid-Test Ratio Also called quick ratio A more stringent measure of a company’s ability to pay its current liabilities Cash + Short-term investments + net receivables Total current liabilities Managers, stockholders and creditors care about the liquidity of a company’s assets. The current ratio measures ability to pay current liabilities with current assets. A more stringent measure of ability to pay current liabilities is the acid-test or quick ratio. This ratio eliminates the less liquid current assets from the numerator – inventory and prepaid expenses. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accounting for Inventory
Chapter 6 Chapter 6 reviews accounting for inventory. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Inventory Items held by the company for re-sale Current asset on the Balance Sheet Items sold shifted to Cost of Goods Sold Expense on the Income Statement Sales revenue based on retail price of inventory Cost of Goods Sold based on cost of inventory Companies that sell products have inventory. They purchase items and then re-sell them. Inventory is a current asset on the balance sheet. When items are sold, the cost of the items is transferred to an expense account called “Cost of Good Sold”, which is often abbreviated COGS. It’s important to keep in mind that to make a profit, companies must sell inventory for a price higher than its cost. Revenue is based on the selling or retail price of the inventory. Cost of goods sold is the cost of the inventory items to the company that is selling them. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Gross Profit Sales Revenue minus Cost of Goods Sold Also called Gross Margin Represents markup on products “Gross” because expenses have not been deducted Gross profit is an important measure for a company. Another term for gross profit is gross margin .It is computed by subtracting cost of goods sold from sales. It represents the mark up on goods. It is called “gross” profit because the company has yet to deduct all its expenses. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Two Systems Periodic Count items to determine quantity on hand Used for inexpensive items Used by small businesses Low cost Perpetual Running record of inventory kept by computer program Used by large businesses Scanners and bar codes used to record transactions Companies can chose from two systems to account for inventory. Companies that use periodic inventory tend to be smaller businesses that sell inexpensive items. This system requires that inventory items are counted to determine the amount on hand. Periodic is a low cost method of keeping track of inventory. With the advent of scanners, bar codes and computerized registers, more and more companies use perpetual inventory systems. With this system, inventory is updated for every transaction that impacts it – sales, purchases, returns. Most large retailers use perpetual inventory. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Net cost of purchases Purchase price + Freight-in Transportation costs Unsuitable goods returned to seller - Purchase returns Reduction in amount owed - Purchase allowances The cost of purchasing inventory consists of several items – all of which need to be included in the cost of inventory. Freight-in is added to the purchase price of the items. Freight-in is the shipping costs the company paid to get the items sent. Purchase returns and allowances are subtracted. Both involve reductions to the customers’ balances. Purchase returns occur when customers return unwanted goods. With purchase allowances, the goods aren’t physically returned, but the company reduces the amount owed. Purchases discounts are when the company offers a discount if the customer pays the bill within a certain number of days. Purchase Discounts For early payment = Net cost of purchases Copyright ©2008 Pearson Prentice Hall. All rights reserved

Discount terms Companies offer incentive for early payment 2/10, n/30 2% discount if bill paid in ten days Full amount due in 30 days Purchase discounts Company receives discount if it makes payment early Reduces cost of inventory Sales discounts Company offers discount to customers for early payment Reduces cash received on accounts receivable A purchase discount is a decrease in the buyer’s cost of inventory earned by paying quickly. Many companies offer payment terms of “2/10 n/30.” This means the buyer can take a 2% discount for payment within 10 days, with the final amount due within 30 days. Another common credit term is “net 30,” which tells the customer to pay the full amount within 30 days. When the company offers discounts to its customers, it is called a “sales discount”. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Perpetual Entries To record purchases of inventory on account JOURNAL Date Accounts Debit Credit Inventory Accounts payable When a company using the perpetual inventory purchases inventory the above entry is made. 5-257 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2009 Prentice Hall

Perpetual Entries To record sale of inventory on account Two entries required JOURNAL Date Accounts Debit Credit Accounts receivable Sales Cost of goods sold Inventory Retail price A sale of inventory requires two entries. One to record the sale at retail price. If the customer is purchasing on account, accounts receivable is debited. The second entry has a debit to COGS, which goes to the income statement, and a credit to inventory, which reduces the asset account. This entry is done at the cost of the items. Cost Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2009 Prentice Hall

Net Sales Sales revenue Unsuitable goods returned to company - Sales returns Reduction in amount owed - Sales allowances Just as several amounts go into “net cost of purchases”, three items are deducted to determine “net sales”. Sales revenue is the amount earning by selling products to customers. If items are returned to the company by the customer, sales returns is debited. Sales allowances are similar to returns, except the items are physically returned. The company reduces the customer’s account receivable. Sales discounts are just like purchases discounts with the roles reversed. The company grants the customer a discount if payment is received within a specified number of days. For early payment Sales Discounts = Net Sales Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 2 Understand the various inventory methods
Learning Objective 2 discusses understanding the various inventory methods. Understand the various inventory methods Copyright ©2008 Pearson Prentice Hall. All rights reserved

Inventory Costing Methods
To determine the cost of inventory sold or on hand, the units are multiplied by the unit cost Inventory items are often purchased at different prices throughout the year Company selects a costing method to determine which unit cost to use While companies choose between two inventory systems – periodic and perpetual – they also select an inventory costing method. Inventory items are purchased several times throughout the year. More often than not, the cost of those items differ for each purchase. When computing the cost of goods sold or the dollar amount of ending inventory, a company must choose a cost-flow assumption to assign a dollar amount to the units. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Inventory Costing Methods
Specific-unit-cost Average cost First-in, first-out (FIFO) Last-in, first-out (LIFO) The four inventory costing methods are: specific-unit-cost; average cost; first-in, first-out (FIFO); and last-in, last-out (LIFO). Copyright ©2008 Pearson Prentice Hall. All rights reserved

Specific-unit-cost Each item in inventory can be separately identified Used for unique items Cars, fine jewelry Too expensive for homogeneous items Some businesses deal in unique inventory items, such as automobiles, antique furniture, jewels, and real estate. These businesses cost their inventories at the specific cost of the particular unit. The specific-unit-cost method is also called the specific identification method. This method is too expensive to use for inventory items that have common characteristics, such as bushels of wheat, gallons of paint, or auto tires. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Average-cost An average of inventory costs Cost of goods available = Average cost per unit Number of units available Average cost per unit x units sold = Cost of goods sold The average-cost method, as its name implies, averages the cost of inventory items purchased during the year. The cost of goods available is divided by the units available to determine an average cost per unit. The cost of goods available is the dollar amount of beginning inventory plus the net cost of purchases. This average cost per unit is multiplied by either the units sold to determine cost of goods sold, or by the units on hand to determine the amount of ending inventory. Average cost per unit x units on hand = Ending inventory Copyright ©2008 Pearson Prentice Hall. All rights reserved

FIFO Oldest items assumed to be sold first Ending inventory will consist of most recent items purchased FIFO assumes that the company sells the oldest items in inventory first. Therefore, the ending inventory will be made up of the most recent purchases. Copyright ©2008 Pearson Prentice Hall. All rights reserved

LIFO Newest items are assumed to be sold first Ending inventory consists of oldest items in inventory LIFO is the opposite of FIFO. The company assumes that the most recent items purchased are the first to be sold. Therefore, the ending inventory consists of the oldest inventory items. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Subtract units in ending inventory from units available
Cost Beginning inventory 5 $160 $800 Oct. 15 Purchase 11 $170 $1,870 Oct. 26 Purchase $180 $900 Units available 21 $3,570 Ending inventory 8 units Units sold ______ Subtract units in ending inventory from units available E6-15 demonstrates accounting for inventory. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Specific Unit Cost Ending inventory = $160 = $480 $1,380 $180 = $900 Cost of goods sold = Here we determine the specific unit cost. $2,190 $160 = $ 320 $170 = $1,870 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Average Cost Cost of goods available = Average cost per unit Number of units available $3570 = $170 21 Average cost per unit x units sold = Cost of goods sold Now, we determine the average cost. $170 x 13 units = $2,210 Average cost per unit x units on hand = Ending inventory $170 x 8 units = $1,360 Copyright ©2008 Pearson Prentice Hall. All rights reserved

What is the price of the oldest items?
FIFO Ending inventory = Highest ending inventory Newest items $180 = $900 $1,440 $170 = $540 What is the price of the oldest items? Cost of goods sold = This slide shows how to use the FIFO method. $2,160 Oldest items $____ = $_____ $170 = $1,360 Copyright ©2008 Pearson Prentice Hall. All rights reserved

LIFO Ending inventory = Oldest items $160 = $800 $1,310 $170 = $510 Cost of goods sold = This slide shows how to use the LIFO method. Highest Cost of goods Sold $2,260 Newest items $180 = $ 900 $170 = $1,360 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Increasing Costs Cost of goods sold FIFO lowest LIFO highest
Based on older costs LIFO highest Based on recent costs Ending inventory FIFO highest Based on recent costs LIFO lowest Based on older costs In periods of inflation, FIFO will result in the lowest cost of goods sold (and thus higher net income) and the highest balance in inventory on the balance sheet. Since FIFO assumes the oldest items are sold first, these items would based on the older, lower cost items and ending inventory would be the newer, more expensive items. Conversely, LIFO will result in the highest cost of goods sold (and thus lower net income) and the lowest balance in inventory on the balance sheet. If prices are decreasing, the opposite would be true. LIFO would have the highest ending inventory and lowest cost of goods sold. Opposite relationships exist when costs are decreasing Copyright ©2008 Pearson Prentice Hall. All rights reserved

Tax Advantage of LIFO Assuming inventory costs are increasing
LIFO results in higher COGS Higher COGS results in lower net income Why would a company choose LIFO if it results in lower net income and lower asset value on the balance sheet? To pay less income taxes. Assuming increasing prices, LIFO results in higher COGS. Higher COGS results in lower net income. Less income means less taxes. This can result in greater cash flow for the company. Lower net income results in lower taxes Lower taxes results in greater cash flow Copyright ©2008 Pearson Prentice Hall. All rights reserved

Comparison of Inventory Methods
FIFO Balance sheet More recent costs Income Statement Does not match current costs with revenue LIFO Balance Sheet Old, outdated costs Income Statement Matches current costs with revenue When comparing FIFO and LIFO, both have strengths and weaknesses. FIFO gives a more accurate balance sheet number as inventory is made up the most recent costs. However, it matches old inventory costs with current revenues. LIFO results in a less accurate balance sheet number. However, on the income statement, the COGS amount is good match with the revenue. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accounting Principles Related to Inventory
Consistency Companies should use same inventory method from period to period Disclosure Companies should disclosed inventory method used Conservatism Companies should “write down” inventory if market price falls below cost The consistency principle states that businesses should use the same accounting methods and procedures from period to period. Consistency enables investors to compare a company’s financial statements from one period to the next. The consistency principle does not mean that a company is not permitted to change its accounting methods. However, a company making an accounting change must disclose the effect of the change on net income. The disclosure principle holds that a company’s financial statements should report enough information for outsiders to make informed decisions about the company. The company should report relevant, reliable, and comparable information about itself. That means disclosing inventory accounting methods. Without knowledge of the accounting method, a financial statement use could make an unwise decision. Conservatism in accounting means reporting financial statement amounts that paint the gloomiest immediate picture of the company. What advantage does conservatism give a business? Many accountants regard conservatism as a brake on management’s optimistic tendencies. The goal is to present reliable data. Conservatism appears in accounting guidelines such as “anticipate no gains, but provide for all probable losses” and “if in doubt, record an asset at the lowest reasonable amount and report a liability at the highest reasonable amount.” Conservatism directs accountants to decrease the accounting value of an asset if it appears unrealistically high. For inventory, conservatism comes into play with the principle that requires a company to “write down” inventory if its market value falls below cost. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Lower-of-Cost-or-Market (LCM)
Inventory should be reported at whichever is lower – cost or market Market = current replacement cost If cost is lower, no adjustment needed If market is lower, Inventory is decreased to market value Cost of goods sold is increased The lower-of-cost-or-market rule (abbreviated as LCM) is based on accounting conservatism. LCM requires that inventory be reported in the financial statements at whichever is lower—its historical cost or its market value. Applied to inventories, market value generally means current replacement cost (that is, how much the business would have to pay now to replace its inventory). If the replacement cost of inventory falls below its historical cost, the business must write down the value of its goods to market value. The business reports ending inventory at its LCM value on the balance sheet. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 3 Learning Objective 3 shows how to use gross profit percentage and inventory turnover to evaluate operations. Use gross profit percentage and inventory turnover to evaluate operations 5-277 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2009 Prentice Hall 277

Gross Profit Percentage
Key indicator of ability to sell inventory at a profit Sales – Cost of Goods Sold = Gross profit Gross profit = Gross profit percentage Gross profit—sales minus cost of goods sold—is a key indicator of a company’s ability to sell inventory at a profit. Merchandisers strive to increase gross profit percentage, also called the gross margin percentage. Gross profit percentage is markup stated as a percentage of sales Net Sales Revenue Copyright ©2008 Pearson Prentice Hall. All rights reserved

Inventory Turnover How many times a company sells its average level of inventory Compute average inventory Inventory turnover Beginning inventory + Ending inventory 2 A company strives to sell its inventory as quickly as possible because the goods generate no profit until they’re sold. The faster the sales, the higher the income. Inventory turnover, the ratio of cost of goods sold to average inventory, indicates how rapidly inventory is sold. Cost of goods sold Average inventory Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 4 Estimate inventory by the gross profit method
Learning Objective 4 estimates inventory by the gross profit method. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Estimating Inventory by the Gross Profit Method
Cost of goods sold computation - periodic Gross profit method Beginning Inventory + Purchases = Goods available - Ending inventory = Cost of Goods sold Beginning Inventory + Purchases = Goods available - Cost of Goods sold = Ending inventory Often a business must estimate the value of its goods. A fire may destroy inventory, and the insurance company requires an estimate of the loss. In this case, the business must estimate the cost of ending inventory because it was destroyed. The gross profit method, also known as the gross margin method, is widely used to estimate ending inventory. This method uses the familiar cost-of-goods-sold model. However, instead of deducting ending inventory from goods available to determine COGS, cost of goods sold is deducted to estimate ending inventory. An estimate of COGS is computed by multiplying net sales by the cost ratio. The cost ratio is one minus the gross profit percentage. Net sales x (1 – GP%) Copyright ©2008 Pearson Prentice Hall. All rights reserved

Multiply Sales by cost ratio
Beginning inventory $ ,000 Net purchases $ ,000 Goods available $ ,000 Sales $ 200,000 x Cost ratio _____% = Estimated COGS $ __________ Estimated ending inventory $ ,000 Cost ratio = 100% - GP% Exercise E6-26 shows how we determine estimated ending inventory. Multiply Sales by cost ratio Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 5 Learning Objective 5 shows how inventory errors affect the financial statements. Show how inventory errors affect the financial statements Copyright ©2008 Pearson Prentice Hall. All rights reserved

Effects of Inventory Errors
Error in ending inventory impacts two periods First period Cost of goods sold Gross Profit & Net Income Second period Beginning inventory Costs of Goods sold Inverse with error Direct with error An error in ending inventory impacts two periods. In the period of the error, COGS is impacted (remember ending inventory is deducted from goods available to compute Cost of Goods Sold). Since ending inventory is subtracted, the relationship is inverse, that is if ending inventory is understated, COGS will be overstated. The error in gross profit and net income will be the “same way” as the inventory error. So if ending inventory is understated, so will Gross Profit and Net Income. Ending inventory of one period becomes the beginning inventory of the next. Since beginning inventory increases COGS, there is a direct relationship between the inventory error and COGS. Since COGS is subtracted from Net Sales to determine Gross Profit, there is an inverse relationship between the error and Gross Profit and Net Income. Direct with error Direct with error Inverse with error Copyright ©2008 Pearson Prentice Hall. All rights reserved

Effects of Inventory Errors
Period 1 Period 2 Inventory error COGS GP & Net Inc Ending inventory overstated U O Ending inventory understated The table above summarizes the impact of inventory errors (both under and overstated). O = Overstated U = Understated Copyright ©2008 Pearson Prentice Hall. All rights reserved

Plant Assets and Intangibles
Chapter 7 Chapter 7 addresses Plant Assets and Intangibles. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Categories of Long-Lived Assets
Plant assets Tangible Include land, buildings and equipment Intangible assets Carry special rights without physical substance Include patents, copyrights and trademarks Long-lived assets are placed into two categories: plant assets and intangible assets. So far, we have focused on current assets–assets that are converted to cash or used within one year. Long-lived assets are expected to be used for more than one year. Some plant assets, like buildings can last over 50 years. Plant asset are tangible; you can touch them. Common plant assets are land, buildings, equipment, furniture, and vehicles. Intangible assets represent special rights or legal benefits. They do not have physical substance; you can’t touch them. Common intangibles are patents, copyrights and trademarks. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Plant Asset Terminology
Asset Accounts Related Expense Account (Balance Sheet) (Income Statement) Plant Assets Land None Buildings & Equipment Depreciation Furniture & Fixtures Land Improvements Natural Resources Depletion Intangibles Amortization This table shows common accounts within plant assets. The assets appear on the balance sheet, usually in their own section. Natural resources are categorized within plant assets. All plant assets, except land, are depreciated. This results in an expense on the income statements. Intangible assets are amortized, and this expense also appears on the income statement. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 1 Determine the cost of a plant asset
Learning Objective 1 shows us how to determine the cost of a plant asset. Copyright ©2008 Pearson Prentice Hall. All rights reserved

renovation for intended use Insurance in transit, sales
Cost of a Plant Asset Sum of all the costs incurred to bring the asset to its intended use Land Purchase price, commissions, survey & legal costs, removal of old buildings Land Improvements Fencing, paving, security systems, lighting The cost of a plant asset includes more than its purchase price. All necessary costs to get the asset ready for use become part of its cost. For land, this includes commissions to real estate agents, surveying and legal costs. In addition, removal of old buildings (razing) and clearing the land are included. Land improvements are items placed on the land. Land improvements include fencing, paving, driveways, security systems and outdoor lighting. The cost of buildings also includes real estate commissions (like land). Then, there are any taxes necessary to purchase the building, and any repairs or renovations made to get the building ready for its intended use. Machinery and equipment costs include any shipping and insurance while in transit, and any installation and test runs of the machinery. Sales tax is not an expense, but rather a cost of purchasing the machine. Buildings Purchase price, commissions, sales & other taxes, repairs & renovation for intended use Machinery & Equipment Purchase price, Insurance in transit, sales taxes, installation Copyright ©2008 Pearson Prentice Hall. All rights reserved

Lump-Sum Purchases Companies purchase several assets in a group for one price Cost is allocated to individual assets by on their market values Sometimes a company will purchase a group of plant asset for one set price. For example, land, a building and land improvements are all purchased together. For accounting purposes, the assets must be separated into the appropriate accounts. The purchase price is allocated based on the fair values of the individual assets. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 1 Learning Objective 1 addresses accounting for current and contingent liabilities. Account for current liabilities and contingent liabilities Copyright ©2008 Pearson Prentice Hall. All rights reserved

Categories of Current Liabilities
Known amounts Unknown amounts Current liabilities are obligations due with one year of balance sheet date Current liabilities are obligations due with one year of balance sheet date. They are placed into two categories: those with a known amount and those where the amount is unknown. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Current Liabilities of Known Amount
Accounts Payable Amounts owed for products and services purchased on account Short-Term Notes Payable Common form of financing; company incurs interest expense Accrued Liabilities Expense incurred, but not yet paid; often an adjusting entry includes salaries & interest payable Sales Tax Payable Tax levied by state on retail sales; company collects from customer and remits to gov’t Amounts owed for products or services purchased on account are accounts payable. Short-term notes payable, a common form of financing, are notes payable due within 1 year. The company will pay interest on a note payable. Sales taxes are levied in many states on retail sales. The retailer collects the sales tax from the customer and then remits it to the government agency. Accrued liabilities are expenses that have been incurred, but not yet paid. They are often recorded through the adjusting process. Some common accrued liabilities are salaries payable, interest payable and taxes payable. Any company that has employees will have payroll liabilities. Compensation to employees are recorded at the end of each pay period. In addition, the company withholds income and FICA (Social Security) taxes form the employees’ pay. Unearned revenues occur when the customer pays before receiving a good or service. The company owes the customer the product or service. Payroll Liabilities Salaries & wages paid to employees; also includes income taxes and FICA taxes withheld Unearned revenues Customers makes payment before receiving product or service Copyright ©2008 Pearson Prentice Hall. All rights reserved

Entries for Short-Term Notes Payable
Suppose a company purchases inventory by signing a $10,000, 12% 90-day note payable on December 1 Date Accounts Debit Credit 1-Dec Inventory $10,000 Notes Payable, Short-Term Purchased inventory by issuing a $10,000, 12%, 90-day note payable 31-Dec Interest Expense $100 Interest Payable Accrual of interest at year-end (10,000 x 12% x 30/360) Entries for short-term notes payable transactions can be illustrated by an example. Suppose a company purchases inventory by signing a $10,000, 12%, 90-day note payable. On the date of the purchase, inventory would be debited and short-term notes payable would be credited for the $10,000. Assuming a December 31 year end, an adjusting entry would be needed to accrue the interest expense on the note. The interest formula multiplies the principal of the note ($10,000) by the interest rate of 12% by the days the note has been outstanding. December 1 to December 31 is 30 days. Interest rates are expressed annually. So the fraction used is 30 over Interest expense is recorded as is interest payable. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Entries for Short-Term Notes Payable
The maturity date of the note would be March 1 of the following year 1-Mar Notes Payable, Short-Term $10,000 Interest Payable ________ Interest Expense $200 Cash $10,300 Payment of the note and interest at maturity What amount would “zero it out” ? The maturity date would fall on March 1 of the following year. On this date, the company would be the $10,000 plus the interest for the 90 days. Notes payable is debited for the $10,000 and interest payable is debited for the $100. This will “zero out” the amount from the December 31 accrual. Interest expense is recognized for the remaining 60 days the note was outstanding (Jan 1 – March 1). Cash is credited for the full maturity value. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Recording Payroll Each pay period salary expense and withholdings are recorded Salary Expense $$$$ Employee Income Tax Payable FICA Tax Payable Salary Payable Gross Pay Each pay period, an entry is made to record payroll. Salary expense is debited for the gross pay of the employees. This is the amount they earned before any deductions. Employee income tax payable is credited for any federal and state income taxes withheld from wages. At regular intervals, the company deposits these tax withholdings at a financial institution, which in turn, remits the taxes to the appropriate government body. FICA Taxes work in a similar manner. FICA refers to Social Security and Medicare taxes. Salaries Payable is credited for net pay – the gross pay less the withholdings. This is also called “take-home” pay. Net Pay Copyright ©2008 Pearson Prentice Hall. All rights reserved

Current Portion of Long-Term Debt
Some long-term debt is paid in installments Any amount due in the upcoming year is reclassified as a current liability Long-term debt are liabilities that have due dates more than one year from balance sheet date. Some long-term debt is due in installments. Any portion that is due in the upcoming year must be reclassified as a current liability. That means the amount is transferred from the long-term liability section to the current liability section. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Current Liabilities That Are Estimated (Amounts Unknown)
Estimated Warranty Payable Contingent Liabilities The second category of current liabilities are those with amounts unknown, which must be estimated. These include estimated warranty liability and contingent liabilities. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Estimated Warranty Payable
Companies guarantee products through warranty agreements Warranty expense is estimated in same period as sale of product Matching principle JOURNAL Date Accounts Debit Credit Warranty Expense $$$$ Estimated Warranty Payable When customers purchase products. often they are covered by a warranty. This creates a liability for the company. Instead of waiting until products are brought in for warranty work, the liability is estimated in the year of the sale. This provides proper matching of the expense to the revenue. The entry to estimate the warranty liability is above. When products are brought in for warranty work, the liability is reduced. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Contingent Liabilities
Potential liability that depends on a future event arising out of past events Likelihood of future event is assessed as: Probable Reasonably possible Unlikely A contingent liability is not an actual liability. Instead, it’s a potential liability that depends on a future event arising out of past events. Management must assess the likelihood of the future event occurring and categorize it as: probable, reasonably possible or unlikely. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accounting for Contingent Liabilities
Likelihood Accounting Probable Record liability if amount can be estimated Reasonably Possible Include in notes to financial statements Unlikely Do not report The Financial Accounting Standards Board (FASB) provides these guidelines to account for contingent liabilities: 1. Record an actual liability if it’s probable that the loss (or expense) will occur and the amount can be reasonably estimated. Warranty expense is an example. 2. Report the contingency in a financial statement note if it’s reasonably possible that a loss (or expense) will occur. Lawsuits in progress are a prime example. 3. There is no need to report a contingent loss that is unlikely to occur. Instead, wait until an actual transaction clears up the situation. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Long-Term Liabilities: Bonds
To raise capital, companies sell bonds to the public Bonds payable are groups of notes payable issued to multiple lenders, called bondholders Large companies cannot borrow billions from a single lender. So how do large corporations borrow huge amounts? They issue (sell) bonds to the public. Bonds payable are groups of notes payable issued to multiple lenders, called bondholders. A company that needs large amounts of capital borrow large amounts by issuing bonds to thousands of individual investors, who each lend the company a modest amount. The company receives the cash it needs, and each investor limits risk by diversifying investments—not putting all the “eggs in one basket.” Each bond payable is, in effect, a note payable. Bonds payable are debts of the issuing company Copyright ©2008 Pearson Prentice Hall. All rights reserved

Bond Terms Principal Maturity Date Interest Underwriter
Amount borrowed; usually in $1000 units Also called face value, or par value Date bond is due; 5, 10 or 20 year terms are common Maturity Date Company must pay bondholders interest in regular intervals over the term of the bond Interest Purchasers of bonds receive a bond certificate, which carries the issuing company’s name. The certificate also states the principal, which is typically stated in units of $1,000; principal is also called the bond face value, maturity value, or par value. The bond obligates the issuing company to pay the debt at a specific future time called the maturity date. Interest is the rental fee on borrowed money. The bond certificate states the interest rate that the issuer will pay the holder and the dates that the interest payments are due (generally twice a year). Issuing bonds usually requires the services of a securities firm, such as Merrill Lynch, to act as the underwriter of the bond issue. The underwriter purchases the bonds from the issuing company and resells them to its clients, or it may sell the bonds to its clients and earn a commission on the sale. A securities firm that purchases the bond issue and resells to clients Underwriter Copyright ©2008 Pearson Prentice Hall. All rights reserved

Types of Bonds Term bonds All bonds in an issue mature at one specific date Serial bonds Bonds in the issue mature installments Secured (mortgage) bonds Bondholders have right to company assets if interest and principal is not paid Unsecured (debenture) bonds Backed only by the good faith of the issuing company All the bonds in a particular issue may mature at a specified time (term bonds) or in installments over a period of time (serial bonds). Serial bonds are like installment notes payable. Some of Southwest Airlines long-term debts are serial in nature because they are payable in installments. Secured, or mortgage, bonds give the bondholder the right to take specified assets of the issuer if the company defaults—that is, fails to pay interest or principal. Unsecured bonds, called debentures, are backed only by the good faith of the borrower. Debentures carry a higher rate of interest than secured bonds because debentures are riskier investments. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Bond Premium and Discount
Issue price above face value Market rate of interest is greater than stated rate of interest Discount Issue price below face value Market rate of interest is less than stated rate of interest A bond issued at a price above its face (par) value is said to be issued at a premium. Premium on Bonds Payable has a credit balance and discount on Bonds Payable carries a debit balance. Bond Discount is, therefore, a contra liability account and a bond issued at a price below face (par) value has a discount. Bonds are always sold at their market price, which is the amount investors will pay for the bond. Two interest rates work to set the price of a bond. ■ The stated interest rate, also called the coupon rate, is the interest rate printed on the bond certificate. The stated interest rate determines the amount of cash interest the borrower pays—and the investor receives—each year. ■ The market interest rate, or effective interest rate, is the rate that investors demand for loaning their money. The market rate varies by the minute. A company may issue bonds with a stated interest rate that differs from the prevailing market interest rate. In fact, the 2 interest rates often differ. Market interest rate = rate investors demand for loaning money; changes frequently Stated interest rate = printed on the bond certificate; determines amount of cash interest; remains constant Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 2 Account for bonds payable
Now that bond terminology has been explained, Learning Objective 2 addresses how to account for bonds payable. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Issuing Bonds Payable at Face Value
Suppose a company issues $100,000 of 8% bonds payable that mature in ten years; the bonds pay interest semi-annually Date Accounts Debit Credit 1-Jan Cash $100,000 Bond payable Issued $100,000, 8%, 10-year bonds at face value 1-Jul Interest Expense _________ ______________ Paid semi-annual interest on bonds The most straightforward situation occurs when a company issues bonds at face value. Suppose a company issues $100,000 of 8% bonds payable that mature in ten years. Like most bonds, interest is paid semi-annually. On the date of issue, cash is received and the bonds are issued. Every six months, an interest payment is made to bondholders. Interest expense is debited and cash is credited for $ The $4000 was computed by multiplying the face value of $100,000 by the 8% interest by ½ for half of a year. Face value x interest rate x 1/2 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Issuing Bonds at a Discount
If stated interest rate of bonds is less than market interest rate, bondholders will not pay face value for bond Market price of bond drops below face value Cash received from bond issue is less than face value If the stated rate of interest is less than the current market rate, investors will not pay full face value for the bond. The price of bond drops below face value. The cash the company receives will be less than face value. This is called a discount. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Issuing Bonds at a Discount
Suppose a company issues $100,000 of 9%, five-year bonds when the market interest rate is 10% The market price of the bonds is $96,149 Date Accounts Debit Credit 1-Jan Cash $96,149 Discount on Bonds Payable $3,851 Bonds payable $100,000 Issued $100,000, 9%, 10-year bonds at a discount Market conditions may force a company to issue bonds at a discount. Suppose a company issued $100,000 of 9%, 5-year bonds when the market interest rate is 10%. Since the bonds pay less interest than the market demands, the price of the bonds drops to $96,149. The difference between the face value and price is debited to the discount account. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Carrying Amount: Bonds Issued at a Discount
Bonds are shown at their carrying amount on the balance sheet Carrying amount = Face value Less Discount Balance Balance Sheet January 1 Long-Term Liabilities: Bonds Payable $100,000 Less: Discount ($3,851) $96,149 Bonds are shown at their carrying amount on the balance sheet. For bonds issued at a discount, the carrying amount is the face value minus the balance in the bond discount. For the company on the previous slide, the balance sheet presentation for the bond is above. Bonds Payable are in the long-term liability section. The bond is listed at face and discount is shown as a reduction. The carrying amount is the difference. At the issue date, the carrying amount is the same as the price. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 3 Measure interest expense 5-314
Learning Objective 3 shows how to measure interest expense associated with bonds payable. Measure interest expense 5-314 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2009 Prentice Hall 314

Interest Expense on Bonds Issued at a Discount
The company must pay interest based on the face value even though it received less than face value Interest Expense > Cash Payment Interest Expense = Carrying Amount of Bond x Market Interest Rate Discount is amortized (reduced) over the bond term. Interest expense on a bond issued at a discount is greater than the cash interest payment. This is because the company pays interest based on the face value of the bonds ($100,000) but did not receive the full face value from the bondholders. To compute interest expense, the carrying amount of the bond is multiplied by the market rate of interest. Since most bonds pay interest semi-annually, the market rate is halved. The discount is also amortized, which means reduced. The amount of amortization is the difference between the interest expense and cash payment. Discount Amortization = Interest Expense - Cash Payment Copyright ©2008 Pearson Prentice Hall. All rights reserved

Recording Interest on Bonds Issued at a Discount
Referring to the previous example, interest expense on July 1 would be recorded as follows: Interest expense is debited for the carrying amount x market rate x 1/2 Cash is credited for the face value x stated rate x 1/2 Discount is credited for the difference between the expense and payment Date Accounts Debit Credit 1-July Interest Expense (96,149 x 5%) $4,807 Discount on Bonds Payable $307 Cash ($100,000 x____) _________ To pay semiannual interest and amortize bond discount For the company we have been looking at, interest expense for the first payment would be recorded as follows: Interest expense is debited for the carrying amount multiplied by the market rate cut in half. The carrying amount at this date is the same as the price—$96,149. The market rate is 10%, half of which is 5%. Cash is credited for the face value times the stated rate cut in half. The face value is $100,000 and stated rate is 9%, half of which is 4.5% Discount is credited for the difference between the interest expense and cash payment. This will reduce the discount. Stated rate x 1/2 Copyright ©2008 Pearson Prentice Hall. All rights reserved

Discount on Bonds Payable Issue Date, Jan. 1 1st Int. Pmt, July 1 $3,851 $307 Balance, July. 1 $3,544 Balance Sheet July 1 Long-Term Liabilities: Bonds Payable $100,000 Less: Discount ($3,544) $96,456 A T-account of the Discount shows the impact of the two entries. On the issue date, the account was increased by $3851–the difference between the price of the bond and the face value. With the first interest payment entry, the discount was amortized $307, resulting in a balance of $ The carrying amount of the bond is now $96,456. The face value has stayed the same (and will always), but the discount is now smaller. The result is a larger carrying amount. This process will continue with each interest payment. The discount will get smaller until it is zero at maturity. The carrying amount will grow larger until it reaches face value at maturity. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Issuing Bonds at a Premium
If stated interest rate of bonds is greater than market interest rate, bondholders will pay more than face value for bond Market price of bond increases above face value Cash received from bond issue is greater than face value If the stated rate of interest is greater than the current market rate, investors will pay full more than face value for the bond. The price of bond increases above face value. The cash the company receives will be greater than face value. This is called a premium. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Issuing Bonds at a Premium
Suppose a company issues $100,000 of 9%, five-year bonds when the market interest rate is 8% The market price of the bonds is $104,100 Date Accounts Debit Credit 1-Jan Cash $104,100 Premium on Bonds Payable _______ Bonds payable $100,000 Issued $100,000, 9%, 10-year bonds at a premium Market conditions may be such that the company can issue bonds at a premium. Suppose a company issued $100,000 of 9%, 5-year bonds when the market interest rate is 8%. Since the bonds pay more interest than the market demands, the price of the bonds increases to $104,100. The difference between the face value and price is credited to the premium account. Cash price – face value Copyright ©2008 Pearson Prentice Hall. All rights reserved

Carrying Amount: Bonds Issued at a Premium
Bonds are shown at their carrying amount on the balance sheet Carrying amount = Face value Plus Premium Balance Balance Sheet January 1 Long-Term Liabilities: Bonds Payable $100,000 Plus: Premium $ 4,100 $104,100 Bonds are shown at their carrying amount on the balance sheet. For bonds issued at a premium, the carrying amount is the face value plus the balance in the bond premium. For the company on the previous slide, the balance sheet presentation for the bond is above. Bonds Payable are in the long-term liability section. The bond is listed at face and premium is shown as an addition. The carrying amount is the sum. At issue date, the carrying amount is the same as the price. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Interest Expense on Bonds Issued at a Premium
The company pays interest based on only the face value even though it received more than face value. Interest Expense < Cash Payment Interest Expense = Carrying Amount of Bond x Market Interest Rate Interest expense on a bond issued at a premium is less than the cash interest payment. This is because the company pays interest based on the face value of the bonds ($100,000) but received more the full face value from the bondholders. To compute interest expense, the carrying amount of the bond is multiplied by the market rate of interest. Since most bonds pay interest semi-annually, the market rate is halved. The premium is also amortized, which means reduced. The amount of amortization is the difference between the interest expense and cash payment. Premium is amortized (reduced) over the bond term. Premium Amortization = Cash Payment – Interest Expense Copyright ©2008 Pearson Prentice Hall. All rights reserved

Recording Interest on Bonds Issued at a Premium
Referring to the previous example, interest expense on July 1 would be recorded as follows: Interest expense is debited for the carrying amount x market rate x 1/2 Cash is credited for the face value x stated rate x 1/2 Premium is debited for the difference between the expense and payment Date Accounts Debit Credit 1-July Interest Expense (104,100 x 4%) $4,164 Premium on Bonds Payable $336 Cash ($100,000 x 4.5%) $4,500 Issued $100,000, 9%, 10-year bonds at a discount For the company we have been looking at, interest expense for the first payment would be recorded as follows: Interest expense is debited for the carrying amount multiplied by the market rate cut in half. The carrying amount at this date is the same as the price - $96,149. The market rate is 8%, half of which is 4%. Cash is credited for the face value times the stated rate cut in half. The face value is $100,000 and stated rate is 9%, half of which is 4.5% Premium is debited for the difference between the interest expense and cash payment. This will reduce the premium. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Premium on Bonds Payable 1st Int. Pmt, July 1 Issue Date, Jan. 1 $336 $4,100 $3,764 Balance, July. 1 Balance Sheet July 1 Long-Term Liabilities: Bonds Payable $100,000 Plus: Premium $3,764 $103,764 A T-account of the Premium shows the impact of the two entries. On the issue date, the account was increased by $4100–the difference between the price of the bond and the face value. With the first interest payment entry, the premium was amortized $336, resulting in a balance of $ The carrying amount of the bond is now $103,764. The face value has stayed the same (and will always) but the premium is now smaller. The result is a smaller carrying amount. This process will continue with each interest payment. The premium will get smaller until it is zero at maturity. The carrying amount will grow smaller until it reaches face value at maturity. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Retiring Bonds Before Maturity
Interest rates may change causing companies to retire bonds early Borrowing rates may become less than interest rate on bonds Some bonds are callable Company can pay off bonds a specific price Normally, companies wait until maturity to pay off, or retire, their bonds payable. But companies sometimes retire bonds early. The main reason for retiring bonds early is to relieve the pressure of making high interest payments. Also, the company may be able to borrow at a lower interest rate. Some bonds are callable, which means that the issuer may call, or pay off, those bonds at a prearranged price (this is the call price) whenever the issuer chooses. The call price is often a percentage point or two above the par value, perhaps 101 or Callable bonds give the issuer the benefit of being able to pay off the bonds whenever it is most favorable to do so. The alternative to calling the bonds is to purchase them in the open market at their current market price. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Convertible bonds Bondholders may exchange bonds for company’s stock Offers investor: Assured receipt of interest and principal on bonds Opportunity for gains on stock Some corporate bonds may be converted into the issuing company’s common stock. These bonds are called convertible bonds (or convertible notes). For investors, these combine the safety of (a) assured receipt of interest and principal on the bonds with (b) the opportunity for gains on the stock. The conversion feature is so attractive that investors usually accept a lower interest rate than they would on nonconvertible bonds. The lower cash interest payments benefit the issuer. If the market price of the issuing company’s stock gets high enough, the bondholders will convert the bonds into stock. Investors will accept a lower interest rate on bonds because of the attractiveness of this feature. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 4 Learning Objective 4 helps us to understand the advantages and disadvantage of borrowing. Understand the advantages and disadvantages of borrowing Copyright ©2008 Pearson Prentice Hall. All rights reserved

Financing Operations with Bonds or Stock
When a company needs funds, they can raise money by: Issuing stock No liabilities or interest expense Less risky More costly Issuing bonds or notes Does not dilute control of company Results in higher earnings per share More debt increases risk Managers must decide how to get the money they need to pay for assets. Companies can raise capital by issuing stock or by issuing bonds (or notes) payable. Each strategy has its advantages and disadvantages. Issuing stock creates no liabilities or interest expense and is less risky to the issuing corporation. But issuing stock is more costly. Issuing bonds or notes payable does not dilute control of the corporation. It often results in higher earnings per share because the earnings on borrowed money usually exceed interest expense. But creating more debt increases the risk of the company. Earnings per share (EPS) is the amount of a company’s net income for each share of its stock. EPS is the single most important statistic for evaluating companies because EPS is a standard measure of operating performance that applies to companies of different sizes and from different industries. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Net income divided by shares of stock
Plan A—Borrow at 8% Net Income before expansion $500,000 Additional income 420,000 Less interest expense (500K x 8%) (40,000) 380,000 Less income tax expense (114,000) Expected additional income 266,000 Total company net income $766,000 Earnings per share $________ Example 8-31 illustrates the concept of choosing between stock or bonds to raise funds. Altman & Associates is considering 2 plans for raising $500,000 to expand operations. Plan A is to borrow at 8%, and plan B is to issue 100,000 shares of common stock. Before any new financing, Altman has net income of $500,000 and 100,000 shares of common stock outstanding. Assume you own most of Altman’s existing stock. Management believes the company can use the new funds to earn additional income of $420,000 before interest and taxes. Altman’s income tax rate is 30%. The information above shows how Plan A would impact the income statement. With bonds, the company would incur additional interest expense. The result, after taxes, is additional income of $266,000, bringing total net income of $766,000. To compute earnings per share, net income is divided by the 100,000 shares of stock. Net income divided by shares of stock Copyright ©2008 Pearson Prentice Hall. All rights reserved

Plan B—Issue Stock Net Income before expansion $ 500,000 Additional income 420,000 Less interest expense -- Less income tax expense (126,000) Expected additional income 294,000 Total company net income $ 794,000 Earnings per share: $ In Plan B, Example 8-31, there would be no interest expense and the additional income would amount to $294,000, bringing total net income to $794,000. But earnings per share is much lower in this plan. This is because the company issued 100,000 additional shares. So to compute EPS, the net income is divided by 200,000 shares. So Plan A results in the highest earnings per share and allows the company to retain control. However, Plan A has more risk because of the additional debt. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Times-Interest-Earned
Also called interest-coverage ratio Relates income to interest expense Operating income Interest expense We have just seen how borrowing can increase EPS. But too much debt can lead to bankruptcy if the business cannot pay liabilities as they come due. UAL Inc., the parent company of United Airlines, fell into the debit trap. The debt ratio measures the effect of debt on the company’s financial position but says nothing about the ability to pay interest expense. Analysts use a second ratio—the times-interest-earned ratio—to relate income to interest expense. To compute this ratio, we divide income from operations (also called operating income) by interest expense. This ratio measures the number of times that operating income can cover interest expense. The times-interest-earned ratio is also called the interest-coverage ratio. A high times-interest-earned ratio indicates ease in paying interest expense; a low value suggests difficulty. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Leases Lease–rental agreement in which the tenant (lessee) agrees to make rent payments to the property owner (lessor) Two categories: Operating Capital 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. Leasing allows the lessee to acquire the use of a needed asset without having to make the large up-front payment that purchase agreements require. Accountants distinguish between 2 types of leases: operating leases and capital leases. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Operating Leases Usually short-term or cancelable Lessor retains risks and rewards of owning asset Lessee records “rent expense” when payments are made Operating leases are often short-term or cancelable. They give the lessee the right to use the asset but provide no continuing rights to the asset. The lessor retains the usual risks and rewards of owning the leased asset. To account for an operating lease, the lessee debits Rent Expense (or Lease Expense) and credits Cash for the amount of the lease payment. Operating leases require the lessee to make rent payments, so an operating lease creates a liability even though that liability does not appear on the lessee’s balance sheet. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Capital Leases Long-term noncancelable debt Four criteria Title transfers to lessee at end of lease Lease contains a bargain purchase option Lease term is 75% or more of asset’s life Present value of lease payments is 90% or more than fair value of leased asset Capital leases. Most businesses use capital leasing to finance the acquisition of some assets. A Capital lease is a long-term noncancelable debt. How do we distinguish a capital lease from an operating lease? FASB Statement No. 13 provides the guidelines. To be classified as a capital lease, the lease must meet any 1 of the following criteria: 1. The lease transfers title of the leased asset to the lessee at the end of the lease term. Thus, the lessee becomes the legal owner of the leased asset. 2. The lease contains a bargain purchase option. The lessee can be expected to purchase the leased asset and become its legal owner. 3. The lease term is 75% or more of the estimated useful life of the leased asset. The lessee uses up most of the leased asset’s service potential. 4. The present value of the lease payments is 90% or more of the market value of the leased asset. In effect, the lease payments are the same as installment payments for the leased asset. Accounting for a capital lease is much like accounting for the purchase of an asset. The lessee enters the asset into the lessee’s accounts and records a lease liability at the beginning of the lease term. Thus, the lessee capitalizes the asset even though the lessee may never take legal title to the asset. Most companies lease some of their plant assets. If lease meets one of the above criteria, it is considered a capital lease Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 5 Report liabilities on the balance sheet
Learning Objective 5 addresses the reporting of liabilities on the balance sheet. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Liabilities on the Balance Sheet
Current liabilities are listed and include the current portion of long-term debt Long-term debt is often reported as one amount on the balance sheet A disclosure note provides the detail of long-term debt On the balance sheet, liabilities are categorized as current or long-term. Current liabilities are listed individually and include any current portion of long-term debt. Long-term debt is often just reported as one lump sum. To find the details, one would look to the disclosures notes. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Long-Term Liabilities on the Cash Flow Statement
Issuing bonds and long-term borrowing are reported as financing inflows Payments of bond and loan principal are reported as financing inflows Interest expense is reported in the operating section On the Cash Flow Statement, long-term debt is categorized as financing activity. Receiving the proceeds from bond issue or notes payable provides an inflow of cash. Payment of bonds at maturity and note principal is an outflow. Interest expense paid on bonds and notes is in the operating section. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Capital Expenditure vs. Immediate Expense
Increase capacity or extend life Examples: Major overhaul Building additions Immediate Expense Maintain or restore to working order Examples: Minor repairs Painting After a company has purchased a plant asset, it will incur other costs related to it. The company must decide if the cost is a capital expenditure that becomes part of the cost of the asset, or if it is an expense. If the cost increases the capacity or extends the life of the asset, it should be capitalized. If the cost is just to maintain normal working order of the asset, it should be expensed. Practically speaking, companies often set a dollar amount, say $1000, to help make this decision. If it is under the dollar amount, the item is expensed. If it is above, it is capitalized. NOTE: Most companies set a dollar amount to decide if an expenditure should be capitalized or expensed Copyright ©2008 Pearson Prentice Hall. All rights reserved

Measuring Depreciation on Plant Assets
Plant assets wear out or grow obsolete over time The cost of a plant asset is allocated to an expense over its life Matches expense of using the asset to the revenues the asset helped produce Land has an unlimited life and is the only plant asset not depreciation Plant assets (except land) wear out over time or become obsolete. Because of this, companies allocate the cost of the plant asset to expense over its useful life. The matching principle is demonstrated with this process. The expense of using the asset is matched to the revenues it helps produce. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Depreciation Depreciation is NOT: a process of valuation based on market value decline a method of setting aside cash to replace assets It’s important to remember that depreciation is not a process of valuation. It does not correspond to the decrease in market value that occurs. It also does not set aside funds to purchase new plant assets. Copyright ©2008 Pearson Prentice Hall. All rights reserved

How to Measure Depreciation
Three items needed Cost of the plant asset Estimated useful life How long the company expects to use the asset Estimated residual value Expected cash value of asset at the end of its life Can be zero The expense to record the “using up” of plant assets is called depreciation. Three amounts are needed to compute depreciation. (1) The cost of the plant asset that includes the purchase price, plus all the other necessary costs to get the asset ready for use. (2) The company must estimate a useful life for the asset. This is based on how long the company expects to use the asset in the business. (3) A residual value must also be estimated. This is the expected cash value of the asset and the end of its useful life. Some companies assign a residual value of zero. The asset’s depreciable cost (how much will be allocated to expense) equal the cost less the residual value. Depreciable Cost = Asset’s cost – Estimated residual value Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 2 Account for depreciation
Learning Objective 2 discusses accounting for depreciation. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Depreciation Methods Straight-line (S/L) Units-of-production (UOP) Double-declining-balance (DDB) The three most common methods of depreciation are straight-line, units-of-production and double-declining-balance. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Straight-Line Depreciation
An equal amount of depreciation assigned to each period Cost – residual = Depreciation expense Useful life in years JOURNAL Date Accounts Debit Credit 12-31 Depreciation Expense $$,$$$ Accumulated Depreciation Straight-line is the easiest method. It results an equal amount of depreciation each period. The depreciable cost (cost – residual) is divided by the useful life in years. Remember, the entry to record depreciation is the same regardless of the method. Depreciation expense is debited and will appear on the income statement. Accumulated depreciation, a contra-asset, is credited and will appear on the balance sheet. It will be deducted from the cost of the plant asset to determine its book value. Contra-asset Copyright ©2008 Pearson Prentice Hall. All rights reserved

Impact of Depreciation
Each year: Accumulated Depreciation increases Book value decreases At the end of the asset’s life: Book value = Cost minus accumulated depreciation The word “accumulated” means that this account will grow each year as depreciation is added to it over the life of the plant asset. Since accumulated depreciation is subtracted from the cost of the asset, as it increases, the book value decreases. At the end of the asset’s useful life, the book value will equal its residual. Book value = residual value Copyright ©2008 Pearson Prentice Hall. All rights reserved

Units-of-Production Depreciation per unit is computed Depreciation per unit is multiplied by production for the period Cost – residual = Depreciation expense per unit Useful life, in units Units-of-production is similar to straight line depreciation. Cost less residual is divided by the useful life. Only with this method, the life is expressed in units, not years. The result is depreciation expense per unit. Units can be measured in any input or output of an asset. For example, for a vehicle, a company could use miles driven or for a copy machine, number of copies made. The depreciation per unit is then multiplied by the units produced during the year. This method results in varying amounts of depreciation each period, depending on the use of the asset. Depreciation expense per unit x units produced during the period Copyright ©2008 Pearson Prentice Hall. All rights reserved

Double-Declining-Balance
An accelerated method Larger expense amounts early in asset’s life 2 x Book value = Depreciation expense Useful life Double-declining-balance is an accelerated method. This means that early in the asset’s life, large depreciation amounts are expensed. Later in the life of the asset, the amounts are smaller. This formula does not use residual value until towards the end of the asset’s life. First, the DDB rate is computed. This is found by dividing two by the useful life. This is often referred to as twice-the-straight-line rate. It usually expressed as a percent. The DDB rate is multiplied by the book value of the asset (not cost minus residual). In the first year, the book value will equal the asset’s cost. However, each year as accumulated increases, book value decreases, and thus, so does depreciation expense. You need to be careful with this method not to depreciate below residual. The formula is not set up to “stop” when depreciable cost equals residual value. In the last year, or earlier in some cases, the depreciation expense is “forced” so that ending book value equals residual. DDB rate (%) x (Cost – Accumulated Depreciation) Accumulated Depreciation increases each year Book value decreases each year Copyright ©2008 Pearson Prentice Hall. All rights reserved

Straight-Line Cost – residual = Depreciation expense Useful life in years = $3,000 annual depreciation expense Exercise 7-19 first calculates the straight-line depreciation of an asset at $3,000 per year. $15,000 - $3,000 4 years Copyright ©2008 Pearson Prentice Hall. All rights reserved

Units-of-Production Cost – residual = Depreciation expense per mile Useful life, in miles $15,000 - $3,000 = $0.12 depreciation per mile 100,000 miles Year Miles Depreciation 1 34,000 $0.12 $ ,080 2 28,000 $ ,360 3 18,000 $ ,160 Next, Exercise 7-19 calculates the units-of-production method, showing depreciation of $.12 per mile. Copyright ©2008 Pearson Prentice Hall. All rights reserved

E7-19 Double-Declining-Balance Yr Beginning Book Value DDB rate Depr.
How is the DDB rate computed? Yr Beginning Book Value DDB rate Depr. Exp. Accum. Depr. Ending Book Value 1 $ ,000 50% $ 7,500 $ 7,500 $ ,500 2 $ ,500 $ 3,750 $ 11,250 $ ,750 3 $ ,750 ** $ $ 12,000 $ ,000 Finally, Exercise 7-19 first calculates depreciation using the double-declining-balance method, showing a depreciation expense of $7,500 (first year). Why wasn’t the DDB rate used in year three? How was the $750 computed? Copyright ©2008 Pearson Prentice Hall. All rights reserved

Which method reflects usage
Which method would provide larger expense amounts in year one? Yr S/L UOP DDB 1 $3,000 $4,080 $7,500 2 $3,360 $3,750 3 $2,160 $ 750 Now, we compare the results of the three methods of depreciation. Which method would be easiest for companies to use? Which method reflects usage of the asset? Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 3 Select the best depreciation method 5-353
Learning Objective 3 shows us how to select the most appropriate depreciation method. 5-353 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2009 Prentice Hall 353

Depreciation for Tax Purposes
Most companies use straight-line for external reporting Most companies use accelerated depreciation for tax purposes Modified Accelerated Cost Recovery System (MACRS) Larger deductions early in assets’ lives helps reduce taxes and increase cash flow Most companies use straight-line depreciation for external reporting. It provides an equal amount each year. However, companies can choose different methods for tax purposes than they do for accounting purposes. The IRS, to encourage investment in long-term assets, developed a special accelerated depreciation method abbreviated MACRS. It is similar to the DDB method. This allows greater tax deductions early in assets’ lives and reduces taxable income. Therefore, cash that would have been used to pay taxes can now be used for other purposes. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Partial Year Depreciation
Companies purchase plant assets when needed–not just at beginning of year To compute depreciation for a partial year 1. Compute depreciation for a full year 2. Multiply by fraction of the year the asset is owned Not applicable to units-of-production Life is not based on years If an asset was purchased May 1, what fraction would be used? Companies don’t usually purchase all their plant asset on January 1. While this would make depreciation calculations easier, it is not a practical way to do business. To compute depreciation for a partial year, determine depreciation for a full year and then multiply by a fraction–the numerator is the number of months the asset was used during the year (purchase date to end of year); the numerator is 12 for the months in a year. This does not apply to UOP because the life is not expressed in years, but in units. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Changing Useful Life of Asset
A company may change useful based on new information or experience Called a change in estimate Depreciation formula needs to be revised Book value at time of change New knowledge may come to the attention of management that causes the estimated life of an asset to be revised. In accounting, this is an example of a change in estimate. When this occurs, the deprecation formula needs to be revised. The book value at the time of the change is computed (cost less accumulated deprecation up to the date of the change) is divided by the remaining useful life (from that day forward). Remaining useful life Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 4 Analyze the effect of a plant asset disposal
Learning Objective 4 analyzes the effect of plant asset disposal. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Disposal of Plant Assets
When a company is finished using an asset, the asset can be: Discarded Sold Exchanged Before accounting for the disposal: Depreciation is updated Final book value is determined When an company is finished using a plant asset, it can discard the asset, sell it for cash or exchange it for another asset. Before the disposal is recorded, depreciation must be updated and a final book value is determined. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Discarding Plant Asset
Accumulated depreciation and cost of asset removed from records Loss recorded (unless asset is fully depreciated and no residual value) JOURNAL Date Accounts Debit Credit Accumulated depreciation Loss on disposal of plant asset Plant asset (equipment, bldg) If a company discards an asset (throws away and receives nothing), it will incur a loss. The only exception to this would be if the asset was fully depreciated and had a residual value of zero. The plant asset account and its related accumulated depreciation must be removed from the records, because the company no longer has the asset. Accumulated is debited for its balance and the plant asset account is credited for its cost. A loss is debited for the difference, which in this case, will equal the asset’s book value. The loss is an income statement account that will reduce net income. Copyright ©2008 Pearson Prentice Hall. All rights reserved

How is book value computed?
Selling a Plant Asset If cash received > Book value GAIN Income Statement account Similar to revenue; increases net income LOSS If cash received < Book value Income Statement account Similar to an expense; decreases net income When an asset is sold for cash, the company can incur a gain or a loss. If the cash received for the asset is greater than the book value, a gain will be recorded. A gain is similar to a revenue. It is reported on the income statement and increases net income. If the cash received is less than the book value, then a loss is recorded. The following slide shows the journal entries to record sales of plant assets in both situations. How is book value computed? Book value = _________________________ Copyright ©2008 Pearson Prentice Hall. All rights reserved

Record loss on sale of equipment Record gain on sale of equipment
JOURNAL Date Accounts Debit Credit Cash Accumulated Depreciation Loss on sale of equipment Equipment Record loss on sale of equipment Gain on sale of equipment Record gain on sale of equipment Like the disposal entry, the plant asset account and its related accumulated depreciation are removed from the records. However, with a sale, a debit to cash will be recorded. Gains are on the credit side and losses on the debit. The gain or loss will equal the difference between the cash received and the book value of the asset. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Book value at time of sale: Cost $ 8,700 Accumulated depreciation 2004 ($8,700 x 2/5) $ 3,480 2005 ($ ) x 2/5 $ 2,088 January - September x 9 /12 $1,566 $5,046 Book value September 30 $3,654 Cash received $2,500 Loss on sale $1,154 Exercise 7-23 shows how to record the loss on the sale of an asset. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Record loss on sale of equipment
JOURNAL Date Accounts Debit Credit Cash $2,500 Accumulated Depreciation $5,046 Loss on sale of equipment $1,154 Equipment $8,700 Record loss on sale of equipment Exercise 7-23 continues with the journal entry to record this loss. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 5 Account for natural resources and depletion
Learning Objective 5 discusses accounting for natural resources and depletion. Account for natural resources and depletion Copyright ©2008 Pearson Prentice Hall. All rights reserved

Natural Resources Come from the earth Oil, minerals, coal and timber Depletion records the expense related to extracting the natural resource Similar to units-of-production depreciation JOURNAL Date Accounts Debit Credit 12-31 Depletion Expense $$,$$$ Accumulated Depletion Natural resources are extracted from the land—for example, oil, coal, timber and mineral ore. The process of allocating the cost of a natural resource to an expense is called depletion. The method to compute the amount is very similar to the units-of-production depreciation method. The journal entry is similar as well. Just substitute the word “depletion” for “depreciation”. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 6 Account for intangible assets and amortization
Learning Objective 6 shows how to account for intangible assets and amortization. Account for intangible assets and amortization Copyright ©2008 Pearson Prentice Hall. All rights reserved

Intangible Assets Represent special rights and benefits Have no physical form Very valuable in today’s information-driven society Examples include patents and copyrights Intangible assets are special rights and benefits. They have no physical form; you can’t touch them. In today’s information-driven society, intangibles can be a company’s largest asset. Examples include patents, copyrights, customer lists, exclusive contracts and many others. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Categories of Intangibles
Finite lives that can be measured Amortized using the straight-line method Intangible asset is reduced by amortization No Accumulated Amortization account Indefinite Lives Not amortized Tested annually for loss in value Intangibles are placed into two categories based on their lives. Those intangibles that have lives that can be measured are amortized.= Amortization is like depreciation; it allocates the cost of the intangible over its life–usually using the straight-line method. One difference from depreciation, however, is that there is no “accumulated amortization” account. Instead, the asset is reduced directly. The other category of intangibles is those with indefinite lives. These assets are not amortized. Instead, they are tested annually for any loss in value. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Specific Intangibles Patents Copyrights Trademarks & Trade Names
Federal grants that give holder exclusive right to produce and sell an invention for 20 years Copyrights Exclusive right to sell a book, music, file or other work of art; lasts for the life of the author + 70 years Trademarks & Trade Names Distinctive identification of product or service; a logo or catch phrase Franchises & Licenses Right to sell a product or service with specific Conditions, such as chain restaurants Here, we describe some common intangibles. Patents are purchased from the federal government and grant the exclusive right to produce and sell an invention for 20 years. Often companies assign a shorter life because other companies “infringe” upon the patent. It usually takes litigation to solve this issue. Copyrights are the exclusive right to a literary or artistic work. The original copyright is purchased from the government, but then the holder can sell to others. The life of a patent is the author’s life plus 70 years. Unique symbols or sayings that identify a company’s product or service are trademarks and trade names. Think of the brand name Coca-Cola or the Nike “swoosh”. Franchises give the owner the right to sell a product or service with specific conditions. The holder pays the corporation a fee to use the business name and sell its product and services. Many chain restaurants, like Burger King, are set up in this manner. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Goodwill Very specific meaning in accounting Only recorded when an entire business is purchased Purchase price exceeds fair value of net assets of business Represents earning power of purchased business Not amortized Goodwill is a term used in many different ways. In accounting, the meaning is very specific. A company can only record goodwill as an intangible asset if it purchasing another company, and the purchase price is greater than the fair value of the company’s net assets. Theoretically, if a company is willing to buy another company for more than its worth, it must represent superior earnings power that the acquired company holds. Goodwill is an example of an asset that has an indefinite life, and therefore, it is not amortized. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Purchase price of MySpace $18 Fair value of net assets Current assets $10 Long-term assets $15 Total liabilities ($24) $1 Goodwill $17 Exercise 7-27 shows the calculation for goodwill. Copyright ©2008 Pearson Prentice Hall. All rights reserved

JOURNAL Date Accounts Debit Credit Current assets $10 Long-term assets $15 Goodwill $17 Total liabilities $24 Cash $18 Exercise 7-27 continues with the journal entry for the goodwill calculation. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Research & Development Costs
Not an intangible asset Required to be expensed as incurred No guarantee expenditures will result in a successful project One might think that companies that spend large sums on research and development would record an intangible asset. However, since many of these projects are unsuccessful, they are required to be recorded as an expense. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 7 Learning Objective 7 discusses how to report plant asset transactions on the statement of cash flows. Report plant asset transactions on the statement of cash flows Copyright ©2008 Pearson Prentice Hall. All rights reserved

Plant Assets and Cash Flow Statement
Operating section Depreciation, amortization and depletion are noncash expense Added back to net income to determine operating cash flows Investing section Purchases of plant assets and intangibles result in an outflow of cash Sales results in inflow of cash Plant asset transactions appear on many places on the Cash Flow Statement. In the operating section, depreciation, amortization and depletion expense are added back to net income. These are non-cash expenses and, when added to net income, help determine cash provided by operating activities. Purchases and sales of plant assets appear in the investing section. If plant assets are purchased with cash, it is shown as an investing outflow. The cash proceeds received from selling plant asset is shown as an inflow. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 1 Explain the features of a corporation
Learning Objective 1 addresses the features of a corporation. Explain the features of a corporation Copyright ©2008 Pearson Prentice Hall. All rights reserved

Characteristics of a Corporation
Separate Legal Entity Corporation distinct from owners; artificial person Continuous Life/Transfer of Ownership: Company continues to exist & operate regardless of ownership changes Separation of Ownership & Management: Stockholders elect Board of Directors who, in turn, appoint officers Limited Liability Stockholders are not personally liable for corporate debts A corporation is a business entity formed under state law. It is a distinct entity, an artificial person that exists apart from its owners, the stockholders or shareholders. The corporation has many of the rights that a person has. For example, a corporation may buy, own, and sell property. Assets and liabilities in the business belong to the corporation and not to its owners. The corporation may enter into contracts, sue, and be sued. Corporations have continuous lives regardless of changes in their ownership. The stockholders of a corporation may buy more of the stock, sell the stock to another person, give it away, or bequeath it in a will. The transfer of the stock from one person to another does not affect the continuity of the corporation. In contrast, proprietorships and partnerships terminate when their ownership changes. Stockholders have limited liability for the corporation’s debts. They have no personal obligation for corporate liabilities. The most that a stockholder can lose on an investment in a corporation’s stock is the cost of the investment .Limited liability is one of the most attractive features of the corporate form of organization. It enables corporations to raise more capital from a wider group of investors than proprietorships and partnerships can. By contrast, proprietors and partners are personally liable for all the debts of their businesses. Stockholders own the corporation, but the board of directors—elected by the stockholders—appoints officers to manage the business. Thus, stockholders may invest $1,000 or $1 million in the corporation without having to manage it. Corporations are separate taxable entities. They pay several taxes not borne by proprietorships or partnerships, including an annual franchise tax levied by the state. The franchise tax keeps the corporate charter in force. Corporations also pay federal and state income taxes. Corporate earnings are subject to double taxation on their income. Corporations pay income taxes on their corporate income. Then, stockholders pay personal income tax on the cash dividends received from corporations. Proprietorships and partnerships pay no business income tax. Instead, the tax falls solely on the owners. Because stockholders have only limited liability for corporation debts, outsiders doing business with the corporation can look no further than the corporation if it fails to pay. To protect a corporation’s creditors and stockholders, Both federal and state governments monitor corporations. The regulations mainly ensure that corporations disclose the information that investors and creditors need to make informed decisions. Accounting provides much of this information. Corporate Taxation Corporations are taxed on their earnings; dividends distributed to owners are also taxed Government Regulation Corporate activities are monitored by government regulations Copyright ©2008 Pearson Prentice Hall. All rights reserved

Organizing a Corporation
Incorporators Organize the corporation Pay fees Sign charter File documents with the state Agree to bylaws The creation of a corporation begins when its organizers, called the incorporators, obtain a charter from the state. The charter includes the authorization for the corporation to issue a certain number of shares of stock. A share of stock is the basic unit of ownership for a corporation. The incorporators (1) pay fees (2) sign the charter (3) file documents with the state and (4) agree to a set of bylaws, which act as the constitution for governing the company. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Authority Structure in a Corporation
Stockholders Elect the Board of Directors which elects the Chair of the Board (CEO) and the Ultimate control of the corporation rests with the stockholders who elect a board of directors that sets company policy and appoints officers. The board elects a chairperson, who usually is the most powerful person in the organization. The chairperson of the board of directors has the title Chief Executive Officer (CEO). The board also designates the president, who is the chief operating officer (COO) in charge of day-to-day operations. Most corporations also have vice presidents in charge of sales, manufacturing, accounting and finance (the chief financial officer, or CFO), and other key areas. President (Chief Operating Officer) who leads Vice Presidents and other corporate officers who Manage the day-to-day operations Copyright ©2008 Pearson Prentice Hall. All rights reserved

Stockholders’ Rights Vote at stockholder meetings Receive dividends Receive share if corporation liquidates Maintain proportionate ownership Preemptive right Ownership of stock entitles stockholders to 4 basic rights, unless a specific right is withheld by agreement with the stockholders: 1. Vote. The right to participate in management by voting on matters that come before the stockholders. This is the stockholder’s sole voice in the management of the corporation. A stockholder gets 1 vote for each share of stock owned. 2. Dividends. The right to receive a proportionate part of any dividend. Each share of stock in a particular class receives an equal dividend. 3. Liquidation. The right to receive a proportionate share of any assets remaining after the corporation pays its liabilities in liquidation. Liquidation means to go out of business, sell the assets, pay all liabilities, and distribute any remaining cash to the owners. 4. Preemption. The right to maintain one’s proportionate ownership in the corporation. Suppose you own 5% of a corporation’s stock. If the corporation issues 100,000 new shares, it must offer you the opportunity to buy 5% (5,000) of the new shares. This right, called the preemptive right, is usually withheld from the stockholders. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Parts of Stockholders’ Equity
Paid-in capital Represents amounts contributed by stockholders Include stock accounts Retained earnings Amounts earned and kept by the corporation Stockholders’ equity represents the stockholders’ ownership interest in the assets of a corporation. Stockholders’ equity is divided into two main parts: 1. Paid-in capital, also called contributed capital. This is the amount of stockholders’ equity the stockholders have contributed to the corporation. Paid-in capital includes the stock accounts and any additional paid-in capital. 2. Retained earnings. This is the amount of stockholders’ equity the corporation has earned through profitable operations and has not used for dividends. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Classes of Stock Common Basic form of common stock Have rights of ownership Benefit most of company succeeds Risk most if company does not succeed Preferred Have preference in receiving dividends and assets in case of liquidation Hybrid between common stock and debt Rare for corporations to issue Every corporation issues common stock, the basic form of capital stock. Unless designated otherwise, the word stock is understood to mean “common stock.” Common stockholders have the 4 basic rights of stock ownership, unless a right is specifically withheld. The common stockholders are the owners of the corporation and they stand to benefit the most if the corporation succeeds because they take the most risk by investing in common stock. Preferred stock gives its owners certain advantages over common stockholders. Preferred stockholders receive dividends before the common stockholders and they also receive assets before the common stockholders if the corporation liquidates. Owners of preferred stock also have the 4 basic stockholder rights, unless a right is specifically denied. Preferred stock is rare. A recent survey of 600 corporations revealed that only 9% of them had preferred stock All corporations have common stock. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Classes of Stock Par value Arbitrary amount assigned to share of stock In most states, represents minimum price for shares Legal capital No-par Does not have a par value May have a stated value Stock may be par-value stock or no-par stock. Par value is an arbitrary amount assigned by a company to a share of its stock. Most companies set the par value of their common stock low to avoid legal difficulties from issuing their stock below par. Most states require companies to maintain a minimum amount of stockholders’ equity for the protection of creditors, and this minimum is often called the corporation’s legal capital. For corporations with par-value stock, legal capital is the par value of the shares issued. No-par stock does not have par value. But some no-par stock has a stated value, which makes it similar to par-value stock. The stated value is an arbitrary amount similar to par value. In a recent survey, only 9% of the companies had no par stock outstanding. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 2 Account for the issuance of stock
Learning Objective 2 addresses how to account for the issuance of stock. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Issuing Common Stock at Par
A company issues 100,000 shares of $5 par value common stock at par The common stock account is always credited in the amount of the shares issued multiplied by par value Date Accounts Debit Credit Cash $500,000 Common stock Large corporations need huge quantities of money to operate. Corporations may sell stock directly to the stockholders or use the service of an underwriter, such as the brokerage firms Merrill Lynch and Goldman Sachs. Companies often advertise the issuance of their stock to attract investors. The Wall Street Journal is the most popular medium for such advertisements. To record when a corporation issues stock to the public and entry is made debiting the asset received, which is usually cash and crediting common stock. The dollar amount credited to common stock account is found by multiplying the shares issued by the par value. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Issuing Common Stock Above Par
A company issues $100,000 shares of $5 par value stock for $12 per share The amount above par is credited to Paid-in Capital in Excess of Par Date Accounts Debit Credit Cash $1,200,000 Common stock $500,000 Paid-in capital in excess of par ________ Many times a corporation issues stock at a price above par value. This adds an additional account to the journal entry–Paid-in capital in excess of par. This account is credited for the difference between the issue price of the stock and the par value. (100,000 shs x $12 price) (100,000 shs x $5 par) What amount will make the entry balance? Copyright ©2008 Pearson Prentice Hall. All rights reserved

Issuing Common Stock for Noncash Assets
Assets recorded at their fair values Common stock and paid-in capital credited accordingly Suppose a company purchased equipment valued at $800,000 by issuing 50,000 shares of its $5 par common stock Fair value of equipment Date Accounts Debit Credit Equipment _________ Common stock Paid-in capital in excess of par $550,000 When a corporation issues stock and receives assets other than cash, the company records the assets received at their current market value and credits the stock and additional paid-in capital accounts accordingly. The assets’ prior book value isn’t relevant because the stockholder will demand stock equal to the market value of the asset given. The example above shows that equipment is recorded at its fair value and common stock at par value. Paid-in capital is credited for the difference. Shares issued x par value Copyright ©2008 Pearson Prentice Hall. All rights reserved

Preferred Stock Follows the same pattern as common stock entries Preferred stock is credited for the shares issued multiplied by the par value A separate paid-in capital account is used if stock is issued above par Accounting for preferred stock follows the pattern of common stock. When a company issues preferred stock, it credits Preferred Stock at its par value, with any excess credited to Paid-in Capital in Excess of Par—Preferred. This is an entirely separate account from Paid-in-Capital in Excess of Par—Common. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Authorized, Issued and Outstanding
Authorized – maximum number of shares company can issue as indicated in its charter Issued – number of shares company has sold to shareholders Outstanding – number of shares currently in shareholders’ possession Any difference between issued and outstanding is due to treasury stock It’s important to distinguish among 3 distinctly different numbers of a company’s stock. Authorized stock is the maximum number of shares the company can issue under its present charter. Issued stock is the number of shares the company has issued to its stockholders. Outstanding stock is the number of shares that the stockholders own (that is, the number of shares outstanding in the hands of the stockholders). Outstanding stock is issued stock minus treasury stock. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 3 Describe how treasury stock affects a company
Learning Objective 3 describes how treasury stock affects a company. Describe how treasury stock affects a company 5-392 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2009 Prentice Hall 392

Treasury Stock Company’s own stock that it has issued and later reacquired Reasons: All authorized shares have been issued and shares are needed for employee stock purchase plans Company wants to purchase its shares at a low price and the re-issue them at a higher price Management want to avoid a takeover A company’s own stock that it has issued and later reacquired is called treasury stock. In effect, the corporation holds this stock in its treasury. Corporations purchase their own stock for several reasons: 1. The company has issued all its authorized stock and needs some stock for distributions to employees under stock purchase plans. 2. The business wants to increase net assets by buying its stock low and hoping to resell it for a higher price. 3. Management wants to avoid a takeover by an outside party. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accounting for Treasury Stock
Recorded at cost (not par value) Contra-equity account (debit balance) Reduces stockholders’ equity and assets If sold above, paid-in capital from treasury stock transactions is credited Treasury stock is recorded at cost—without regard to the par value of the stock. Treasury Stock has a debit balance, the opposite of the other equity accounts. Therefore, Treasury Stock is contra stockholders’ equity, reported beneath Retained Earnings on the balance sheet. Treasury Stock’s balance is subtracted from equity. When treasury stock is purchased, both the equity and the assets (cash) of the company decrease. When treasury stock is resold above cost, and account called paid-in capital from treasury stock transactions is used. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Suppose a company purchased 10,000 shares of its own $1 par common stock for $200,000 Date Accounts Debit Credit Treasury stock $200,000 Cash An example will illustrate how to account for treasury stock. A company purchases 10,000 of its own $1 par common shares for $200,000. Treasury stock is debited and cash is credited. Note that the par value of the stock is not used. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Later, the company resells the treasury shares for $250,000 Date Accounts Debit Credit Cash $250,000 Treasury stock _________ Paid-in capital from treasury stock transactions $50,000 Later the company resells the treasury shares for $250,000. Cash is debited for the selling price and treasury stock is credited for the cost of the shares. The excess goes to the new paid-in capital account. Amount company paid to buy shares Copyright ©2008 Pearson Prentice Hall. All rights reserved

Retained Earnings Balance = Net incomes – net losses – dividends declared Accumulated earnings the company keeps Not a reservoir of cash Normal credit balance Debit balance = Deficit Losses and dividends exceed earnings The Retained Earnings account carries the balance of the business’ net income less its net losses and less any declared dividends accumulated over the corporation’s lifetime. Retained means “held onto.” Successful companies grow by reinvesting back into the business the assets they generate through profitable operations. The Retained Earnings account is not a reservoir of cash for paying dividends to the stockholders. In fact, the corporation may have a large balance in Retained Earnings but not have enough cash to pay a dividend. Cash and Retained Earnings are two entirely separate accounts with no particular relationship. The balance in Retained Earnings says nothing about the company’s Cash balance. A credit balance in Retained Earnings is normal, indicating that the corporation’s lifetime earnings exceed lifetime losses and dividends. A debit balance in Retained Earnings arises when a corporation’s lifetime losses and dividends exceed lifetime earnings. Called a deficit, this amount is subtracted to determine total stockholders’ equity. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Dividends Distribution to stockholders Three forms Cash Stock Noncash assets A dividend is a corporation’s return to its stockholders of the benefits of earnings. Dividends usually take 1 of 3 forms: Cash, Stock or Noncash assets. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Cash Dividends Company must have both: Enough Retained Earnings to declare the dividend Enough Cash to pay the dividend Board of Directors has authority to declare the dividend Most dividends are cash dividends. Finance courses discuss how a company decides on its dividend policy. Accounting tells a company if it can pay a dividend. To do so, a company must have both enough Retained Earnings and enough Cash to pay to declare the dividend the dividend. A corporation declares a dividend before paying it. Only the board of directors has the authority to declare a dividend. The corporation has no obligation to pay a dividend until the board declares one, but once declared, the dividend becomes a legal liability of the corporation. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Dividend Dates Date of Declaration Board of Directors announces dividend Corporation is now obligated to pay Date of record Stockholders who own shares on this date will receive dividend Date of payment Payment sent to shareholders on record On the declaration date, the board of directors announces the dividend. Declaration of the dividend creates a liability for the corporation. As part of the declaration, the corporation announces the record date, which follows the declaration date by a few weeks. The stockholders on the record date will receive the dividend. Payment of the dividend usually follows the record date by a week or two. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accounting for Dividends
Date of Declaration Accounts Debit Credit Retained Earnings $$$$$ Dividends Payable Declaration is recorded by debiting Retained Earnings and crediting Dividends Payable. Liabilities increase, and equity goes down. Equity Decreases; Liabilities Increase Copyright ©2008 Pearson Prentice Hall. All rights reserved

Accounting for Dividends
Date of Record – no entry Date of Payment Accounts Debit Credit Dividends Payable $$$$$ Cash There is no journal entry for the date of record. Payment is recorded by debiting Dividends Payable and crediting Cash. Both assets and liabilities decrease. The corporation shrinks. Liabilities Decrease; Assets Decrease Copyright ©2008 Pearson Prentice Hall. All rights reserved

Retained Earnings Beginning Balance Dividends Declared Net Income Ending Balance The T-Account above shows the activity in the retained earnings account. Net Income is added to the beginning balance and dividends declared are subtracted. If retained earnings increases during the year, it means that net income exceeded dividends. If the account decreases, the reverse is true. If retained earnings increases, net income > dividends If retained earnings decreases, net income < dividends Copyright ©2008 Pearson Prentice Hall. All rights reserved

Preferred Dividends Preferred shareholders receive dividends before common shareholders Dividend rate expressed as: Percent of par value Dollar amount per share Cumulative – any unpaid dividends are carried forward until paid Dividends in arrears When a company has issued both preferred and common stock, the preferred stockholders receive their dividends first. The common stockholders receive dividends only if the total dividend is large enough to pay the preferred stockholders first. Dividends on preferred stock are stated either as a percent of par value or a dollar amount per share. For example, preferred stock may be “6% preferred,” which means that owners of the preferred stock receive an annual dividend equal to 6% of the stock’s par value. If par value is $100 per share, preferred stockholders receive an annual cash dividend of$6 per share (6% of $100). Alternatively, the preferred stock may be “$3 preferred,” which means that the preferred stockholders receive an annual dividend of $3 per share regardless of the stock’s par value. The allocation of dividends may be complex if the preferred stock is cumulative. Corporations sometimes fail to pay a dividend to preferred stockholders. This is called passing the dividend, and the passed dividends are said to be in arrears. The owners of cumulative preferred stock must receive all dividends in arrears plus the current year’s dividend before any dividends go to the common stockholders. In most states preferred stock is cumulative unless it is specifically labeled as noncumulative. Therefore, most preferred stock is cumulative. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Preferred Dividend Example
A corporation has 10,000 shares of $100, 8% cumulative preferred stock outstanding It also has 80,000 shares of $1 par common stock outstanding The Board of Directors declares dividends as follows: Year 1 = $ 20,000 Year 2 = $150,000 An example illustrates how cumulative preferred works. A corporation has 10,000 shares of 8%, $100 par cumulative preferred stock in addition to its 80,000 shares of $1 par common. The Board of Directors declares a $20,000 dividend in the first year and a $150,000 dividend in the second year. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Preferred Dividend Example
Preferred Dividend : ,000 shares x $100 par x 8% = $80,000 Preferred Common Year 1 $20,000 $ Year 2 Dividends in arrears $60,000 Current year $80,000 $140,000 $10,000 The preferred dividend is found by multiplying the shares by the par value by the dividend rate. In this example, it equals $80,000. This means preferred shareholders will receive the first $80,000 of dividends declared each year. If the dividend wasn’t large enough to give preferred their set amount, the amount owed to preferred carries forward. In year one, preferred gets the entire $20,000. Dividends in arrears equals $60,000 ($80K - $20K). In year two, preferred receives its dividends in arrears plus the current year dividend of $80,000. This totals to $140,000. Common receives the remaining $10,000. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Stock Dividends Proportional distribution of shares to stockholders Reasons corporations distribute stock dividends: Provide dividend, yet conserve cash Reduce market price of shares Decrease retained earnings and increase common stock Total equity is unchanged A stock dividend is a proportional distribution by a corporation of its own stock to its stockholders. Stock dividends increase the stock account and decrease Retained Earnings. Total equity is unchanged, and no asset or liability is affected. The corporation distributes stock dividends to stockholders in proportion to the number of shares they already own. In distributing a stock dividend, the corporation gives up no assets. A corporation may choose to distribute stock dividends for these reasons: 1. To continue dividends but conserve cash. A company may need to conserve cash and yet wish to continue dividends in some form. So the corporation may distribute a stock dividend. Stockholders pay no income tax on stock dividends. 2. To reduce the per-share market price of its stock. Distribution of a stock dividend usually causes the stock’s market price to fall because of the increased supply of the stock. The objective is to make the stock less expensive and therefore attractive to more investors. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Stock Dividends Small Less than 25% of outstanding shares Recorded at market value Large Greater than 25% of outstanding shares Recorded at par value Generally accepted accounting principles (GAAP) label a stock dividend of 25% or less as small and suggest that the dividend be recorded at the market value of the shares distributed. Stock dividends above 25% as considered large and are recorded at par value. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Shares issued x market value
10% stock dividend – small: recorded at market value 10% x 500,000 shares issued = 50,000 Market value = $17 per share Accounts Debit Credit Retained Earnings __________ Common stock ___________ Paid-in capital in excess of par $845,000 Shares issued x market value Exercise 9-27 shows how to account for a small stock dividend. Since the company declared a 10% stock dividend, it is considered small and recorded at market value. The company had 500,000 shares outstanding – 10% results in a 50,000 share dividend. Retained earnings is debited for 50,000 shares multiplied by the market value of $17 per share. Common stock is credited for the 50,000 shares multiplied by the ten cent par value. The excess is credited to paid-in capital in excess of par. Shares issued x par Copyright ©2008 Pearson Prentice Hall. All rights reserved

Increase by shares in stock dividends
Stockholders' Equity Common stock, $0.10 par, 2,000,000 shares authorized, ___________shares outstanding $55,000 Paid-in capital in excess of par $1,807,000 Retained earnings $6,272,000 Other ($195,000) Total stockholders' equity $7,939,000 Increase by shares in stock dividends The stockholders’ equity after the stock dividend is above. The common stock account increased by $5000 and the description now reads 550,000 shares outstanding. Paid-in capital increased by $845,000. Retained earnings decreased by $850,000. The total remains unchanged. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Stock Splits Increase in shares coupled with a proportionate reduction in par value 2-for-1 split doubles the shares outstanding and halves the par value No entry made Description of stock changed on balance sheet A stock split is an increase in the number of shares of stock authorized, issued, and outstanding, coupled with a proportionate reduction in the stock’s par value. For example, if the company splits its stock 2 for 1, the number of outstanding shares is doubled and each share’s par value is halved. A stock split, like a large stock dividend, decreases the market price of the stock—with the intention of making the stock more attractive in the market. A 2-for-1 stock split means that the company will have twice as many shares of stock authorized, issued, and will have twice as many shares of stock authorized, issued, and outstanding after the split as it had before each share’s par value will be cut in half. No entry is made to record a stock split. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Summary of Transaction Effects
Assets = Liabilities + Equity Issue stock Increase No effect Purchase treasury stock Decrease Sell treasury stock Declare cash dividend Pay cash dividend Stock dividend Stock split This table shows how the transactions explained in this chapter impact the accounting equation. Note how stock dividends and stock splits have no effect on the equation, but cash dividends have a net effect of decreasing both assets and equity. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 5 Use stock values in decision making
Learning Objective 5 shows how to use stock values in decision making. Use stock values in decision making Copyright ©2008 Pearson Prentice Hall. All rights reserved

Stock Value Terms Market value Redemption value Liquidation value
Price one can buy or sell one share of stock for; varies with company performance and economy Market value Set price company is required to pay to retire preferred stock Redemption value Required payment to preferred shareholders if the company liquidates Liquidation value A stock’s market value, or market price, is the price a person can buy or sell 1 share of the stock for. Market value varies with the corporation’s net income, financial position, and future prospects, and with general economic conditions. In almost all cases, stockholders are more concerned about the market value of a stock than any other value. Preferred stock that requires the company to redeem the stock at a set price is called redeemable preferred stock. The company is obligated to redeem (pay to retire) the preferred stock. Therefore redeemable preferred stock is really not stockholders’ equity. Instead it’s a liability. The price the corporation agrees to pay for the stock, set when the stock is issued, is called the redemption value. Liquidation value is the amount that a company must pay a preferred stockholder in the event the company liquidates (sells out) and goes out of business. The book value per share of common stock is the amount of owners’ equity on the company’s books for each share of its stock. If the company has only common stock outstanding, its book value is computed by dividing total equity by the number of shares of common outstanding. Recall that outstanding stock is issued stock minus treasury stock. If the company has both preferred and common outstanding, the preferred stockholders have the first claim to owners’ equity. Preferred stock often has a specified redemption value. The preferred equity is its redemption value plus any cumulative preferred dividends in arrears. Book value per share of common is then computed as follows: Total stockholders’ equity minus preferred equity divided by the number of shares of common stock outstanding. Common equity # of common shares outstanding Book value Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 6 Compute return on assets and return on equity
Learning Objective 6 discusses computing return on assets and return on equity. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Return on Assets (ROA) Measures company’s use of assets to earn income for financers of the business Creditors Stockholders Net income + Interest expense The rate of return on total assets, or simply return on assets (ROA), measures a company’s use of its assets to earn income for the 2 groups who finance the business: Creditors to whom the corporation owes money. Creditors want interest. Stockholders who own the corporation’s stock. They want net income. The sum of interest expense and net income is the return to the 2 groups who finance a corporation. This sum is the numerator of the return-on-assets ratio. The denominator is average total assets. Net income and interest expense come from the income statement. Average total assets is computed from the beginning and ending balance sheets. What is a good rate of return on total assets? 10% is considered strong in most industries. However, rates of return vary by industry. Average total assets Copyright ©2008 Pearson Prentice Hall. All rights reserved

Return on Equity (ROE) Shows relationship between net income and equity Computed only on common stock Should be higher than return on assets Stockholders risk more than bondholders Net income – Preferred dividends Average common stockholders’ equity Rate of return on common stockholders’ equity, often called return on equity (ROE), shows the relationship between net income available to common and average common stockholders’ equity. Return on equity is computed only on common stock because the return to preferred stockholders is the specified dividend. The numerator of return on equity is net income minus preferred dividends. The denominator is average common stockholders’ equity—total stockholders’ equity minus preferred equity. ROE is higher than ROA for a successful company. Stockholders take a lot more investment risk than bondholders, so the stockholders demand that ROE exceed ROA. If ROA were higher, that would mean that the return on debt— interest—is higher than the return on equity—net income. The higher the rate of return, the more successful the company. In most industries, 15% is considered a good ROE. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Learning Objective 7 Report equity transactions on the statement of cash flows Learning Objective 7 reports equity transactions on the statement of cash flows. Copyright ©2008 Pearson Prentice Hall. All rights reserved

Equity Transactions on the Cash Flow Statement
All equity transactions are financing activities Financing inflow Issuing stock Financing outflow Purchase of treasury stock Payment of dividends Equity transactions are financing activities on the cash flow statement because the company is dealing with its owners. Financing transactions that affect both cash and equity fall into three main categories: ■ issuance of stock–a financing inflow ■ treasury stock–a financing outflow ■ dividends–a financing outflow Copyright ©2008 Pearson Prentice Hall. All rights reserved

Long-Term Investments and International Operations
Chapter 10 Chapter 10 covers long-term investments and international operations. 10-422 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 422

Stock Investments Investor – entity that owns stock of a corporation
Investee – corporation that issued the stock ABC Company purchases 1000 shares of XYZ Corporation: In earlier chapters, the accounting for stocks and bonds from the perspective of the company that issued the securities was explained . In this chapter, the perspective switches to companies who purchase stocks and bonds, as long-term investments. The entity that owns the stock of a corporation is the investor. The corporation that issued the stock is the investee. ABC is the investor XYZ is the investee 10-423 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 423

Reporting Investments on the Balance Sheet
Assets to the investor Short-term investments Also called marketable securities and often classified as trading securities Must be liquid Intended to be converted to cash within one year Long-term investments Expected to be held longer than one year An investment is an asset to the investor. The investment may be short-term or long-term. Short-term investments—also called marketable securities—are current assets. To be listed as short-term on the balance sheet, the investment must be liquid (readily convertible to cash). Also, the investor must intend either to convert the investment to cash within 1 year or to use it to pay a current liability. This was covered in Chapter 5. Investments that aren’t as short-term are listed as long-term investments, a category of noncurrent assets. Long-term investments include stocks and bonds that the investor expects to hold for longer than 1 year. 10-424 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 424

Accounting Methods for Long-Term Investments
Percent owned by investor Accounting method Up to 20% Available-for-Sale % Equity Method More than 50% Consolidation The accounting rules for investments in stock depend on the percentage of ownership by the investor. If the investor owns less than 20% of the stock, the available-for-sale method is used. When the investor owns 20 – 50% of stock, the investor is considered to have influence over the investee. This changes how we account for these investments. The equity method is used in this situation. If an investee owns more than 50% of the stock, it controls the investee. In this situation the financial statements are consolidated – combined as if they are one entity. 10-425 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 425

Learning Objective 1 Account for available-for-sale investments 10-426
Learning Objective 1 is to account for available-for-sale investments. 10-426 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 426

Available-for-Sale Investments
Can be classified as current or long-term Based on how long management intends to hold the investment Initially recorded at cost Cash dividends received are recorded as revenue Stock dividends indicated by memorandum Reported at market value on the balance sheet Considered more relevant for decision making Available-for-sale investments are stock investments other than trading securities. They are classified as current assets if the business expects to sell them within the next year. All other available-for-sale investments are classified as long term. Cost is used as the initial amount for recording the investments. These investments are reported on the balance sheet at current market value. Cash dividends received on the investment is reported as revenue by the investor. However, stock dividends are not recorded in the accounts. Instead, a memorandum entry is made indicated the number of shares received. Available-for-sale investments are accounted for at market value because the company expects to sell the stock at its market price. Market value is the amount that you can buy or sell an investment for. Because of the relevance of market values for decision making, available-for-sale investments in stock are reported on the balance sheet at their market value. 10-427 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 427

Valuing Investments at Year-End
Increase in market value Decrease in market value Unrealized Gain Unrealized Loss Allowance to Adjust Investment to Market is a companion account to Long-Term Investments At the end of each year, the available-for-sale investments must be adjusted to equal their fair values. If the market value has increased, an unrealized gain is recorded. If market value has decreased, and unrealized loss is recorded. The other side of the entry is a debit or credit to allowance to adjust investment to market, which is a companion account to the investments. A debit balance in the allowance indicates that market value is greater than cost; a credit balance indicates the opposite. Debit balance = Market > Cost Credit balance = Market < Cost 10-428 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 428

Unrealized Gain or Loss
Reported in two places on the financial statements Income Statement Other comprehensive income – separate section below net income Balance Sheet Accumulated other comprehensive income – separate section of stockholders’ equity The unrealized gain or loss appears in two places on the financial statements. The account is considered a part of other comprehensive income, which can appear at the bottom of the income statement, after net income is computed. It also appears in the accumulated other comprehensive income section on the balance sheet. This section is part of stockholders’ equity. Note that unrealized gains or losses do not enter into the determination of net income. Unrealized gains or losses on available-for-sale investments do not impact net income 10-429 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 429

Selling Available-for-Sale Investments
Results in a realized gain or loss reported on the income statement Difference between cost and selling price When an available-for-sale investment is sold, a realized gain or loss is recognized. This amount does appear on the income statement and impacts net income. The gain or loss is the difference between the cost and the selling price of the investment. 10-430 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 430

E10-13 Date Accounts Debit Credit (a) Long-term Investment (400 x $32)
$12,800 Cash (b) $400 Dividend revenue Exercise demonstrates how to account for available-for-sale investments. In letter (a), a company purchases 400 shares of Kraft for $32 per share. Long-term investments is increased for $12,800. In letter (b) dividends are received in the amount of $1 per share. Since the company has 400 shares, $400 of dividend revenue is recorded 10-431 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 431

E10-13 Market value at year end 15,200 (400 shares x $38)
Balance in LT Investment 12,800 Unrealized gain 2,400 Date Accounts Debit Credit (c) Allowance to Adjust Investment to Market $2,400 Unrealized Gain on Investment In letter (c), year end market value is given as $38 per share. When multiplied by the number of shares, the total market value is $15,200. The balance in long-term investments is $12,800. Since market value is greater than the balance, an unrealized gain is recorded. An allowance account is used to “write up” the investment to equal market. 10-432 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 432

E10-13 The investment is sold when the market value is $23
This results in a loss Cost minus selling price Date Accounts Debit Credit (d) Cash ($23 x $400) $9,200 Loss on sale of investments _______ Long-term Investment (cost from letter a) $12,600 In letter (d), the investment is sold when the market price is $23. This results in cash proceeds of $ This is less than the cost of the investment of $12,600. Therefore, a loss on sale is recorded. What amount will balance the entry? 10-433 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 433

Learning Objective 2 Use the equity method to account for investments
Learning Objective 2 addresses using the equity method to account for investments. Use the equity method to account for investments 10-434 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 434

The Equity Method Investor owns 20 – 50% of investee’s voting stock
Investor has significant influence over the investee Investment recorded at cost Investment is increased by investee earnings Investment is decreased by investee dividends The equity method is used to account for investments in which the investor owns 20% to 50% of the investee’s stock. An investor with a stock holding between 20% and 50% of the investee’s voting stock may significantly influence the investee. Such an investor can probably affect dividend policy, product lines, and other important matters. Investments accounted for by the equity method are recorded initially at cost. Under the equity method the investor applies its percentage of ownership in recording its share of the investee’s net income and dividends. Because of the close relationship between the investor and investee, the investor, increases the Investment account and records Investment Revenue when the investee reports income. As the investee owners’ equity increases, so does the Investment account on Intel’s books. The Investment account is decreased for the receipt of a dividend on an equity method investment. Why? Because the dividend decreases the investee’s owners’ equity and thus the investor’s investment. 10-435 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 435

Long-Term Investment Share of Dividends Original Cost
Share of Net Income Ending Balance The T-Account above shows the activity in the long-term investment account using the equity method. The account is increased for the original cost and the investor’s share of investee net income. It is decreased by the investor’s share of investee dividends. 10-436 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 436

Multiply the percent the investor owns by the investee net income
Date Accounts Debit Credit (a) Long-term Investments $1,000,000 Cash (b) __________ Equity method investment revenue E10-14 will demonstrate the accounting for investments using the equity method. In letter (a) Intel, the investor purchases 25% of Thai for $1,000,000 which increases the Long-Term Investment account. In letter (b), Thai reports net income of $640,000. Intel records 25% as an increase to the investment and as earnings. Multiply the percent the investor owns by the investee net income 10-437 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 437

Enter the amounts from entry (a) and (c)
Date Accounts Debit Credit (c) Cash $105,000 Long-term investments Long-Term Investments Enter the amounts from entry (a) and (c) (a) _________ (c)__________ In letter (c), Intel reports is share of Thai’s $420,000 dividend as a reduction to the investment account. The ending balance in the investment account is shown in the T-account. It is the result of the three entries made. (b) ,000 1,055,000 10-438 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 438

Learning Objective 3 Understand consolidated financial statements
Learning Objective 3 is to understand consolidated financial statements. 10-439 5-439 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 439 439

Consolidated Subsidiaries
Investor owns more than 50% of voting stock of investee Investor controls investee Investor is called the parent company Investee is called a subsidiary (sub) Financial statements of a parent and its subsidiaries are combined Consolidated as if one company Consolidated subsidiaries are those in which the: investor owns more than 50% of the voting stock of the investee. investor controls the investee. investor is the parent company and the investee is the sub (subsidiary). 4. financial statements of the parent and its subs are combined. 10-440 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 440

Consolidated Worksheet
Tool to combine parent and subsidiary financial statements at year-end Parent and subsidiary accounts are placed side-by-side in columns Worksheet entries are made to eliminate reciprocal accounts Parent’s investment and Sub’s equity Receivables and payables between parent and sub To prepare consolidation financial statements, accountants use a worksheet. The accounts of the parent and sub are placed in the first two columns (as shown in the next slide). Entries are made on the worksheet to eliminate reciprocal accounts. It’s important to note that these entries only appear on the work sheet. They are NOT posted to the accounts of the parent or sub. Reciprocal accounts are (1) the parent’s investment and the sub’s equity accounts and (2) inter-company receivables and payables between the parent and the subsidiary. 10-441 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 441

The first worksheet shows how the worksheet begins by listing the accounts of both parent and sub. The second worksheet shows the elimination entries. Elimination entry (a) for the parent and subsidiary ownership accounts. Entry (a) credits the parent’s Investment account to eliminate its debit balance. Entry (a) also eliminates the subsidiary’s stockholders’ equity accounts by debiting the subsidiary’s Common Stock and Retained Earnings for their full balances. Without this elimination, the consolidated financial statements would include both the parent company’s investment in the subsidiary and the subsidiary company’s equity. But these accounts represent the same thing—Subsidiary’s equity—and so they must be eliminated from the consolidated totals. If they weren’t, the same resources would be counted twice. In this example, Parent Corporation has an $40,000 note receivable from Subsidiary, and Subsidiary has a note payable to Parent. The parent’s receivable and the subsidiary’s payable represent the same resources—all entirely within the consolidated entity. Both, therefore, must be eliminated and entry (b) accomplishes this. The $40,000 credit in the elimination column of the work sheet zeros out Parent’s Note Receivable from Subsidiary. The $40,000 debit in the elimination column zeros out the Subsidiary’s Note Payable to Parent. In the third worksheet the consolidated balances are computed by adding together the parent and sub accounts balances and subtracting the elimination entry amounts. 10-442 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 442

Goodwill and Minority Interest
Recorded in consolidation process as an intangible asset Occurs when parent purchases sub for more than the fair value of its net assets Minority Interest Recorded in consolidation process and can be included in liabilities Occurs when parent owns less than 100% of sub Goodwill and Minority Interest are 2 accounts that only a consolidated entity can have. Goodwill, which was addressed in Chapter 7, arises when a parent company pays more to acquire a subsidiary company than the market value of the subsidiary’s net assets. As we saw in Chapter 7, goodwill is the intangible asset that represents the parent company’s excess payment to acquire the subsidiary. Minority interest arises when a parent company owns less than 100% of the stock of a subsidiary. The remainder of the subsidiaries’ stock is minority interest to GE. Minority Interest can be included along with the liabilities on the balance sheet of the parent. 10-443 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 443

Learning Objective 4 Account for long-term investments in bonds 10-444
Learning Objective 4 is to account for long-term investments in bonds. 10-444 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 444

Long-Term Bond Investments
Major investors Financial institutions Insurance companies Called held-to-maturity investments Reported at amortized cost Bonds carrying amount is amortized to face value at maturity value The major investors in bonds are financial institutions—pension plans, mutual funds, and insurance companies An investment in bonds is classified either as short-term (a current asset) or as long-term. Short-term investments in bonds are rare. Here, we focus on long-term investments called held-to-maturity investments. Bond investments are recorded at cost. Years later, at maturity, the investor will receive the bonds’ face value. Often bond investments are purchased at a premium or a discount. When there is a premium or discount, held-to-maturity investments are amortized to account for interest revenue and the bonds’ carrying amount. Held-to-maturity investments are reported by their amortized cost method, which determines the carrying amount. 10-445 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 445

Investor (Bondholder)
Bonds Investor (Bondholder) Issuing Corporation Investment in bonds Bonds payable Interest expense Interest revenue The relationship between the investor (bondholder) and the issuing corporation is diagrammed above. To the issuing corporation, the bond is debt that requires the payment of interest–an expense. To the investor, the bonds are an asset that receives interest revenue. 10-446 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 446

E10-19 Skoda should use the amortized cost method to account for the bond investment The investment is recorded at cost $20,000 x .97 E10-19 demonstrates how to account for long-term bond investments. Skoda purchases $20,000 bonds at 97% of face value). The investment account is recorded at its cost of $19,400. 10-447 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 447

Face value x interest rate x months/12
On December 31, interest earned on the bond investments is accrued ___________________________ Amortization is recorded $20,000 – 19,400 = $600 $600/60 months = $10 per month $10 per month x 3 months = $30 Face value x interest rate x months/12 On December 31, two entries are required. First, interest earned is accrued. The amount is computed by multiplying the face value of bond by the interest rate by the time period the bond has been held–three months (Sept. 30 – Dec. 31). Next the bond investment is amortized. The bond was purchased at a $600 discount and has a five-year term (60 months). Therefore, the discount is amortized $10 per month. The entry will increase the investment account and record additional interest revenue for the three months. 10-448 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 448

Learning Objective 5 Account for international operations 10-449
Learning Objective 5 is to account for international operations. 10-449 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 449

International Accounting
Most corporations operate in multiple countries Most use their own currency Several European countries use the euro Many U.S. companies do a large part of their business abroad. Most countries use their own national currency. An exception is the of European Union nations—France, Germany, Italy, Belgium, and so on use a common currency ,the euro, whose symbol is E. If a U.S. company sells products to companies in France, will it receive U.S. dollars or euros? If the transaction is in dollars, the company in France must buy dollars to pay Intel in U.S. currency. If the transaction is in euros, than the U.S. company will collect euros and must sell euros for dollars. 10-450 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 450

Foreign Currency Terms
Exchange rate Price of one currency stated in terms of another currency Converting the cost of an item stated in one currency into another currency Translation Import/Export Ratio Relationship of a country’s imports to exports The price of one nation’s currency can be stated in terms of another country’s monetary unit. This measure of one currency against another is called the foreign-currency exchange rate. We can convert the cost of an item stated in one currency to its cost in a second currency. We call this conversion a translation. The import ratio is the relationship of a country’s imports to its exports. For example, Japanese exports often exceed Japan’s imports. Customers of Japanese companies must buy yen (the Japanese unit of currency) to pay for their purchases. This strong demand drives up the price of the yen. In contrast, the United States imports more goods than it exports. Americans must sell dollars to buy the foreign currencies needed to pay for the foreign goods. As the supply of the dollar increases, the price of a dollar falls. Currencies are often described as “strong” or “weak.” The exchange rate of a strong currency is rising relative to other nations’ currencies. The exchange rate of a weak currency is falling relative to other currencies. Exchange rate of currency is rising relative to other nations Strong Currency Exchange rate of currency is falling relative to other nations Weak Currency 10-451 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 451

Accounting for Foreign Currency Transactions
Export Sales in which payments will be made in a foreign currency Import Purchases that will be paid in a foreign currency Changes in exchange rates between sale or purchase and payment will result in a foreign currency gain or loss Exports occur when a U.S. company sells products to another country. If payment will be received in the foreign currency, a gain or loss will occur if the exchange rate changes. Imports occur when a U.S. company purchased products from another country. If the U.S. company makes payment in the foreign currency, it may incur a gain or loss from the change in the exchange rates. 10-452 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 452

Export Entries A U.S. company sells goods to a Mexican company for one million pesos when the exchange rate is $0.086 When payment is received the exchange rate is $0.083 Shipp Belting sells goods to Artes de Mexico for a price of 1 million pesos on July 28. On that date, a peso is worth $ One month later, on August 28, the peso has weakened against the dollar so that a peso is worth only $ Shipp receives 1 million pesos from Artes on August 28, but the dollar value of Shipp’s cash receipt is $3,000 less than expected. Shipp ends up earning less than hoped for on the transaction. The above journal entries show how Shipp would account for these transactions. 10-453 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 453

Import Entries A U.S. company buys inventory from a supplier in Switzerland for 20,000 Swiss francs when the exchange rate is $0.80 They make payment when the exchange rate is $0.78 Purchasing in a foreign currency also exposes a company to foreign-currency exchange risk. To illustrate, assume Shipp Belting buys inventory from Gesellschaft Ltd., a Swiss company. The price is 20,000 Swiss francs. On September 15 Shipp receives the goods, and the Swiss franc is quoted at $0.80. When Shipp pays 2 weeks later, the Swiss franc has weakened against the dollar—to $0.78. Shipp would record the purchase and payment as shown above. 10-454 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 454

Consolidation of Foreign Subsidiaries
Two challenges: (1) Foreign accounting practices differ from American GAAP (2) Subsidiary statements may be in foreign currency and need translation Results in a foreign currency translation adjustment A U.S. company with a foreign subsidiary must consolidate the subsidiary’s financial statements into its own statements for reporting to the public. The consolidation of a foreign subsidiary poses 2 special challenges: 1. Many foreign countries require accounting treatments that differ from American accounting principles. For reporting to the American public, the subsidiary’s statements must conform to American generally accepted accounting principles (GAAP). 2. The subsidiary’s statements may be expressed in a foreign currency. First, we must translate the subsidiary’s statements into dollars. Then the 2 companies’ financial statements can be consolidated. The process of translating a foreign subsidiary’s financial statements into dollars usually creates a foreign-currency translation adjustment. 10-455 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 455

Translation Adjustment
Assets and liabilities are translated into dollars at current exchange rate on financial statement date Stockholders’ equity is translated into dollars at older, historical exchange rates Differing rates creates out-of-balance condition Foreign currency translation adjustment is the balancing amount A translation adjustment arises due to changes in the foreign exchange rate over time. In general, ■ Assets and liabilities are translated into dollars at the current exchange rate on the date of the statements. ■ Stockholders’ equity is translated into dollars at older, historical exchange rates. This difference in exchange rates creates an out-of-balance condition on the balance sheet. The translation adjustment brings the balance sheet back into balance. 10-456 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 456

International Standards
Most accounting methods are consistent throughout the world Differences do exist for: Inventory – LIFO method of inventory not used in the U.K. Goodwill – In Germany and Japan, the account is amortized; not in the U.S. Research & Development costs – Capitalized in Japan; expensed in the U.S. Most accounting methods are consistent throughout the world. Double-entry accounting, the accrual system, and the basic financial statements are used worldwide. Differences, however, do exist among countries. For example, in the U.K. the LIFO method of inventory is not allowed for tax purposes, so it is rarely used. Goodwill, which is tested for impairment in the U.S., is amortized in Germany and Japan. Research and development cost are required to expensed in the U.S. In Japan, these costs can be capitalized. 10-457 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 457

Learning Objective 6 Report investing transactions on the statement of cash flows Learning Objective 6 is to report investing transactions on the statement of cash flows. 10-458 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 458

Investing Activities on the Cash Flow Statement
Purchases and sales of long-term investments are investing activities Investing inflow Proceeds from sales of long-term investments (available-for-sale, equity method and held-to-maturity) Investing outflow Purchases of all categories of long-term investments Purchases and sales of investments are considered investing activities. When long-term investments are sold, the cash proceeds are an investing inflow. When long-term investments are purchased with cash, an investing outflow is reported. Both inflows and outflows included all types of long-term investments. 10-459 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 459

The Income Statement & the Statement of Stockholders’ Equity
Chapter 11 Chapter 11 covers the income statement and the statement of stockholders’ equity. 11-461 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 461

Learning Objective 1 Analyze a corporate income statement 11-462
Learning Objective 1 analyzes a corporate income statement. 11-462 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 462

Continuing Operations
Income from day-to-day normal business activities Includes: Revenues and operating expenses Gains and losses Income tax expense Can help predict future annual income The top of an income statement reports the income from continuing operations. This is where the results of day-to-day activities are reported. Here you’ll find revenues and expenses, gains and losses from sales of plant assets and investments, plus income tax expense. Since these items are “continuing”, financial statement users look to income from continuing operations as a place to help predict future income of the company. 11-463 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 463

Investment Capitalization Rate & Value of Stock
Estimated value of common stock Estimated annual future income = Investment capitalization rate Compared to market value of the company Rate used to estimate value of stock To estimate the value of a company’s common stock, financial analysts determine the present value of the stream of future income and divide by the investment capitalization rate. This rate is based on the risk that a company might not be able to earn annual income similar to current year income for the indefinite future. The rate is also called the investment capitalization rate because it is used to estimate the value of an investment. The higher the risk, the higher the rate, and vice versa. The estimated value of the common stock is compared to the market value of the company. This can be found by multiplying the number of common shares by the market price per share. The higher the rate, the higher the risk # of common shares Market price per share X 11-464 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 464

Investment Decision Rule
If the estimated value of the company: Buy; stock price may increase Current market value of the company Exceeds Hold; stock price steady Equals An investment decision rule can made using the estimated value of the company. If the estimated value exceeds the current market value, most would say it is wise the buy shares because the price of the stock is likely to increase. If the estimated value equals the current market value, an investor who has the stock should hold, or keep, the shares and expect the stock price to remain steady. If the estimated value is less than the current value of the company, an investor should sell the shares as the price is likely to decrease. Sell; stock price may go down Is less than 11-465 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 465

Discontinued Operations
Company sells a segment of the business Identifiable part of business Reported beneath income from continuing operations Net of income taxes Not considered in predictions of future earnings Most large companies engage in several lines of business. We call each identifiable part of a company a segment of the business. A company may sell a segment of its business. Discontinued operations are reported along with their income tax effect beneath income from continuing operations. Financial analysts typically do not include discontinued operations in predictions of future corporate income because the discontinued segments will not continue to generate income for the company. Gains and losses on the sales of plant assets are not reported as discontinued operations. These items are not so unusual, and they recur from time to time, so they appear in the “Other” section of the income statement. 11-466 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 466

Extraordinary Items Gains and losses that are both infrequent and unusual Include losses from natural disasters and expropriation of assets by foreign governments Do NOT include gains or losses from lawsuits, restructuring or sale of plant assets Reported after continuing operations net of income taxes Extraordinary gains and losses, also called extraordinary items, are both unusual for the company and infrequent. Losses from natural disasters (such as earthquakes, floods, and tornadoes) and the expropriation of company assets by a foreign government are extraordinary. Extraordinary items are reported along with their income tax effects. Gains and losses due to lawsuits, restructuring, and the sale of plant assets are not extraordinary items. They are considered normal business occurrences and are reported as Other Gains and Losses. 11-467 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 467

Cumulative Effect of Change in Accounting Method
Change from one accounting method to another FIFO to LIFO Straight-line depreciation to double-declining balance Makes difficult to compare year-to-year statements Reported in special section usually after extraordinary items Companies sometimes change from one accounting method to another, such as from double-declining-balance (DDB) to straight-line depreciation, or from first-in, first-out (FIFO) to average cost for inventory. An accounting change makes it difficult to compare one period with preceding periods. Without detailed information, investors can be misled into thinking that the current year is better or worse than the preceding year, when in fact the only difference is a change in accounting method. Companies report accounting changes in a special section of the income statement. This section usually appears after extraordinary items. 11-468 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 468

Earnings per Share (EPS)
Key measure of company’s success: Net Income - Preferred Dividends Average number of common shares outstanding Reported for each element of net income: The final segment of the income statement reports earnings per share. Earnings per share (EPS) is the amount of a company’s net income per share of its outstanding common stock. EPS is a key measure of a business’s success because it shows how much income the company earned for each share of stock. Stock prices are quoted at an amount per share, and investors buy a certain number of shares. EPS is used to help determine the value of a share of stock. The corporation lists its various sources of income separately: continuing operations, discontinued operations, and so on. It also lists the EPS figure for each element of net income. Recall that EPS is earnings per share of common stock. But the holders of preferred stock have first claim on dividends. Therefore, preferred dividends must be subtracted from net income to compute EPS. Preferred dividends are not subtracted from discontinued operations, extraordinary items, or the cumulative effect of accounting changes. Discontinued operations, extraordinary items, etc. Preferred dividends only subtracted for continuing operations and net income 11-469 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 469

Comprehensive Income Change in stockholders’ equity from all non-owner transactions Net Income plus: Unrealized gains (losses) on available-for-sale investments Foreign currency translation adjustments Not included in net income or EPS calculations All companies report net income or net loss on their income statements. In Chapter 10, companies with unrealized gains and losses on certain investments and foreign-currency translation adjustments also report another income figure. Comprehensive income is the company’s change in total stockholders’ equity from all sources other than from the owners of the business. Comprehensive income includes net income plus Unrealized gains (losses) on available-for-sale investments and Foreign-currency translation adjustments. These items do not enter into the determination of net income or of earnings per share. 11-470 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 470

E11-12 E11-12 demonstrates several of the concepts described. First, the items are put into proper income statement form. The continuing operations section includes revenue and operating expenses. Then, other revenues are added and income taxes are computed. Next, the extraordinary gain is reported separately, net of its income tax effect. Since the item is gain, there will be additional income taxes paid. So the $1300 gain is reduced to $800 after taxes are deducted. 11-471 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 471

Earnings per share (1600 shares) Divide net income by # of shares
Income from continuing operations 3.19 Extraordinary gain 0.50 Net Income $ _________ Divide net income by # of shares EPS is computed by taking line items from the income statement and dividing them by the 1600 shares of common stock outstanding. Part 2 wants an estimate of the price of one share of stock. We can use formula for the estimated value of stock. Divide the income from continuing operations by the given interest rate of 7%. Take that result and divided by the number of common shares to get an estimated value of one share of stock. 11-472 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 472

Learning Objective 2 Account for a corporation’s income taxes 11-473
Learning Objective 2 addresses how to account for a corporation’s income taxes. 11-473 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 473

Corporate Income Taxes
Federal corporate income tax rate = 35% Income tax expense Reported on income statement Based on current year earnings Income tax payable Current liability on the balance sheet Amount to be paid to government Corporations pay income tax as individuals do, but corporate and personal tax rates differ. The current federal tax rate on most corporate income is 35%. Most states also levy income taxes on corporations, so most corporations have a combined federal and state income tax rate of approximately 40%.To account for income tax, the corporation measures: (1) Income tax expense, an expense on the income statement. Income tax expense is based on current year earnings. (2) Income tax payable, a current liability on the balance sheet. Income tax payable is the amount of tax to pay the government in the next period. 11-474 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 474

Differences Between Accounting Income and Taxable Income
Income Statement Reports results of operations Based on accrual account Income Tax Return Filed with IRS to determine taxes owed Based on tax laws Depreciation common difference Straight-line for accounting purposes Accelerated for tax purposes The income statement and the income tax return are entirely separate documents: ■ The income statement reports the results of operations. ■ The income tax return is filed with the Internal Revenue Service (IRS) to measure how much tax to pay the government in the current period. For most companies, tax expense and tax payable differ. Some revenues and expenses affect income differently for accounting and for tax purposes. The most common difference between accounting income and taxable income occurs when a corporation uses straight-line depreciation in its financial statements and accelerated depreciation for the tax return. 11-475 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 475

Deferred Taxes When corporations use different methods for accounting and taxes: Income tax expense does not equal income tax payable The result is a deferred tax liability or asset When corporations use different methods for accounting and taxes, income tax expense (based on accounting income) will not equal income tax payable (based on tax laws). The result is a deferred tax liability or asset. If income tax expense is less than income tax payable, the result is a deferred tax liability. If the reverse situation occurs, a deferred tax asset will be recorded. Deferred tax liability Income tax expense < Income tax payable Deferred tax asset Income tax expense > Income tax payable 11-476 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 476

Prior Period Adjustments
Correction of an accounting error from a previous period Related revenue or expense item has been closed into Retained Earnings Beginning retained earnings is adjusted for the amount of the error Occasionally a company records a revenue or an expense incorrectly. If the error is corrected in a later period, the balance of Retained Earnings is wrong until corrected. Corrections to Retained Earnings for errors of an earlier period are called prior period adjustments. The prior-period adjustment appears on the statement of retained earnings. 11-477 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 477

Learning Objective 3 Analyze a statement of stockholders’ equity
Learning Objective 3 analyzes a statement of stockholders’ equity. 11-478 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 478 478

Statement of Stockholders’ Equity
Includes all equity accounts (example on following slide) Show activity in each account: From beginning balance to ending balance Increases and decreases Also includes accumulated other comprehensive income: Unrealized gain or loss on investments Foreign currency translation adjustment Companies report a statement of stockholders’ equity, which includes retained earnings. The statement of stockholders’ equity is formatted like a statement of retained earnings but with a column for each element of stockholders’ equity. The statement of stockholders’ equity thus reports the reasons for all the changes in equity during the period. 11-479 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 479

Statement of Stockholders' Equity Common stock Add'l Paid-in Capital
Common stock Add'l Paid-in Capital Retained Earnings Treasury Stock Total Stockholders' Equity Beginning Balance X (X) Issuance of stock Net income Cash dividends Stock dividends Purchase of treasury stock Sale of treasury stock Ending Balance Which account does net income affect? What’s the net effect of a stock dividend on total equity? Above is a template for a basic statement of stockholders equity. Across the top are the equity accounts and along the side the transactions that impacted the accounts are listed. First the beginning balances are listed. Notice that treasury stock is in brackets, indicating a negative balance, since it is a contra-equity account. If the corporation issues stock the stock account and additional paid-in capital both increase. Net income increases retained earnings. Cash dividends decrease retained earnings, as do stock dividends. However, stock dividends also increase stock and paid-in capital, so the net effect on total equity is zero. The purchase of treasury stock increases the treasury stock account (which makes it a larger negative number). The sale of treasury stock, increases paid-in capital and decreases treasury stock. Ending balances are computed. 11-480 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 480

Learning Objective 4 Understand managers’ and auditors’ responsibilities for the financial statements Learning Objective 4 addresses understanding managers’ and auditors’ responsibilities for the financial statements. 11-481 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 481

Management’s Responsibility
Internal controls over financial reporting in accordance with GAAP Standard for preparing financial statements Designed to produce relevant and reliable information for investors and creditors Management declares its responsibility for the internal controls over financial reporting in accordance with GAAP. GAAP is the standard for preparing the financial statements. GAAP is designed to produce relevant, reliable and useful information for making investment and credit decisions. 11-482 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 482

Auditor’s Report Companies hire Certified Public Accountants (CPAs) to examine financial statements Examination is called an external audit CPAs are to independent of the company they are auditing CPA firms issue audit reports Provide opinion if financial statements are in accordance with GAAP 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 and then issue an audit report. 11-483 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 483

Types of Audit Reports Unqualified Qualified Adverse Disclaimer
Clean opinion; Statements are fairly presented Unqualified “Except for” opinion; Statements are reliable except for one or more items Qualified Statements are unreliable and not in accordance with GAAP Adverse Audit reports usually fall into one of four categories: 1. Unqualified (clean). The statements are reliable. 2. Qualified. The statements are reliable, except for 1 or more items for which the opinion is said to be qualified. 3. Adverse. The statements are unreliable. 4. Disclaimer. The auditor was unable to reach a professional opinion. No opinion; auditor was unable to form an opinion Disclaimer 11-484 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 484

The Statement of Cash Flows
Chapter 12 Chapter 12 covers the statement of cash flows. 12-486 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 486

Learning Objective 1 Identify the purpose the statement of cash flows
Learning Objective 1 shows the purpose of the statement of cash flows. 12-487 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 487

Cash Flow Statement Shows cash receipts and payments during a period
Purposes: Predicts future cash flows Evaluates management decisions Determines ability to pay dividends and interest Shows relationship of net income to cash flows The balance sheet reports financial position, and balance sheets from two periods show whether cash increased or decreased. But that doesn’t tell why the cash balance changed. The income statement reports net income and offers clues about cash, but the income statement doesn’t tell why cash increased or decreased. We need a third financial statement. The statement of cash flows reports cash flows—cash receipts and cash payments. The statement of cash flows serves these purposes: 1. Predicts future cash flows - Past cash receipts and payments are reasonably good predictors of future cash flows. 2. Evaluates management decisions. Businesses that make wise decisions prosper, and those that make unwise decisions suffer losses. The statement of cash flows reports how managers got cash and how they used cash to run the business. 3. Determines ability to pay dividends and interest. Stockholders want dividends on their investments. Creditors demand interest and principal on their loans. The statement of cash flows reports on the ability to make these payments. 4. Shows the relationship of net income to cash flows. Usually, high net income leads to an increase in cash, and vice versa. But cash flow can suffer even when net income is high. 12-488 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 488

Importance of Cash Flow
A company needs both net income and strong cash flow to succeed Companies want to earn net income because profit measures success. Without net income, a business sinks. There will be no dividends, and the stock price suffers. High net income attracts investors, but you can’t pay bills with net income. That requires cash. A company needs both net income and strong cash flow. Income and cash flow usually move together because net income generates cash. Sometimes, however, net income and cash flow take different paths. 12-489 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 489

Learning Objective 2 Distinguish among operating, investing and financing cash flows Learning Objective 2 addresses how to distinguish among operating, investing and financing cash flows. 12-490 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 490

Cash Flow Categories Operating activities Investing activities
Related to the transactions that result in net income Most important as they reflect core of the business Investing activities Related to long-term assets How a company uses its resources in the long-term Financing activities Related to long-term debt and equity How a company obtains resources A business engages in 3 types of business activities: Operating activities, Investing activities and Financing activities. Operating activities create revenues, expenses, gains, and losses—net income, which is a product of accrual-basis accounting. The statement of cash flows reports on operating activities. Operating activities are the most important of the 3 categories because they reflect the core of the organization. A successful business must generate most of its cash from operating activities. Investing activities increase and decrease long-term assets, such as computers, land, buildings, equipment, and investments in other companies. Purchases and sales of these assets are investing activities. Financing activities obtain cash from investors and creditors. Issuing stock, borrowing money, buying and selling treasury stock, and paying cash dividends are financing activities. Paying off a loan is another example. Financing cash flows relate to long-term liabilities and owners’ equity. 12-491 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 491

Formats for Operating Cash Flows
Indirect Reconciles net income to cash provided by operating activities Easier to prepare Direct Shows cash inflows and outflows by type Easier to interpret There are 2 ways to format operating activities on the statement of cash flows: (1) the indirect method, which reconciles from net income to net cash provided by operating activities. This method is most frequently used because it is easier to prepare. (2) the direct method, which reports all cash receipts and cash payments from operating activities. This approach is easier for the user to understand. The 2 methods use different computations, but they produce the same figure for cash from operating activities. The 2 methods do not affect investing or financing activities. 12-492 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 492

Learning Objective 3 Prepare a statement of cash flows by the indirect method Learning Objective 3 prepares a statement of cash flows by the indirect method. 12-493 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 493 493

The Indirect Method Net Income Reconciling adjustments:
+ Depreciation/depletion/amortization + Losses on sales of long-term assets - Gains on sales of long-term assets + or - changes in current assets & current liabilities Net cash provided by operating activities The indirect approach starts with net income, which is accrual accounting amount. Reconciling adjustments are made to net income to convert it to cash provided by operating activities. Non cash expenses, such as depreciation, depletion and amortization, are added. Any losses on sales of long-term assets (investments and plant assets) are added and gains are subtracted. Changes in current asset and current liability accounts are also added or subtracted. 12-494 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 494

Reconciling Items Goal: To convert accrual net income to operating cash flow Start with net income and adjust for noncash items Add back noncash expenses Subtract gains and add losses These amounts do not reflect cash flows Add or subtract changes in current assets and current liabilities The goal of the reconciling items is to convert net income to cash provided by operating activities. Since noncash expenses reduce net income, but did result in a cash flow. Therefore, these items are added back to net income. Gains and losses are the differences between the book value of the asset and cash received. They do not represent a cash amount. Therefore, to “take them out” of net income, gains are subtracted and losses are added. The cash proceeds will be reported in the investing section. Next, the increase or decrease in each current asset (except cash) and current liability is computed. This change will be added or subtracted as will be explained on the following slide. 12-495 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 495

Current Assets and Current Liabilities
Each account relates to an income statement item Accounts receivable Sales Salaries payable Salaries expense The change in each account is computed Change = Current year balance – prior year balance Current assets inverse relationship Subtract increases from net income; add decreases Current liabilities direct relationship Add increases to net income; subtract decreases Each noncash current asset and current liability relates to an income statement account. For example, accounts receivable goes with sales, and salaries payable goes with salaries expense. To convert the net income amount to a cash amount, the change is computed and added or subtracted. To compute the change in the account, subtract the prior year balance from the current year balance. With current assets, an inverse relationship exists between the change in the account and whether it is added or subtract. If a current asset increases, subtract the change. If it decreases, add it. The relationship between current liabilities and cash flow is direct. If a current liability increases, add the change. If it decreases, subtract it. 12-496 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 496

E12-15 Item O I or F + or - a. Net Income O + b. Cash dividend F - c.
Sale of LT investment I d. Loss on sale of equip. e. Amortization f. Issuance of LTNP g. Depreciation expense h. Issuance of stock ___ E12-15 helps to identify the cash flow categories (operating, investing or financing) and whether the amount is added or subtracted. This exercise assumes the indirect approach to the operating section. What type of account is stock? 12-497 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 497

E12-15 Item O I or F + or - j. Increase in accts pay O + k. NIF l.
Purchase of equipment with note payable NIF l. Payment of long-term debt F - m. Purchase building I n. Accrual of salary expense N o. Purchase of long-term investment Some items are considered investing and/or financing, but do not involve cash. Letter (k) is an example. Purchasing equipment is an investing activity. Issuing a note payable is financing. However, no cash is involved. These events are required to be disclosed. 12-498 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 498

E12-15 Item O I or F + or - p. Decrease in inventory O + q.
Increase in prepaid expenses - r. Sale of land I s. Decrease in accrued liabilities For (p) (q) and (r) remember–current assets go the opposite way of the change, and current liabilities go the same way. 12-499 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 499

Preparing the Operating Section – Indirect Method
Use current year income statement for the following amounts Net Income Depreciation, depletion and amortization expense Gains or losses on sales of assets Use comparative balance sheets to compute the changes in current assets and current liabilities To prepare the operating section using the indirect method, you need a current year income statement and comparative balance sheets. From the income statement, the “bottom line”, net income, is the starting point. Then, find depreciation expense (and depletion and amortization if applicable) and add them to net income. Also, look in the “other income” section for any gains or losses. Next, use the balance sheet to compute the increase or decrease in each noncash current asset and current liability. Follow the rules to determine whether to add or subtract it. 12-500 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 500

The Indirect Method Add back to net income Subtract from net income
Here’s an illustration on how to use the income statement to obtain the amounts needed. Subtract from net income Use as first line in operating section 12-501 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 501

Subtracted from net income
Added to net income Subtracted from net income Subtracted from net income This illustration shows how the preparer computed the change in the current asset and current liability accounts. Next, the add or subtract rules were followed. Added to net income 12-502 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 502

Remember: inverse relationship
Net Income $ 35,000 Reconciling items: Depreciation 18,000 Loss on sale of land 5,000 Changes in current assets & current liabilities Increase in current assets _______ Decrease in current liabilities (20,000) Net cash provided by operating activities $ 11,000 Remember: inverse relationship E12-17 will help practice on how to prepare the operating section using the indirect method. Start with net income and then add back depreciation expense and the loss. Overall, current assets increased, so that amount is subtracted. Current liabilities decreased, so that amount is subtracted as well. Combine all five amounts to determine net cash provided by operating activities. 12-503 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 503

Investing Activities Affect long-term assets: Plant assets Investments
Notes receivable Purchases = outflows Sales = inflows After the operating section is prepared, the investing activities are analyzed. Investing activities affect long-term assets, such as plant assets, investments and notes receivable. When plant assets and investments are purchased, a cash outflow results. When sold, cash is received. Notes receivable result in outflows when loans are made; inflows result when collections are received. Loans made = outflows Collections = inflows 12-504 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 504

Computing Purchases and Sales of Plant Assets
Plant assets, net, beginning balance + Acquisitions - Depreciation Book value of assets sold = Plant assets, net, ending balance From Balance Sheet From Income Statement To prepare the investing section, each long-term asset account is analyzed from beginning to ending balance. These amounts can be obtained from the balance sheet. For plant assets, accumulated depreciation is combined with the asset account; thus, the term “net”. Cash paid to acquired plant assets, increases the net account and results in an outflow of cash. The depreciation amount can be found on the income statement. It is an “add-back” in the indirect approach to the operating section. Net plant assets are decreased by the book value of any assets sold. We will use this amount shortly to determine the cash inflows from sales. The end result is the ending balance. From Balance Sheet 12-505 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 505

Proceeds from Sales of Plant Assets
Compare book value of assets sold to gain or loss Gain or loss located on income statement Book value + Gain on sale Cash Proceeds To compute the cash received from the sale of a plant asset, compare the book value of the asset to the gain or loss reported on the income statement. If the asset was sold at a gain, add the gain to the book value to determine the cash proceeds. If it was sold at a loss, subtract the loss from the book value. Book value – Loss on sale 12-506 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 506

Computing Purchases and Sales of Investments
Investments, beginning balance + Purchases - Cost of investments sold = Investments, ending balance To compute cash proceeds of investments sold: Investments are bit simpler than plant assets as there is no accumulated depreciation. The investments account is increased by the cost of purchases and decreased by the cost of investments sold. If investments are sold, compare the cost to the gain or loss on the income statement. Add the gain or subtract the loss to compute the cash proceeds. Cost + Gain on sale Cash Proceeds Cost – Loss on sale 12-507 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 507

Computing Loans Made and Collections on Notes
Notes receivable, beginning balance + Loans made - Collections = Notes receivable, ending balance Notes receivable are increased when the company makes loans to outsiders. This results in an outflow of cash. Notes receivable are decreased when collections are made, which results in a cash inflow. 12-508 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 508

Issuance of new shares = inflows Cash dividends = outflows
Financing Activities Affect long-term liabilities & equity: Long-term Debt Notes payable Bonds payable Common stock and Paid-in Capital Retained earnings Payments = outflows Borrowings = inflows Financing activities, the third category, involve long-term liabilities and equity accounts. Long-term debt includes both notes payable and bonds payable. Cash inflows occur when the borrowing occurs. For bonds, this is when the bonds are issued. When loan payments or the bond face value is paid, a cash outflow occurs. The equity accounts include common stock and paid-in capital, both of which increase when stock is issued. Retained earnings (also an equity account) is decreased when dividends are declared. Cash dividends are a financing outflow. Issuance of new shares = inflows Cash dividends = outflows 12-509 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 509

Computing Issuance and Payments of Long-Term Debt
Long-term debt, beginning balance + Issuance of new debt - Payments of debt = Long-term debt, ending balance Long-term debt accounts are increased when new debt (a note payable or bond payable) is issued. The accounts are decreased when payments are made. For notes, this is the principal portion of the debt (not interest). For bonds, this is the face value (not interest). 12-510 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 510

Computing Issuance of Stock and Purchases of Treasury Stock
Common stock, beginning balance + Issuance of new stock = Common stock, ending balance Inflow of cash Treasury stock, beginning balance + Purchase of treasury stock = Treasury stock, ending balance If the common stock account increases during the year, it means the company issued new shares, which would bring cash in to the corporation. The treasury stock account, a contra-equity, is increased when the company purchases its own shares. This would result in an outflow of cash. Outflow of cash 12-511 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 511

Computing Dividend Payments
Retained earnings, beginning balance + Net Income - Dividends declared = Retained earnings, ending balance From income statement Retained earnings is increased by net income and decreased by dividends declared. The net income can be found on the income statement and is the starting point for the operating section (indirect method). Dividends declared often result in a cash outflow. 12-512 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 512

Noncash Investing and Financing Activities
Transactions that involve long-term assets, long-term debt and/or equity But do not increase or decrease cash Examples: Purchasing plant assets by signing a note payable Issuing stock for land Stock dividends Some transactions meet the criteria to be an investing and/or financing activity, but do not involve cash. These items are disclosed either at the bottom of the cash flow statement or in the disclosure notes. Some examples include: purchasing plant assets (investing) by signing a note payable (financing); issuing stock (financing) for land (investing); and stock dividends (financing) 12-513 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 513

Proves that cash flow statement “works”
Now that operating, investing and financing activities have been explained, they can all be put together to form a cash flow statement. Each category is totaled. Then, the three categories are combined and will equal the increase or decrease in the cash account. The increase or decrease is added to the beginning balance to equal the ending balance. This proves that the cash flow statement explains the change in cash. Proves that cash flow statement “works” 12-514 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 514

Learning Objective 4 Prepare a cash flow statement by the direct method Learning Objective 4 prepares a cash flow statement by the direct method. 12-515 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 515

Direct Method FASB prefers as it provides clearer information
Rarely used as it requires more calculations Refers to how operating section is prepared Investing and Financing activities always prepared using the direct method Goal: Convert each income statement item into a cash amount Or exclude if a noncash item The Financial Accounting Standards Board (FASB) prefers the direct method of reporting operating cash flows because it provides clearer information about the sources and uses of cash. But only about 1% of companies use this method because it takes more computations than the indirect method. Investing and financing cash flows are unaffected by the operating cash flows. 12-516 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 516

Direct Method Income Statement Cash Flow Statement Sales
Collections from customers Payments to suppliers Cost of goods sold Payments to employees Salaries expense Under the direct method, accrual income statement items are converted in to cash inflows or outflows as illustrated above. Interest payments Interest expense Income tax paid Income tax expense 12-517 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 517

Direct Method Formulas
RECEIPTS Income Statement Balance Sheet Change From customers Sales + Decrease in accounts receivable - Increase in accounts receivable Of interest Interest revenue Decrease in interest receivable Increase in interest receivable The changes in current asset and current liability accounts are used to convert the income statement amounts to cash flow amounts. The income statement sales is connected to accounts receivable and interest revenue to interest receivable. 12-518 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 518

PAYMENTS Income Statement Balance Sheet Change To suppliers Cost of goods sold + Increase in inventory - Decrease in inventory AND Decrease in accounts Payable Increase in accounts payable To convert cost of goods sold, two balance sheet accounts are used–inventory and accounts payable. 12-519 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 519

PAYMENTS Income Statement Balance Sheet Change For expenses Operating expenses + Increase in prepaid - Decrease in prepaids OR Decrease in accrued liabilities Increase in accrued liabilities With operating expenses, it depends on if the expense is related to a prepaid (like insurance) or a liability (like property taxes payable). 12-520 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 520

PAYMENTS Income Statement Balance Sheet Change To employees Salaries expense + Decrease in salaries payable - Increase in salaries payable For interest Interest expense Decrease in interest payable Increase in interest payable Both salaries and interest expense usually have a related payable by the same name. 12-521 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 521

PAYMENTS Income Statement Balance Sheet Change For income taxes Income tax expense + Decrease in income tax payable - Increase in income tax payable Income taxes follow the same pattern as interest and salaries. 12-522 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 522

E12-27 Credit sales $60,000 Ending accounts receivable 32,000
Beginning accounts receivable 22,000 Increase in accounts receivable 10,000 Collections from customers Add or subtract? E12-27 provides practice on some of these direct method cash flow formulas. To convert credit sale to collections from customers, the change in accounts receivable is computed. In this case, receivables increased by $10,000. This increase is subtracted from credit sales. If more customers buy on account, how would that affect cash flow? 12-523 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 523

E12-27 Cost of goods sold $111,000 Ending inventory 21,000
Beginning inventory 24,000 Decrease in inventory (3,000) Ending accounts payable 8,000 Beginning accounts payable 14,000 Decrease in accounts payable 6,000 Payments to suppliers $114,000 For cost of goods sold, both the change in inventory and accounts payable is computed. The decrease in inventory is subtracted, and the decrease in accounts payable is added to determine payments to suppliers. 12-524 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 524

Direct Method Noncash expenses not listed
Depreciation, depletion and amortization Gains and losses not included Gain or loss does not equal cash received Cash proceeds included as an investing inflow Investing and financing activities reported as explained previously Notice with the direct method that noncash expenses, such as depreciation, are not listed. Also, gains and losses are not included. Gains and losses are not the same as cash proceeds. The cash received from the sale of long-term assets is reported in the investing section. The investing and financing sections of the cash flow statement are the same as explained previously. 12-525 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 525

Financial Statement Analysis
Chapter 13 Chapter 13 covers financial statement analysis. 13-527 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 527

Learning Objective 1 Perform a horizontal analysis of a company’s financial statements Learning Objective 1 shows how to perform a horizontal analysis of a company’s financial statements. 13-528 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 528

Comparative Financial Statements
Investors and creditors cannot based decisions on one year’s data Most financial statements cover at least two years so comparisons can be made Horizontal analysis Study of percent changes in accounts from year-to-year Investors and creditors cannot evaluate a company by examining only one year’s data. This is why most financial statements cover at least two periods. In fact, most financial analysis covers trends of 3 to 5 years. The goal of financial analysis is to predict the future. Many decisions hinge on the trend of revenues, expenses and net income. Have revenues increased from last year? By how much? Suppose sales have increased by $50,000. Considered alone this fact is not very helpful, but the percentage change in sales helps a lot. It’s better to know that sales have increased by 20% than to know that the increase is $50,000. The study of percentage changes from year to year is called horizontal analysis. 13-529 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 529

Horizontal Analysis Step 1: Compute dollar change in account
Step 2: Compute percent change in account Current year balance minus prior year balance Computing a percentage change takes twp steps: 1. Compute the dollar amount of the change from one period (the base period) to the next. 2. Divide the dollar amount of change by the base-period (prior year) amount. Dollar change Prior year balance 13-530 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 530

E13-15 E13-15 demonstrates horizontal analysis of an income statement. First, the 2006 amount is subtracted from the 2007 amount to determine the dollar change. Then, the dollar change is divided by the 2006 amount. This shows that interest expense had the largest percentage increase. 13-531 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 531

Learning Objective 2 Perform a vertical analysis of a company’s financial statements Learning Objective 2 assesses performing a vertical analysis of a company’s financial statements. 13-532 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 532

Vertical Analysis Shows relationship of each financial statement item and its base For the income statement, base is total revenue For the balance sheet, base is total assets Each account is divided by its base Expressed as a percent Vertical analysis shows the relationship of a financial-statement item to its base, which is the 100% figure. All items on the statement are reported as a percentage of the base. For the income statement, total revenue is usually the base. For the balance sheet, the base is total assets. 13-533 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 533

E13-17 E13-17 demonstrates vertical analysis of a balance sheet. The base amount is total assets. Each item is divided by $374,000 to determine percent. This company’s largest asset group is plant assets. 13-534 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 534

Learning Objective 3 Prepare common-size financial statements 13-535
Learning Objective 3 prepares common-size financial statements. 13-535 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 535 535

Common-Size Statements
Financial statements expressed in percentages only No dollar amounts Percentages derived from vertical analysis Financial statements can be modified to report only percentages (no dollar amounts). Such a statement is called a common-size statement. On a common-size income statement, each item is expressed as a percentage of the revenue amount. Total revenue is therefore the common size. In the balance sheet, the common size is total assets. A common-size statement aids the comparison of different companies because all amounts are stated in percentages 13-536 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 536

Example of Common-Size Income Statement
This is an example of a common-size income statement. Notice all items are expressed in percents instead of dollars. 13-537 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 537

Benchmarking Compares company results to set standard
Goal is improvement Example: Company compares its common-size statements to an industry leader Benchmarking compares a company to some standard set by others. The goal of benchmarking is improvement. Suppose you are a financial analyst. You are considering investing in two companies in the same industry. A direct comparison of their financial statements is not meaningful because one is larger. But, you can convert both companies’ income statements to common size and compare the percentages. 13-538 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 538

Learning Objective 4 Use the statement of cash flows for decisions
Learning Objective 4 uses the statement of cash flows for decisions. 13-539 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 539

Using the Statement of Cash Flows
Helpful for finding weaknesses than gauging strength Cash flow signs of a healthy company Operations are the major source of cash Investing activities have more than purchases than sales of long-term assets Financing activities are not dominated by borrowing Analysts find the statement of cash flows more helpful for spotting weakness than for gauging success. Why? Because a shortage of cash can throw a company into bankruptcy, but lots of cash doesn’t ensure success. Here are some cash-flow signs of a healthy company: ■ Operations are the major source of cash (not a use of cash). ■ Investing activities include more purchases than sales of long-term assets. ■ Financing activities are not dominated by borrowing. 13-540 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 540

Learning Objective 5 Compute the standard financial ratios 13-541
Learning Objective 5 shows how to compute the standard financial ratios. 13-541 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 541

Measuring Ability to Pay Current Liabilities
Current assets – current liabilities; Expressed as a $ amount Working capital Current assets Current liabilities Expressed as a ratio; Rule of thumb = 1.5 Current ratio Working capital measures the ability to pay current liabilities with current assets. In general, the larger the working capital, the better the ability to pay debts. Recall that capital is total assets minus total liabilities. Working capital is like a “current” version of total capital. Two decision-making tools based on working-capital data are the current ratio and the acid-test ratio. The most common ratio using current assets and current liabilities is the current ratio, which is current assets divided by current liabilities. The current ratio measures the ability to pay current liabilities with current assets. In general, a higher current ratio indicates a stronger financial position. The business has sufficient current assets to maintain its operations. What is an acceptable current ratio? The answer depends on the industry. The norm for companies in most industries is around The acid-test (or quick) ratio tells us whether the entity could pass the acid test of paying all its current liabilities if they came due immediately. The acid-test ratio uses a narrower base to measure liquidity than the current ratio does. To compute the acid-test ratio, we add cash, short-term investments, and net current receivables (accounts and note receivable, net of allowances) and divide by current liabilities. Inventory and prepaid expenses are excluded because they are less liquid. A business may be unable to convert inventory to cash immediately. An acid-test ratio of 0.90 to 1.00 is acceptable in most industries. Cash + ST investments + Net receivables Current liabilities Expressed as a ratio; Rule of thumb = Acid-test ratio 13-542 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 542

Measuring Ability to Sell Inventory and Collect Receivables
Cost of goods sold Average inventory Measures how often a company sell inventory; Varies greatly among industries Inventory turnover A grocery store would have a high inventory Turnover; a furniture store - low Accounts receivable turnover Net sales Average net accounts receivable Measures how often a company collects AR Companies generally seek to sell their inventory as quickly as possible. The faster inventory sells, the sooner cash comes in. Inventory turnover measures the number of times a company sells its average level of inventory during a year. A fast turnover indicates ease in selling inventory; a low turnover indicates difficulty. A value of 6 means that the company’s average level of inventory has been sold 6 times during the year, and that’s usually better than a turnover of 3 times. But too high a value can mean that the business is not keeping enough inventory on hand, which can lead to lost sales if the company can’t fill orders. Therefore, a business strives for the most profitable rate of turnover, not necessarily the highest rate. To compute inventory turnover, divide cost of goods sold by the average inventory for the period. We use the cost of goods sold—not sales—in the computation because both cost of goods sold and inventory are stated at cost. Inventory turnover varies widely with the nature of the business. To evaluate inventory turnover, compare the ratio over time. A sharp decline suggests the need for corrective action. Accounts receivable turnover measures the ability to collect cash from customers. In general, the higher the ratio, the better. However, a receivable turnover that is too high may indicate that credit is too tight, and that may lose sales to good customers. To compute accounts receivable turnover, divide net sales by average net accounts receivable. The ratio tells how many times during the year average receivables were turned into cash. A receivable turnover of 12 would mean a company collects the AR balance once a month 13-543 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 543

Days’ Sales in Receivables
Shows how many days’ sales remain in accounts receivable One day’s sales = Net sales 365 days Step one: Days’ Sales in Receivables = Average net accts rec. One day’s sales Step two: Businesses must convert accounts receivable to cash. All else being equal, the lower the receivable balance, the better the cash flow. The days’-sales-in-receivables ratio shows how many days’ sales remain in Accounts Receivable. Compute the ratio by a 2-step process: 1. Divide net sales by 365 days to figure average sales per day. 2. Divide average net receivables by average sales per day. The fewer the days, the more quickly receivables are being converted to cash 13-544 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 544

Located on the balance sheet
Current ratio: Current assets $185,000 = 1.67 Current liabilities ________ Located on the balance sheet E13-20 requires computing all the previous five ratios. First the current ratio is found by dividing current assets by current liabilities. 13-545 ©2008 Pearson Prentice Hall. All rights reserved. Copyright ©2008 Pearson Prentice Hall. All rights reserved 545

E13-20 (b) Acid-test ratio: Cash + ST Inv. + Net Rec.
Current liabilities $17, , ,000 $92,000 = 0.83 $111,000 Next, the acid-test ratio eliminates the less liquid current assets from the numerator. The same denominator is used as the current ratio. 13-546 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 546

Located on the income statement
Inventory turnover: Cost of goods sold = 4.42 Average inventory $74,000 times Beginning inventory + ending inventory 2 Inventory turnover uses average inventory in the denominator. Add the beginning and ending balances together and divide by two. Then divide the average inventory into the cost of goods sold. ($77,000 + $71,000)/2 13-547 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 547

(Current year + preceding year)/2
Receivables turnover: Net Credit Sales $654,000 = 9.55 Average receivables $68,500 times Beginning receivables + ending receivables 2 Receivables turnover also uses an average amount in the denominator – receivables. This average is divided into net credit sales. ________________________________ (Current year + preceding year)/2 13-548 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 548

Use the amount computed for receivable turnover
Days' Sales in Receivables: One day's sales Net credit sales $654,000 = $1,791.78 365 days 365 Days' Sales in Receivables Average net receivables 38.23 days Use the amount computed for receivable turnover Days’ sales in receivables has two steps: Divide net credit sales by 365 days. Then (2) divide that amount into average net receivables (computed on previous slide). 13-549 ©2008 Pearson Prentice Hall. All rights reserved. Copyright ©2008 Pearson Prentice Hall. All rights reserved 549

Measuring Ability to Pay Debts
Total liabilities Total assets Tells proportion of assets financed with debt; Average for most companies = .62 Debt ratio The higher the ratio, the greater the pressure to pay debt Times-Interest-Earned Income from operations Interest expense Measures # of times interest can cover interest Two indicators of the ability to pay total liabilities are the debt ratio and the times-interest earned ratio because it owes less. This relationship between total liabilities and total assets is called the debt ratio. It tells us the proportion of assets financed with debt. A debt ratio of 1 reveals that debt has financed all the assets. A debt ratio of 0.50 means that debt finances half the assets. The higher the debt ratio, the greater the pressure to pay interest and principal. The lower the ratio, the lower the strain. The average debt ratio for most companies ranges around 0.62, with relatively little variation from company to company. Analysts use a second ratio—the times-interest earned ratio—to relate income to interest expense. To compute the times-interest earned ratio, divide income from operations (operating income) by interest expense. This ratio measures the number of times operating income can cover interest expense and is also called the interest-coverage ratio. A high ratio indicates ease in paying interest; a low value suggests difficulty. High ratio indicates ease of paying interest; low indicates difficulty 13-550 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 550

Measuring Profitability
Net Income/Net sales Shows percentage of each sales dollar that makes it to the “bottom line” Return on sales Net income + Interest expense Average total assets Measures success in using assets to earn a profit Return on total assets The fundamental goal of business is to earn a profit, and so the ratios that measure profitability are reported widely. In business, return refers to profitability. Consider the rate of return on net sales, or simply return on sales. This ratio shows the percentage of each sales dollar earned as net income. Companies strive for a high rate of return. The higher the percentage, the more sales dollars are providing profit The rate of return on total assets, or simply return on assets, measures a company’s success in using assets to earn a profit. Creditors have loaned money, and the interest they receive is their return on investment. Shareholders have bought the company’s stock, and net income is their return. The sum of interest expense and net income is the return to the 2 groups that have financed the company. This sum is the numerator of the ratio. Average total assets is the denominator. popular measure of profitability is rate of return on common stockholders’ equity, often shortened to return on equity. This ratio shows the relationship between net income and common stockholders’ investment in the company—how much income is earned for every $1 invested. To compute this ratio, first subtract preferred dividends from net income to measure income available to the common stockholders. Then divide income available to common by average common equity during the year. Common equity is total equity minus preferred equity. Return on equity Net Income – Preferred Dividends Average common stockholders’ equity How much income is earned for every dollar invested 13-551 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 551

Earnings per Share (EPS)
Key measure of company’s success Net Income - Preferred Dividends Average number of common shares outstanding Most widely quoted ratio Earnings per share of common stock, or simply earnings per share (EPS), is the amount of net income earned for each share of outstanding common stock. EPS is the most widely quoted of all financial statistics. It’s the only ratio that appears on the income statement. Earnings per share is computed by dividing net income available to common stockholders by the number of common shares outstanding during the year. Preferred dividends are subtracted from net income because the preferred stockholders have a prior claim to their dividends 13-552 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 552

Learning Objective 6 Use ratios in decision making 13-553
Learning Objective 6 uses ratios in decision making. 13-553 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 553

Analyzing Stock Investments
Price –Earnings Ratio Market price per share of common stock Earnings per share Compares market price to earnings Dividend per share Market price per share Compares dividends per share to market price Dividend yield Investors buy stock to earn a return on their investment. This return consists of 2 parts: (1) gains (or losses) from selling the stock and (2) dividends. The price/earnings ratio is the ratio of common stock price to earnings per share. This ratio, abbreviated P/E, appears in The Wall Street Journal stock listings and online. online. It shows the market price of $1 of earnings. Dividend yield is the ratio of dividends per share of stock to the stock’s market price. This ratio measures the percentage of a stock’s market value returned annually to the stockholders as dividends. Preferred stockholders pay special attention to this ratio because they invest primarily to receive dividends. Book value per share of common stock is simply common stockholders’ equity divided by the number of shares of common stock outstanding. Common equity equals total equity less preferred equity .Book value indicates the recorded accounting amount for each share of common stock outstanding. Many experts believe book value is not useful for investment analysis because it bears no relationship to market value and provides little information beyond what’s reported on the balance sheet. But some investors base their investment decisions on book value. Total stockholders’ equity – preferred equity # of common shares outstanding Book value per share 13-554 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 554

Other Measures Economic Value Added ® (EVA)
Measures if operations have increased stockholder wealth EVA = Net income + Interest expense – Capital charge Capital charge = Notes payable + Current maturities of long-term debt + Long-term debt + Stockholders’ Equity Leading companies use economic value added (EVA®) to evaluate operating performance. EVA® combines accounting and finance to measure whether operations have increased stockholder wealth. EVA® can be computed as follows: All amounts for the EVA® computation, except the cost of capital, come from the financial statements. The cost of capital is a weighted average of the returns demanded by the company’s stockholders and lenders. Cost of capital varies with the company’s level of risk. The idea behind EVA® is that the returns to the company’s stockholders (net income) and to its creditors (interest expense) should exceed the company’s capital charge. The capital charge is the amount that stockholders and lenders charge a company for the use of their money. A positive EVA® amount suggests an increase in stockholder wealth, and so the company’s stock should remain attractive to investors. If EVA® is negative, stockholders will probably be unhappy with the company and sell its stock, resulting in a decrease in the stock’s price. Different companies tailor the EVA® computation to meet their own needs. X Cost of capital Average return demanded by investors and creditors 13-555 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 555

Red Flags in Financial Statement Analysis
Earnings problems Decrease in net income over several years Decreased cash flow Operating cash flow consistently less than net income Recent accounting scandals have highlighted the importance of red flags in financial analysis. The following conditions may mean a company is very risky: ■ Earnings Problems. Have income from continuing operations and net income decreased for several years in a row? Has income turned into a loss? This may be okay for a company in a cyclical industry, such as an airline or a home builder, but a company may be unable to survive consecutive loss years. ■ Decreased Cash Flow. Cash flow validates earnings. Is cash flow from operations consistently lower than net income? Are the sales of plant assets a major source of cash? If so, the company may be facing a cash shortage. 13-556 Copyright ©2008 Pearson Prentice Hall. All rights reserved ©2008 Pearson Prentice Hall. All rights reserved. 556

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