Financial Accounting Harvard Pre Term

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FinancialAccounting
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FinancialAccounting
PretestIntroduction
WelcometothepreassessmenttestfortheFinancialAccountingOnlineCourse.Thistestwillallowyoutoassessyourknowledgeofbasicandadvancedfinancialaccounting.
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GoodLuck!
WelcometoFinancialAccounting
Youareabouttobeginaninteractiveexperiencethatwillintroduceyoutofinancialaccounting,thelanguageofbusiness.Successfulcompletionofthiscoursewillenableyoutounderstand
howaccountingsystemsareusedtorecordthedaytodayeconomicactivitiesofabusinessandtogeneratereportsaboutitsfinancialhealthandperformance.
UsingtheTutorial
ThestructureoftheHBSFinancialAccountingTutorialanditsnavigationaltoolsareeasytomaster.Ifyou'rereadingthistext,youmusthaveclickedonthenavigationitemlabeled
"UsingtheTutorial"ontheleft.
PleaseclickontheHelpiconintheupperrightcornerofthetutorialtoviewaclickableanimationonhowtousethistutorial.
TheSetting
ThisHBSFinancialAccountingTutorialusesabusinesscontexttohelpyoulearnthefundamentalsoffinancialaccounting.
YouaresettingupastorecalledGlobalGrocer.Itwillcarrygourmetfoodsandcondiments,unusualspicesandspecialtykitchenimplementsfromallovertheworld.GlobalGrocerisa
franchisebusinessitwillpayafranchisingcompany,GlobalGrocerInternational,afranchisefeefortheuseofthenameandformarketingsupport.Youareplanningtohaveagrand
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storeopeninginearlySeptember,withabigsaleonitemsrelatedtovariousfallandharvestcelebrationsaroundtheworld.
Youhavealimitedamountofcashavailabletostartupthebusiness,butyouhopetoobtainbankloansandalsoraisecapitalfromoutsideinvestors.Youwillbekeepingtheaccounts(or
bookkeeping)fortheGlobalGrocerstore.Completingthistutorialwillprepareyouforthatrole.
TheAccountingProcess
Thistutorialisbasedonamodeloftheaccountingprocessinasmallbusiness.
Financialaccountingisafinancialinformationsystemthattracksandrecordsanorganization'sbusinesstransactionsandaggregatesthemintoreportsfordecisionmakersbothinside
andoutsidethebusiness.Atransactionisaneventthathasconsequencesforabusiness'financialcondition.Theeventcouldbeeitherexternalorinternaltothebusiness.
(1)Intherunningofabusiness,variousdecisionsaremadeandimplementedasbusinesstransactions.Forexample,inatypicalbusiness,managerswillraisecapitalfrominvestors
andbanks,rentorbuyequipment,andpurchaseandsellmerchandiseandservices.Eachbusinesstransactionisrelatedtooneofthreetypesofactivities:operating,investingand
financingactivities.
(2)Eventhemostsimpleorganizationshavenumerousbusinesstransactionsthathavetobetrackedandrecorded.Transactionsareformallyrecordedinadatabasecalledajournal,and
thenorganizedbyaccountsintoaledger.
(3)Reportpreparationrequirestheaggregationofaccountingtransactionsintostatementsorreportsthatdescribethefinancialstatusofthebusinessanditsperformance.Themost
commonfinancialaccountingreportsarethebalancesheet,theincomestatementandthestatementofcashflows.
(4)Financialstatementsareusedbydecisionmakersinsideandoutsidethebusiness.Forexample,managersusethemtodecidewhetherthefirmismakingaprofit,whether
customerincentivesareworking,orwhethertotakealoanandexpandthebusiness.
Ifabusinessraisescapitalfromoutsideinvestors,theinvestorswillexaminethecompany'sfinancialstatementstojudgewhetherthefundstheyhaveinvestedhavebeenusedwisely.
(5)Financialreportingconceptsandprinciplestelluswhenandhowtomeasure,recordandclassifybusinesstransactionsandaggregatethemintofinancialreports.Byfollowingthese
conceptsandprinciples,financialreportingsystemsprovideinformationthatisconsistentovertimeandacrossdifferentbusinesses,andaccountingbecomesalanguagethatiswidely
understood.
(6)Auditorsareindependentpartieswhoperiodicallyexamineacompany'sfinancialstatementsandthesystems,internalcontrolsandrecordsusedtoproducethestatements.Sincea
company'smanagersprodicetheirownreportcards,i.e.,thecompany'sfinancialstatements,auditorsplayanimportantroleasacontrolmechanism.Theyattestthatthefinancial
statementsconformtogenerallyacceptedaccountingprinciplesandtheyprovideassurancethatthecompany'saccountsarepresentedfairly.
(7)Basedontheiranalysesoffinancialstatements,financialstatementuserstakeactions,whichinturn,affectthefutureoperating,investingandfinancingdecisionsmadebythe
organization.Hence,thefinancialreportingsystemisaninformationfeedbackloopbetweenusersoffinancialstatementsandthedecisionmakerswithintheorganization.
ModuleOverview
Ineachchapterofthistutorial,youwilllearnnewfinancialaccountingtermsandconceptsandhowtousethisknowledgewithinthecontextoftheGlobalGrocersetting.Youwillalsobe
givenexercisestopracticeandtestwhatyouhavelearnedatseveralpointsineachchapter.
The"TermsandConcepts"chapterintroduceskeyfinancialaccountingtermsandfivefundamentalfinancialaccountingconcepts.Itprovidesabriefoverviewofthethreemost
importantfinancialstatements.
Thechapterslabeled"TheBalanceSheet,""TheIncomeStatement,"and"TheStatementofCashFlows"explainrelevantnewfinancialaccountingconceptsandusetheconceptsto
constructafinancialstatement.YouwillseehowGlobalGrocer'sfinancialstatementsareaffectedbyitsbusinesstransactionsduringthefirstmonthofoperations.
Inthe"AccountingRecords"chapteryouwilllearnhowtoformallyrecordGlobalGrocer'sbusinesstransactionsintoitsjournalandledgerandhowtousetheserecordstoprepareits
financialstatements.Indoingso,youwillrevisitandrecordalltheeventsthatoccurredatGlobalGrocerduringthefirstmonthonly,thistime,youwillusetheformalbookkeeping
structuresusedinfinancialaccountingsystems.
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ModuleOverview(continued)
Chapters1through6coverthefinancialreportingbasics.BeginninginChapter7,"RevenuesandReceivables,"youwillbeginlearningaboutmoreadvancedfinancialreportingtopics.
Theadvancedaccountingchapterlabelsareindicativeofthetopiccovered.Theseinclude"InventoriesandCostofSales,""DepreciationandLongLivedAssets,""Liabilitiesand
FinancingCosts,""InvestmentsandInvestmentIncome,""DeferredTaxesandTaxExpense,"and"Owners'Equity."Ineachofthesechaptersyouwillhavetoresolveasetofaccounting
challengesfacingGlobalGrocer.YoursolutionstothoseaccountingchallengeswillbuildonthebasicfinancialaccountingknowledgeyouacquiredinyourstudyofChapters16.
Asyouwilllearn,accountingpracticesintheUnitedStatesaregovernedbyasetofaccountingrulesreferredtoasGenerallyAcceptedAccountingPrinciples(GAAP)Theserulesand
theirapplicationsarecoveredindepthinthistutorial.BecausethereisadistinctpossibilitytheserulesmaybereplacedbyanothersetofsimilarrulesreferredtoasInternational
FinancialReportingStandards(IFRS)in2015,thetutorial,whereappropriate,referstoIFRSaswellasitsGAAPcounterpart.
Exercise1.1
Financialaccountingisaninformationsystemthat:
Choosethewordthatbestcompletesthefollowingsentence:Infinancialaccounting,anorganization'sbusinesstransactionsareclassifiedintooperatingactivities,_________
activitiesandfinancingactivities.
Sinceauditorshavetoattesttothevalidityofacompany'sfinancialstatements,whatisanimportantcharacteristicforanauditorfromthefollowingchoices?
TermsandConcepts
Inthischapter,youwillexplorethethreemainfinancialstatementsinsomedetail,andyouwillbeintroducedtofivebasicfinancialaccountingconcepts:entity,moneymeasurement,
goingconcern,consistencyandmateriality.Youwillalsolearnabouttwoimportantqualitiesoffinancialaccountinginformationrelevanceandreliabilityandhowtheuseofaccrual
accountingandgenerallyacceptedaccountingprinciplesaidaccountantsintheirquestforthesequalities.
OverviewofFinancialReports
Inthissection,youwillbeintroducedtothethreemainfinancialreportsorstatements.Eachstatementwillbecoveredinmoredetailinthefollowingchapters.
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BalanceSheet
Abalancesheet,alsocalledastatementoffinancialposition,isareportoftheorganization'sfinancialsituationataparticularpointintime.Itliststheentity'sassets,liabilitiesand
owners'equity.Itiscalledabalancesheetbecauseitreportsthebalanceoramountineachasset,liabilityandowners'equityaccount.
ThisisGlobalGrocer'sbalancesheetonemonthafteritopensforbusiness.Wewilluseittoexplainkeybalancesheetrelatedterms.Thechapterlabeled"TheBalanceSheet"covers
thebalancesheetinmoredetail.
(1)Attopofeachfinancialstatementisthenameoftheorganizationorentityforwhichthestatementhasbeenprepared.Thetermentityisusedtoindicatetheseparateeconomic
unitforwhichfinancialrecordsarebeingkeptandfinancialstatementsprepared.Commontypesofaccountingentitiesarebusinesses,politicalandcharitableorganizations,city
governments,universities...anyorganizationthatneedstorecordandcommunicateitsfinancialactivities.
(2)Abalancesheet,alsocalledastatementoffinancialposition,isareportoftheorganization'sfinancialsituationataparticularpointintime.Itliststheentity'sassets,liabilities
andowners'equity.Itiscalledabalancesheetbecauseitreportsthebalanceoramountineachasset,liabilityandowners'equityaccount.Chapter3coversthebalancesheetin
greaterdetail.
(3)Eachbalancesheetispreparedasofaspecificdate,whichisrecordedatthetopofthestatement.Inthenextchapter,youwillpreparethisopeningbalancesheetforGlobal
Grocer,datedAugust31,2004.
(4)Assetsareeconomicresourcesacquiredinabusinesstransactionthatareobtainedorcontrolledbyanentity,andareexpectedtoproducefutureeconomicbenefits.Forexample,
thisbalancesheetshowsthatonSeptember30,2004,amongotherassets,GlobalGrocerhadacashassetrecordedat$95,500andawarehouseproperty(buildingandland)recorded
at$69,700.
(5)Aliabilityisanobligationtotransfereconomicresourcestoentitiesoutsidethebusiness.Liabilitiesrepresentthecapitalprovidedtothebusinessbycreditors.Forexample,aloan
fromabankisaliability,suchastheonelistedonGlobalGrocer'sSpetember30,2004balancesheetasshorttermdebt.Undertheloancontract,GlobalGrocerhasanobligationto
repaythebankfromwhichitobtainedtheloan.
(6)Owners'Equity,alsoknownasstockholders'orshareholders'equity,representstheresidualinterestoftheownersinthebusiness.Theowners'interestiswhat'sleftoverafter
deductingliabilitiesfromassets.ThecommonstocklistedonGlobalGrocer'sSpetember30,2004balancesheetindicatesthatitsownershavecontributedcapitaltothecompany,and
inreturn,havereceivedcommonstockcertificatesestablishingtheirownershipinterest.
IncomeStatement
Theincomestatementdetailstheentity'soperatingperformanceduringaspecificperiodoftime,knownastheaccountingperiod,displayedatthetopofthestatement.Inthis
incomestatementforGlobalGrocer,theaccountingperiodisthemonthofSeptember2014.
Theincomestatementliststherevenuesearnedandexpensesincurredduringtheperiodsubtractingexpensesfromrevenuesresultsinthemeasurementofnetincomeforthe
period.
Thechapterlabeled"TheIncomeStatement"coverstheincomestatementingreaterdetail.
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(1)Justasinthebalancesheet,theincomestatementcontainsthenameoftheentityatthetop.
(2)Theincomestatementdetailstheentity'soperatingperformanceduringaspecificperiodoftimeknownastheaccountingperiod.Theincomestatementliststherevenuesearned
andexpensesincurredduringtheperiodsubtractingexpensesfromrevenuesresultsinthemeasurementofnetincomefortheperiod.Chapter4coverstheincomestatementin
greaterdetail.
(3)Thedateisdisplayedatthetopofthestatement.InthisexampleincomestatementforGlobalGrocer,theaccountingperiodisthemonthofSeptember2004.
(4)Sales,sometimesdenotedasSalesrevenueorRevenues,isthesumoftheeconomicbenefitstheentityhasearnedduringtheaccountingperiodinexchangeforthegoodsand
servicesithasprovidedtoitscustomers.Theeconomicbenefitsmaybeincreasesinassetsordecreasesinliabilities.
(5)Expensesaretheassetsusedorliabilitiesincurredbytheentityduringanaccountingperiodtoprovidethegoodsandservicesthatgeneratedrevenueduringtheperiod.
(6)Netincomeorprofit,ornetprofit,isthedifferencebetweenthesalesandexpensesoftheaccountingperiod.Becauseitappearsasthelastlineoftheincomestatement,itisoften
referredtoasthebottomline.
StatementofCashFlows
Thestatementofcashflowsdetailsthesourcesandusesofcashbytheentityoveranaccountingperiod.Fortheconvenienceoffinancialstatementusers,thestatementofcashflowsis
organizedbytypeofbusinessactivity:operating,investingandfinancing.
Thechapterlabeled"TheStatementofCashFlows"coversthestatementofcashflowsingreaterdetail.
(1)Justasinthebalancesheetandtheincomestatement,thestatementofcashflowsindicatesthenameoftheentityatthetop.
(2)Thestatementofcashflowsdetailsthesourcesandusesofcashbytheentityoveranaccountingperiod.Fortheconvenienceoffinancialstatementusers,thestatementofcash
flowsisorganizedbytypeofbusinessactivity:operating,investingandfinancing.Chapter6coversthestatementofcashflowsingreaterdetail.
(3)Thedateisdisplayedatthetopofthestatement.InthisstatementofcashflowsforGlobalGrocer,theaccountingperiodisthemonthofSeptember2004.
(4)Operatingactivitiesarethoseactivitiesthatarerelatedtothedeliveryofgoodsandservices.Thecashimpactofsuchactivitiesisrecordedintheoperatingactivitiessectionofthe
statementofcashflows.AtGlobalGrocer,thissectionofthestatementofcashflowswould,forexample,reportcashcollectedfromcustomers,cashpaidtosuppliersandcashpaidto
employeesaspartofitsdailybusinessactivities.
(5)Investingactivitiesarethoseactivitiesthatarerelatedtothepurchaseandsaleoflonglivedassets.Theimpactofsuchactivitiesonthecashaccountisrecordedintheinvesting
activitiessectionofthestatementofcashflows.AtGlobalGrocer,thissectionofthestatementofcashflowswould,forexample,reportthecashusedtopurchaseavan.
(6)Financingactivitiesrelatetoborrowingorretiringdebtandtoincreasingordecreasingowners'equityinthefirm.Theimpactofsuchactivitiesonthecashaccountisrecordedin
thefinancingactivitiessectionofthestatementofcashflows.AtGlobalGrocer,cashfrombankloansandamountsreceivedfromownersarereportedinthissectionofthestatement
ofcashflows.
Exercise2.1
TheBalanceSheetissonamedbecause:
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Abalancesheetisprepared_________.
Anincomestatementisprepared__________.
Astatementofcashflowsisprepared_________.
Choosethepairofwordsthatbestcompletesthefollowingsentence:Cashheldbyabusinesswouldbestbelistedas_________onthebalancesheetabankloantakenbythe
businesswouldbelistedas_________.
ClassifythefollowingasOperating,InvestingorFinancingactivities:
Purchaseorsaleofbuilding
Raisingcashfrominvestors
Sellingproductsandservices
IntroductiontoConcepts
FinancialAccountingconceptsformthefoundationonwhichthefinancialaccountingsystemandreportsarebuilt.Entitiesandthenatureoftheireconomicactivitieschangeandevolve
overtime.Accountingmustbeabletoaccommodateandreflectthosechanges.Accountingconceptsprovideguidancetoresolveaccountingissuesthatmayarisetodayorinthefuture.
IntheUnitedStates,theFinancialAccountingStandardsBoard(FASB)setsaccountingstandards.Ithasadoptedasetofessentialaccountingconcepts.Theyformthebasisofalarge
numberofaccountingstandardsthatprovideguidancetoaccountantsonhowtoaccountforspecifictypesoftransactions.Thesestandardsandthedetailsonhowtoapplythem,if
printedinhardcopy,wouldnumberinthethousandsofpages.
Fivebroadaccountingconceptsentity,moneymeasurement,goingconcern,consistencyandmaterialitywillbediscussedinthissection.Otherconceptswillbediscussedin
subsequentchapters.
EntityConcept
Theentityconceptisthemostbasicaccountingconcept.Itstatesthataccountsarekeptforanentityasdistinctfromthepeoplewhoown,runordobusinesswiththeentity.
Theentityconceptissimplebutpowerful.Itallowstheaccountanttodrawavirtualboundaryaroundtheentityandhencelimittheactivitiesthatneedtobetrackedandrecorded.
MoneyMeasurementConcept
Themoneymeasurementconceptstatesthatfinancialaccountingdealsonlywiththingsthatcanberepresentedinmonetaryterms.Thisconceptissointuitivethatitisusually
takenforgranted.But,sinceitissoimportant,itisstatedasabasicaccountingconcept.
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GoingConcernConcept
Goingconcernisaccounting'swayofsayingthatanentityisexpectedtoremaininoperationfortheindefinitefuture.Thegoingconcernconceptdirectstheaccountantto
explicitlymakethisassumptionintheabsenceofevidencetothecontrary.
Thesignificanceofthegoingconcernconceptcanbeunderstoodbyconsideringthealternative:thattheentityisabouttogooutofbusiness.Ifthiswasthecase,allitsresources
shouldbevaluedattheircurrentworthtopotentialbuyers.Thegoingconcernconceptdirectstheaccountant,underthenormalcourseofbusiness,toignorethisdoomsdayscenario.
ConsistencyConcept
Theconsistencyconceptstatesthatanentityshouldusethesameaccountingmethodsandproceduresfromperiodtoperiodunlessithasasoundreasontochangemethods.
Theconsistencyconceptneedstobeexplicitlystatedbecausesomeaccountingstandardsallowafairdegreeofvariationinhowtransactionsarerecorded.Theconsistencyconcept
reducesthelikelihoodofopportunisticorwhimsicalchangesinaccountingproceduresbyanentity.
Notethattheconsistencyconceptdoesnotforbidaswitchinaccountingprocedures.Ifanentitydoesmakeaproceduralaccountingchange,itsmanagementandauditorsarerequired
tonotethechangeintheirdiscussionoftheentity'saccounts.
Notealsothatinthecontextofaccountingconcepts,consistencymeansconsistencyovertime.
MaterialityConcept
Thematerialityconceptstatesthatanentityneedonlyapplyproperaccountingtoitemsthatarematerial,i.e.,significanttopotentialusersofthefinancialstatements.This
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conceptallowstheaccountanttobepracticalinchoosingtheappropriatedegreeofprecisionintheaccounts.
Justwhatismaterialandnotmaterialisnotmadespecificinaccounting.Thegeneralruleisthat,"Anitemismaterialifitsdisclosurewouldimpactthedecisionsoftheusersofthe
accounts."Theapplicationofthisrulerequiresaccountantstojudgewhatusersoffinancialstatementswouldconsidersignificanttotheirdecisions.Asinmostmattersrequiring
judgments,reasonablepeoplecandiffer.Determiningmaterialityisnoexception.
Exercise2.2
Anonprofitagencycannotbeafinancialaccountingentity.
GlobalGroceristheentityforwhichyouwillkeepthebooks.WhichofthefollowingeventswillaffectGlobalGrocer'saccounts?
WhichofthefollowingwillnotberecordedonGlobalGrocer'sbooksbecauseitviolatestheMoneyMeasurementconcept:
"Accountingdoesnotreportwhattheassetsofabusinesscouldbesoldforifthebusinessceasedtoexist".Thisisaresultofthe:
QualityAttributes
Inanyfinancialaccountingsystem,thereareanumberofdecisionstobemade:whethertorecordatransaction,whentorecorditandhowtorecordit.Also,therearedifferentwaysto
aggregatetheaccountbalancesinfinancialreports.Anysuchsystemmusthaveasetofcriteriaorguidelinestohelpmakethosedecisions.Thissectionaddressessomeofthoseissues.It
discussesdesiredfinancialaccountingqualityattributesandsomeoftheguidancethatflowsfromtheseattributes.
RelevanceandReliability
Infinancialaccounting,thequalityoftheoutputdependsontherelevanceandreliabilityofthedatapresented.
Relevancereferstothetimelinessandusefulnessoftheinformationtoitsusers.Reliabilityreferstotheobjectivityandverifiabilityoftheinformation.Differentwaysofrecognizing,
measuringandrecordinganeventmayyieldmoreorlessreliableormoreorlessrelevantaccountbalances.
Often,judgmenthastobeusedtomakethetradeoffbetweenrelevanceandreliability,i.e.,thereisn'tawaytorecordatransactionthatwillmaximizeboththesedesirable
properties.Insuchcases,reliabilityisgenerallygivenprecedenceoverrelevance.
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Exercise2.3
Choosethepairofwordsthatbestcompletesthefollowingsentence:Sincefinancialaccountingreportsareusedtomakedecisionsthataffecttheentity,financialaccountingstrives
topresentinformationabouttheentitythatis__________and_________.
Choosethepairofwordsthatbestcompletesthefollowingsentence:Relevanceoffinancialinformationreferstoits___________and___________.
Whichofthefollowingpairsofattributesbestcontributestothereliabilityoffinancialdata:
Whenrelevanceandreliabilityareinconflict,financialaccountingwillfavorrelevance.
AccrualAccounting
Accrualaccountingisanimportanttoolinthequestforrelevanceinaccountingreports.Thismethodofaccountingprovidesinformationaboutacompany'sassets,liabilitiesandowners'
equitythatcannotbeobtainedbyaccountingforonlycashreceiptsandoutlays.
Accrualaccountingfocusesontheeconomiccharacteristicsoftransactionsratherthantheircashflows.
Accrualvs.CashBasis
Accrualaccountingattemptstorecordthefinancialeffectsonabusinessoftransactionsthathaveeconomicconsequencesforthebusinessintheaccountingperiodwhenthe
transactionoccursratherthanonlyintheperiodswhencashisreceivedorpaidbythecompany.
Atthisstage,somesimpleexampleswillhelpgivemeaningtothetermaccrualaccountingascontrastedwithcashbasisaccounting.
Whenappliedconsistently,accrualaccountingisameansofenhancingtherelevanceoffinancialstatements.Cashbasisaccountingresultsininadequateandmisleadingfinancial
statementsforallbutthemostsimpleofbusinesses.Asaresult,accrualaccountingistheaccountingsystemofchoicethroughouttheworldtoday.
Accrualaccountingattemptstorecordthefinancialeffectsonabusinessoftransactionsthathaveeconomicconsequencesforthebusinessintheaccountingperiodwhenthe
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transactionoccursratherthanonlyintheperiodswhencashisreceivedorpaidbythecompany.
Atthisstage,somesimpleexampleswillhelpgivemeaningtothetermaccrualaccountingascontrastedwithcashbasisaccounting.
Whenappliedconsistently,accrualaccountingisameansofenhancingtherelevanceoffinancialstatements.Cashbasisaccountingresultsininadequateandmisleadingfinancial
statementsforallbutthemostsimpleofbusinesses.Asaresult,accrualaccountingistheaccountingsystemofchoicethroughouttheworldtoday.
GAAP
Financialaccountingreportsareusedbyinvestors,regulators,employees,customersandanumberofotherexternalparties.Sothatthisdiverselistofuserscanunderstandanentity's
financialstatements,accountantsmustfollowcertainguidelinesorstandardswhenpreparingfinancialaccountingreports.Theseprinciples,morenumerousthantheaccounting
concepts,areexplicitrulesthatareusedtoimprovethereliabilityandcomparabilityoffinancialreports.
GenerallyAcceptedAccountingPrinciples(GAAP)areguidelinesthataccountants,managersandauditorsmustfollowwhilepreparingandauditingaccountinginformationforexternal
reportingpurposes.Forexample,GAAPrequirestheuseofaccrualaccounting.TheapplicationofGAAPrulesresultsinreasonablyreliablefinancialinformation,whilealsopermitting
eachentitytoreasonablydescribeitsownbusinessstrategyandperformancethroughrelevantaccountinginformation.
Inthistutorial,youwilluseGAAPtorecordGlobalGrocer'sbusinesstransactions.However,youwillnotneedtoactuallylookuporrefertotheGenerallyAcceptedAccountingPrinciples
eachtime.Instead,thistutorialwillsimplyshowyouhowtorecordGlobalGrocer'stransactionsaccordingtoGAAP.
TheFinancialAccountingStandardsBoard(FASB)determinesGAAPintheUnitedStates.TherealsoexistsanInternationalAccountingStandardsBoard(IASB),which,amongother
activities,hasundertakenamajorefforttoharmonizeaccountingstandardsaroundtheworld.
IFRS
ConvergenceProject
TheInternationalAccountingStandardsBoard(IASB)publishesInternationalFinancialReportingStandards(IFRS).TheFASBandtheIASBhaveamajorprojectunderwaytobring
aboutaconvergenceofGAAPandIFRS.Asaresultofthisproject,usersofthistutorialcanassume,unlessnotedotherwise,thattheaccountingforaparticulartransactiondescribedin
thetutorialisessentiallythesameunderbothGAAPandIFRS.Asnotedearlier,IFRScouldreplaceGAAPasearlyas2015.
PrinciplesvsRules
PrinciplesBasedversusRulesBased
IFRStendstobestatedasintheformofbroadprinciples.Incontrast,muchofGAAPtendstobestatedintheformofbrightlinerules.Forexample,asyouwilllearnlateralongwith
variousaccountingrules,underGAAPifatermofaleaseisequalto75percentoftheeconomiclifeoftheleasedproperty,theleasewillbeaccountedforasacapitallease.Ontheother
hand,iftheleaseitemisequalto74percentorlessoftheleasedproperty'seconomiclife,theleasewillbeaccountedforasanoperatinglease.IFRStakesadifferentapproach.Itmakes
thedistinctionbetweenacapitalandanoperatingleasebasedonwhichpartythelessororthelesseesubstantiallybearstheriskandrewardofownership.
Thedistinctionbetweentheprinciplebasedandrulebasedaccountingstandardsisimportant.Underaprinciplestandardsmodel,theaccountingfortransactionsismorelikelyto
reflectthesubstanceofthetransaction.Underarulebasedstandardsmodel,theaccountingforatransactionismorelikelytoreflecttheformofthetransaction.
AsGAAPandIFRSconverge,itisanticipatedthatGAAPwillbecomemoreprinciplebased.
Recap
Inthischapter,youhave
brieflyexploredthreefundamentalaccountingstatements,
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learnedabouttheentityconcept,themoneymeasurementconcept,thegoingconcernconcept,theconsistencyconceptandthematerialityconcept,
startedtoappreciatetheinherentconflictbetweenrelevanceandreliabilitythataccountantsmustresolveinsettingstandardsandpreparingfinancialreports,
beenintroducedtoaccrualaccountingandGAAPandtheiruseinfinancialaccountingpractice,and
learnedthatinthenearfutureGAAPmaybereplacedbyIFRS.
TheBalanceSheet
Inthischapter,youwilllearnhowabalancesheetisorganizedandaboutitsmainorganizingprinciple,theaccountingequation.Twoconceptsthatareimportantforthepreparationofthe
balancesheet,dualaspectandhistoricalcost,willbeexplained.Theywillbeusedtorecordtheoperating,investingandfinancingactivitiesyouhaveundertakentogetGlobalGrocerready
forbusiness.Finally,twofinancialratiosthatcanbecomputedfromthebalancesheetcurrentratioandtotaldebttoequityratiowillbediscussed.
Layout
Thebalancesheet,alsoknownasastatementoffinancialposition,isasnapshotataspecificpointintime,oftheresourcescontrolledbyanentity(assets),theclaimsagainstthose
resources(liabilities),andtheowners'residualinterestintheentity(owners'equity).Inthesidebysideformatshown,assetsarelistedontheleftsideofthebalancesheetliabilities
andowners'equityarelistedontheright.
HereisGlobalGrocer'sbalancesheetasitwillappearattheendofbusinessonSeptember30,afteramonthofoperations.
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(1)GlobalGrocer,Inc.isnamedatthetop,andthebalancesheetdateisindicated.ThisisGlobalGrocer'sbalancesheetasitwillappearattheendofbusinessonSeptember30,2004,
afteramonthofoperations.
(2)Inthesidebysideformatshown,theentity'sassetsarelistedontheleftitsliabilitiesandowners'equityarelistedontheright.Notethattotalassetsequalstotalliabilitiesplus
owners'equity.
Exercise3.1
Whichoneofthefollowingbestdescribesabalancesheet?
Assets
Let'snowlookatthelefthandsideofthebalancesheet.Itliststheassetaccounts,whichrepresenttheeconomicresourcesofthefirm.Toberecordedasanasset,aneconomicresource
mustmeetfourrequirements:
Acquiredatmeasurablecost
Obtainedorcontrolledbytheentity
Expectedtoproducefutureeconomicbenefits
Arisesfromapasttransactionorevent
AssetExamples
HerearethreeassetsthatyouwillrecordonGlobalGrocer'sAugust31,2014balancesheet(notshown).Eachsatisfiesallfourcriteriaforbeingrecordedasanasset.
NotAssets
HerearesomeitemsthatGlobalGrocerwillnotlistasassetsonitsbalancesheet.Eachfailstosatisfyatleastoneofthefourcriteriaforbeingrecordedasanasset.
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Tangibility
Anitemcanbeanassetwhetherornotithasphysicalsubstance,i.e.,whetherornotitcanbetouchedandfelt.Assetslikecomputersandbuildingshavingphysicalsubstanceare
tangibleassets.Otherassets,likelicensesandprepaidexpensesthatlackphysicalsubstance,areintangibleassets.
Liquidity
Onthebalancesheet,assetsareorganizedintotwocategories:currentandnoncurrent.Currentassetsincludecashandthoseassetsthatareexpectedtobeconvertedintocashor
consumedwithin12monthsofthebalancesheetdate.Noncurrentassetsareassetsthatareexpectedtoprovideeconomicbenefitsforperiodslongerthanayear.
ThefirstcurrentassetonGlobalGrocer'sSeptember30,2014balancesheetiscash.Itisfollowedbythreeotherassetswhoseeconomicbenefitsturnintocashorareexpectedto
expireduringthe12monthsfollowingthebalancesheetdate.Theyareaccountsreceivable(moneyowedtoGlobalGrocerbycustomers),merchandiseinventory(goodsavailable
forsale)andprepaidexpenses(rentpaidinadvanceforthestore).
TheendofSeptemberbalancesheetalsoincludesseveralnoncurrentassets:land,awarehouse,somestorefixturesfordisplaypurposes,andafranchisefeeasset.Theseassets
areexpectedtoprovideeconomicbenefitsformorethanoneyearfromthebalancesheetdate.Sometangible,noncurrentassetswithlimitedlives,suchasthewarehouse
building,haveanassociatedcontraassetaccount,calledaccumulateddepreciation,thatreducestherecordedvalueoftheasset.
IntheU.S.,assetsarereportedinastandardorderonthebalancesheet.Currentassetsarelistedfirst,startingwithcash,andfollowinginorderofliquidityi.e.,availabilityto
meetcurrentobligations.Forexample,cashismorereadilyavailablethanaccountsreceivabletopaycreditorclaims.Prepaidexpenses,thelastitemlistedasacurrentasset,is
probablynotavailableatall.Noncurrentassetsarelistednext,typicallystartingwithland,plantandequipment,followedbyintangibleassets,suchasthefranchisefee.
Exercise3.2
Considereachitemlistedintheleftcolumnofthetablebelow.Usethedropdownmenusprovidedtoindicatewhethertheitemmeetseachofthefourassetcriteria.Itemsthatmeet
allfourcriteriaareassets.
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Exercise3.3
Whichoneofthefollowingbestdescribesanassetthatisexpectedtoprovideeconomicbenefitsforthreeyearsanddoesnothavephysicalsubstance?
Liabilities
Nowweshiftourattentiontotherightsideofthebalancesheet,startingwithliabilities.Aliabilityrepresentsanobligationsoftheentitytootherparties.Toberecordedasaliability,an
obligationmustmeetthreerequirements:
Itinvolvesaprobablefuturesacrificeofeconomicresourcesbytheentity
Theeconomicresourcetransferistoanotherentity
Thefuturesacrificeisapresentobligation,arisingfromapasttransactionorevent
Examples
ConsiderthreeliabilitiesthatyouwillrecordonGlobalGrocer'sAugust31,2014balancesheet(notshown).Eachsatisfiesallthreecriteriaforbeingaliability.
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NotLiabilities
HerearesomeitemsthatyouwillnotrecordasliabilitiesonGlobalGrocer'sbalancesheet.Eachfailstosatisfyatleastoneofthethreecriteriaforbeingrecordedasaliability.
LiabilityTypes
Liabilitiesareorganizedintotwocategories:currentandnoncurrent.Currentliabilitiesareobligationsthatareexpectedtobecomeduewithin12monthsofthebalancesheetdate.
Noncurrentliabilitiesareobligationsthatareexpectedtobecomeduemorethan12monthspastthebalancesheetdate.
TherearethreecurrentliabilitiesonGlobalGrocer'sSeptember30,2014,balancesheet:accountspayable(moneyowedbyGlobalGrocertoitssupplierswhowillbepaidduringthe
comingyear),taxespayable(moneypotentiallyowedtothetaxauthorities)andashorttermdebt(aloantoGlobalGrocerthatitmustpaybackwithinayearofthebalancesheet
date).
GlobalGrocerhasonenoncurrentliabilityonitsSeptember30,2014,balancesheet:amortgagepayable.Themortgageisalongtermloan.ItrepresentsmoneyowedbyGlobal
Grocertoabank,withpaymentstobemadeformorethan12monthsfromthebalancesheetdate.
Exercise3.4
Considertheitemslistedintheleftcolumnofthetablebelow.Usethedropdownmenusprovidedtoindicatewhethertheitemmeetseachofthethreeliabilitycriteria.Items
meetingallthreecriteriaareliabilities.
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Owners'Equity
Owners'Equityistheresidualinterestoftheentity'sownersinthecompany'sassets.Itistheamountremainingafterliabilitiesaredeductedfromassets.
Exercise3.5
OnJune30,2014,Ardelcompanyhastotalassetsof$12,500,000.Ithastotalliabilitiesof$10,500,000.WhatistheamountofArdel'sowners'equityonJune30,2014?
TheAccountingEquation
Asimplerelationshipconnectsassets,liabilitiesandowners'equity.Thekeyfeatureofabalancesheetisthattotalassetsisalwaysequaltototalliabilitiesplusowners'equity.This
relationshipbetweenassetsandliabilitiesplusowners'equityisknownasthefundamentalaccountingequation.
Theleftsideoftheaccountingequationtotalassetsrepresentsallofanentity'sresourcesthathaveprobablefutureeconomicbenefitsthattheentityhasobtainedorcontrolsasaresult
ofpasttransactionsorevents.Therightsideoftheequationtotalliabilitiesplusowners'equityrepresentsthesourcesforthoseresources.Therefore,thetwosidesmustbeequalatall
times.
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Exercise3.6
Whichoneofthefollowingbestdescribesthefundamentalaccountingequation?
Concepts
Inthissectionwewillintroducetwomoreaccountingconcepts,namelythedualaspectandhistoricalcostconcepts.Theyareparticularlyrelevanttothebalancesheet.Thesetwo
conceptsprovideguidanceonthevaluationofassets,liabilitiesandowners'equity.
DualAspect
Thedualaspectconceptformalizestheideathattherearetwosidestoeveryaccountingtransaction.Recordingbothsidesofeachtransactionisknownasdoubleentry
bookkeeping.
Thedualaspectconcepthasaveryimportantimplication:afterbothsidesofeachaccountingtransactionarerecordedontheentity'sbooks,thebasicaccountingequationshould
remainbalanced.
Exercise3.7
Thedualaspectconcepttellsusthat
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HistoricalCost
Thehistoricalcostconcept,alsoknownasthecostconcept,providesguidanceastotheamountatwhichatransactionshouldbereportedinitiallyintheentity'saccounts.It
requiresthattransactionsberecordedintermsoftheiractualpriceorcostatthetimethetransactionoccurred.
GlobalGrocerisplanningtobuyawarehouseproperty.Thehistoricalcostconceptdirectsyoutorecordthewarehousepropertyatitsacquisitioncostof$70,000.Othersmaythinkthe
warehousepropertyisworthmoreorlessthantheamountGlobalGrocerpaid,buttheirviewsareirrelevant.Theaccountingrecordswillrecordthewarehousetransactioninitiallyat
theamountactuallypaidforit.
Relevance/Reliability
Thehistoricalcostconceptprovidesadegreeofreliabilityintheentity'saccounts.Itallowstheaccountanttoignoreopinionandhearsayaboutthemonetaryvalueofitems,andto
reportamountsbasedonactualtransactions.But,theuseofthehistoricalcostconceptalsomeansthatsomeamountsonanentity'sbalancesheetarebasedonhistoricalvalues,
determinedatthetimeofpurchase,whichcouldpredatethecurrentbalancesheetdatebyyears.Consequently,itisunlikelythattheassetamountsonthebalancesheetreflectthe
valuethattheassetswouldfetchiftheyweresoldtoday.Inthissense,thefinancialstatementsmaybe'lessrelevant'forthepurposesofusersoftheentity'sbalancesheets,thanif
currentmarketpriceswerereported.
Asnotedearlier,whenrelevanceandreliabilityhavetobetradedoff,financialreportingpracticetendstofavorreliability.Hencerelianceonthehistoricalcostconceptmay
sometimesyieldmorereliablebutlessrelevantfinancialinformation.
However,accountantsarenotblindtotherelevanceissue.Asyouwilllearninmoreadvancedaccountingclasses,manymonetaryassetsarerecordedinitiallyattheircost,and
subsequentlymeasuredandreportedinthebalancesheetattheirmarketvalue.Monetaryassetsareitemssuchasmarketablesecurities.Theirmarketvaluecangenerallybe
estimatedreasonablyreliably.Inaddition,youwilllearnhowaccountantsenhancerelevancebyrecordingsometransactionstoreflecttheirsubstanceratherthantheirform.
WhileIFRSfavorsthehistoricalcostmodel,itdoespresentasanacceptablealternativetreatmenttherevaluationoflandandbuildingstotheirmarketvalue,iftheirvaluecanbe
measuredreliablysubsequenttotheirinitialrecognitionatcost.
Exercise3.8
SunElectronicspurchasesastampingmachinefor$10,000.Almostimmediately,atradeembargorestrictsthenumberofstampingmachinesthatcanbeimportedintotheU.S.
Basedonwantadsinthecommercialsectionofthenewspaper,stampingmachineslikeSun'sarenowsellingfor$15,000.SunElectronicsshouldimmediately
Exercise3.9
Tousersofanentity'sfinancialstatements,whichofthefollowingisapotentiallimitationofthehistoricalcostconcept:
Review
Theexercisesinthissectioncoverallthematerialyouhavelearnedaboutthebalancesheetuptothispoint.Takeafewmomentstotestyourunderstandingofthismaterial.
Exercise3.10
Choosethepairofwordsthatbestcompletesthefundamentalaccountingequation:_________________=Liabilities+________________
Exercise3.11
Whichoneofthefollowingisnotarequirementforanitemtobeanasset:
Exercise3.12
GlobalGrocerhaspurchasedawarehousebuildingwithanexpectedusefullifeof10yearsfor$40,000.Whichofthefollowingisthebestdescriptionofthisnewasset?
Exercise3.13
Aliabilityonthebalancesheetrepresents_________________oftheentity.
Exercise3.14
OnJanuary1,2014,ScottManufacturinghasassetsof$1,600,000andliabilitiesof$900,000.Itsowners'equityis
Let'sGetGlobalGrocerStarted
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YouhavespentmuchofAugustraisingfinancingandmakingthenecessaryinvestmentsandpreoperatingdecisionstogetGlobalGrocerreadytoopenitsdoorsonSeptember1.
AlthoughthetransactionstookplaceduringAugust,forsimplicity,youwillrecordthemalltogetheronAugust31stbeforethestoreopens.Ofcourse,youstartwithanemptybalance
sheet.
CommonStock
ShortTermDebt
FranchiseFee
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PrepaidRent
WarehouseProperty
Mortgage
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StoreFixtures
MerchandiseInventory
Hiring
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Exercise3.15
SupposeBarnumandSonsobtainsa5year,$100,000bankloan,payableatmaturity.Whichoneofthefollowingdescribestheeffectofthistransactiononitsbalancesheet?
TransactionExercises
Theexercisesinthissectiondescribevarioustransactionsandaskyouhowtheyaffectthebalancesheet.Takeafewmomentstotestyourunderstandingofthismaterial.
Exercise3.16
Exercise3.17
OnJune2,2014,Mansfieldpurchasesacomputersystemfor$22,000fromInfostoreSystems.Mansfieldpays$10,000incashandpromisestopayInfostoretherestinequal
installmentsovertherestoftheyear.Thecomputersystemisexpectedtolast4years.Whichofthefollowingwouldyoudointhissituation?
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Exercise3.18
Exercise3.19
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Ratios
Usersoffinancialstatementsuseatechniqueknownasfinancialratioanalysistoassessthefinancialpositionandperformanceofanentity.Financialratiosareratiosbasedonthe
amountsinthefinancialstatements.Twosimplebalancesheetbasedratiosareintroducedinthissection.Theyarethecurrentratioandthelongtermdebttoequityratio.
CurrentRatio
Anentity'sabilitytomeetitscurrentobligationsthoseduewithinthecomingyearisanimportantmeasureofitsfinancialhealth.Theseshorttermobligationsareusually
repaidinthenormalcourseofbusiness,astheentity'scurrentassetsareconvertedtocash.Forexample,cashisgeneratedwhenmerchandiseinventoryissoldforcash,orwhen
accountsreceivablesarecollectedincashfromcustomers.Thiscashcanthenbeusedtopayaccountspayable.
Thecurrentratio,or,ratioofcurrentassetstocurrentliabilitiesisameasureofanentity'sabilitytomeetitsmaturingshorttermobligations.
Inthecurrentratio,thenumerator,currentassets,representstheresourcesoftheentitythatareeithercashorexpectedtosoonbeconvertedintocash.Cashandtheseasset
conversionstocashcanbeusedtosatisfytheimmediateclaimsofshorttermcreditors.Thedenominator,currentliabilities,representsthecurrentclaimsofcreditorsthatmust
beextinguishedinthenearterm.
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CurrentRatio=CurrentAssets
CurrentLiabilities
Interpretation
Whilethereisnosingleidealcurrentratio,financialstatementusersoftenemploytheruleofthumbthatahealthybusinesswillhaveaminimumcurrentratioof2.Because
theappropriatecurrentratiovariesbyindustries,financialstatementuserstendtofocusonanentity'scurrentratiorelativetothoseofother,similarbusinesses.IntheU.S.,
thepharmaceuticalindustryhashadanaveragecurrentratioof1.8overthepastdecadethesoftwareindustry,ontheotherhand,hashada2.9averagecurrentratiooverthe
sametimeperiod.Softwarecompanies,withtheirlimitedneedforfixedassets,traditionallyholdamuchlargerproportionoftheirassetsincashandmonetarycurrentassets,
andthisisreflectedintheirsignificantlyhighercurrentratios.
Iffinancialstatementusersnoticethatanentityhasacurrentratiothatsignificantlyhigherthanthatofitspeers,theymaybeconcernedthattheentityholdsmorecashor
inventorythanabusinessneeds.Thismaysignalthatitislockinguppotentiallyproductivecapital.If,ontheotherhand,anentityhascurrentratiothatissignificantlylower
thanthatofitspeers,financialstatementusersmayquestionitsabilitytosatisfyitscurrentobligationsinatimelymanner.
Exercise3.20
FarrahCompany'sDecember31,2014balancesheetshowscurrentassetsof$250,000andcurrentliabilitiesof$100,000.Itscurrentratiois
TotalDebttoEquityRatio
Thecompositionofacompany'slongtermcapitalstructureprimarilyitstotalinterestbearingdebtandowners'equityisofinteresttofinancialstatementusersseekingto
assessthelongtermfinancialviabilityofanentity.Ofparticularinterestistheratiooftotaldebt(capitalthataccruesinterestandhastoberepaidtolenders)toequitycapital
(capitalthatdoesnotdemandinterestanddoesnothavetoberepaid).
Thetotaldebttoequityratioisusefulforjudginganentity'slongtermfinancialviability.Asthenamesuggests,itistheratioofallinterestbearingdebtonthebalancesheet,to
totalequity.Thisratiomeasuresfinancialleverageorthedegreeoftheentity'sindebtednessrelativetoitsequityfunding.
Debtandequityareverydifferentkindsofcapital.Whenanentityassumesdebt,i.e.,acceptsaloan,ithastopayinterestandalsorepaytheloantothedebtholderoveran
agreeduponperiodoftime.Iftheentityrunsintohardtimesandfailstopayitsmaturingfinancialobligationstoitsdebtholders,theycanforcetheentityintobankruptcy.
Equitycapital,ontheotherhand,isaresidualclaimontheentity'sassets.Ifacompanybecomesinsolvent,equityholdersgetwhatremainsafterdebtholdershavebeen
satisfied.
So,thelargerthesizeofanentity'sdebtobligationsrelativetoequity,i.e.,thelargeritstotaldebttoequityratio,thegreateristheimpliedstrainontheentitytomakeregular
paymentstodebtholders,andthehigheristheriskofbankruptcy.
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TotalDebttoEquityRatio=TotalDebt
TotalEquity
Interpretation
Thereisnosingleidealtotaldebttoequityratio.Overthepastcoupleofdecades,intheU.S.,theaveragetotaldebttoequityratioforpubliccompanieshasrangedfrom0.5to
1.0.However,itcanvaryconsiderablyfromoneindustrytoanother.Businessesinstableindustrieswithtangibleassetsthatmakegoodcollateraltendtoborrowheavilyto
financethoseinvestments,sotheytendtohavehightotaldebttoequityratios.Incontrast,volatilebusinesseswithfewtangibleassetstendtohavelowtotaldebttoequity
ratios.IntheU.S.,thesoftwareindustry,whichtraditionallyholdsverylittledebt,hashada0.10averagetotaldebttoequityratiooverthepastdecade.Ontheotherhand,
financialfirms,whichtraditionallyareveryhighlyleveraged,havehadatotaldebttoequityratioof3.3overthesametimeperiod.
Ifacompanyhasatotaldebttoequityratiothatissignificantlyhigherthanthatofitspeers,financialstatementusersmaybeconcernedaboutitsabilitytomaketherequired
paymentstoitsdebtholdersandthecompany'slongtermsolvencymaybequestioned.
If,ontheotherhand,acompanyhasatotaldebttoequityratiothatissignificantlylowerthanthatofitspeers,financialstatementusersmayquestionwhetherthecompanyis
beingaggressiveenoughinpursuingprofitablegrowthopportunitiesbyraisingdebtwhennecessarytofinancethoseopportunities.
Aswithotherfinancialratios,thereisnosingleperfecttotaldebttoequityratioforanybusiness.Whatisimportantisacompany'stotaldebttoequityratiorelativetothoseof
other,similarbusinesses,andalsohowtheratiochangesovertime.
Exercise3.21
Whichoneofthefollowingchoicesbestcompletesthissentence:Thetotaldebttoequityratioisusefulforjudging___________________.
RatioExercises
Theexercisesinthissectiontestyourunderstandingofthetwosimplebalancesheetbasedratios:currentratioandtotaldebttoequityratio.Pleasetakeamomenttocomplete
theseexercises.
Exercise3.22
Exercise3.23
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Recap
Inthischapteryoulearned:
Howabalancesheetisorganized.
Assets,liabilitiesandowners'equityweredefined.
Thekeyrelationshiplinkingassets,liabilitiesandowners'equitythefundamentalaccountingequationwasexplained.
ThedualaspectandhistoricalcostconceptswereintroducedandusedtorecordallofGlobalGrocer'sbusinesstransactionsinAugust.
Howtocomputeandusetwosimplebutimportantbalancesheetratiosthecurrentratioandthetotaldebttoequityratio.
TheIncomeStatement
Inthischapter,youwilllearnmoreabouttheincomestatementandhowitisorganized.Youwillalsobeintroducedtothreenewaccountingconceptstherealization,matchingand
conservatismconceptsaswellashowtoapplythemtorecordtheresultsofGlobalGrocer'sbusinessoperationsduringthemonthofSeptember.Finally,youwilllearnabouttwo
ratiosthatareimportantmeasuresofoperatingperformance:thegrossmarginandreturnonsalespercentages.
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Layout
Inthissection,youwilllearnhowtheincomestatementisorganized.Anincomestatementisafinancialdescriptionofanentity'soperatingperformanceduringanaccounting
period.Itreportstheentity'ssales,expensesandnetincomeorlossfortheperiod.Theincomestatement'sbasicequationisSalesminusExpensesequalsNetIncome.
HereisasampleincomestatementforGlobalGrocerforitsfirstaccountingperiod,themonthofSeptember.
(1)Theincomestatementheadingliststhenameoftheentity,GlobalGrocer.
(2)Thenextlineindicatestheaccountingperiodcoveredbytheincomestatementinthiscase,themonthofSeptember2004.
(3)Salesareincreasesinassetsordecreasesinliabilitiesduringaperiodresultingfromdeliveringgoods,renderingservicesorotheractivitiesconstitutingtheentity'scentral
operations.
(4)Fromsales,wesubtracttheexpensesassociatedwithgeneratingthesalesoftheperiod.Expensesaredecreasesinassetsorincreasesinliabilitiesduringaperiodresultingfrom
adeliveryofgoods,renderingofservices,orotheractivitiesconstitutingtheentity'scentraloperations.
GrossMargin
Thefirstsegmentoftheincomestatementshowsthecompany'ssales,thecostofthosesalesandthedifference,whichisknownasgrossmargin.
Wecalculatedgrossmarginbysubtractingfromsalesthecostofgoodssold("COGS").Nextwesubtracttheentity'sotherexpensesofrunningthebusinesstodeterminenet
income.
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(1)FromSales,wesubtractthecostofthegoodssoldduringtheaccountingperiod.
(2)Theexcessofthesalesamountoverthecostofgoodssoldamountor,salesminuscostofgoodssoldisreferredtoasthegrossmarginorgrossprofit.Itiscalledgrossprofit
becauseoperatingexpenseshavenotyetbeenaccountedfor.
Thefirstsegmentoftheincomestatementshowsthecompany'ssales,thecostofthosesalesandthedifference,whichisknownasgrossmargin.
Wecalculatedgrossmarginbysubtractingfromsalesthecostofgoodssold("COGS").Nextwesubtracttheentity'sotherexpensesofrunningthebusinesstodeterminenet
income.
OtherLineItems
YouwillnoticeonGlobalGrocer'sincomestatementthattheexpensesofrunningthebusinesslistedbelowthegrossmarginaredisplayedinthreecategories:operating
expenses,interestexpenseandincometaxexpense.
(1)ForGlobalGrocer,expenseslistedbelowthegrossmarginareoperatingexpenses,interestexpenseandincometaxexpense.
(2)Operatingexpenses,astheirnameimplies,relatetotheoperationsofthebusiness.Theseincludethemarketing,sellingandadministrativeexpensesincurredinrunninga
business.Theyareoftenreportedasasingleaccount,selling,generalandadministrative(SG&A)expenses.
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(3)Grossmarginminusoperatingexpensesyieldsoperatingincome(alsoknownasoperatingprofit).Itisameasureoftheprofitgeneratedfromthedaytodayrunningofthe
business.
(4)Interestexpenseisthecostofdebtfinancingfortheaccountingperiod.IfGlobalGrocerhadinvestedanyexcesscashduringthisaccountingperiod,interestincome,ifany,
wouldbereportedinthissectionoftheincomestatement.Operatingprofitminusinterestexpenseyieldsincomebeforeincometaxes.
(5)Incomebeforeincometaxesminusthetaxexpenseyieldsnetincome.Sincetaxeswillnotbedueuntilnextyear,thetaxexpenseisanestimateofthetaxesthatmighthaveto
bepaidontheprofitwhenGlobalGrocer's2004taxreturnisfiled.
(6)Thenetincomeforaperiod,i.e.,theearningsoftheentity,netofallexpenses,isoftencalledprofitornetprofitwhenitispositive(i.e.,saleshavebeengreaterthantotal
expenses),orlossornetlosswhenitisnegative(i.e.,saleshavebeenlessthantotalexpenses).
LinktoBalanceSheet
Thebalancesheetsatthebeginningandendofanaccountingperiodarelinked,bytheincomestatementfortheperiod,throughtheretainedearningsaccountintheowners'equity
sectionofthebalancesheets.
RetainedEarnings
Theretainedearningsaccountisthesumofthecompany'snetincometodate,lessdividends,ifany,paidtotheowners.Thenetincomefortheperiodisaddedtotheretained
earningsamountreportedontheperiod'sbeginningbalancesheettodeterminetheperiod'sendingretainedearnings,beforeanydividendpayments.
Dividends
Dividendsaredistributionsofearningstoowners,usuallyintheformofcash.ThepaymentofadividendreducestheRetainedEarningsaccount.
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Summary
Insummary,twoeventschangetheretainedearningsaccountduringanaccountingperiod.First,theNetIncome(loss)earnedbytheentityduringtheperiodincreases
(decreases)theretainedearningsaccount.Second,anydividendspaid(distributionsmadetoinvestors)duringtheperiodreducetheretainedearningsaccount.
Thepaymentofdividendsisnotanexpenseitisadistributionofequitycapitaltoinvestors.Hence,thepaymentofdividendsisnotrecordedontheincomestatementinstead,
itdirectlyreducestheretainedearningsaccount.
Exercise4.1
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DuringthemonthofApril2015,MansfieldCompanyrecordssalesof$5,000,andtotalexpensesof$3,000.WhatisMansfield'snetincomeforApril2015?
Exercise4.2
SupposeMansfieldhasaretainedearningsbalanceof$20,000onApril1,2015.DuringthemonthofApril,itearnsanetincomeof$2,000andalsopaysadividendof$500toits
investors.WhatisitsretainedearningsbalanceattheendofApril2015?
Concepts
Inthissection,wewillintroducethreemoreaccountingconcepts:therealization,matchingandconservatismconcepts.Theyareparticularlyrelevanttotheincomestatement.
Thesethreeconceptsprovideguidanceastothetimingoftherecognitionandamountsofsalesandexpensestoberecordedbytheentity.Liketheotherfinancialreporting
concepts,whenproperlyapplied,theyreflectabalancebetweenrelevanceandreliabilityinthereportedamounts.
RealizationConcept
Realizationistheprocessofconvertingassets,suchasmerchandiseforsale,intocash,cashequivalents,orgoodaccountsreceivable.
Realizationplaysanimportantroleindeterminingwhenrevenueisrecognized.Twoconditionsmustbesatisfied.First,therevenuemustbeearned,whichtypicallymeansthat
thecustomerhasreceivedthegoodorservice.Second,therevenuemusthavebeenrealizedorrealizable,implyingthatthecustomerhaspaidorisexpectedtopayforthe
merchandise.
Realizationistheprocessofconvertingassets,suchasmerchandiseforsale,intocash,cashequivalents,orgoodaccountsreceivable.
Realizationplaysanimportantroleindeterminingwhenrevenueisrecognized.Twoconditionsmustbesatisfied.First,therevenuemustbeearned,whichtypicallymeansthat
thecustomerhasreceivedthegoodorservice.Second,therevenuemusthavebeenrealizedorrealizable,implyingthatthecustomerhaspaidorisexpectedtopayforthe
merchandise.
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IFRS
TheIFRSandGAAPrevenuerecognitionrulesdifferintheirwordingandunderlyingtheory.IFRSrecognizesrevenuewhenthe"risksandrewardsofownershipare
transferred."Incontrast,GAAP,amongotherrequirements,recognizesrevenuewhenitis"earned."Despitethesedifferences,inmostcasestheaccountingforrevenue
transactionswillbethesameundereitherconcept.
IFRSrecognizesrevenuewhenallthefollowingconditionshavebeensatisfied:
Thesellerhastransferredtothebuyerthesignificantrisksandrewardsofownershipofthegoods
Thesellerretainsneithercontinuingmanagerialinvolvementtothedegreeusuallyassociatedwithownershipnoreffectivecontroloverthegoodsold
Theamountofrevenuecanbemeasuredreliably
Itisprobablethattheeconomicbenefitsassociatedwiththetransactionwillflowtothesellerand
Thecostsincurredortobeincurredinrespectofthetransactioncanbemeasuredreliably.
Exercise4.3
FollowingGAAP,considereachsituationdescribedbelowandindicatewhetherrevenuehasbeenearnedandwhetheritisrealizedorrealizablebychoosingtheappropriate
entriesineachcell.
MatchingConcept
TheGAAPandIFRSrevenuerecognitioncriteriatellsuswhentorecognizerevenue.TheMatchingconceptindicateswhatexpensesshouldberecognizedwhenrevenueis
recorded.
Thetimingofexpenserecognitionisimportantsincerevenuelessexpensesequalsnetincome.TheMatchingConceptstipulatesthatexpensesshouldberecognizedinthesame
periodastherelevantrevenuesarerecognized.Costsrelatedtothisperiod'sactivitiesbutwhicharenotdirectlyrelatedtoproductsandservicessold,areexpensedthisperiod.
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TheRealizationconcepttellsuswhentorecognizerevenue.TheMatchingconceptindicateswhatexpensesshouldberecognizedwhenrevenueisrecorded.
Thetimingofexpenserecognitionisimportantsincerevenuelessexpensesequalsnetincome.TheMatchingConceptstatesthatexpensesshouldberecognizedinthesame
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ConservatismConcept
TheRealizationConceptanditsassociated"earned"requirementsprovideguidanceastowhentorecognizerevenuesandtheMatchingConceptprovidesguidanceastowhento
recognizeexpenses.TheConservatismConceptgoesonestepfurtherbyrecommendingthatprudencebeexercisedinrecordingrevenuesandexpenses.Itsaysthatrevenues
shouldberecognizedonlywhenreasonablycertain,butexpensesshouldberecognizedassoonasreasonablypossible.
Conservatisminfinancialaccountingmeansthatanentityshouldrecognizeonlythoserevenuesforwhichthereisahighdegreeofconfidencethattheywillbeearnedand
realized.
Expenses,ontheotherhand,shouldberecordedassoonastheyseemlikelytobeincurred.Iftheentityisuncertainwhethertorecognizeanexpenseorabouttheamountofan
expense,theconservatismconceptencouragesittoproactivelyestimatethecostandrecordtheexpense.
Theconservatismconceptalsoappliestothebalancesheet.Itsuggestsprudenceintherecordingofassets(recordwhenreasonablycertain)andintherecordingofliabilities
(recordassoonasreasonablypossible).Further,iftwodifferentestimatesofabalancesheetamountwereequallyacceptable,theconservatismconceptwouldguideaccountantto
recordthesmalleramountwhenmeasuringassetsandthelargeramountforliabilities.
Caremustbetakenwhenapplyingtheconservatismconcept.Otherwise,itcanleadtobiasinfinancialstatementsbyunderstatingprofitsinoneperiodonlytobefollowedby
overstatementinasubsequentperiod.
Let'sGetGoing
ItisSeptember1andthisisGlobalGrocer'sbalancesheet.DuringAugust,youraisedcapitalforGlobalGrocer,paidafranchisefee,boughtstorefixtures,purchasedawarehouse
property,rentedastoreandstockedupmerchandiseinventory.Youalsohiredtwoexperiencedemployeeswhowillstartworktoday.
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(1)Thecurrentasset,accountsreceivable,andtheowners'equityaccountretainedearnings,whichhavezerobalancesatpresent,willbeaffectedbytheoperationsthatcommence
today.
TheFirstFewSales
ThestoreopensonWednesday,September1,andasexpected,thefirstfewdaysofstoreoperationsareslow.Severalpeoplestopbytobrowse,pickupbrochuresandtastethe
freesamples.Thestoremakesthreesalesbytheendofitsfirstdayofoperations.
Thedollaramountofeachsale,thecashreceived,creditprovidedtocustomersandrecordedasaccountsreceivableandthecosttoGlobalGrocerofthegoodssold(COGS)are
showninthistable.Ineachofthesesales,goodshavebeendeliveredtothecustomerandcashhaseitherbeencollectedorisexpectedbecollectedbyGlobalGrocer.Therevenues
havebeenearnedandarerealizedorrealizable.Therevenuerecognitionconceptrequiresthatyourecordtherevenuefromthesefirstdaysales.
Recording
Salesandexpensesareincomestatementaccounts.However,theyalsoaffectthebalancesheet,inparticular,theretainedearningsaccount.Inordertobuildonour
understandingofthefundamentalaccountingequation(Assets=Liabilities+Owners'Equity),wewillillustratetheimpactofthesefirstdaysalesonGlobalGrocer'sbalance
sheet,andalsobegintoconstructitsincomestatementforSeptember2014.Attheendoftheaccountingperiod,themonthofSeptember,wewillcompleteGlobalGrocer's
incomestatement.
CashSale
Let'srecordthesaleofthegiftbasket,wherethecustomerpaidtheentireamountincash.
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CreditSale
Let'srecordthesaleoftheItalianpesto,wherethecustomerputtheentireamountoncredit.
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Exercise4.4
Recordtheeffectofthethirdandfinalsaleoftheweek:100poundsofColombiancoffeearesoldfor$400.Thecustomerpaid$150incashandput$250onacreditaccount
withGlobalGrocer.Whichoneofthefollowingchoicescorrectlydescribestheeffectonbalancesheetoftherevenuerecognizedfromthissale?
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NowrecordthematchedCOGSexpenserelatedtothesaleof100poundsofColombiancoffee.GlobalGrocerpaid$2.60perpoundforthecoffeeinitsinventory.Whichoneof
thefollowingchoicescorrectlydescribestheeffectonbalancesheetoftheCOGSexpenserecordedforthissale?
BalanceSheetEffect
Theeffectonthebalancesheetofthisprofitablesaleof100poundsofColombiancoffeeforcashandcreditisshownhere.Thecashaccountincreasedby$150,accounts
receivableincreasedby$250,merchandiseinventorydeclinedby$260andretainedearningsincreasedby$140.Thefundamentalaccountingequationremainsinbalance.
OverallEffect
Thethreesalesonthefirstdayresultinrevenuesof$1,000(giftbasket,$100+pesto,$500+coffee,$400)andrelatedcumulativeCOGSof$600(giftbasket,$40+pesto,
$300+coffee,$260).$250ofthesalesrevenuewascollectedincashand$750wasrecordedasareceivable.Inventorywasreducedby$600.Thesetransactionsresultedina
$400increaseinretainedearnings.
Onthepartialincomestatementweareconstructing,werecordthecumulativesalessofarof$1,000andCOGSof$600.Thegrossmarginearnedsofaris$400,exactlyequal
totheincreaseinretainedearningsduetotheseprofitablesales.
Let'sTallySept.Operations
OvertherestofSeptember,asGlobalGrocer'sreputationspreads,salespickup.Duringthefirstaccountingperiod,September1throughSeptember30,salestotaled$16,000
(includingthethreefirstdaysales),ofwhich$11,000wascollectedincashand$5,000wasputonaccount.Costofgoodssoldamountedto$7,500.Customersdidnotmakeany
paymentstowardstheircreditaccounts,andnoinventorywaspurchased.
YouhavetrackedandrecordedsalesandCOGS,andcalculatedgrossmarginforthemonthofSeptember.Itistimetorecordtheotherexpensesoftheaccountingperiod.
ExpensesofthePeriod
Youwillnowrecordtheoperating,interestandtaxexpensesfortheperiod.Thesearecoststhatarenotassociatedwithfuturerevenues,sowewillmatchthemtotherevenue
recognizedforthemonth.
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Salaries
First,werecordthesalariesexpenserelatedtoemployeesalaries.Youandthetwoemployeeseachwerepaid$1,000incashforthemonth'swork,foratotalmonthlysalary
expenseof$3,000.Thistransactionincreasestheoperatingexpensesontheincomestatementby$3,000.Likeallexpenses,thisexpensereducesretainedearningsonthe
balancesheet.Thesalarieswerepaidincash,sothecashaccountalsodecreasesby$3,000.
Utilities
Theutilitiesexpenseforthemonthwas$500,alsopaidincash.
RentExpense
Storerentis$1,000permonth.GlobalGrocerhadalreadyprepaidthreemonths'rent,reflectedintheprepaidexpensesbalanceof$3,000ontheAugust31balancesheet.
Recognitionoftherentexpenseof$1,000forthemonthofSeptemberrequiresanequalreductionintheprepaidexpensesassetaccount.Takespecialnoteofthistransaction:
nocashisexchangedatthispoint,buttherentexpenseassociatedwiththepassageofthemonthisrecorded.Thisisaccrualaccounting.
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Depreciation
Thenextoperatingexpenseswewillrecordareassociatedwiththeuseoftangiblenoncurrentassetsthewarehousebuildingandstorefixtures.GlobalGroceracquiredthese
assetswiththeexpectationthattheywouldprovideeconomicbenefitsforanumberofyears.Thematchingconceptrequiresthatthecostofeachoftheseassetsbespreadover
itsusefullife,andineachaccountingperiodanexpenseberecordedtoreflectthereductionintheusefullifeoftheasset.ThisexpenseiscalledDepreciationExpense.
Depreciationofatangiblelonglivedassetalsoreducesthebalancesheetvalueoftheasset.Thisisaccomplishedusinganaccumulateddepreciationaccount,acounterpart
totheassetaccount,butwiththeoppositesign.Itsneteffectisareductionintherecordedvalueofanasset.Anasset'shistoricalcost(itsdepreciablepurchaseprice)minusits
accumulateddepreciationyieldsitsnetbookvalue.Thenetbookvalueofeachlonglivedassetisusedtocomputetotalassetsonthebalancesheet.
NetBookValue=HistoricalCostAccumulatedDepreciation
Warehouse
Weestimatethatthewarehousedepreciationexpenseforeachmonthofitsuseis$300.Thecontraassetornegativeassetaccount,accumulateddepreciationonthe
warehousebuilding,isincreasedby$300,andthedepreciationexpensereducesretainedearningsbythesameamount.Ineffect,the$300increaseintheaccumulated
depreciationcontraassetaccountdecreasestotalassetsby$300,andthefundamentalaccountingequationismaintained.
OntheSeptember30balancesheet,thewarehousebuildingwillhaveanetbookvalueof$39,700,andthisamountwillbeincludedinthecalculationofGlobalGrocer'stotal
assetsattheendofSeptember.
NetBookValue=HistoricalCostAccumulatedDepreciation
=$40,000$300=$39,700
StoreFixtures
GlobalGrocerhasanotherlongliveddepreciabletangibleasset,storefixtures.ItshouldalsobedepreciatedtoreflectitsreducedexpectedusefullifeattheendofSeptember.
Onemonth'sdepreciationonthestorefixturesisestimatedat$100.Thisishowwerecordthe$100monthlydepreciationexpenserelatedtothestorefixtures.
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Land
GlobalGrocerhasanotherlonglived,tangibleasset:land.Forfinancialreportingpurposes,landisassumedtohaveanindefinitelife.Asaresult,itsusefullifeisassumedto
remainundiminishedduringthepassageofanaccountingperiod.Therefore,landisneverdepreciated.Untilitissold,thelandwillremainonGlobalGrocer'sbalancesheet
atitshistoricalcostof$30,000.
Exercise4.5
Thestorefixtureswerepurchasedfor$5,000attheendofAugust.AttheendofSeptember,therelatedaccumulateddepreciationonthatassetis$100.Whatisthenetbook
valueofthestorefixturesassetontheSeptember30balancesheet?
Amortization
Foranintangiblelonglivedasset,werecordareductioninitsremainingusefullifebyrecordinganamortizationexpensethatdirectlyreducesthevalueoftheassetonthe
balancesheet.Notethatamortizationanddepreciationexpensesbothreflectthediminishingusefullivesofassets.However,theeffectofeachisrecordeddifferentlyonthe
balancesheet.Depreciationexpenseisrecordedforeachdepreciabletangibleassetanditaccumulatesinarelatedcontraassetaccountonthebalancesheet.Amortization
expenseisrecordedforeachamortizableintangibleasset,andthereisnoassociatedcontraassetaccount:amortizationexpensedirectlyreducestherelatedintangibleasset
accountonthebalancesheet.
FranchiseFee
Thefranchisefeeisalonglived,intangibleasset.Itwillbenefitthestorefortwoyears,attheendofwhichitwillexpire.TheSeptemberamortizationexpenseonthe
franchisefeeisestimatedtobe$750.
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OperatingExpenses
Let'sgatherupallofGlobalGrocer'soperatingexpensesforthemonthofSeptember.Thesalaries,utilities,rent,depreciationandamortizationexpensetotaled$5,650.With
Salesof$16,000,COGSof$7,500andoperatingexpensesof$5,650,GlobalGrocer'sSeptemberoperatingincomeis$2,850.
DebtService
Let'snowrecordGlobalGrocer'sinterestexpenseforSeptember.ThedebtonGlobalGrocer'sbalancesheetinvolvesacontractualobligationtopayinterest.GlobalGrocerhas
twooutstandingdebtobligations.
ShortTermInterest
First,let'srecordtheinterestexpenseonthe$50,000shorttermdebt,andthepaymentmadetothelender.Forthisloan,GlobalGrocerwillrecordaSeptemberinterest
expenseof$250anda$250reductioninthecashaccount.
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MortgageInterest
GlobalGrocer'smortgageisalongtermloanwiththewarehousebuildingascollateral.Thecashpaymentof$250coversthe$150interestforSeptemberandreducesthe
loanprincipalby$100.First,recordtheSeptemberinterestexpenseof$150onthisloan,paidincashtoWebsterBank.
MortgagePrincipal
Wealsohavetorecordthepaymentofanadditional$100incashthismonthtoaccountforthereductionintheoutstandingmortgageloanprincipal.Thistransactionhasno
effectontheincomestatement.Itreducescashandthemortgagepayableaccountby$100each.
InterestExpense
GlobalGrocer'stotalinterestexpenseforthemonthofSeptemberis$400:$250interestexpenseontheshorttermloan,and$150interestexpenseonthemortgage.
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TaxExpense
TocompleteGlobalGrocer'sSeptemberincomestatement,youmustrecorditsincometaxexpenseforthemonth.Youestimatethatthisperiod,GlobalGrocerwillowe$950
(reflectingataxrateof38%)ofitsincomebeforeincometaxestothetaxauthorities.Therefore,itrecordsataxexpenseof$950forthemonthofSeptember.
Congratulations!
Congratulations!YouhavecompletedGlobalGrocer'sincomestatementforthemonthofSeptember.GlobalGrocerearnedanetincomeof$1,500duringitsfirstmonthof
operations.
Preparingforthefuture
AsSeptemberprogresses,youassessGlobalGrocer'sfinancialsituationandpreparefortheupcomingholidayseason.Apartfromtheoperationswhoseeffecthasjustbeenrecorded
onGlobalGrocer'sSeptemberincomestatement,youalsoundertakesomeactivitiesthatdonotaffectthismonth'snetincomestatement.
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Exercise4.6
OnSeptember28,yourparents,thrilledatGlobalGrocer'searlysuccess,invest$30,000inthebusinessandinreturnreceivecommonstock.Howwillthistransactionaffect
GlobalGrocer'sfinancialcondition?
Exercise4.7
BusinessispickingupatGlobalGrocer,andyouneedavanforthegrowingvolumeofpurchasesanddeliveries.OnSeptember10,youpurchaseasecondhandvan.Itisthen
repairedandpaintedwiththeGlobalGrocerlogo.ItisdeliveredtoyouonSeptember30.Thetotalcostis$10,000.Youpayincashondeliveryofthevan.
HowdoesthepurchaseofthevanonSeptember30affectGlobalGrocer'sSeptemberincomestatement?
Exercise4.8
GlobalGrocer'smerchandisestockhasbeengettingseriouslydepletedduringthissuccessfulfirstmonth.OnSeptember20,youordered$8,500ofinventory.Itarriveson
September30.Youpay$2,500cashandputtherestonacreditaccountwithGlobalGrocerInternational.TheeffectofthistransactiononSeptember'sincomestatementwould
be:
Exercise4.9
Asagreed,startinginOctoberGlobalGrocerwillhavetopayGlobalGrocerInternationalforinventorypurchasedinSeptemberoncredit.Also,youwillneedtostockupforthe
upcomingholidayseason.Allofthiswillusecash.Accordingly,youpresentGlobalGrocer'saccountstoWebsterBankand,onSeptember30obtaina$20,0003monthshortterm
loan,interestandprincipaltobepaidatmaturity.
RecallthatGlobalGrocerhasamonthlyaccountingperiod.Whichoneofthefollowingwillbethemostappropriateaccountingtreatmentoftheinterestexpenseonthisnew
loan?
EndofPeriod
ThisisGlobalGrocer'sSeptember30balancesheet.ItincludesallthechangesthatoccurredduetooperationsduringthemonthofSeptember.Italsoincludestheinvestingand
financingactivitiesyouundertooktopreparefortheholidayseasonandforfuturebusinessexpansion,insofarasthoseactivitiesimpacttheSeptemberaccounts.
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Ratios
Usersoffinancialstatementsuseanumberoffinancialratiosbasedonincomestatementnumbers.Wewilldiscusstwoofthemoreimportantones:grossmarginasapercentageof
salesandreturnonsalespercentage.Bothratioscanhelpusevaluateacompany'ssuccessatmaintainingitschosenprice/coststrategy.
GrossMarginPercentage
Grossmarginasapercentageofsalesisdollargrossmargindividedbysales,expressedasapercentage.Dollargrossmarginissalesminuscostofgoodssold.Itrepresentsthe
markuponthecostoftheproductssoldbyacompany.
Byexpressingdollargrossmarginasapercentageofsales,wecancomparethegrossmarginofacompanyatdifferentpointsintime,orthegrossmarginpercentagesofdifferent
companiesinsimilarbusinesses.Thistypeofanalysisprovidesfinancialstatementusersusefulinsightsintoacompany'spricingstrategyandpractices.
Comparison
Forexample,considerCompanyAwith$100millioninsalesand$60millioninCOGS.Itsdollargrossmarginis$40million,anditsgrossmarginpercentageis40%.Now
considerCompanyB,inthesameindustry,with$200millioninsalesand$140millioninCOGS.B'sdollargrossmarginis$60million,anditsgrossmarginpercentageis
30%.
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Acompany'sgrossmarginpercentageisinfluencedbyitsindustry,itsownpricingstrategy,andtheefficiencywithwhichitproducesitsgoodsandservices.Acomparisonof
CompanyAandCompanyB'sgrossmarginpercentagesraisesseveralquestions:Whyisthereadifferencebetweenthegrossmarginpercentagesoftwocompaniesinthe
sameindustry?IsCompanyAfollowingahighpricestrategy?IsCompanyBfollowingadiscountedpricestrategy?Doesitplantosellalargervolumebydiscountingpriceto
earnahigherdollargrossmargin?Thistypeofanalysisisparticularlyusefulwhenacompany'sperformanceiscomparedagainstthatofindustrybenchmarksorstandards.
Interpretation
Overthepastdecade,U.S.softwareandpharmaceuticalcompanieshaveaveragedgrossmarginpercentagesofabout70%.Incomparison,overthesameperiod,grossmargin
percentagesintheU.S.automotiveindustryhaveaveragedabout22%.
Thehighgrossmarginpercentagesinsoftwareandpharmaceuticalsispartlyexplainedbythefactthatintheseindustries,researchexpenses,whichrepresentamajorshareof
totalexpenses,arenotincludedinthecostofgoodssold.Theactualcostofproducingasoftwareprogramonadiskinasoftwarebusinessorofproducingtabletsforpatientsata
pharmaceuticalcompanythecostofgoodssoldisextremelysmall,resultinginverylargegrossmarginsrelativetosales.Also,patentprotectionscanlimitproductcompetition
andresultinhigherprices.Thecostofproducingautomobiles,ontheotherhand,ishighrelativetotheirsellingpriceandtheindustryisverycompetitive.Thislimitsthe
abilityofautomobilecompaniestoachievehighgrossmarginpercentages.
Exercise4.10
ReturnonSalesPercentage
Returnonsalespercentageiscalculatedasnetincomeperdollarofsales,ornetincomedividedbysales,expressedasapercentage.
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Byexpressingnetincomeasapercentageofsales,i.e.,byusingreturnonsales,wecancomparetheperformanceofacompanyatdifferentpointsintime,ortheperformancesof
differentcompaniesinsimilarbusinesses.Thistypeofanalysisprovidesfinancialstatementusersusefulinsightsintoacompany'spricingstrategyanditsabilitytocontrolcosts.
Comparison
Forexample,CompanyP,withsalesof$100million,hasagrossmarginpercentageof50%and,withanetincomeof$20million,areturnonsalespercentageof20%.
CompanyQ,withsalesof$200million,alsohasagrossmarginpercentageof50%,but,withanetincomeof$30,hasareturnonsalespercentageof15%.
Acompany'sreturnonsalespercentagedependsonthenatureoftheindustrythecompanyisin,itsownbusinessstrategy,anditsefficiencyindeliveringitsgoodsand
services.Becausenetincomeisaffectedbyinterestandtaxexpense,unlikethegrossmarginpercentage,returnonsalesisaffectedbythecompany'scapitalstructureandits
taxregime.
Interpretation
Overthepastdecade,returnonsalespercentagesintheU.S.softwareindustryhaveaveragedabout4%,thatis,negativefourpercent!Despitetheirextremelyhighgross
marginpercentages,averagingabout70%,asagroup,softwarecompanieshavehadnegativereturnonsales.
Duringthesameperiod,U.S.pharmaceuticalcompanieshaveaveragedreturnofsalesofabout10%.Thepharmaceuticalindustry,likethesoftwareindustry,incurshigh
researchcosts,butithasmanagedtoconvertitshighgrossmarginpercentages,alsoaveragingabout70%,intohighreturnsonsalespercentages.Forcomparisonpurposes,
returnonsalespercentageshaveaveragedabout3%intheautomotiveindustryduringthesametimeperiod.
Exercise4.11
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Recap
Inthischapteryoulearned:
Howanincomestatementisorganizedandconstructed.
Salesanddifferentcategoriesofexpensesaredefinedandtherelationshipbetweentheincomestatementforaperiodandthebalancesheetsatthebeginningandendof
theperiod.
Therevenuerecognition,matchingandconservatismconceptsandhowtheyareusedtorecordthefinancialeffectsofGlobalGrocer'soperationsduringthemonthof
September.
Thedefinitionanduseoftwoimportantincomestatementratiosthegrossmarginpercentageandthereturnonsalespercentage.
AccountingRecords
Inthischapter,youwilllearnasimpleversionofthestepsbywhichaccountingsystemstrackandrecordfinancialaccountingtransactionsduringanaccountingperiod.Youwillalso
learnhowtoprepareabalancesheetandanincomestatementattheendofanaccountingperiod.YouunderstandtheeconomicandaccountingimpactofGlobalGrocer'sAugustand
September2014accountingtransactionsinthischapter,youwillrecordtheminthejournalandledgerwhichwillbeusedtopreparethebalancesheetandincomestatementfor
thoseperiods.Attheendofthechapter,youwillbeabletopracticewhatyouhavelearned.
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Overview
Inanyaccountingsystem,aseriesofsystematicstepshelptheentityanditsaccountantstrackandrecorditsfinancialactivitiesduringanaccountingperiodandtopreparethe
desiredfinancialstatementsattheendoftheperiod.Thisflowchartdepictsasimpleaccountingsystem.
(1),(2)Astransactionsoccur,eachisanalyzedtodecidewhichaccountsitaffectsandhow.Thissteprequiresaknowledgeofaccountingconceptsandjudgmentonthepartofthe
personrecordingthetransaction.ThisistheanalysisweperformedinearlierchapterstorecordincreasesanddecreasesinvariousaccountseachtimeGlobalGrocercompleteda
transaction.
(3)Next,thetransactionisrecordedinajournal.Ajournalisachronologicalrecordoftheentity'stransactionsastheyoccur.Notethatoncethetransactionanalysishasbeendone,
makingajournalentry,orjournalizingthetransaction,isapurelymechanicalstep.
(4)Afterthejournalentryismade,thetransactionisrecordedorpostedtotheledger.Postingtheentryintotheledger,too,isamechanicalstep.Theledgerisagroupingof
transactioninformationbyaccount.Accountsintheledgerareclassifiedaseitherbalancesheetaccounts(forexample,thecashaccount)orincomestatementaccounts(forexample,
thesalesaccount).
(5)Theaccountingentrieswehavemadetodatearecalledoriginalentries.Theywereinitiatedbytransactionswithinternalandexternalparties.Attheendoftheaccounting
periodanotherkindofentryadjustingentriesmustberecordedsothattheaccountbalancesreflectfairlythesituationattheendoftheperiod.Thesetransactionsdonotinvolve
internalandexternalparties.Forexample,anentrymustbemadetoreflectadepreciationexpensefortheperiodduetothepassageoftime.
(6)Attheendoftheaccountingperiod,afteralloftheoriginalandadjustingentrieshavebeenenteredinthejournalandpostedtotheledger,thevariousledgeraccountswillshow
abalance.Thebalancesheetaccountbalancesarecarriedforwardtothenextperiod.Theincomestatement(temporaryaccounts)areclosedandresettozerobytransferring(inour
simplesystem)theirbalancestoretainedearnings.
(7)Aftertheclosingprocess,thebalancesinthepermanentaccountsprovidetheinformationneededtopreparethebalancesheetattheendoftheaccountingperiod.Theincome
statement(temporary)accountclosingentriesprovidetheinformationneededtopreparetheincomestatementfortheperiod.(Otherfinancialstatements,beyondthescopeofthis
chapter,canalsobepreparedatthispoint).
DoubleEntryAccounting
Recallthedualaspectconcept:therearetwosidestoeveryfinancialtransaction.Adoubleentryaccountingsystemrecordsthedualeffectsofeachfinancialtransaction.Each
transactionaffectsatleasttwoaccounts.
Consideratransactionyouhavealreadyencountered:raising$80,000cashbyissuingcommonstock,GlobalGrocer'sfirsttransaction.GlobalGrocerrecievedcashandissued
commonstock.Accountanalysisindicatesthattwoaccountswereaffectedbythistransaction:thecashaccountandthecommonstockaccount.Thefinancialaccountingsystem,a
doubleentrysystem,recordedanincreaseof$80,000inthecashaccountandanincreaseof$80,000inthecommonstockaccount.Thisishowwerecordedthetransactionwhenit
occurred.
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Nowyouwilllearntorecordtheeffectofsuchatransactionusingtheconventionsofafinancialaccountingsystem.
JournalEntries
Whenatransactionoccursandhasbeenanalyzed,anentryhastobemadeinthejournal.Thejournalisachronologicalrecordoftheentity'stransactions.
DebitsandCredits
Eachchangetoanaccountconsistsofadollaramountandadirection(whetheritisanincreaseoradecrease).Inaccounting,weindicatethedirectionofthechangebya
specializeduseofthewordsdebitandcredit.Whilelearningfinancialaccounting,youshouldforgetdaytodaymeaningsofthewordsdebitandcredit.Youonlyneedto
remembertheaccountingmeaningoftheseterms.
Soyousee,debitandcreditdonotmeanbadorgood.Neitherofthemevenmeansincreaseordecreaseeverytimeitisused.Youwillseewhatthesetermsdomeanin
accountingwhenyoulearntoentertransactiondataintheledger.
(1)Forassetaccounts,increasesarerecordedasdebits,decreasesarerecordedascredits.
(2)Forliabilitiesandowners'equityaccounts,decreasesarerecordedasdebits,increasesarerecordedascredits.
(3)Forthesalesaccount,anincrease(i.e,therecognitionofrevenue)isrecordedasacredit,because,infact,asaleisanincreaseinowners'equity.Salescanalsodecreasefor
example,whenasaleisreversed,thensalesoftheperioddecrease,andthesalesaccountisdebited.
(4)Foranexpenseaccount,anincrease(i.e.,therecordingofanexpensebytheentity),isrecordedasadebit,because,infact,anexpenseisadecreaseinowners'equity.
Expensescanalsobereversedorreduced,andthen,theappropriateexpenseaccountsarecredited.
Eachchangetoanaccountconsistsofadollaramountandadirection(whetheritisanincreaseoradecrease).Inaccounting,weindicatethedirectionofthechangebya
specializeduseofthewordsdebitandcredit.Whilelearningfinancialaccounting,youshouldforgetdaytodaymeaningsofthewordsdebitandcredit.Youonlyneedto
remembertheaccountingmeaningoftheseterms.
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Soyousee,debitandcreditdonotmeanbadorgood.Neitherofthemevenmeansincreaseordecreaseeverytimeitisused.Youwillseewhatthesetermsdomeaninaccounting
whenyoulearntoentertransactiondataintheledger.
Eachchangetoanaccountconsistsofadollaramountandadirection(whetheritisanincreaseoradecrease).Inaccounting,weindicatethedirectionofthechangebyaspecialized
useofthewordsdebitandcredit.Whilelearningfinancialaccounting,youshouldforgetdaytodaymeaningsofthewordsdebitandcredit.Youonlyneedtorememberthe
accountingmeaningoftheseterms.
Soyousee,debitandcreditdonotmeanbadorgood.Neitherofthemevenmeansincreaseordecreaseeverytimeitisused.Youwillseewhatthesetermsdomeaninaccounting
whenyoulearntoentertransactiondataintheledger.
Exercise5.1
ThisisalistofGlobalGrocer'stransactionsduringthemonthofAugust,inpreparationforitsSeptember1opening.Recordajournalentryforeachtransaction.Notethatfor
convenience,allthesetransactionswererecordedonGlobalGrocer'sbooksonAugust31.
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Ledger
Afterajournalentryhasbeenmade,itispostedtotheledger,whichcontainsTaccounts,oneforeachaccount.AccountantsuseTaccountsasanaidtodoubleentrybookkeeping,
onethathelpstrackchanges(debitsandcredits)todifferentaccounts,andwhenusedcorrectly,ensuresthatthebasicaccountingequationholdsaftereachtransaction.
TAccounts
EachTaccountisassociatedwithasingleaccount,suchasCash,AccountsPayable,CommonStockorSales.TheTaccountisliterallyalarge'T'withanaccountnameontop.Theleft
sideoftheTaccountisthedebitside.TherightsideoftheTaccountisthecreditside.So,infinancialaccounting,debitmeansleftside,andcreditmeansrightside.Beforeyou
proceed,youmustmemorizethisfact.
Atanygiventime,eachaccounthasabalance(themonetaryamountinthataccount).Anaccountmayhaveadebit(leftside)oracredit(rightside)balance.
PuttingitTogether
Combiningthejournalrelateduseofdebitandcreditwiththeirledgerrelatedmeanings,immediatelytellsushowtopostjournalentriestotheledger.Forassetaccounts,
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increasesarerecordedonthedebitsideortheleftsideoftheTaccount.DecreasesinassetaccountsarerecordedonthecreditortherightsideoftheTaccount.
Forliabilityandowners'equityaccounts,decreasesarerecordedonthedebitortheleftsideofeachTaccount.Increasesinliabilityandowners'equityaccountsarerecordedonthe
creditorrightsideoftheTaccount.
Increasesinsalesarerecordedascreditsandincreasesinexpensesarerecordedasdebits.
Combiningthejournalrelateduseofdebitandcreditwiththeirledgerrelatedmeanings,immediatelytellsushowtopostjournalentriestotheledger.Forassetaccounts,increases
arerecordedonthedebitsideortheleftsideoftheTaccount.DecreasesinassetaccountsarerecordedonthecreditortherightsideoftheTaccount.
Forliabilityandowners'equityaccounts,decreasesarerecordedonthedebitortheleftsideofeachTaccount.Increasesinliabilityandowners'equityaccountsarerecordedonthe
creditorrightsideoftheTaccount.
Increasesinsalesarerecordedascreditsandincreasesinexpensesarerecordedasdebits.
PosttoLedger
Pressthe'PosttoLedger'buttontopostalloftheAugustjournalentriesyouhavepreparedforGlobalGrocer.Youwillseethateachpostingislabeledwiththenumberofthe
correspondingjournalentry,makingiteasytotraceandcheckthedebitsandcreditsineachtransaction.
August31BalanceSheet
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InAugust,GlobalGrocerhadnooperations.ItsaccountsweresetuponAugust31.Onthatdate,therewerenoadjustingentriesorclosingentriestobemade.Thebalancesheet
accountsintheledgerprovidetheinformationneededtoprepareGlobalGrocer'sbalancesheetasofAugust31.
Septemberaccounts
GlobalGrocerbeganoperationsonSeptember1,2014.LetusformallytrackandrecorditsfinancialtransactionsinSeptember.Wewillessentiallyrepeattherecordkeepingwe
performedintheincomestatementchapteronly,thistime,insteadofrecordingtheeffectofeachtransactiondirectlyontothebalancesheetandtheincomestatement,wewill
recorditinthejournalusingdebitsandcredits,andpostittoTaccountsintheledger.Attheendofthemonth,wewillprepareadjustingentriesandclosingentries,postthemtothe
ledgerandpreparethebalancesheetandincomestatementforSeptember.
FirstSale
RecallthatthestoreopenedonWednesday,September1andmadethreesalesbytheendofitsfirstdayofoperations.Thefirstsaleofonegiftbasketfor$100,ispaidforincash.
GlobalGrocerincreaseditsassetcashby$100andrecognizedrevenueof$100.Torecordthistransaction,debitcashandcreditsalesfor$100each.Thisisthejournaltorecordthe
revenuefromthesale.
COGSEntry
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Thelargegiftbaskethadcost$40.GlobalGrocerdecreaseditsassetmerchandiseinventoryby$40andrecordedanequalcostofgoodssoldexpense.Thisismeansadebittocostof
goodssoldexpenseandacredittomerchandiseinventoryof$40each.
Post1stSaletotheLedger
Next,thejournalentryispostedtotheledger.NotethateachpermanentorbalancesheetaccounthastheAugustendingbalanceasitsSeptemberbeginningbalanceeach
temporaryorincomestatementaccountstartsthisnewaccountingperiodwithazerobalance.
Exercise5.2
Now,youmakethejournalentriesrelatedtothenextsaleonSeptember1:thesaleof25jarsofItalianpesto.Besuretorecordjournalentriestorecognizerevenuesandthe
matchedcostofgoodssold.
Exercise5.3
RepeatthepreviousexerciseforthethirdsaleonSeptember1:thesaleof100poundsofColombiancoffeeforcashandcredit.Onceagain,besuretorecordjournalentriesto
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recognizerevenuesandthematchedcostofgoodssold.
PostingSalestoLedger
Pressthe'PosttoLedger'buttontopostthejournalentriesfortheinitialthreesalesintotheledger.
ThirdPartyTransactions
WefastforwardtoSeptember30andrecordtheeffectofallofGlobalGrocer'stransactionswithexternalentities.DuringSeptember,GlobalGrocerrecordedtotalsalesof$16,000
ofwhich$11,000wascollectedincash,andatotalcostofgoodssoldexpenseof$7,500.Customersdidnotmakeanypaymentstowardstheircreditaccounts,andnoinventorywas
purchased.OnSeptember30,monthlysalaryexpenseof$3,000andutilitiesexpenseof$500wasfullypaidincash.Inaddition,loanservicepaymentsweremade,and,you
undertooksomepreparationsfortheupcomingholidayseason.
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AdjustingEntries
Recallthatinaccrualaccounting,attheendofeachaccountingperiod,anumberofadjustingentrieshavetobemade.Thesetransactions,whichdonotinvolveanyexternalparties,
representexpensesthatarenotassociatedwitheitherthegoodsorservicessoldduringtheperiodorwithfuturerevenues.Theymustthereforeberecordedinthecurrentperiod.
AttheendofSeptember,thefirstmonthofoperations,thereareseveraladjustingentriestobemade.Wecanidentifytheaccountsthatneedtobeadjusted.Theyare:prepaid
expenses,warehousebuilding,storefixtures,franchisefeeandtaxespayable.Takenotethatadjustingentriesdonotinvolveanyeconomicexchangewithathirdparty.
Exercise5.4
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ClosingEntries
Nowitistimetocloseouteachtemporaryorincomestatementaccountandresetittoazerobalance,inpreparationforthenextaccountingperiod.Noticethatthesalesaccounthasa
creditbalance,andalltheexpenseaccountshavedebitbalances.
PreparetheBalanceSheet
Afterclosingouttheincomestatement(temporary)accounts,thebalancesintheledger'sbalancesheet(permanent)accountsaretransferredtothebalancesheetattheendofthe
period.
PreparetheIncomeStatement
Theclosingentryshowsthebalancesinalltheincomestatementaccountsjustbeforetheywereclosed,andhenceprovidestheinformationneededtopreparetheincomestatementof
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theperiod.
Recap
Inthischapter,youwereintroducedtoasimpleformoftheformalbookkeepingperformedbyanyaccountingsystem.Youlearnedthat:
Indoubleentrybookkeeping,bothsidesofeachtransactionarerecorded,andatleasttwoaccountsareaffected.
Afteranalyzingatransaction,ajournalentryispreparedusingtherulethatdebitsindicateincreasesinassetsandinexpensesandcreditsindicateincreasesinliabilities,
owners'equityandsales.
JournalentriesarepostedintoaledgerofTaccountswhere'debit'meansleftsideoftheTaccountand'credit'meansrightsideoftheTaccount.
Oncealltransactionswithoutsideentitiesarerecordedfortheperiod,adjustingentriesaremadetoparticularaccounts.
Aclosingentryismadetocloseorresetallsalesandexpenseaccountstozero
Finally,thebalancesheetandincomestatementareprepared.
WeappliedthesestepstoGlobalGrocer'sAugustandSeptembertransactions,and,byfollowingtheprocess,generateditsbalancesheetsandincomestatementfortwoaccounting
periods.
TheStatementofCashFlows
Inthischapter,youwilllearnaboutthestatementofcashflows,oneofthethreebasicfinancialstatementspreparedandpresentedbyanentity.Itprovidesinformationaboutthe
entity'ssourcesandusesofcashduringanaccountingperiod.
Thestatementofcashflowscanbepresentedintwodifferentformatscalledthedirectmethodandtheindirectmethod.Youwilllearnhowtoconstructanduseeachtypeofstatementof
cashflowsforGlobalGrocer.
DirectMethod
Thedirectmethodstatementofcashflowsforanaccountingperiodsummarizesthetransactionsthathavebeenpostedtothecashledgeraccountduringtheperiod.Thisinformation
ispresentedinthreecategories:operating,investingandfinancingactivities.HereyouseeGlobalGrocer'sdirectmethodstatementofcashflowsforthemonthendingAugust31,
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2014.Theindirectmethodstatementofcashflowswillbediscussedlaterinthischapter.
(1)Operatingactivitiesaredirectlyrelatedtothedeliveryofgoodsandservicesthatgeneraterevenuesandexpensesintheincomestatement.Theoperatingactivitiessectionshows
thecashflowsfromtheseactivities.Theyaretypicallybrokendownintocashcollectedfromcustomers,cashpaidtosuppliers,cashpaidforotherdaytodayoperatingcostsandcash
taxes.IntheU.S.,GAAPrequiresthatinterestpaidorreceivedincashduringtheperiodbeincludedintheoperatingsectionofthestatementofcashflows.
DuringAugust,GlobalGrocerusedcashfortwooperatingactivities:itpaid$8,000tosuppliersofmerchandiseanditprepaid$3,000cashtowardsstorerent.Intotal,$11,000cash
wasusedforoperatingactivitiesduringAugust.
(2)Investingactivitiesrelatetothepurchaseandsaleoflonglivedassets.InAugust,GlobalGrocerhadthreeinvestingactivitiesinvolvingcash,allofwhichdepletedthecashaccount
thepurchaseofthewarehousepropertyused$70,000cash,thepurchaseofstorefixturesused$5,000cashandthepaymentofthefranchisefeetoGlobalGrocerInternationalused
$18,000cash.Intotal,investingactivitiesused$93,000incashduringAugust.
(3)Thefinancingactivitiessectionshowsthecasheffectsofraisingorretiringdebt,newissuesorrepurchasesofequity,andthepaymentofanycashdividends.DuringAugust,
GlobalGrocerraised$80,000cashfromacommonstockissue,raised$50,000cashfromashorttermbankloanand$25,000cashfromamortgage.Intotal,financingactivities
provided$155,000cashduringAugust.
Asalreadynoted,anyinterestpaidtoserviceoutstandingloansisnotrecordedinthissectionbyGAAP,itisincludedintheoperatingsectionofthestatementofcashflows.
Preparation
Thedirectmethodstatementofcashflowsisconstructedattheendofanaccountingperiodusingthecashaccountintheledger.Cashisanassetaccount.Eachdebittocashduring
theperiodisanincreaseintheentity'scashbalance(asourceofcash)andeachcreditisadecrease(auseofcash).Wesimplyclassifyeachdebitandcreditinthecashaccountas
eitheranoperating,investingorfinancingitemandrearrangethemintothesethreecategoriestoobtainthedirectmethodstatementofcashflows.
Exercise6.1
ThisisGlobalGrocer'sCashTaccountforthemonthofSeptember.Eachcashtransactionisidentifiedwithasmalldescription.Foreachtransaction,indicatewhetheritisan
operating,investingorfinancingtransaction.Whenyouhavecorrectlyclassifiedeachcashtransaction,youwillhavepreparedSeptember'sdirectmethodstatementofcashflows
forGlobalGrocer!
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IndirectMethod
Thesecondformatusedtopresentthestatementofcashflowsistheindirectmethod.Itisalsoorganizedbyoperating,financingandinvestingactivities.Herearetwostatementsof
cashflowsforGlobalGrocerforSeptembertheoneontheleftisadirectmethodstatementofcashflowsandtheoneontherightisanindirectmethodstatementofcashflowsforthe
sameperiod.Bothstatementsshowthatduringthemonth,operatingactivitiesgenerated$4,600incash,investingactivitiesused$10,000incashandfinancingactivitiesprovided
$49,900incash.
Differences
Thetwostatementsdifferinonlyonearea:theformatandinformationincludedinthecashflowsfromoperatingactivitiessection.Theinvestingandfinancingcashflowssections
areexactlythesameinbothtypesofstatementsofcashflows.
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AccrualsandDeAccruals
Recallthataccrualaccountingrecordstheeconomiceffectsoftransactionsintheperiodinwhichthosetransactionsoccur,ratherthanintheperiodsinwhichcashisreceivedor
paidbytheentity.Underaccrualaccounting,werecordsomeaccrualsthathaverelatedcashflowsinthefuture,andtheresultantbalancesheetsandincomestatementsreflectthe
effectsofthoseaccrualsratherthanusefuturecashflows.
AnExample
Forexample,onSeptember1,GlobalGrocermadea$400saleofColombiancoffee,collected$150incashandrecorded$250asareceivable.The$250increaseinreceivableswas
anaccrual.Itwillresultinaninflowof$250incashinafutureperiod,butthefull$400wasrecordedasasaleonSeptember1.
If,onSeptember1,startingwiththesalesamount$400,wewishtocalculatethecasheffectofthattransaction,wehavetodeaccrue,orreversethe$250accountsreceivablerelated
salesaccrualtoarriveatthe$150casheffectofthecoffeesale,i.e.,$400minus$250equals$150.Intheindirectmethodstatementofoperatingcashflows,eachadjustmenttonet
incomeisthesumofoneormoredeaccrualsfortheperiod.
Whytheindirectmethod?
Giventherelativecomplexityoftheoperatingsectionofanindirectmethodstatementofcashflows,youmightwonderwhydoaccountantsusethematall?Answer:Becausethe
operatingsectionoftheindirectmethodstatementexplainsthedifferencebetweenthenetincomeandtheoperatingcashflowsoftheperiod,itprovidesreaderswithinformation
abouttheextenttowhichandthemeansbywhichtheentity'snetincomeoftheperiodhasresultedinoperatingcashflows.
TheFinancialAccountingStandardsBoardrequiresentitiesthatusethedirectmethodintheirstatementofcashflowstopresentaseparatereconciliationofnetincometo
operatingcashflowsusingtheindirectmethod.Asaresult,mostcompanieschoosetopresentonlytheindirectmethodstatementofcashflows.
Exercise6.2
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TheHuntingtonCompanyusesthedirectandindirectmethodstatementsofcashflows.Forthe10cashflowitemslistedbelow,indicatethesectionthattheywouldappearinon
thestatementsofcashflowlisted:
A.Directmethodcashflowfromoperatingactivitiessection
B.Indirectmethodcashflowoperatingactivitiessection
C.Investingactivitiessection
D.Financingactivitiessection
Barron&Sons'cashbalanceincreasedby$55,000during2014.Duringthatyear,itraised$23,000cashfromfinancingandused$12,000cashforinvestingactivites.Whatwas
Barron&Sons'netcashfromoperatingactivitesduring2014?
NetIncome&Op.CashFlows
Accrualaccountingfocusesoncapturingtheeconomicmeaningofatransaction,ratherthanitscasheffects.Thisusuallyresultsinadifferencebetweenaperiod'snetincomeandthe
operatingcashflowtotheentity,althoughbotharetheresultofoperationsduringtheperiod.Forexample,inAugust,GlobalGrocerhadazeronetincome,butithadanegative
operatingcashflowof$11,000.
Thispictureshowshowtheindirectmethodstatementofcashflowsreconcilesthedifferencebetweenaperiod'saccrualaccountingbasednetincomeanditscashflowfrom
operations.
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(1)Adeaccrualisanadjustmentmadetonetincometoarriveatthecasheffectofoperatingactivities.Wewillanalyzeexamplesofeachtypeofdeaccrualinturn.
(2)DeAccrualofPeriod'sDepreciation/Amortization.Anoncashexpense(i.e.neitherthedebitorcreditsideofthetransactioninvolvescash).
(3)SalesRelatedDeAccruals
Thedifferencebetweensalesandcashcollectedfromcustomersduringtheperiod.Inthiscaseaccountsreceivable(anasset)increasedduringtheperiod.
(4)COGSRelatedDeAccruals
Thedifferencebetweencostofgoodssoldexpenseandcashpaidtosuppliers.Thisadjustmentisthenetoftwoadjustments.Inventories(anasset)andaccountspayable(aliability)
bothincreased.
(5)Deaccrualsrelatedtocurrentperiodexpensesfundedinpriorperiods.Inthisexampleprepaidexpense(anasset)decreased.
(6)Deaccrualsrelatedtocurrentperiodexpensesthatwillbepaidinfutureperiods.Otherpayables(aliability)increased.
(7)Thedifferencebetweenvariousexpensesoftheperiod(otherthancostofgoodssold)andcashpaidtoexternalpartiessuchassuppliers,utilitiesproviders,landlords,banks,and
taxauthorities.
operations.
operations.
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operations.
operations.
RecaptheIndirectMethod
Youhavejustlearnedthereasoningbehindeachofthesedeaccrualsintheindirectmethodstatementofcashflows.
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Westartwithnetincomeoftheperiod,adddepreciationandamortizationexpense,adddecreases(orsubtractincreases)inaccountsreceivable,adddecreases(orsubtractincreases)
ininventory,addincreases(orsubtractdecreases)inaccountspayable,adddecreases(orsubtractincreases)inprepaidexpenses,andaddincreases(orsubtractdecreases)inother
payables.Thiswillgiveusnetcashprovidedorusedbyoperatingactivitiesduringtheperiod.
Takeagoodlookattheadjustmentstonetincome:theyarethemselvesnotcashflows.Thesearethesalesandexpenserelateddeaccrualsmadetoreconcilethedifferencebetween
netincomeandcashflowfromoperations.Theseamountsarecalculatedfromthechangebetweenthebeginningandendingbalancesofparticularcurrentassetandcurrentliability
accountsduringtheaccountingperiod,excludingchangesinthecashaccountandshorttermdebt(afinancingitem).
RelationtoBalanceSheet
Theindirectmethodstatementofcashflowsdoesnotrequireanynewaccounts.Inpractice,theindirectmethodstatementofcashflowsforanaccountingperiodisconstructedusing
theperiod'snetincome,theperiod'sdepreciationandamortizationexpenses,differencesbetweentheperiod'sbeginningandendingcurrentassetandliabilitiesaccounts,excluding
cashandshorttermdebt.Hereisaschematicoftheentireindirectmethodstatement,indicatingthesourcesofthevariouslineitemamounts.
Sept.IndirectStatement
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Exercise6.3
MansfieldCompany'scomparativebalancesheetsforDecember31,2013andDecember31,2014showthechangeslistedinthetableabove.Foreachchange,usethedropdown
menustoindicatetheadjustmentthatmustbemadetoits2014netincomeintheoperatingsectionofitsindirectmethodstatementofcashflowsfortheyearendingDecember
31,2014.
Interpretation
Netcashflowisaveryimportantfinancialmetricinanybusiness.Usersoffinancialstatementswanttoknowhowmuchcashwasgeneratedorusedbyabusinessduringan
accountingperiodandhowitwasgeneratedorused.Theinferencesmadebyareaderfromastatementofcashflowsdependonthetypeofcompanythestatementrepresentswhat
industryitisinandthelifestageitisin.Astartupsoftwarecompanyisexpectedtohaveasignificantlydifferentpatternofcashflowsfromthoseofamaturechemicals
manufacturer.
ForanewbusinesslikeGlobalGrocer,usersoftheentity'sfinancialstatementslookforevidencethatthebusinessisraisingsufficientcashtosupportthenecessaryinvestmentsand
rampupofoperationsthroughtheearlyperiodsofslowsalesandcollectionsfromcustomers.Thestatementofcashflowscanaidinthistypeofanalysis.Forexample,GlobalGrocer's
AuguststatementofcashflowsshowsthatitsAugustoperationsdidnotgenerateanycash(infact,theyconsumedcash).Allofitscashwasgeneratedfromfinancingactivities,and
abouttwothirdsofthecashraisedwasuseduptosetupthebusiness.AsGlobalGrocerstartsupoperations,improvementsinitsabilitytosatisfyitscashneedsfromoperationswill
beevaluated.
Inthecaseofamorematurebusiness,usersofanentity'sfinancialstatementslookforevidencethatitsoperationsaregeneratingenoughcash,andthatitisusingfinancing
prudentlyenoughtosupportitsgrowth,paydividends,andinvestinlongterm,productiveassets.Thestatementofcashflowscanalsoaidinthistypeofanalysis.
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AnalysisofIndirectStatement
Byorganizingtheinformationinaparticularway,theindirectmethodstatementofcashflowsprovidesimportantinformationtousersofanentity'sfinancialstatementsthatisnot
availablefromadirectmethodstatementofcashflows.
Theoperatingsectionoftheindirectmethodstatementofcashflowsexplicitlyprovidesthedepreciationandamortizationexpensesfortheperiod,informationthatwouldotherwise
bescatteredinthebalancesheetandembeddedinvariousexpenseaccountsontheincomestatement.Itisexpectedthatamaturecompany'scapitalexpendituresitscashpayments
fornoncurrentassetsmeetorexceedthedepreciationexpenseoftheperiod.Thiswouldindicatethatthecompanyisreplacinglonglivedassetsataboutthesameorgreaterrate
thantheireconomicbenefitsarebeingconsumed.
Supposeacompanyhasasignificantlyhighernetincomethannetcashflowfromoperationsinsuccessiveperiods.Thismaybeexplainedbythefactthatthecompanyisgrowing
rapidly,makingsalesoncredit,andraisingthenecessarycashfromfinancingactivities.But,itcouldalsoindicatethatthecompany,despiteahealthynetincome,isfailingtocollect
cashfromitscustomersinatimelymanner.Thesesortsofeffectswouldbeeasilyseenfromthechangeinreceivablesintheoperatingsectionoftheindirectmethodstatementofcash
flow.
Therearemanydifferenttypesofanalysesthatmaybeconductedwiththeinformationavailableinanindirectmethodstatementofcashflowtoassessthehealthofortrendsinthe
healthofanentity.Theyarebeyondthescopeofthisintroductorytutorial.
Recap
Inthischapter,youlearnedaboutthestatementofcashflows,animportantfinancialstatementpreparedbyentities.Youlearnedthat:
Thestatementofcashflowsclassifiesandorganizesinformationaboutthecashflowsduringanaccountingperiodasoperating,investingorfinancing.
Therearetwoformatsforthestatementofcashflows:thedirectmethodandtheindirectmethod.Theydifferintheirpresentationofoperatingcashflows.
Underthedirectmethod,intheoperatingsection,areincludedanumberoflineitems,eachofwhichisacashinflowtothereportingentityoracashoutflowtoanexternal
entity.
Theoperatingsectionintheindirectmethodstartswiththenetincomeandmakeaseriesofdeaccrualadjustmentstoitinordertoderivethenetcashfromoperations.
ThedirectmethodstatementofoperatingcashflowscanbeprepareddirectlyfromtheentriesinthecashTaccountduringtheaccountingperiod.
Theindirectmethodstatementofoperatingcashflowsispreparedfromtheperiod'sincomestatementaccountsandtheperiod'sbeginningandendingbalancesheets.
FinalExam1Introduction
WelcometothepostassessmenttestfortheHBSFinancialAccountingTutorial.Thistestwillallowyoutoassessyourknowledgeoffinancialaccountingfundamentals.
Navigation:
PleasenotethatyoucanreturntoskippedquestionsusingtheJumptounansweredquestionselectionmenuorthenavigationalarrowsatanytime.Althoughyoucanskipa
question,youmustnavigatebacktoitandansweritallquestionsmustbeansweredfortheexamtobescored.
GoodLuck!
WelcometothesecondpostassessmenttestfortheHBSFinancialAccountingTutorial.Thistestwillallowyoutoassessyourknowledgeoffinancialaccountingfundamentals.
Navigation:
PleasenotethatyoucanreturntoskippedquestionsusingtheJumptounansweredquestionselectionmenuorthenavigationalarrowsatanytime.Althoughyoucanskipa
question,youmustnavigatebacktoitandansweritallquestionsmustbeansweredfortheexamtobescored.
IMPORTANT:Takethisexamonlyaftertakingthepreviousfinalassessmentexam.Therearethreefinalassessmentexams.Thus,ifyoudidnotreceivea
passingscoreonthefirst,itiscriticalthatyoureviewthecoursematerialcarefullybeforetakingthisexam.
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GoodLuck!
RevenueandReceivables
Sofarinthetutorialyouhavebeenintroducedtotheaccountingconcepts,theaccountingrecordingsystemandthebasicfinancialstatements.Intherestofthetutorialyouaregoingto
lookmorecloselyattheaccountingforspecificoperating,investing,andfinancingtransactions.
Inthischapter,youwillexpandyourunderstandingofaccountingfortheoperatingitemsrevenuesandaccountsreceivable.Asintheearlierchaptersyouwilllearnthroughdoing.You
willresolvetheOctoberaccountingconcernsrelatedtorevenueandaccountsreceivablethataroseduringGlobalGrocer'spreparationofitsOctoberfinancialstatements.
Review
Beforemovingon,youmaywanttoreviewthebasicrevenuerecognitionconceptstudiedearlier.Asyouwillrecall,revenueisrecognizedwhenitisearnedandrealizedorrealizable.
Earned:Inmostcases,revenueisearnedwhenasalehastakenplace,whichiswhen:
thecustomerhasagreedtobuythegoodsandservices
thegoodsorserviceshavebeendeliveredand
thesellerhasperformedsubstantiallyallofitsobligationtothebuyer
Realizable:Therealizedorrealizablecriterionissatisfiedifthesellerhasreceivedpaymentorreasonablyexpectstobepaid.
Exercise7.1
DuringthemonthofOctober,GlobalGrocer'sbusinesspickedupquiteabit.OctobersalesweremorethantriplesalesforSeptember.
Beforeconsideringsomeadditionalsalesrelatedtransactionsthatyouwilllookatinamoment,thecompanymadecashsalesfor$19,000,creditsalesfor$45,000andcollected
$5,000fromcustomerssettlinguptheiraccounts.ThebalanceintheaccountsreceivablesonOctober1was$5,000.
Let'smakethejournalentriesfortheOctobersales,receivablesandcollections,andthenpostthemtotheGeneralLedger.
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TheledgerbalancesarenowtransferredtotheBalanceSheetandIncomeStatement,andtheSalesaccountisclosedout.
1.Salesequalcashsalespluscreditsales.
2.Accountsreceivablearelastmonths'balanceplusthismonth'screditsaleslessthismonth'scollectionsfromcustomers.
Issues
WhilepreparingtheendofmonthfinancialstatementsforOctober,severalconcernsarose.Youdecidednottoincludetheseeventsinyourfinancialstatementsuntilyouhada
chancetostudythemandidentifytheproperaccountingmethod.Theywere:
AcustomerpurchasedagiftcertificateduringOctober.IthasnotbeenredeemedbytheendofOctober.
Youbelievethatseveralcustomerswhooweyoumoneymaynotbeabletopaytheirbillsinfull.
SeveralcustomersreturnedmerchandiseduringOctober.YoubelievesomeofyourOctobersalesmaybereturnedinNovember.
Inordertogeneratecash,yougaveyourlargercustomerstheopportunitytoreceivea2%discountiftheypaidtheiraccountwithin10daysoftheirpurchases.
UnredeemedGiftCertificate
InearlyOctober,GlobalGrocerintroducedgiftcertificates.Twogiftcertificateshadbeensoldbutonlyonehadbeenredeemedformerchandisewithinthemonth.Thelastcertificate
for$80wasstilloutstanding.
Fromanaccountingperspective,thesalemettherealizationcriteriasincethecustomerpaidforthecertificatewhenitwaspurchased.However,asoftheendofOctobertherevenue
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hadnotbeenearnedasgoodsorserviceshadnotbeendelivered.
SinceoneofthenecessarycriteriaforrecognizingrevenuehasNOTbeenmet,thegiftcertificateshouldnotbeincludedinthesalesrevenuetotalsforthemonth.Howthenshouldit
berecorded?
DeferredRevenue
InordertorecordSarahJane's$80giftcertificate,youneedtocreateanewaccountcalled"Deferredrevenue".Deferredrevenueisfuturerevenuethathasalreadybeencollected
buthasyettobeearned.Itisshownintheliabilitiessectionofthebalancesheet,reflectingGlobalGrocer'sobligationtoprovidemerchandisetotheholderofthegiftcertificatein
thefuture.
Let'snowrecordSarahJane'sinitialgiftcertificatetransactioninthegeneralledgeraccounts.
Nowwecanmovethetransactionfromthegeneralledgertothemonthlyfinancialstatements.Remember,thissalestransactionmustremainonthebalancesheetandcannotgo
intotheincomestatementasrevenueuntilitisbothearnedandrealized.
HerearetheendofmonthOctoberfinancialstatementsshowingtheadditionofthe"deferredrevenuegiftcertificate"account.
RedeemingCertificates
Howistheredemptionofthegiftcertificaterecorded?Let'sjumpaheadtoNovember.ItisSarahJane'sbirthdayandsheredeemsher$80giftcertificate.Atthattime,the
revenuewillbemovedfromDeferredRevenuetoSales.ThisishowyouwillrecordtheNovembertransaction.
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Exercise7.2
AssumeanothergiftcertificatesoldbyGlobalGrocerforcashinOctoberhadnotyetbeenredeemed.Thiscertificatewasfor$60.Makethenecessariesentriesatmonth'send
below.
InNovember,the$60giftcertificatesoldinOctoberisredeemedformerchandise.Thecostofthemerchandiseis$40.Maketheaccountingentryfortheredemptionofthegift
certificatebelow.
Thenmaketheentryforthesoldmerchandise.Ifyouneedtoreviewhowtorecordcostofgoodssoldandmerchandiseinventorytransactions,gobackto[AccountingRecords:
Septemberaccounts:COGSEntry].
BadDebts
InearlyOctober,GlobalGrocermadeacreditsaleofsoftdrinkstoalocalcompany.Aweeklater,GlobalGrocerlearnedthatthecompanyhaddeclaredbankruptcyandtherewouldbe
nohopeofrecoupingthemoneyowedtoGlobalGrocer.Youwroteoffthecompany'sreceivable,butwonderediftherewouldbeothersimilarsituationsinthefuturewhichmight
meanyourendofOctoberaccountsreceivablemaynotallbecollected.
Youdecidetodowhatmanycompaniesdocreateanallowanceforbaddebts.Thepurposeofanallowanceaccountistorecordyouraccountsreceivableattheamountyouexpectto
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receiveinthefuture.
Let'sseehowthisisdone.
Estimation
Step1:EstimateBadDebtAmount
Tocreateanallowance,GlobalGrocermuststartbyestimatingtheamountofitsOctoberaccountsreceivablethatmighteventuallybecomebaddebts.
Basedontheirpastexperience,somecompaniesassumethatbaddebtswillbeaconstantpercentageofaccountsreceivable.Notknowingwhichaccountsreceivablewillactuallynot
bepaid,theyusethepercentagetocalculatetheallowanceforbaddebts.Forexample,attheendof4monthsyouwillbeabletoageyouraccountsreceivablebyhowoldtheyare.
Basedonthisanalysisyouwillbeabletomakeabetterestimateofyourbaddebtallowance.
Forexample,forGlobalGrocer,October31accountsreceivabletotaled$45,000.Ifyouexpect$900or2%ofthesereceivableswillnotbecollected,youwilluse$900astheestimate
fortheOctoberbaddebtallowanceuntilyouhavemoredatatogoon.Infuturemonths,youwillknowmoreaboutthespecificaccountsandamountofbaddebtsandwillbeableto
modifytheestimateifnecessary.
AllowanceSetUp
Step2:Setupanallowanceaccount&recordbaddebtexpense
Torecordthebaddebtexpensetwonewaccountsmustbesetuptheallowanceforbaddebtsaccountandthebaddebtexpenseaccount.Forjournalentrypurposes,theallowance
forbaddebtsaccountistreatedlikealiabilityaccount.Thebaddebtexpenseaccountisanincomestatementaccount.Torecognizetheestimated$900baddebtexpense,this
incomestatementaccountisdebited$900.Theoffsetting$900creditentryistotheallowanceforbaddebts.
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HerearetheendofmonthOctoberfinancialstatementsbeforerecordinganallowanceforbaddebts.(Andbeforethetwoadjustmentstogrosssaleswewilldiscussnext)
Writeoffs
Thefinalstepistorecordabaddebtwriteoffwhenitbecomesclearthataparticularcustomercannotpaythedebt.
Step3:Recordbaddebtwriteoff
Again,letusjumpaheadtoNovember.Youlearnthatasaleof$155madeinOctoberwillneverbepaidbythecustomer.Hereisthejournalentrythatyouwouldmaketorecordthe
eventanditsimpactonthegeneralledger.
Noticethewriteoffofthe$155accountreceivabledoesnotcreateanexpense.TheexpensewasalreadyrecordedinOctoberwhentheallowanceforbaddebtwassetup.
Exercise7.3
GlobalGrocerestablishedanallowanceforbaddebtsattheendofOctober.InNovember,GlobalGrocerwroteoffa$200accountreceivablebecausepaymentwasconsideredtobe
remote.Whatwouldbetheeffectofthe$200accountreceivablewriteoffbeonGlobalGrocer'sNovemberfinancialstatements?
Refunds
InOctober,GlobalGrocersoldtomatoestoacustomerfor$43.Thenextday,thecustomerreturnedthetomatoes,complainingthattheywerequitetasteless.Yougavethecustomera
fullrefundandwroteoffthecostofthereturnedbadtomatoes.AttheendofOctober,youthoughttheremightbemorereturnsofproducesoldinOctoberinNovember.Yourecognize
thatifOctobersalesarereturnedinNovemberandyouignorethispossibility,Octobersaleswillbeoverstated.
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YoudecidetousetheallowancemethodtoaccountforthepossibilityoffuturereturnsofOctobersales,inmuchthesamewaythatyouusedtheallowancemethodtoaccountforthe
possibilityofbaddebts.
Estimating
Step1:EstimateSalesReturns
Mostcompaniesmakeanestimateoftheamountoftheirsalesthatwillbereturnedbasedonpreviousexperience.ForGlobalGrocer,youestimatethattheremaybethreemore
largereturnsoftomatoesaswellassomeothergoods,thathadbeensoldinOctoberfor$200.
OnceGlobalGrocerhadmoreexperienceinthebusiness,itsestimateswouldbebasedonmorecompleteinformationusingitsrecordsshowingrefundsoverseveralmonthsor
years.
AllowanceSetUp
Step2:Setuptheliabilityallowanceaccountandsalesrefundallowancedeductionfromgrosssalesaccount.
Torecognizethereturnsandaccompanyingrefunds,youcreatealiabilityaccountcalled"Allowanceforsalesreturns".Theaccountrepresentstheamountofrefundsthecompany
expectstomakeonOctobersalesduringfutureaccountingperiods.TheEstimatedSalesRefundaccountbalanceisadeductionfromgrosssales.Ontheincomestatementthis
accountisrenamedandappearsas"Allowanceforsalesreturns."Donotletthisrenamingoftheincomestatementaccountconfuseyou.Theliabilityaccountofthesamenameis
stillonthebalancesheet.
HereishowthebalancesheetandincomestatementforGlobalGrocerswilllookaftertheadditionoftheallowanceforrefunds.
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ActualReturns
Step3:Recordactualreturns
Let'snowseewhathappenswhenacustomerwhopurchasedtomatoesfor$55inOctoberreturnsforarefundinNovember.
Exercise7.4
If,inNovemberafterGlobalGrocercreatedtherefundallowanceaccountattheendofOctober,arefundfor$30wasgiventoacustomer,whatwouldbetheeffectofthe$30refund
onGlobalGrocer'sNovemberfinancialstatements?
PromptPaymentDiscounts
AsownerofGlobalGrocer,yourealizedyoucouldgeneratecashfasterifyourcreditcustomerspaidformerchandiseassoonaspossible.Togivethemanincentivetodoso,towardthe
endofOctoberyoubeganofferinga2%discountontheamountowedifcustomerspayswithin10daysoftheirpurchase.Thisisknownasapromptpaymentorcashdiscount.
Intotal,outoftencustomersinOctober,fivehadalreadytakenadvantageoftheoffer.AttheendofOctober,fourmorecustomerswerestilleligibletobenefitfromthediscount.Sales
tothesecustomerstotal$4800.IfthecustomerstakeadvantageofthepromptpaymentdiscountinNovember,yourOctober31accountsreceivablebalancewillbeoverstated.You
decidetosetupanallowanceaccountfordiscountsinanticipationofpromptpaymentsbysomeofthesecustomers.
Estimation
Youfollowedthesamestepsasyoudidfortheotherallowanceaccounts:
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Step1:EstimatetheAllowanceforCashDiscounts
Liketheothertwoallowancemethods,youusethecompany'spastexperiencetoestimatetheallowance.
InOctober5outof10gotthediscount...
so50%ofremainingcustomersmighttakethediscount:
4X.5=2
Creditsalestothefourcustomers=$4800
Discountestimate=$4800/2customersXthediscountof.02
=$48
AllowanceSetUp
Step2:Setuptheliabilityallowanceaccountandcashdiscountallowancedeductionfromgrosssalesaccount.
Theallowanceforcashdiscountsisaliabilityaccount.ThecorrespondingaccountEstimatedcashdiscountsisshownintheincomestatementasadeductionfromgrosssales.Like
thesalesrefundsadjustmenttogrosssales,thisincomestatementaccountisalsorenamedintheincomestatement.Itwillappearas"allowanceforcashdiscounts".Donotbe
confused.Theliabilityofsamenameisstillonthebalancesheet.
Herearethejournalentriesnecessarytocreatethetwoaccounts.
HereishowthebalancesheetandincomestatementforGlobalGrocerwilllookaftertheadditionoftheallowanceforcashdiscounts.
CashCollections
Step3:Customerpaysandtakesdiscount
Againlet'smoveaheadtoNovember.Acustomerpaysintimetoreceivethecashdiscount.Thiscustomerpurchased$500worthofgoodsandwillreceivea$10discount.
Herearethejournalentriestorecordthepaymenttransactionandthediscount.Notethatthreeaccountsareaffectedbytheentriesaccountsreceivable,cashandallowancefor
cashdiscounts.
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Exercise7.5
AnotherGlobalGrocercustomerpaysintimeandreceivesthe2%discountinNovember.Thecustomerpurchasedgoodsworth$100.Whataretheentriestorecordthepayment
andthediscount.
AdjustingAllowances:Month'sEnd
Again,let'sjumpaheadtoNovember.ThistimetoNovember30.YouareinthemidstofpreparingtheendofmonthstatementsforNovember.Asforothergeneralledgeraccounts,
youwilltallyupthetransactionsmadetotheallowanceaccountsduringthemonth.
YouthenneedtoadjusttheallowanceaccountstothecorrectendofNovemberbalance,reflectingthenewestimatesforbaddebts,refunds,anddiscounts.Yourentriesmustalsotake
intoaccounttheerrorsinyourestimatesleftfromthepreviousmonth.
Forexample,herearetheNovembertransactionspostedtothebaddebtallowanceaccount.YouestimatedcorrectlythatbaddebtsonOctoberreceivableswouldtotal$900,sothe
endofmonthbalanceinthataccountiszero.Therewasnoerrorinyourestimateofbaddebtsyouwere"righton"!
Updating
Let'snowmaketheadjustmenttothebalanceinthebaddebtallowanceaccount,updatingittoreflectanewestimateforbaddebtsattheendofNovember.
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Overestimations
Let'snowadjusttheallowanceaccountforcashdiscounts.
AttheendofOctober,youestimatedthattheactualdiscountstakenwouldbe$48.Infact,thediscountexpensewasonly$25.Youhadoverestimated,soattheendofNovember
therewasacreditbalanceof$23stillintheallowanceaccount.
Youdecidedtomodifyyourestimateforthismonth.YoumadenewcalculationsforNovemberandyourestimateforcashdiscountsattheendofNovemberis$80.
Thebalanceintheallowanceaccountshouldthereforebe$80goingforward.Tobringitto$80fromthepresent$23,acreditentryfor$57needstobemadetotheaccountanda
correspondingdebitentrytocashdiscounts.
HerearetheentriestotheaccountsandtheirimpactontheGeneralLedger.Notethattheentryfor$57simultaneouslysolvestheissueoftheestimationerrorfromOctoberaswell
astheneedtocreateanewallowanceforcashdiscountsonNovembersales.
Underestimations
Finally,let'slookattheallowanceforrefunds.Lastmonth,yougaveadollarestimateof$200forrefunds.Refundswereactually$220.Youunderestimatedthenumberofrefunds
andthereisadebitbalanceof$20intheallowanceforsalesrefundsaccount.Thismustbecorrected.
ForNovember,youdecidetoincreasetheallowanceto$300.Thebalanceintheallowanceaccountshouldthereforebe$300goingforward.
Tobringtheallowanceaccountforrefundsto$300,acreditentryof$320mustbemadeandacorrespondingdebitentryof$320totheestimatedrefundaccount.
Notethattheentryfor$320simultaneouslysolvestheissueofthe$20estimationerrorfromOctoberaswellastheneedtocreateanewallowanceforrefundsonNovembersales.
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Exercise7.6
Hereisanexampleofacompanywithabaddebtallowance.Asyoucansee,atthebeginningofthemonthofJune,thebalanceinthebaddebtallowanceaccountwas$500.Shown
herearealsoallthetransactionsintheallowanceaccountduringthemonth.
ForJuly,thecompanywantstoincreaseitsbaddebtallowanceto$600.
Makeallthenecessaryentriestoincreasethebaddebtallowanceto$600forthenextaccountingperiod.
Ratios
Financialanalystsincorporateaccountreceivablesinratiostogainsomeinsightintothequalityandreliabilityofcurrentassetsandtheirabilitytogeneratecashinthefuture.The
followingtworatiosrepresentsomeofthosemostcommonlyused.
Baddebtallowancetogrossaccountsreceivable
Turnoverofaccountsreceivableor"daysreceivable"or"dayssalesoutstanding"orsimply"DSO's"
Let'sseehoweachiscalculatedandinterpreted.
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BadDebtRatio
Thebaddebtratioisthepercentageofacompany'sgrossreceivablesthatitdoesnotexpecttobepaid.Acompanywithalowbaddebtratiobelievesitismorelikelytoreceive
paymentofmoreofitsreceivablesoutstandingthanacompanywithahighbaddebtratio.Financialstatementusersusethebaddebtratioagainsttheirknowledgeoftheissuers'
businessandindustrytoassessthereliabilityofthecompany'snetaccountsreceivablebalance.Theratioiscalculatedasfollows:
Interpretation
Baddebtratiosvaryconsiderablyfromindustrytoindustry,rangingfromlessthan1%toover15%.Companiesinhealthandcommunicationsindustrieshaveahigherbaddebt
ratiothanthoseintheenergyordefenseindustries.Belowisatablewithbaddebtratioofseveralcommunicationcompanies.Whiletheirratiosvaryconsiderablyfromeach
other,overalltheyarefairlyhighascomparedwithcompaniesfromotherindustries.
Analystslooktoseeifacompany'sbaddebtratioisincreasingovertime,orifitissignificantlygreaterthanthatofothercompaniesinitsindustry.Ineithercase,thismight
indicatethatthecompanyisfailingtoproperlyscreenpotentialclientsbeforeofferingthemcredit.Itmightalsomeanthatthecompanyispursuinglesscreditworthycustomers
inanattempttogeneratesaleswhichitisnotgettingelsewhere.
Fromamanagerialperspective,thegreateryourcompany'sbaddebtratiois,themoreitcostsyoutoextendcredittoyourcustomers.Ifyouareattemptingtoanalyzethe
incrementalprofitabilityofasale,thecostofprovidingcredittoacustomerisoneofthecostselementstoinclude.Anincreaseinthecostofextendingcreditmeansadecreasein
netprofitfromasale.
Exercise7.7
WhatisGlobalGrocer'sbaddebtratioforOctober?
Herearesomerelevantfigures:
Allowancesforbaddebts:$900
GrossAccountsReceivables:$45,000
DaysReceivableRatio
The"daysreceivable"ratioorthe"dayssalesoutstanding"(DSO)ratioindicatestheaveragenumberofdaysnecessaryforthecompanytocollectitsoutstandingaccounts
receivable.Thedaysreceivableratioissometimescalledreceivablesturnover,becauseittellsyouhowfastthereceivableareturningoverandbeingconvertedintocash.
Tocalculatedaysreceivable,theformulais:
DaysReceivable=NetaccountsreceivableX#ofdaysintheperiod
Totalsalesintheperiod
Interpretation
Asistruewithbaddebtratios,daysreceivablesvariesconsiderablybetweenindustries.Retailapparelchainshaveveryshortdaysreceivablewhileheavyequipment
manufacturers,bycomparison,havemuchlongerdaysreceivable.
Herearethedaysreceivablesaveragesfromseveraldifferentindustries.Theyvaryfromasfewas1dayforfinancialservicefirmstoasmanyas52daysfortheminingindustry.
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Analystscompareacompany'sdaysreceivablestothatofitsindustrypeers.Theslowingofacompany'sdaysreceivablesorahighdaysreceivablescomparedtoitscompetitors
hasanegativeimpactonthefirm'sliquidityittiesupcapitalthatmightotherwisebeusedtofinancetheproductionofsaleableassets.Anincreasingdaysreceivableratiomight
alsobeanindicationthatmoreofthereceivableswillbecomebaddebts.
Inperiodsofeconomicdownturn,manycompaniesexperienceanincreaseindaysreceivableandbaddebtsastheircustomersfinditmoredifficulttomeettheirobligations.
Exercise7.8
TheDensityCompanyproducesplasticlinersforcookingproducts.
Herearesomerelevantfiguresconcerningtheiractivitiesfortheyear2005(365days):
Totalsales:$16,080million
NetAccountsReceivable:$2,569million
WhatisDensityCompany'sDaysReceivablefor2005?
Attheendofafullyearofoperations,GlobalGrocer'stotalsalesandnetreceivablesareasfollows.YouwanttoknowwhatGlobalGorcer'sdaysreceivablesare.
$2,574,361intotalsales
$197,485innetreceivables
CalculateGlobalGrocer'sdaysreceivableusingtheformula.Whatdoyouget?
Recap
Inthischapter,youlearnedmoreabouthowtoaccountforspecifictransactionsconcerningrevenuesandaccountsreceivable.
Forreceivables,youwereintroducedtotheconceptofdeferredrevenueandhowtohandlecertaintransactionswherethebasiccriteriaforrevenuerecognitionarenotmetat
thetimeofsale.
Forbaddebts,refunds,andpromptpaymentdiscounts,youlearnedhowtocreateallowanceaccountsandhowtomanagethoseaccountsovermultipleaccountingperiods.
Finally,youwerealsointroducedtotwoimportantratiosusedtoevaluateaccountsreceivable:thedaysreceivableratioandthebaddebtratio.
Herearetheupdatedstatementswiththetaxeffectofthemonth'stransactionstakenintoaccount.
InventoriesandCostofSales
Inthischapter,wewilllookmorecloselyataccountingforinventoriesandthecostofsales.
Sofarwehaveassumedthatinventoriesconsistonlyofpurchasedfinishedgoodsimmediatelyreadyforsale.Theseinventoriesareknownasboughtmerchandiseinventories.We
willfirstreviewaccountingforboughtmerchandiseinventories.
GlobalGrocerwillthenexpanditsactivitiesintomanufacturingandyouwilllearnaboutcalculatingthecostofgoodssoldforamanufacturingoperationandaccountingfor
manufacturedinventoriesthatareamixofrawmaterials,workinprocessandfinishedgoods.
Laterinthechapter,GlobalGrocerwillfindthattheinputpricesforsomeofthemerchandisethatithaspurchasedhavechanged,raisingquestionsabouthowtorecordinventory
andcostofgoodssold.Youwillbeintroducedtodifferentapproachesforvaluinginventoriesthatdealwiththischallenge,inparticular,theLastIn,FirstOut(LIFO)andFirstIn,
FirstOut(FIFO)methods.Eachofthesemethodsalsohasimplicationsformeasuringthecostofgoodssold.
Finally,someofGlobalGrocer'sinventorywillbedamagedandyouwillbeintroducedtothe"lowerofcostormarket"rulewhichweuseinsuchcasestodeterminethenewvalue
forinventory.
Asintheearlierchaptersyouwilllearnthroughdoing.YouwillresolveGlobalGrocer'sOctoberaccountingconcernsrelatedtothecostofgoodssoldandinventoriesforthenew
manufacturingoperationandpreparethecompany'sNovemberfinancialstatements.
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ReviewofMatching
Beforemovingon,let'sreviewthekeyconceptsthataffectthereportingofinventoryandcostofsales:thehistoricalcostandmatchingconceptsstudiedearlier.
Asyouwillrecall,goodsavailableforsaleareheldininventoryatGlobalGroceratthecostatwhichtheywerepurchased.Thatistheirhistoricalcost.Whentheinventoryissold,the
costoftheitemsbecomespartofcostofgoodssold(COGS)fortheperiod,ensuringthatthecostofthegoodsare"matched"totherevenuesfromthesale.
HereisthetablefromChapter4:TheIncomeStatement(TheIncomeStatement:Concepts:MatchingConcept)whichsummarizestherequirementsforexpenserecognition
accordingtothematchingconcept.Additionally,adiscussionoftheHistoricalCostconceptcanbefoundinChapter3:BalanceSheet:Concepts:HistoricalCost.
BoughtMerchandiseFlow
Hereistheflowofinventorycostsforamerchandiseoperationthatbuysitsfinishedgoods.Goodsarepurchasedreadyforsalefromsuppliersandheldininventoryuntiltheyare
sold.Whentheyaresoldtheircostismovedtothecostofgoodssold(COGS)account.Assuch,theymovefromtheBalanceSheettotheIncomeStatement.
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MerchandiseCOGS
InthemonthofNovember,GlobalGrocerrecorded$89,000inboughtmerchandisesales.Youneedtocalculatethecostofgoodssold(COGS)relatedtothesesales.Todoso,recall
thatthechangeininventoryduringaperiodissimplythedifferencebetweenpurchases(whichincreaseinventory)andtransfersfrominventorytocostofgoodssold(whichdecrease
inventory).Costofgoodssoldcanthenbecalculatedusinginformationonthebeginningandendinginventoryvaluesandpurchasesasfollows:
CostofGoodsSold=BeginningInventory+purchasesendinginventory
Exercise8.1
BoughtmerchandiseinventoryonhandonOctober31,2014was$51,000.DuringNovember,2014,GlobalGrocerspurchasedadditionalmerchandisecosting$62,000.Acountof
boughtmerchandiseinventoryonNovember30,2014indicatedthatinventorycosting$46,000remained.
WhatwasthecostofgoodssoldforboughtmerchandiseinventorysalesduringthemonthofNovember?
JournalEntries
Let'snowmaketheNovemberjournalentriesforboughtmerchandise.Webeginwiththe$62,000Novembermerchandiseinventorypurchases.Assumethepurchaseswereall
madeoncredit.NextwewillrecordtheNovembermerchandisecostofgoodssold.
Remember,beginninginventorywas$51,000thecostofgoodssoldwas$67,000,andendinginventorywas$46,000.
UpdatetheFinancials
ThecostofgoodssoldaccountisclosedouttotheIncomeStatementandtheremainingledgerbalancesarenowtransferredtotheBalanceSheet.Apartiallyupdatedbalancesheet
andincomestatementasofNovember30,2014areshownbelow.
Asyouwillsoondiscover,someadditionaltransactionswillbeincludedlater.
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NewChallenges
InNovember,youencounteredseveraladditionalaccountingchallengesrelatedtoGlobalGrocer'sinventoryaccountingthathavenotyetbeenrecorded:
Jammanufacturingoperationswerelaunchedduringthemonthandyouwonderhowtoaccountforinventoriesandcostofgoodssoldunderthesecircumstances.
YoureceivedtwoshipmentsofthesameDijonmustardatdifferentprices.Now,youneedtodetermineCOGSforthemustardsold.
DuringanastyrainstormsomecasesofyourgourmetFrenchteaweredamaged.Youneedtorecordthechangeinvalueofyourinventory.
JamProduction
InNovemberGlobalGrocerlaunchedajammanufacturingoperation.Bytheendofthemonth,thecompanyhadinventoriesofuncookedberries,jamjars,andsomejamthatwas
stillcooking.Ithadseveralfinishedjamjarsawaitingsaleandhadalreadysoldothers.Theissuesyouneedtoaddressare:
Jamproductionrequirednewoutlaysforlabor,ingredients,cookingmaterials,etc.Howshouldtheseoutlaysberecorded?
SomeofthejamwasstillinproductionattheendofNovember.Howshouldyouvaluejamthatishalfwaythroughthecookingprocess?
Whatdiditcosttoproduceajarofjam?
Howdoyoudeterminethecostofthejamsoldandunsoldjamthatremainedinthestore?
Process
HereisadiagramillustratingtheflowofcostsrelatedtomanufacturingoperationslikeGlobalGrocer'sjamproduction.Incontrasttothediagramforretailoperations,the
manufacturingoperationsdiagramhasthreeseparateinventoryaccounts:RawMaterials,WorkinProgressandFinishedGoods.
Clickonthemouseiconinthediagramtoseewhichcostsshouldgoineachoftheseaccounts.
Abbreviationsarefrequentlyusedfortwooftheseaccounts.Theworkinprocessinventoryaccountisoftenreferredtoas"WIP"andthecostofgoodssoldaccountisknownas
"COGS".
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RawMaterials:thecostsofmaterialsonhandbutnotyetplacedintoproduction.Deliverycostsrelatedtoobtainingtherawmaterialswouldalsobeincludedhere.
WorkInProgress(WIP):thecostofrawmaterialsonwhichproductionhasbeenstartedbutnotcompletedplusthedirectlaborappliedspecificallytothismaterialanda
shareofmanufacturingoverheadcosts,whicharemanufacturingrelatedcostsotherthandirectlaborandmaterials.
FinishedGoods:costsidentifiedwithcompletedbutunsoldunitsonhandattheendoftheaccountingperiod.
CostofGoodsSold(COGS):costsidentifiedwiththegoodssoldtocustomersduringtheaccountingperiod
Exercise8.2
Hereisalistofcostsfromaspaghettimanufacturingcompany.Assignthesecoststotheaccountwhereyouthinktheyfitintothemanufacturingprocessbyselectingthecostwith
yourmouseanddroppingitintotheappropriateaccountbox.
Costs
Let'slookathowtoaccountforGlobalGrocer'sfirstmanufacturedproduct,redraspberryjam.Tomanufactureredraspberryjam,GlobalGrocerconvertedthebackofthe
warehouseintoakitchen.Astoveandcookingequipmentwaspurchased.DuringNovember,thefollowingoutlaysandchargeswereincurred:
1.$14,500forredraspberries,sugarandglassjars
2.$700indeliverychargesuponreceiptoftheraspberriesandothermaterials
3.$3000inlaborcostsforthenewjamchef
4.$600inlaborcostsforsupervisoryworkbyyouroperationsmanager
5.$250inlaborcostsforcleaningtheadministrativeoffice
6.$8000forastoveandcookingequipment(paidincash)$80indepreciationexpenseistoberecordedpermonth
7.$500inmaintenancematerialsforthecookingequipment
8.$150inpublicitytolaunchthejamsales
Someoftheseexpendituresshouldgototheinventoryaccountsandsometootheraccounts.Youwillneedtodeterminewhereeachonegoes.
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CostsIncluded
Manufacturinginventoriesarerecordedatthecostofproduction.Thecostsincludedarethosedirectlyconnectedwithpurchasingandtransportingmaterialstotheproduction
siteandconvertingthemtoafinishedproduct.Thesearetermedproductcosts.
Allproductrelatedcostsremainininventoryuntilthegoodsaresold.Then,costsforthegoodssoldaretransferredtoCOGSattheendoftheaccountingperiod.
Therearedifferentkindsofproductcosts.Themainonesarelistedhere:
Labor:Thecompensationofallmanufacturinglaborthatcanbetracedtotheproductionoftheproduct.
Materials:Acquisitioncostsofallmaterialsthateventuallybecomepartoftheproduct.
ManufacturingOverhead:Manufacturingcoststhatarecloselyrelatedtothemakingoftheproduct,butthatarenotspecificallyproductionlaborormaterials.
Depreciationonmanufacturingequipmentisanexample.
CostsExcluded
Sellingexpenses,andadministrativeexpensesarenotincludedinmanufacturedinventorycostsand/orCOGS.Theyareconsideredtobeoperatingexpenses,notproductcosts,
andareexpensedasincurred.
Examplesare:
Advertisingcostsfortheproduct
Thecostoftherunningthepurchasingdepartment
Officecleaningexpenses
Boughtmerchandiseinventoryisalsonotincludedinthemanufacturedinventoryaccount.Theircostsareassignedtoaseparateinventoryaccount.
ProductCosts
Let'srevisitthelistofoutlaysandchargesassociatedwithGlobalGrocer'sjamoperationinNovember.Whicharecostsrelatedtotheproductionprocess(tobeincludedin
inventoryand/orCOGS)?Whichonesarenot?
Usingthedropdownfields,indicatewhetheryouthinkthatthecostshouldbeincludedininventory?
Theprocessbywhichcostssuchasthoselistedhereareallocatedtoproductsortodifferentactivitieswithinthecompanyisknownascostaccounting.Ifyouwouldliketolearn
moreaboutcostaccounting,refertotheHBScostaccountingonlinetutorialattheHarvardBusinessSchoolPublishingwebsite.
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InventoryAccounts
BytheendofNovember,GlobalGrocerhadraspberryjamsalesof$30,000.Followingthematchingprinciple,thecostsofproducingthejamthathadbeensoldshouldbe
transferredtotheCOGSaccount.
Whatamountshouldbetransferred?Whichcostswenttoproducingthejamthatwassold?
Todeterminethis,let'slookmorecloselyatthethreeproductioninventoryaccounts,RawMaterials,WorkinProcess,andFinishedGoods.
RawMaterials
Thefirststepintheproductionprocessistheacquisitionofrawmaterials.Oncepurchased,rawmaterialsacquisitioncostsaredebitedtoincreasetheRawMaterialsinventory
accountalongwithanyassociateddeliverycosts.
HereisthelistofGlobalGrocer'scostsforrawmaterialspurchases.Maketheentriesandclick"postit"toupdatethegeneralledger.Allpurchasesweremadeoncredit.
$14,500forberries,sugarandjars
$700indeliverycosts
Firstdotheentriesforthe$14,500purchasesandthentheentryforthedeliverycosts.
WorkinProcess
Inmostcasescompaniesdonotknowthequantityofmaterialsusedintheproductionprocessuntiltheyhavecountedtheirrawmaterialsinventoryonhandattheendofthe
accountingperiod.Thisisgenerallydonebydirectobservation.
Ifyouknewtheinventoryamountintherawmaterialsaccountatthebeginningoftheaccountingperiodandtherawmaterialsinventoryamountattheendoftheaccounting
period,whatotherinformationwouldyouneedtocalculatetherawmaterialsputintoproduction?
FinishedGoods
ByNovember30,GlobalGrocerhadmade6000jarsofjam.Althoughsomejamstillremainedinproduction,youdeterminedthat$15,000incostshadbeenincurredto
completethejarsalreadyfinished.This$15,000costoffinishedgoodsshouldbetransferredtotheFinishedGoodsinventoryaccount.
TomakethejournalentrytotransferfromtheworkinprocessaccountthecostofthejamjarsmadeinNovembertotheFinishedGoodsinventoryaccountandupdatethe
generalledgeraccounts,pressthePOSTITbuttonbelow.
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TrackingInventory
Therearetwoapproachestokeepingtrackofinventories.Theyaretheperiodicandtheperpetualmethods.Undertheperpetualmethod,theinventoryaccountisadjustedas
eachadditionandwithdrawalismade.Wedonotillustratethismethodhere.
Theperiodicmethod,asitsnameindicates,adjuststheinventoryaccountperiodicallybasedonactualinventorycounts.Forexample,attheendofeachaccountingperiod,
inventoryonhandiscountedandvalued.Thisamountbecomestheendinginventory.
TheperiodicmethodwasusedatGlobalGrocertodeterminetheendingrawmaterials,workinprogress,andfinishedgoodsinventories.
CostofGoodsSold
Ofthe6000jarsofjamcosting$15,000madebyGlobalGrocer,4000jarscosting$10,000weresold.Onlythecostofthefinishedjarsofjamstillonhand$5000should
remaininthefinishedgoodsinventoryaccount.Thecostoffinishedjarsofjamsoldshouldbetransferredtocostofgoodssold.Rememberatotalcostof$15,000wasincurredto
makeallofthefinishedjarsofjam.
Now,makethejournalentriestotransferthecostofthejarsofjamsoldtotheCOGSaccount.Clickonthe"postit"buttontoupdatethegeneralledgeraccounts.
FinancialStatementUpdate
Let'supdatetheBalanceSheetandIncomeStatementfortheraspberryjamproduction.Wewillalsoupdateitforthejamsalesof$30,000($10,000oftheseweremadeincash
$20,000oncredit)
Here,thegeneralledgerbalancestransfertothefinancialstatementsforthemonthendingNovember30.Tolookmorecloselyatthevariousdepreciationaccounts,clickonthe
mouseonthebalancesheet.Therelatedassetamountsaretheasset'soriginalcost(Ifyouareunsureofthedepreciationaccountinguseddonotworry.Youwilllearnmoreabout
depreciationaccountinginthenextchapter).
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Exercise8.3
Younowknowthecosttoproducethe4000jarsofjamsoldinNovemberbyGlobalGrocerwas$10,000.
Youalsoknowthattherevenuesgeneratedbythesaleofthe4000jarswas$30,000.
WhatisthedollargrossmarginonasingleraspberryjampotsoldbyGlobalGrocerinNovember?
PriceChange
Let'snowlookatanotherNovemberinventoryaccountingchallenge.Thisoneinvolvesboughtmerchandiseinventory.
InNovember,GlobalGrocerputinitsfirstordersforDijonmustardfromFranceandsubsequentlyreceivedtwoshipmentsofthesamemustard.Becauseofanexchangerate
change,mustardinthefirstshipmentof1440jarscost$2.00ajarversus$2.20inthesecondshipmentof2160jars.AttheendofNovember,yourealizethatyouhavesoldsome
mustardfrombothshipments,butyouarenotsurehowmanyofeachshipmentsinceonebottleofmustardisindistinguishablefromanother.Yourealizethatyouhavean
inventoryaccountingproblemandyouwonderwhatyoushouldrecordforinventoryandforCOGSfortheperiod.
Complicationsarisewhenthepricesofproductinputs(materialsandlabor),orthepricesofmerchandisepurchasedforsalechange.Anychangesininputorpurchasepricesaffect
boththecostoftheproductssoldandthecostofinventoryonhand.
Wheninventorycostchangesoccur,managersmustchoosewhichproductsthechangeininputorpurchasepricesshouldaffectthosethathavebeensoldorthosestillininventory.
InventoryValuation
ForGlobalGrocer,thecostofthemustardpurchasedforsaleincreasedwiththechangeintheexchangeratefrom$2.00to$2.20.1440jarswerereceivedat$2.00and2160jars
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at$2.20.Yousold2400jarsinNovemberandneedtoknowthecostofthe2400jarssold.But,rememberyourdilemma,youdon'tknowwhichshipmentthejarssoldcamefrom.
Ifyouassumethatallofthesecondshipment's$2.20mustardjarsweresoldbeforethe$2.00ones,thenCOGSwouldbehigherandendinginventorylowerthanifyouassume
thatallofthefirstshipment's$2.00mustardjarsweretheonessoldfirst.Inthiscase,COGSwouldbelowerandendinginventoryhigher.
WhichapproachshouldGlobalGroceruse?Eachoftheseinventoryaccountingapproachesbasedupontheassumedflowofcostsgivesadifferentanswer.
FlowAssumptions
OnewaytothinkabouthowtovalueinventoryandCOGSwhentherearecostchangesistoimaginethatinventoryisstoredinalargetubinsuccessivelayers.Togetthe
inventoryout,youcaneitheremptyitfromthebottomofthetub,orfromthetop.Twoofthemostfrequentlyusedinventorycostingapproachesare"FIFO"and"LIFO".FIFO,
whichstandsforFirstInFirstOut,assumesthatyouemptythetubfromthebottom,sothattheearliestlayerofinventorycostswouldbethefirstremovedandputintoCOGS.
LIFO,orLastInFirstOut,assumesthatyoudrawfromthetopofthetub,sothatthemostrecentlyaddedlayerofinventorycostswouldbethefirsttakenout.
Costvs.PhysicalFlows
Itisimportanttorememberthatdifferentinventoryaccountingmethods,suchasFIFOandLIFO,reflectdifferentassumptionsabouttheflowofcostsoutoftheinventory
account.Thesecostassumptionsdonotnecessarilyreflecttheactualphysicalflowoutofitsphysicalinventory,whichmaybeverydifferentaltogether.
Forexample,ifwewereabreadmanufacturer,wecoulduseaLIFOcostassumptionforfinancialreportingonbreadinventories,butwhenitactuallycametosellingbreadwe
wouldclearlywanttoselltheoldestloavesfirst.Otherwise,ourphysicalbreadinventorywouldconsistsofmoldyloaves.
FIFO
TheFIFOor"FirstIn,FirstOut"inventoryvaluationapproachassumesthatthecostofproductscomingintoinventoryfirstarealsothosecoststhatrelatetothecurrentsales.As
aresult,thecostsofmorerecentlypurchased/producedgoodsarethosecostsremainingintheinventoryaccount.
Hereisanexampleofacompanythatsold250computers.Inthefirstpartofthemonth,100computerswereproducedatacostof$500each.Laterinthemonth,200ofthe
samecomputerswereproducedatacostof$600each.ToseewhattheinventoryvalueisusingFIFO,clicktheplaybutton.
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FIFOCostFlows
HereisavisualrepresentationofGlobalGrocer'ssituationusingthe"tub"toshowtheflowofcostsformustardunderFIFO.Thecostofmustardjarspurchasedfirstthoseat
$2.00arethosethatgointotheCOGScalculationfirst.Remember,GlobalGrocersold2400jarsofmustardduringNovember.
Exercise8.4
Let'spracticetheFIFOmethodbycalculatingGlobalGrocer'sendingfinishedmustardinventory.WeknowthatCOGSequals$4992,asshowninthediagrambelow(from
previousscreen).Theinventory"tub"aftertakingouttheCOGScostsnowonlyhasonelayerofcostleftinitjarsvaluedat$2.20each.
Calculatetheendinginventory.Rememberthat1440jarsat$2.00and2160jarsat$2.20werepurchasedintotal,2400jarsweresold.Choosetheappropriatevaluesfor
COGSandtotalinventoryatthesametime.
LIFO
TheLIFO(LastIn,FirstOut)approachusestheoppositecostflowassumptiontoFIFO.UnderLIFOcostofgoodssoldiscalculatedassumingthatthecostofthemostrecently
purchased/producedgoodsininventoryaretheonesthataresoldfirst.
Hereisalookatour"tub"usingtheLIFOcostassumption.UnderLIFO,thecostlayersinourtubaredrawnfromtheTOPandthecostofthemostrecentlyaddedlayeris
includedfirstinthecalculationofCOGS.
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Exercise8.5
Let'snowcalculateGlobalGrocer'smustardinventoryandCOGSusingtheLIFOmethod.
Remember,1440jarsarrivedinthefirstdeliverycosting$2.00ajar.2160jarsarrivedintheseconddeliverycosting$2.20and2400jarsofmustardweresold.
Topracticewhatyoulearnedaboutinventorycalculation,let'staketheexampleofacompanysellingtoytrainsontheinternet.Hereistheinformationconcerningoneofthe
trainmodelsinitsinventory.
Question:IfthecompanywantstokeepCOGSforthistrainmodellowinordertorecordhigherprofits,whichinventorymethodshoulditadopt?Thecompanysold1700X22
Speedthrutrainsintheaccountingperiod.
Comparison
HereisGlobalGrocer'sinventoryandCOGSunderFIFOandLIFO.ForGlobalGrocer,LIFOresultsinhigherCOGS(lowerearnings)andlowerinventoryvaluationthanFIFO.
ThisdifferencearisesbecausethecostofthemustardmerchandiseincreasedduringthemonthofNovember.Ifthecostofmustardhadfallen,FIFOwouldhavegenerated
higherCOGSandlowerinventory.
FirmschooseLIFOorFIFOforavarietyofreasons.Butoneimportantconsiderationistaxes.UndertheUStaxcode,ifacompanyusesLIFOfortaxreturnpurposes,itmust
alsouseLIFOforfinancialreportingpurposes.Asaresult,intheUS,manycompanieswhosemerchandiseorproductioncostsarerisingwithinflationtendtouseLIFOsinceit
enablesthemtoreportlowertaxableincomeandtopaylowertaxesthanunderFIFO.Incontrast,companieswithfallingperunitinventorycosts,suchasfirmsinthecomputer
andelectronicsindustries,tendtouseFIFObecausethismethodleadstolowertaxableincomefortheirfirms.
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LIFOReserve
USGAAPrequirescompaniesusingLIFOtodiscloseinthenotesaccompanyingtheirfinancialstatementstheFIFOcostequivalentoftheirLIFOinventories.Thecost
differencebetweenFIFOandLIFOinventoryiscalledtheLIFOreserve.
ForGlobalGrocer,theLIFOreserveonlyappliestotheDijonmustardinventoryattheendofNovember.Thisisbecause,apartfromtheDijonmustard,nopricechanges
occurredforanyoftheothergoodsinGlobalGrocer'sinventory.Also,thisisthefirstmonththatGlobalGrocerhaspurchasedDijonmustardand,thus,thereisnotany
mustardfrompreviousperiodsininventory.
ThetermLIFO"reserve"appliestothedifferencebetweentheinventorycostunderLIFOandFIFO.Toarriveattheamount,yousimplysubtracttheLIFOinventorycostfrom
theFIFOinventorycost.
WhatwouldbetheamountoftheLIFOreserveforGlobalGrocer?
GlobalGrocer'sDijonmustardinventoryandCOGSunderthetwomethodsisshownhere.
Exercise8.6
HereistheinformationfromFordMotorCompany's2012AnnualReportshowing2011and2012inventoriesatFIFObeforethecalculationoftheLIFOreserve($millions):
IfFord'sbalancesheetshowstotalinventoriesaftertheadjustmentfortheLIFOreserveat$7,362MMfor2012,whatistheamountoftheLIFOreservefor2012?
LIFOAccounting
AfterlearningallaboutLIFOandFIFO,youdecidetouseLIFOforGlobalGrocer'sinventoryvaluation.Let'smaketheentries.Mustardpurchasesandsalesofmustardto
customershavealreadybeenaccountedfor.YoujustneedtomaketheentriestotransferthecostofthemustardsoldtoCOGSaccordingtoLIFO.
Remember,theamountsunderLIFOareasseenbelow.WewillupdatethebalancesheetandincomestatementstoreflectthenewinventoryandCOGSamountsunderLIFO
inafewmoments.
SpecificIdentification
InventorymethodsotherthanLIFOandFIFOthatyoushouldbeawareincludethespecificidentificationandaveragecostmethods.ThesemethodsarenotaspopularasLIFO
andFIFO,andsowewillnotdiscussthemindetail.
IfyouhadbeenabletokeeptrackofeachandeverymustardjaratGlobalGrocer,youmightbeabletousethe"SpecificIdentification"methodofinventoryvaluationbecause
youwouldknowexactlywhichjarsyousoldandwhattheycost.
Whilethismethodresolvesthequestionofwheretoassignthechangeininputcosts,forcompanieswithlargeinventoriesorundifferentiatedproducts,itwouldbeverytime
consumingandcostly.
Thespecificidentificationinventorymethodmightbeused,forexample,byadealerinrareantiqueswhofollowedcloselythesaleofeachitem.
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AverageCost
Anothermethodisthe"AverageCost"method.TodeterminethecostofinventoryandCOGS,theweightedaveragecostofthegoodsintheperiod'sbeginninginventoryandall
goodsplacedininventoryduringtheperiodiscalculated.ThenewweightedcostperunitisusedtocostCOGSandendinginventory.
Forexample,forGlobalGrocer'smustard,theweightedaveragepricewouldbecalculatedasfollows(rememberGlobalGrocerdidnothaveabeginningmustardinventory
balance):
ThiswouldmakeCOGS=$2.12x2400jarssold=$5088.
Inventorywouldthenbe$2.12x1200(jarsleftininventory)=$2544.
Exercise8.7
Matchthefollowingdescriptionstotheappropriateinventorycalculationmethodbytracinganarrow.Hint:assumethatmultiplegoodswerebroughtintoinventoryat
differentcosts.
InventoryWritedown
OnNovember22,therewasaterriblerainstorm.Awindowinthewarehouseblewopenandthedecorativepaperpackagingon300cansofgourmetFrenchteawasdestroyed.
Theteainside(intincans)remaineduntouched.Fortunately,thedamagedteacouldbesold.
Youpaid$9atinfortheteaandnowneedtoaccountfortheimpairedvalueoftheinventoryinyourfinancialstatements.Youwonderedwhatvaluetogivetothedamagedtinsof
tea.Youbelievethatafirmthatbuysdamagedinventorywouldbuythedamagedteatinsfor$5acan.
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LowerofCostorMarket
Undernormalcircumstances,inventoryisreportedatitscostthecostatwhichitwaspurchasedorproduced.Ifaneventoccurs,suchastherainstorm,thatreducesthevalue
oftheinventorybelowitsoriginalcost,theinventorymustbewrittendowntoitsnewsellingpricelessthecostofdisposal.Thisrequirementisreferredtoasthe"lowerofcost
ormarket"rule.
Theaccountingentrytowritetheinventorydowntoitslowervalueis:
Debit:Costofgoodssold(tochargethewritedowntoincome)
Credit:Inventory(towritetheinventorydowntoitsnewvalue)
Entries
Onceyouhavedeterminedthenewvalueforthedamagedtea,youneedtomakeanentryinGlobalGrocer'saccountingrecordstoreflectthechangeininventoryvalue.
GlobalGrocer's300tinsofdamagedteacanshadapriorvalueof$9x300=$2700theirnewvalueis$5x300or$1500.Therewasnocostofdisposal.Theamountofthe
writedownis:$2700$1500=$1200.
Makethejournalentrybelowandclickon"Postit"tohaveittransferredtotheGeneralLedger.
UpdatingtheFinancials
LetusnowupdateGlobalGrocer'sfinancialstatementswiththechangestoInventoriesandCostofGoodsSold.
InventoryRatios
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Effectiveinventorymanagementisanimportantdeterminantofhowwellacompanymanagesitsworkingcapital(currentassetscurrentliabilities).Theshorterthetimeperiod
anitemisininventory,thelowertheaverageinvestmentininventory.Tworatiosinventoryturnoveranddaysinventoryareusedtogaugetheeffectivenessofinventory
investmentmanagement.
Turnover
The"inventoryturnover"ratiomeasurestheaveragenumberoftimesinventoryissoldduringtheyear.TurnoveriscomputedbydividingCostofGoodsSoldbytheaverage
inventoryonhandduringtheyear.
Let'slookatanexampletoseehowitworks.HereisthedataforafictitiouscompanyFoosieCorporationforthefiscalyear2014:
DaysInventory
The"daysinventory"calculationconvertstheturnoverratiotoitsdaysequivalent.Theformulaforcomputingdaysinventoryis365dividedbytheturnoverratio:
365/(COGS/AverageInventory)
Let'slookagainatFoosieCorporation.FoosieCorporation'sinventoryturnoverwas14.4.Toconvertittodaysinventory,divide365bytheinventoryturnoverof14.4togetdays
inventoryof25.Onaverageittook25days(365/14.4)forFoosieCorporationtosellitsstockininventory.
Interpretation
Desirableinventoryturnoversvaryconsiderablyfromindustrytoindustryandcompanytocompany.Managerskeepacloseeyeoninventoryturnoversforsignsofinventory
buildupswhichcouldindicateobsolescenceoranticipatedsalesgrowthinthenextperiod.
WhetheracompanyusesLIFOorFIFOhasanimpactoninventoryratiosifinputcostsareincreasing,daysinventoryforacompanyunderLIFOwillbelowerthanunderFIFO.
ThiscanmakeitdifficulttocomparetheinventoryratiosofcompanieswhensomeusetheLIFOmethodandotherstheFIFOmethod.Onewaytoovercomethisproblemisto
convertaLIFOinventoryamounttoitsFIFOvalueequivalentbyaddingtheLIFOreservebacktotheLIFOinventoryamountandthenusingtheLIFOinventory'sFIFO
equivalenttocomputeinventoryratios.
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Exercise8.8
Let'snowcalculatedaysinventoryforGlobalGrocer.Generallydaysinventoryiscalculatedforayearperiod.Sincewedonothaveayear'sworthofresultsforGlobalGrocer,we
willcalculatetheturnoverrateforthreemonths(onequarter)ofactivitytodate.Thisturnoverratecanbeconvertedtoanannualequivalentbymultiplyingtheturnoverrateby4
(4quartersinayear).
WeknowthatGlobalGrocerbeganoperationsonSeptember1with$19,000ofinventoryanditsinventory(boughttogetherwithmanufactured)balanceonNovember30,2014
was$49,048.Duringthisperiod,thecostofgoodssoldtotaled,$134,432($7,500inSeptember,$43,500inOctober,and$83,432inNovember).
WhatistheannualizedinventoryturnoverrateandthedaysinventoryforGlobalGrocer?
Recap
Inthischapteryoulearnedhowtoaccountforinventoriesandcostofgoodssold,bothforamerchandisingoperationandamanufacturingoperation.
Formanufacturing,youlearnedwhatexpensesgointothecostofproducingagoodandwereintroducedtothethreeinventoryaccountsusedbymanufacturing
companies:rawmaterials,workinprocess,andfinishedgoods.
Tobeabletoaccountforthecostofgoodswheninputpriceschange,youlearnedaboutalternativeapproachestoinventoryvaluation,includingLIFOandFIFOandthe
impactoftheiruseonthebalancesheetandtheincomestatement.RecallthatIFRSdoesnotpermitLIFO.
Yousawhowdamagedinventoryledtoawritedownfromapplyingthe"lowerofcostormarket"rule,whichrequiresthatalossberecognizedwhenthemarketvalueof
particularinventoryitemsfallsbelowtheirhistoricalcost.
Finally,youwereintroducedtotwonewratios:DaysinventoryandInventoryturnover.Theseratiosprovideinformationabouthoweffectivelyinventoriesarebeing
managed.
Usingyournewknowledge,youupdatedGlobalGrocer'sbalancesheetandincomestatementforthemonthendingNovember30,2014.Herearetheupdatedstatements.
DepreciationandNonCurrentAssets
Inthischapteryouwilllearnaboutlonglivednonmonetaryassetsandhowtoaccountforthem.Keymanagementchallengesyouwillcoverinclude:
Howtoaccountfortheacquisition,improvementanddisposaloflonglivedassets,
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Howtoestimateandaccountfortheuseofalonglivedassetovertime,whichaccountantsrefertoasdepreciation,
Whentorecognize"intangibleassets",aspecialcategoryoflonglivedassets.
GlobalGrocer'sbusinesshasgrownprogressivelyoverthepastmonthsandhasledtoanincreaseinitslonglivedassets.WearenowattheendofDecemberandyouwillhavethe
opportunitytomaketheentriestorecordtheeventsinDecemberrelatedtoGlobalGrocer'slonglivedassets.
Let'sstartbyreviewingwhatyoualreadylearnedaboutassetsanddepreciation.
What'sanasset?
Youpreviouslylearnedthattobecalledan"asset"aresourcehastomeetfourcriteria.Ithastobe:
acquiredatameasurablecost
obtainedorcontrolledbytheentity
expectedtoproducefutureeconomicbenefits
theresultofapasttransactionorevent
Thesefourcriteriaapplyequallytocurrentassetsandtolonglivedassets.Longlivedassetsdifferfromcurrentassetsinthattheyareexpectedtoprovideeconomicbenefitsbeyond
oneyear,whereas,currentassetsaregenerallyconsumedorconvertedintocashwithinayear.
Ifyouwouldliketoreviewmorethoroughlywhatyoulearnedaboutthedefinitionofanasset,youmayreferbacktothesectionentitled:TheBalanceSheet:Assets.
Categories
Longlivedassetsfallintooneoftwocategories:tangibleassetsandintangibleassets.Tangibleassetscanbeseenortouched,whereasintangibleassetsare,asthenameindicates,
withoutphysicalsubstance.
Examplesoftangibleassetsareland,building,fixtures,equipment,andnaturalresourcesusedinproductionsuchasamine,fishreserve,ortimberlands.
Examplesofintangibleassetsarepatents,copyrights,franchiselicenses,andtrademarks.Someintangibleassetsarereferredtoas"intellectualproperty".Wewillstudyother
examplesofintangibleassetsinthischapter.
KeyConcept
Theaccountingforlonglivednonmonetaryassetsfollowsthehistoricalcostconcept.Underthehistoricalcostconcept,longlivednonmonetaryassets(referredtoaslonglived
assetsintherestofthischapter)arerecordedinitiallyattheircost,whichisthenallocatedusingadepreciationmethodtotheperiodsduringwhichtheassetisusedinbusiness.
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Challenges
InpreparingthefinancialsstatementfortheendofDecember,2014,yourunintosomeaccountingchallengesconcerninglonglivedassets.Theseinclude:
AcquisitionCost:GlobalGroceracquiredapackagingmachinefor$18,000.Deliveryandinstallationcostswere$2,000(totalcost$20,000).Howshouldyourecordthe
deliveryandinstallationcharges?
AssetUsage:Followingthepurchaseofthepackagingmachine,youneedtoaccountfortheuseofthislongtermassetforthemonthofDecember.
Improvements:Duringthemonth,youspent$86,000torepairandimprovethewarehouse.Howshouldthisoutlayberecordedinyourfinancialstatements?
AssetSales:GlobalGrocer'solddeliveryvanwassoldinDecember.Howshouldyourecordthesale?
IntangibleAssets:GlobalGrocerinvestedinresearchanddevelopmenttocreateanewjamrecipethatwillbeusednextmonth.Youevenhaveasamplereadyandwonder
howtorecordthistransaction.
AcquisitionCost
OnDecember1,2014,GlobalGrocerpurchasedanewpackagingmachineforthepackagingofjamjars.Itcost$18,000andwasdeliveredthesameday.Bytheendoftheday,the
machinewasupandrunning.Thecosttodeliverandinstallitwas$2,000.
ItisnowDecember31,2014andyouneedtorecordthepurchaseandthecostsforinstallationanddelivery.Arethedeliveryandinstallationcostsanexpense,orshouldtheybe
consideredpartofthepurchasecostofthepackagingmachine?
Capitalization
Theacquisitionofafixedasset,suchasGlobalGrocer'spurchaseofthepackagingmachine,isoftenreferredtoasacapitalinvestment.Costsassociatedwiththeacquisitionofthe
assetthatareincurredinbringingtheassettoitsintendedlocationandtogetitreadyforuseare"capitalized",i.e.includedaspartofthetotalcostoftheassetthatappearsonthe
balancesheet.
Iftheacquiredassetisland,therealtor'sfeeandthecostofclearingorpreparingthelandforconstructionarecapitalizedandincludedinthetotalcost.Iftheacquiredassetis
machinery,thecostofdelivery,installationand,ifnecessary,thetrialrunsareallcapitalized.
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Exercise9.1
OnDecember1,FoosieCorp.acquiredanewcarfromadealerfor$32,000.Thecompanyalsopaid$160salestaxonthepurchase,$200fortheannualcarregistrationfee,and
$75tofillthetankwithgas.Whatwouldbethevalueofthenewcarinthecompany'sbooksimmediatelyfollowingthesetransactions?
Accounting
Let'slookatGlobalGrocer'spackagingmachine.Younowknowthatthetotalcapitalinvestmentinthepackagingmachineisthecostofacquisition$18,000andthecosttoget
themachineinplaceandupandrunning$2,000.GlobalGrocerpaidcashforthesecapitalizeditems.SoGlobalGrocer'stotalinvestmentis$20,000andallofitmustbe
"capitalized".
YoumaynowmaketheentriestorecordtheadditionofthisassettoGlobalGrocer'sbalancesheet.
Clickonthe"postit"buttontoupdatethegeneralledger.
AssetUsage
TheDecemberacquisitionofthepackagingmachinefor$20,000(discussedpreviously)raisesthequestionofhowtoestimatethecostofusingthemachineduringthemonth.
Youwillrecallthatthecostofusageiscalleddepreciation.Inearliertutorialchapters,wetoldyouthedepreciationcosteachmonth.Butnowitistimetolearnhowthecostis
calculated.
Depreciation
Asanassetlosesitsabilitytoproducefutureeconomicbenefitsforthecompany,itissaidtobe"depreciating".Thislossoffutureabilitytoproducebenefitsrepresentsacosttothe
companywhichisrecognizedovertheusefullifeoftheasset.Inaccordancewiththematchingprinciple,ineachaccountingperiodadepreciationexpense,basedontheasset's
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originalcost,isrecordedasanexpenseintheincomestatement.
AccumulatedDepreciation
HereisthebreakdownofthewarehouseandequipmentassetaccountforGlobalGrocerattheendofNovember.ItshowseachofthetangibleassetsownedbyGlobalGrocerand
theiraccumulateddepreciationonNovember30,2014.
Methods
Managersarepermittedtouseanumberofdifferentmethodstodetermineafirm'speriodicdepreciationcost.GAAPrequiresthedepreciationmethodadoptedbesystematic
andrational.IFRSrequiresthedepreciationmethodadoptedreflectthepatterninwhichtheasset'sfutureeconomicbenefitsareexpectedtobeconsumedbythereporting
entity.Themainmethodsusedinpracticeare:
StraightLineDepreciation:Underthe"straightline"method,thedepreciationexpenseforagivenlonglivedassetisthesamedollarvalueforeachperiodoftheasset's
usefullife.Straightlinedepreciationisthemostcommonlyusedmethodofdepreciation.Ithastheadvantageofbeingsimpleandagoodapproximationformostsituations.It
assumesanassetsabilitytoproducefutureeconomicbenefitsisusedupataconstantrateoveritslife,whichisareasonableassumptionformanyassets.
AcceleratedDepreciation:Theabilityofsomeassetstoproducefutureeconomicbenefitsisusedupatadecliningrateovertheirlife.The"accelerateddepreciation"method
hasbeendevelopedtoallowfora"frontloaded"usagepattern,wheretheperiodicdepreciationexpensedeclinessteadilyovertheasset'susefullife.
Straightlinemethod
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Underthestraightlinemethod,theannualdepreciationexpenseforanassetisestimatedasfollows:
AssetCostEstimatedSalvageValue
EstimatedYearsofUsefulAssetLife
EstimatedSalvageValue:thesalvagevalueofanassetisalsoacompanyestimatemadeatthetimetheassetispurchased.Itisthetheamountthecompanyexpectsto
receivefromdisposingoftheassetattheendofitsexpectedusefullife.
EstimatedYearsofUsefulAssetLife:theusefulor(economic)lifeofanassetisacompanyestimatemadeatthetiemtheassetispurchased.Itisaffectedbyphysical
deteriorationovertime,obsolescenceandusage.
Forexample,ifthecostofacaris$19,000,itsexpectedusefullifetotheowneris5years,anditsestimatedresalevalueafter5yearsis$3,000,thentheamountofyearly
depreciationwouldbeasfollows:
$19,000$3,000=$3,200peryear
5
Hereisagraphoftheyearlydepreciationexpenseforthecarusingthe"straightline"method.Eachyear20%ofthecar'sdepreciablevalue(its$19,000costlessitsestimated
salvagevalueof$3,000)willbedepreciated.
After5years,thecarwillhaveabookvalue(itscostlessaccumulateddepreciation)equaltoitsestimatedsalvagevalueof$3,000.
Afterseveralyearsofusinganasset,acompanymayreviseitsestimatesoftheasset'susefullifeandsalvagevalue.Itcanchangetheseestimatesandreestimatethe
depreciationexpensefortheassetgoingforward.Butitmaynotrevisethedepreciationexpenseoraccumulateddepreciationrecordedinprioryears.
Exercise9.2
YoumaynowcalculatethedepreciationexpenseforGlobalGrocer's$20,000packagingmachine.Assumethatthemachinehasasalvagevalueof$2000andausefullifeof6
years.Whatistheannualdepreciationexpenseunderthestraightlinemethod?
AcceleratedMethods
Themostcommonlyusedaccelerateddepreciationmethodisthedoubledecliningbalance(DDB)method.UndertheDDBmethod,theannualdepreciationexpenseis
estimatedasfollows:
2XAsset'sBeginningBookValue
EstimatedYearsofUsefulAssetLife
2:ThisistherateofdepreciationusedunderDDB.Noticethattherateisdoubletheannualdepreciationrateusedunderthestraightlinemethod.
Asset'sBeginningBookValue:Thedepreciationexpenseeachyearisbasedontheasset'sbeginningbookvalue(i.e.itscostlesstheaccumulateddepreciation).Because
thebookvaluefortheassetdeclineseachyear,theannualdepreciationexpenseundertheDDBmethodalsodeclinesovertheasset'slife.
Noticethat,incontrasttothestraightlinemethod,DDBdepreciationdoesnotdirectlyallowforanasset'sexpectedsalvagevalue.Instead,theassetcontinuestobedepreciated
untilitsbookvalueequalsitssalvagevalue,atwhichpointnofurtherdepreciationexpenseisrecorded.
Let'sseehowDDBdepreciationworksforourcarthatcost$19,000,hasausefullifeof5years,andaresalevalueof$3,000.Thedepreciationrateis2/5or40%,whichis
doublethe20%rateusedunderthestraightlinemethod.
Theannualdepreciationexpenseforthecarisasfollows:
Thecarisdepreciateddowntoitssalvagevalueof$3000afteronly4years.Actually,thefullfourthyeardepreciationwouldhavebeen$1,641.60(40%x$4,104)whichwould
havemadetheendingbookvaluelowerthansalvage.Wethereforeonlyrecord$1,104ofdepreciationinyear4sothattheassetisnotvaluedbelowsalvage.Hereisagraphof
theyearlydepreciationexpenseforthecarusingtheDDBmethod.
IntheUSsince1981,taxregulationhasmadeitpossibleforcompaniestouseanalternativeaccelerateddepreciationmethodfortaxpurposeswhichallowsthemtodepreciate
theirassetsevenmorerapidlythanundertraditionalaccountingmethods.Theobjectiveofthelegislationwastostimulatecorporateinvestment.Inmanycases,companies
todaykeeptwoseparatesetsofdepreciationschedulesfortheirassetsonefortaxpurposesandoneforfinancialreportingpurposes.
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Exercise9.3
Inthetablebelow,fillinthecorrectamountsforyearlydepreciationexpenseandtheendofyearnetbookvalueoftheassetundertheDoubledecliningmethod.Thestraight
linemethodisshownforyourinformation.Theasset'scostis$25,000ithasausefullifeof4yearsand,a$5,000salvagevalue.
Toseeifyouranswersarecorrect,clickonthe"Submit"button.
Accounting
Afterlearningaboutthedifferentmethods,youdecidetousethestraightlinemethodtodepreciatethepackagingmachine.Youbelievethatthismethodbestreflectstheusage
patternforthemachineandisthereforeagoodwaytoallocatethecostoftheassettoperiodswhenthebenefitsofusingthemachinewillbeobtained.Yearlydepreciationunder
thismethodis$3000thecorrespondingmonthlychargeistherefore$250(3,000/12months).
Forassetssuchasthepackagingmachine,whichareusedtomanufacturethefirm'sproducts,thedepreciationexpenseischargedtoWorkProcessInventoryasaproductcost
andsubsequentlytransferredtoFinishedGoodsInventoryandeventuallytoCostofSales.ThisprocessisdiscussedintheInventoriesandCostofSaleschapter.Let'snowrecord
thejournalentryforthepackagingmachinedepreciationandposttheentrytothegeneralledger.
IFRSAllowedAlternative
EarlieritwasnotedunderanIFRSallowedalternativetothecostmethod,IFRSpermittedproperty,plantandequipmentafterinitiallybeingrecordedatcosttobemeasured
atitsmarketvalue.Generally,anysubsequentchangeintheasset'smarketvalueisrecordedinothercomprehensiveincome(seeglossary).
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Improvements/Repairs
ThethirdaccountingissueyouencounterconcernsrepairsandimprovementsmadetoGlobalGrocer'swarehouseduringthemonthofDecember.
Theinteriorwallsofthewarehousewerereconstructedtoprovidebetterinsulationforthegoodsstoredwithin.Theworkcost$56,000,$30,000paidincashandthebalanceof
$26,000payableinonemonth.Inaddition,thewarehousewasrepaintedatacostof$30,000,whichhadyettobepaid.
YouwonderedhowtheseoutlaysshouldberecordedinGlobalGrocer'sfinancialstatements.
Asset/Expense
Thecostofanyimprovementsor"betterment"toanexistingassetmustbecapitalized.Abettermentmakestheexistingassetbetterthanitwaswhenitwaspurchasedand/or
extendsitslife.Itisrecordedasanincreaseinthevalueoftheexistinglonglivedasset.Forinstance,ifweaddasunrooftoourcar,wehaveimprovedorbetteredthecar,sothe
costofthesunroofistreatedasanincreaseinthevalueofthecar.
Bettermentsarenotthesameasrepairormaintenancecostswhichareincurredtokeeptheassetingoodconditionandtendtoreoccuratregularintervals.Repairand
maintenancecostsarerecordedasanexpenseandcannotbecapitalized.
Forexample,thecostofchangingourcar'soilorperformingaregularperformancecheckuparemaintenanceexpensesthatyoupaytokeepthecaringoodshape.Theyarenot
coststhatcanbecapitalized.
Accounting
YoudecidethatGlobalGrocer's$56,000reconstructionworktoitswarehouseshouldbecapitalized.Ithassubstantiallyincreasedthevalueofthepropertyandyouestimatethat
theimprovementswillextendthewarehouse'slifeto8years.
Let'srecordtheimprovementbelow.Recallthat$30,000ofthe$56,000improvementispaidforincash,andthebalanceispayablewithinonemonth.
Therepaintingworkcannotbecapitalizeditisaregularmaintenanceexpenserequiredtokeepthewarehouseingoodworkingorderandmustbeexpensedwhenthe
maintenanceisperformed.Maintenanceexpenseonassetssuchaswarehousebuildingswilltypicallybeincludedinlineitemssuchas"OperatingExpenses"or"Generaland
AdministrativeExpenses"ontheincomestatement.
Let'srecordthe$30,000repaintingtransaction.Recallthatwehavenotyetpaidthepainterswhocompletedthework.
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AssetSales
OnDecember1GlobalGrocerboughtanewvancosting$28,000.GlobalGrocerhadanoldvanwhichitsoldonDecember31,2014.Arestaurantownerpurchasedthevanfor
$8,000incash.
ThevanappearedonGlobalGrocer'sbalancesheetaspartofthewarehouseandequipment(net)lineitematitsacquisitioncostof$10,000netofaccumulateddepreciationof
$400onNovember30,2014.Thebookvalueoftheassetwastherefore$9,600.Onemonthlaterwhenyousoldthevan,thevan'saccumulateddepreciationhadincreasedto$600,
reducingthevan'sbookvalueto$9,400.
Youneedtorecordthesaleofthevan.
Gains&Losses
Whenfixedassetsaresoldorscrapped,theymustbetakenoffthefinancialstatementsattheirrecordedor"book"value.However,thebookvalueofafixedassettypicallyisnot
equaltoitsmarketor"fair"value.Theassetwasdepreciatedaccordingtoadepreciationschedulemarketvaluesrarelydeclineinsuchasystematicmannerandareinfluenced
byotherforceswhichcanevenleadtoanincreaseratherthanadecreaseinanasset'svalue.
Atthetimeofsale,anydifferencebetweenthesalespriceandthebookvalueoftheassetisrecordedaseitheragainoraloss,dependingonwhetherthesalespriceisgreateror
lessthanthebookvalueatsaledate.
Unlesstheirmagnitudeissignificantenoughtowarrantlistingasaseparatelineitemontheincomestatement,gainsandlossesonsalearegenerallyincludedinthelineitem
"OtherIncome",shownbelow"OperatingExpenses"or"General&AdministrativeExpenses".Theycannotbereportedasanextraordinaryorarevenueitem.Regardlessofhow
againorlossonthesaleofanassetisreportedintheincomestatement,materialgainsandlossesmustbedisclosedinthenotestothefinancialstatements.
Let'slookatanexampletoseehowtoaccountforthedisposalofanassetataloss.FoosieCorporationownedtwovehicleswhichitsoldin2014.Thefirstwasatwoyearoldcar,
purchasedfor$52,000.Hereistheinformationconcerningthisasset:
Bookvalueondateofsale:$42,400($52,000$9,600inaccumulateddepreciation)
Salesprice:$30,000
Thelossonthesaleofthisassetiscalculatedbysubtractingthebookvaluefromthesaleprice.Inthiscase,thereisalossonthesaleof$12,400($30,000$42,400=$12,400
...i.e.negative$12,400).
Let'stakealookatthejournalentrythatwouldbeusedtorecordthesale.
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FoosieCorporation'sothervehiclewasa1968antiquecarpurchasedin1995for$1700andwasusedforroadwayadvertising.Hereistheinformationconcerningthisasset:
Bookvalueondateofsale:$380($1700$1320inaccumulateddepreciation)
Salesprice:$2,380
Thesalespriceofthecarisgreaterthanitsbookvalue,leadingtoagainonsale.Theamountofthegainis$2,000($2,380$380=$2,000).
Recordthejournalentrythatwouldbeusedtorecordthesale.
Van
RecallthatonDecember31GlobalGrocersolditsvanfor$8,000forcash.Hereisdataonthecostandbookvalueofthevan:
Recordtheentriesforthesaleofthevan.Oncecompleted,youwillseetheupdatedledger.
Intangibles
InDecember,GlobalGrocerinvested$10,000inresearchanddevelopmentcostsandobtainedapatentfortheformulaofitsnewlycreated"PazzazzJam".Productionofthejam
wastobegininJanuary.GlobalGrocer'scostsforthePazzazzJamwere:
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Asyouwillrecall,patentsarerecordedasintangibleassetstheymeetthecriteriaforbeinganasset,butarenottangiblelikeafactoryorautomobile.Youwonderhowtorecordthe
costsofdevelopingthejamprototypeandthenewlyacquiredpatent.
Capitalizing
Researchanddevelopmentactivitiesoftenresultinthecreationofnewproductswhichareexpectedtogeneratefuturerevenues.However,thesetypesofoutlaysarenot
capitalized.Theoutcomeofresearchanddevelopmentisconsideredtoouncertaintomeetthedefinitionofanassetforfinancialreportingpurposes.Asaresult,thecostsofthese
activitiescannotbecapitalizedandmustbeexpensed.
Incontrast,onceanewproducthasbeendiscovered(andtheresearchuncertaintyhasbeenresolved),anylegalcostsoffilingasuccessfulpatentareviewedasbeingan
intangibleassetandarecapitalized.
ForGlobalGrocer,theonlycoststhatcanbecapitalizedarethelegalcostsoffilingforthepatentonthenewjamformula.Theemployeewagesandrawmaterialsusedtodevelop
theprototypeofthenewproductmustbeexpensed.
Accounting
Let'srecordGlobalGrocer'snewintangibleassetthe"PazzazzJam"patentfor$4,000anditsR&DexpensesforDecember.Recallthatthe$4,000legalandotherfeesrelatedto
obtainingthepatenthadyettobepaid,whereasonly$3,000ofthe$6,000inR&Dexpenseshadbeenpaid.
Let'sseethejournalentryandthegeneralledgerupdate.
Amortization
Likefixedassets,mostintangibleassetsareusedupovertime.Patents,forexample,haveatwentyyearlegallifeintheUS.
Toreflectusageovertime,formostintangibleassets,aportionoftheircostiswrittenofforamortizedeachperiod.ThisexpenseassociatedwiththisusageiscalledAmortization
Expenseandusuallyestimatedusingthestraightlinemethod.Theamortizationofintangiblesisthereforeverysimilartothedepreciationoftangibleassets.However,thereis
onenotabledifference.NocontraassetaccountcomparabletoAccumulatedDepreciationiscreatedtorecordthecumulativeamortizationofintangibles.Instead,thecumulative
amortizationchargeiscrediteddirectlytotheintangibleassetaccountitself.
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Exercise9.4
OnNovember30,2014,GlobalGrocerhada$15,750intangibleassetonitsbalancesheetthefranchisefee.Themonthlyamortizationexpenseforthefranchisefeeis$750per
month.
WhatisthebalanceofthefranchisefeeonthebalancesheetonDecember31,2014.
Accounting
Nowlet'smakethejournalentrytorecordtheamortizationexpenseandupdatethegeneralledger.
UpdatedFinancials
Let'supdateGlobalGrocer'sbalancesheetandincomestatementatDecember31,2014fortheeventswehaverecordedthischapterrelatedtoGlobalGrocer'slongtermassets.
Ratios
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Manybusinessesmakesizableinvestmentsinlonglivedassets.Onequestionofinteresttomanagersofthesebusinessesiswhethertheirinvestmentsinthesetypesofassetsare
productive.Onemetricoflonglivedassetproductivityislonglivedassetturnover.Thisratioshowshowquicklythefirmisabletogeneraterevenuesfromtheuseoflonglived
assets.
TheformulafortheLonglivedAssetTurnoverisasfollows:
Revenues
AverageLongLivedAssets
Revenuesarethefirm'soperatingrevenuesfortheyear.Averagelonglivedassetsaretheaverageofthebeginningandendofyearlonglivedassets.
Forexample,LongLivedAssetTurnoverforacompanywith$75millioninrevenuesandtotalassetsof$49millionatthebeginningofthefiscalyearand$51millionattheendof
theyearwouldbecalculatedasshownbelow:
$75,000,000=1.5
(49,000,000+51,000,000)/2
TurnoverbyIndustry
Longlivedassetturnovervariesdramaticallyacrossindustries.Someindustries(suchasutilities)requireheavyinvestmentswhereasothers(suchasconsultingfirms)require
verylittlelonglivedassets.ThesedifferencesinlonglivedassetrequirementswillleadtosignificantdifferencesinLonglivedassetturnoveracrosstheseindustries.
Forexample,supermarketshaveaveryhighassetturnoverwhereasjewelrystorestendtohaveaverylowassetturnover.
Recap
Inthischapter,youlearnedabouttangibleandintangiblelonglivedassetsandhowtoaccountfortheeventsthatcanaffectlonglivedassets.Inparticular,youlearnedhowto:
Recordtheacquisitionofalonglivedasset,recognizingthattheasset'scostincludesanyoutlaysfordeliveryandinstallation.
Estimateandrecordthedepreciationexpensefortheusageofanassetoveritsexpectedlife,undereitherthestraightlineordoubledecliningbalancemethods.
Recordthedisposalofalonglivedassets,includinganylossorgainondisposal.
Accountfortheimprovementofanexistinglonglivedassetandhowtodifferentiatebetweenthebettermentofanassetandmaintenanceexpense.
Identifywhichoutlaysforresearchanddevelopmentrelatedcostscanbecapitalizedandwhichmustbeexpensed.
Recordtheacquisitionandusage(oramortization)ofanintangiblelonglivedasset.
Lastly,thischapterintroducedyoutoanewratioReturnonAssetswhichallowsyoutoevaluatetheeffectivenesswithwhichacompany'smanagesitsassetstogenerate
revenuesandprofitsinthefuture.
GlobalGrocer'sDecember31balancesheetandincomestatement,shownbelow,arenowupdatedandcomplete.
LiabilitiesandFinancingCosts
Inthischapteryouwilllearnmoreaboutliabilitiesandhowtoaccountforthem.WehaveencounteredliabilitiesinearlierchapterswhenGlobalGrocerborrowedfromthebank.
ItsliabilitiesunderthesecontractswerecalledShortTermDebt(usedtosupportitsgeneralbusinessoperations)andMortgagePayable(usedtofinancethepurchaseofits
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warehouse).
GlobalGrocerisfacingsomenewchallengesthatariseinrecordingliabilities.Asaresult,youwilllearnabouthowtovalueandrecordfuturecommitmentsunderazerocoupon
loanandaleasecontract,andwheretheamountandtimingofthecommitmentsareknown.Thisrequiresunderstandingtheconceptofthetimevalueofmoneyandpresent
value.*
*Ifaftercompletingthischapteryoufeelyouneedmoreinstructiononthecompoundinterest,presentvalue,andfuturevalueconcepts,youshouldrefertoBuyingTime,aHarvard
BusinessSchoolwebbasedonlineinteractivetutorial.
Definition
Let'sstartbyreviewingwhatyouhavealreadylearnedaboutliabilities.Youlearnedpreviouslythattoberecordedasaliabilityanobligationmustmeetthreecriteria.
Itinvolvesaprobablefuturesacrificeofeconomicresourcesbytheentity
Thetransferofeconomicresourcesistoanotherentity
Thefuturesacrificearisesfromapasttransactionorevent
Youalsolearnedthatliabilitiesareorganizedintotwocategories:currentandnoncurrent.Currentliabilitiesareobligationsthatareexpectedtobecomeduewithin12monthsof
thebalancesheetdate.Noncurrentliabilitiesareobligationsthatareexpectedtobecomeduemorethan12monthspastthebalancesheetdate.
Examples
HerearethreeexamplesofliabilitiesyoupreviouslyrecordedonGlobalGrocer'sAugust31,2014balancesheet.Youwillnoticeeachobligationmeetsthethreecriteriafor
recognizingaliability.
Attheendofeachreportingperiod,werecordinterestexpensefortheamountofinterestearnedbythelenderduringtheperiod.Thismayhavebeenpaidinadvance,paidat
theendoftheperiodorbeasyetunpaid,requiringustorecordaliabilityfortheunpaidinterest.
HerearesomeitemsthatyoudidnotrecordpreviouslyasliabilitiesonGlobalGrocer'sAugust31,2014balancesheet.Youwillnoticeeachoftheseobligationsfailstomeetat
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leastoneofthethreecriteriaforbeingrecordedasaliability.
ExecutoryContracts
Businessesfrequentlyenterintocontractsknowninlawasexecutorycontracts.Thesearecontractswhereeachpartyhasyettoperformtheirpartofthecontract.Thesecontracts
oftenappeartoobligatetheparties.However,ingeneral,accountingdoesnotrecognizeobligationsunderanexecutorycontractasliabilities.
Examplesofexecutorycontractsthatdonotrequiretherecognitionofaliabilityincludethefollowing.Alawfirmsignsacontracttoperformlegalservicesoverthenext2years.
Sincesigningthecontractisnotperformancebyeitherparty,neitherthelawfirmnoritsclientwouldrecordaliabilityatsigning.Similarly,aliabilityisnotrecordedwhena
purchaseorderisplacedwithasellertoprovidegoodsinthefuture.
Likemanyotheraccountingrules,therearesomeexceptions.Youwillseeoneoftheselaterinthischapter.
KeyConcepts
Severalofthekeyaccountingconceptsthatwediscussedearlier,theGoingConcernconceptandtheConservatismconcept,areparticularlyrelevantforvaluingliabilities.
GoingConcernConcept
Typically,liabilitiesarerecordedattheamountthatwouldberequiredtosettlethematthebalancesheetdate.Indeterminingthisamount,accountingassumestheliabilitywill
besettledinthenormalcourseofbusiness,thatis,thebusinessisconsideredtobeagoingconcern.
Conservatism
Theconservationconceptalsoplaysaroleintherecognitionandmeasurementofliabilities.Itsuggestsitisprudenttorecognizeliabilitiesassoonasreasonablypossibleandto
avoidunderstatingtheamountoftheobligation.
Challenges
GlobalGrocer'sbusinesscontinuestobesuccessfulandalocalfoodwholesalehasagreedtodistributethecompany'snewjamline,butthereisaneedtoincurmoreliabilitiesto
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financeitsgrowth.
GlobalGrocerisconsideringazerocouponloantofinancegrowth
Itisalsoplanningonleasinganautomaticbottlefillingandcappingmachinetolowerthecostofitsmanufacturedjams.
OnetroublingdevelopmentisthatGlobalGrocerhasdiscovereditswarehousewasbuiltnearanoldchemicalwastedump.Thewarehouselandmaybepolluted.Ifthisis
thecase,GlobalGrocerfacesapotentialenvironmentalcleanupcost.Itmaybesubstantial.
WearenowinJanuary.AttheendofJanuaryyouwillhavetheopportunitytomaketheaccountingentriestorecordtheseevents.UpdatedfinancialstatementsforGlobal
Grocer'sfirstyearofoperationsreflectingthesetransactionsandtheothertransactionstofollowintherestofthetutorialwillbepresentedattheendofthistutorial.
ZeroCouponDebt
Inordertofunditsgrowth,GlobalGrocerisconsideringatypeofloanknownaszerocoupondebt.Thetypicalzerocoupondebtarrangementisasfollows:Theborroweragreesto
paythelenderafixedamountinthefutureinreturnforreceivinganamounttodaythatislessthanthefuturepayment.Theborrowerisalsorelievedfromhavingtomake
periodicinterestpaymentstothelender.
FutureValue
Thefinancialconceptsknownasfuturevalue,presentvalueandcompoundinterestarethekeystounderstandingtheeconomicsandtheaccountingfortheproposedzero
couponloan.Let'sspendafewmomentsreviewingtheseconcepts,startingwiththedefinitionandmechanicsoffuturevalues.
FutureValueDefinition:
Thefuturevalueofanyamountofmoneytodayistheamountthatitwouldbeworthifitwereinvestedandgrewatthespecifiedcompoundinterest
rateoveragiventimeperiod.
Interestissaidtocompoundwhentheinterestearnedeachperiodcontinuestobeinvestedtoearnmoreinterest.
Forexample,if$100todaycouldbeinvestedat10%,itsfuturevalueinoneyear'stimewouldbe$110,comprisingtwopartstheinitial$100investmentandoneyear'sworth
ofinterest$10(10%times$100).Ifitwereinvestedat10%fortwoyears,itsfuturevalueintwoyearswouldbe$121againthe$100investment,$10ofinterestforthefirst
year,and$11interestforthesecondyear(10%times$110,thevalueoftheinvestmentatthebeginningofthesecondyear).
PresentValue
Thepresentvalueconceptusesthesamelogicthatweusedtodeterminethefuturevalueofaninvestmenttocomputehowmuchanamounttobereceivedinthefutureis
worthtoday.
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Thebasicideaunderlyingthepresentvalueconceptisthatanamountofmoneyavailabletodayismorevaluablethanthesameamountreceivedinthefuture.Why?Because
themoneyavailabletodaycangrowbyinvestingittoearnmoremoneyastimepasses.
Thebasicpresentvalueideacanbeexpressedmoreformallybythefollowingdefinition.
PresentValueDefinition:
Thepresentvalueofanamounttobereceivedataspecifiedfuturedateistheinvestmentthatwewouldneedtomaketodaythat,withthebenefitof
compoundinterest,wouldgrowtothesameamountasthefutureamounttobereceivedatthefuturedate.
Forexample,assuminga10%interestrate,$110tobereceivedinoneyear'stimewouldbeworthonly$100today.Ifweinvestedthe$100todayat10%,wewouldhaveexactly
$110inoneyear.Wewouldthereforebeindifferentbetweenthetwo.Similarly,$121intwoyearstimewouldbeworth$100today,since$100investedfortwoyearsat10%
wouldgrowto$121.
Exercise10.1
ImpactofChangesinInterestRatesandInvestmentHorizonsonFutureValueofInvesting$1000Today
Assumeyouinvest$1000today.Ifyoureceiveinterestatanannualrateof10%,theinvestmentisworth$1,100inoneyear'stime.
Moveyourmouseoverthecellsinthetableontherightthatcorrespondtoaninterestrate/investmenthorizoncombinationtoseehowthevalueofyourinvestmentchanges.
Howdoesthevaluechangeasyouincreasetheinvestmenthorizon?Whathappensifyoukeeptheinvestmenthorizonfixedandincreasetheinterestrate?
Year0
Year1
Year5
0%
Year10
5%
2 $
10%
6 $
15%
0 $
ImpactofChangesinInterestRatesandInvestmentHorizonsonPresentValueofReceiving$1000inFuture
Assumeyoureceive$1000inoneyear'stime.Ifyoucanearninterestatanannualrateof10%,thepresentvalueofthe$1,000is$909.
Moveyourmouseoverthecellsinthetableontherightthatcorrespondtoaninterestrate/timingofreceiptofthe$1000combinationtoseehowthepresentvaluechanges.
Whathappensasyouincreasetheyearsbeforetheamountisreceived?Whathappensifyoukeeptheyearstillreceiptfixedandincreasetheinterestrate?
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5 $
8 $
0 $
2 $
6 $
9 $
Equations
Wewillbrieflyreviewtheformulasthatareusedtocalculatefutureandpresentvalues.Asyouwillseeinamoment,inpracticeyouwillusetables,calculatorsorcomputersto
generatethesecalculations.
Hereistheformulausedtocalculatethefuturevalue(F)ofanamountPthatisinvestedtodayfornperiodsataninterestratei:
F=P(1+i)n
Where:
F=FutureValue
P=InitialInvestment
i=InterestRate
n=NumberofPeriods
Usingtheabovepresentvalueequation,whatisthefuturevalueattheendof3yearsof$1,000investedat20%today?
Theformulausedtocalculatethepresentvalue(P)ofanamountFthatistobereceivedinnperiodstimewhentheinterestrateisi:
P=F
(1+i)n
Where:
P=PresentValue
F=Futureamountreceived
i=Discountrate
n=Numberofyearstoreceiptoffutureamount
Usingtheabovefuturevalueequation,whatisthepresentvalueattheendof3yearsof$1,000investedat20percenttoday?
PresentValueTables
Manyaccounting,financeandeconomicstextbooksincludetablesthatgivethepresentvalueofadollarreceivedsometimeinthefuture.Yourbriefcaseincludesacomplete
presentvaluetable.
Let'sseehowtousethesetables.Thetableshowsthatthepresentvalueof$1tobereceivedintwoyearstimeassumingacompoundinterestrateof10%is0.826.Thisimplies
thatifweinvested$0.826fortwoyearsat10%ourinitialinvestmentwouldgrowto$1(allowingforsomeroundingerror).
Exercise10.2
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Usingthepresentvaluetable,whatistheapproximatepresentvalueof$1,332tobereceivedin3yearstimegivenaninterestrateof10%peryear?
Semiannualcompounding
Sometimeslendersrequirethatinterestcompoundssemiannually,notannually.Howdowereflectthisinourcalculations?Whatimpactdoesithaveonpresentvalues?
Let'stakealookatwhathappensusingourpreviousexercise,wherewereceive$1332in3yearstime,andinterestratesare10%.Ifinterestcompoundssemiannually,our
10%annualrateisequivalenttoa5%semiannualrate,andthethreeyearsareequivalentto6halfyears.
Usingthepresentvaluetables,thepresentvaluefactorinthe5%interest/6periodscellis0.746.Thepresentvalueof$1,332tobereceivedin3yearstimegivenaninterest
rateof10%withsemiannualcompoundingistherefore:
$1332*0.746=$944
Youcanconfirmthatthisansweriscorrectbycalculatingthepresentvalueofinvesting$994for6periodsat5%interest.
Notethatthepresentvalueof$1332for6halfyearsat5%($994)islessthanthepresentvalueofthesameamountfor3yearsat10%($1000).Thereasonisthatwithsemi
annualcompoundingweareabletogeneratemoreinterestfromourinvestmentsincewebeginearninginterestonourinteresteverysixmonthsratherthaneveryyear.
Exercise10.3
Youaregiventhefollowingalternative:Accept$1,000todayorreceive$1,100inthreeyearstime.Youcandepositmoniesinyoursavingsaccountandearn4percentannual
interestoverthenext3years.Whichalternativewouldyouchoose?
LoanValue
Nowthatyouunderstandhowfutureandpresentvalueswork,youarereadytovaluethezerocouponloanbeingconsideredbyGlobalGrocer.RecallthatGlobalGroceris
reviewinga2year$100,006zerocouponloan.Underthisarrangement,GlobalGrocerwillreceive$82,650attheloaninception,andpaythelender$100,006intwoyears
timewhentheloanmatures.AlthoughGlobalGrocerwillnotmakeanyinterestpaymentsduringtheloan'sterm,thelenderexpectstoearn10%interestontheloan.Thelender
isabletoachievethisbypayingonly$82,650toGlobalGrocerattheloaninceptionandreceiving$100,006attheendofthetwoyearloanterm.Thedifferenceof$17356is
implicitinterestontheloan.GlobalGrocerisattractedtothezerocouponloanopportunitybecausethisdeferralofinterestpaymentswillreducethecashitneedstopaythe
creditorintheshortrun.
Noticethattheloantermsreflectboththefuturevalueandthepresentvalueconcepts.Ifweinvested$82,650at10%fortwoyears,wewouldgenerate$100,006,theloan
payment.Inotherwords,$100,006isthefuturevalueoftheinitialloanamountof$82,650.
Alternatively,theloanamountof$82,650isthepresentvalueoftheloanpaymentof$100,006intwoyearsassuminga10%interestrate.Youcancheckthisbyreferringtothe
presentvaluetables.Thepresentvalueof$1tobereceivedin2yearsat10%is0.826.Thepresentvalueofthefinalpaymenttothecreditoristherefore$100,006*0.826or
$82,605.
Accounting
Now,let'sconsidertheaccountingforGlobalGrocer'szerocouponloan.Todoso,wewillhavetoanswertwoquestions:
Whatamountshouldberecordedastheliabilitythediscountedamountreceivedorthehighermaturityamount?
Sincethereisnotaperiodiccashinterestpayment,whatperiodicinterestexpense,ifany,shouldberecorded?
Initially,zerocouponloansarerecordedasaliabilityattheamountreceived.Then,ineachsubsequentaccountingperiod,interestisaccruedattherateimpliedbythe
arrangement.Theaccruedinterestisrecordedasanexpenseandanadditiontotheloanliabilitybalance.Theinterestaccrualreflectsthefactyouhavehadtheuseofthe
creditor'smoney,whichinturncreatesafutureobligation.Therecordingoftheinterestensuresthatthecostoftheloanisreflectedintheperiodthattheloanwasused.
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Toillustratehowaccountingworksforazerocouponloan,let'sconsidertheloanadvancedtoEastCorporation.Eastborrows$79,700underazerocouponloanandisobligated
topaythelender$99,975attheendoftwoyears.Theloanhasbeenpricedbythelendertoearnanannual12percentreturn,which,fromEast'spointofview,istheloan's
interestrate.
ZeroCouponLoanEntry
GlobalGrocerdecidedtoacceptthezerocouponloanoffer.AttheendofJanuary,GlobalGrocersignedthe$100,006zerocouponloanagreementandreceived$82,650.
CompletetheJanuary31journalentrytorecordGlobalGrocer'szerocouponloanobligation.Dothisbydraggingthecorrectaccountsandamountstotheappropriateplaceson
thejournal.Oncethisiscorrect,theGeneralLedgerwillappear.Thendragtheamountstotheappropriateplacesintheledger.
Leases
GlobalGrocer'smanufacturedjamsareprovingtobeverypopular.Tospeeduptheirproductionandtoreducelaborcosts,GlobalGrocerdecidestoacquireanautomaticbottling
andcappingmachine.Inordertoconservecash,GlobalGrocerintendstoleaseratherthanbuythenewmachine.
Aleasegrantsthelessee,inthiscaseGlobalGrocer,theuseofpropertyforaspecifiedtimeinexchangeforaseriesofperiodicrentalpaymentstotheowneroftheleased
property.Theowneroftheleasedpropertyiscalledthelessor.
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Introduction
Forlegalpurposes,leasesareexecutorycontracts.Normally,asnotedearlier,accountingdoesnotrecognizeexecutorycontractobligationsasliabilities.Butsomeleasesarean
exception.
Eventhoughthelessoristhelegalowneroftheleasedasset,dependingonthetermsofthelease,theleaseobligationmayberecordedbythelesseeasaliabilityandtheleased
assetasanasset.Thislesseeaccountingtreatmentisrequiredwhentheleasearrangementisinsubstanceequivalenttoanassetpurchase.Accountantsrefertothesein
substancepurchasetypeleasesascapitalleases.Allotherleasesarecalledoperatingleases.
ThechallengenowfacingyouistodetermineifGlobalGrocer'smachineleaseisacapitaloranoperatingleaseforaccountingpurposes.
CapitalLeaseAccounting
Becauseoftheownershiplikenatureofthelessee'srightstousetheleasedasset,capitalleaseaccountingassumesthelesseehasinsubstancefinancedtheacquisitionofthe
righttousetheleasedassetwithaninstallmentloan.Consequently,thelesseerecordsinitiallythepresentvalueoftheleasepaymentsasaliabilityalongwithanassetinthe
sameamount.Subsequently,theleasedassetisdepreciatedlikeanysimilarownedassetandtheliabilityisaccountedforasaninstallmentloan.
ACapitalLeaseinsubstanceisan:
AssetPurchase
InstallmentLoanFinancing
GAAPCapitalLeaseCriteria
UnderGAAP,aleasearrangementisclassifiedasacapitalleaseifoneofthefollowingcriteriaaremet:
Ownershipoftheleasedassetistransferredtothelesseeattheendoftheleaseterm
Thelesseehasanoptiontopurchasetheleasedassetatabargainpurchaseprice
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Thetermoftheleaseis75percentormoreoftheleasedasset'seconomiclife(i.e.,itsproductivelife)
Thepresentvalueoftheleasepaymentsdiscountedbythelessee'sborrowingcostis90percentormoreofthefairvalueoftheproperty
Forthepurposeofapplyingthesetests,theleasetermincludesrenewaloptions.
Theparticulardepreciationmethodappliedtotheleasedassetdependsonthebasisforclassifyingtheleaseasacapitallease.Ifthecapitalleaseclassificationisbasedonthe
leasemeetingeitherthe75percentor90percenttest,theassetisdepreciatedovertheleasetermandsalvagevalueisnotconsidered.Incontrast,ifthecapitallease
classificationisbasedontheleasemeetingeitherthebargainpurchaseorownershiptransfertest,theassetisdepreciatedoveritsusefullifetothelesseeandsalvagevalueis
considered.Theusefullifemaybelongerthantheleaseterm.Ifacapitalleaseclassificationcouldbebasedoneitherthebargainpurchaseofownershiptransfertestandone
orbothoftheothertwotests,thebargainpurchaseandtransferownershiptestdepreciationmethodisapplied.
Exercise10.4
Satisfyingwhichoneofthefollowingtestsdoesnotrequireclassificationofaleasearrangementasacapitallease:
IFRSCapitalLeaseCriteria
RisksandRewardsofOwnership
UnderGAAPandIFRS,theaccountingentriesforaleaseclassifiedasacapitalleasearethesame.Thedifferencebetweenthetwostandardsliesinthetestsusedtoidentify
capitalleases.
ThetestsforacapitalleaselistedonthepreviousslideareGAAP.Thisstandardisreferredtoasa"rulebased"or"brightline"accountingstandard.Incontrast,IFRS's
capitalleaseaccountingstandardis"principlebased"accountingstandard.IFRSstipulatesthatifsubstantiallyallthe"risksandrewardsincidenttoownership"liewiththe
lessee,theleaseisacapitallease.Otherwise,itisan"operatinglease."
Exercise10.5
UnderIFRS,leasesthatsubstantiallytransfertothelesseethe"risksandrewards"incidentaltoownershiparecapitalleases.Threeofthefollowingfourleaseagreement
termstransfertherisksandrewardsofownershiptothelessee.Whichleasetermdoesnottransfertherisksandrewardsofownershiptothelessee?:
PresentValue
Thepresentvalueconceptweusedtovalueandrecordazerocouponloanisalsocriticaltounderstandingtheeconomicsofcapitalleases,determiningwhetheraleaseshould
berecordedasacapitallease,andvaluingcapitalleaseassetsandliabilities.
Theleasepaymentsthatthelesseepromisesinthefuturecanbevaluedtodaybytakingtheirpresentvaluesandsummingthemup.
Forexample,considerapersonalcomputerleaseagreementfortwoyearsunderwhichthelesseemakesleasepaymentsof$1,000todayand$1,000inoneyear'stime.Ifthe
leasequalifiesasacapitallease,thelesseeiseffectivelyborrowingtofinancetheuseofthepersonalcomputerfortwoyears.Assumingtheinterestrateusedfortheleaseis
10%,thepresentvalueoftheleasepaymentsis$1,909:
Annuity
Aleaseagreementtypicallyinvolvesmakingidenticalpaymentseachyearforaspecifiedperiod.Thisiscalledanannuity.Manytextbooksincludeanannuitytablethat
showsthepresentvalueofanannuityofonedollarpaymentsfordifferentperiodsandinterestrates.Thistableishelpfulforcalculatinggoodapproximationsofthe
presentvalueofastreamofconstantannualpayments,suchasleaserentals.
Annuitytablesarereadinthesamemanneraspresentvaluetables.Forexample,tofindthepresentvalueofanannuityof$1ayearfor5yearsdiscountedat12percent,
readacrossthe5yearlineuntilitintersectswiththe12percentcolumn.The3.605factoratthispointindicatesthepresentvalueoftheannuityis$3.605.
Onceyouknowthepresentvalueofastreamofonedollarpayments,itissimpletocalculatethepresentvalueofanystreamofconstantdollaramounts.Forexample,ifa5
yearleaseagreementcalledfor5annual$1,000leasepayments,thepresentvalueofthisstreamofpaymentsdiscountedat12percentis$3,605($1,000*3.605).
Belowisaportionoftheannuitytable.Thistutorial'sbriefcaseincludesanexpandedannuitytable.
Exercise10.6
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Usingtheaboveannuitypresentvaluetable,whatisthepresentvalueofa4yearstreamofannual$1,000paymentsdiscountedat6percent?
Illustration
Toillustratetheaccountingforacapitalleaseofapieceofmachinery,assumethefollowing:Theleasemeetsthe75%capitalizationtesttheleasetermis3yearstheannual
rentalis$3,000thelesseeusesstraightlinedepreciationand,thelesseecanborrowmoneyata10percentinterestrate.
Beginningwiththenextpage,youwillseethekeyrolepresentvaluemathematicsplaysinaccountingforcapitalleases.
PresentValueCalculation
Thefirststepinaccountingforthiscapitalleaseistocalculatethepresentvalueoftheleasepayments.Thisamountwillbetheinitialamountrecordedforthecapitallease
relatedliabilityandasset.
Alternatively,wecouldcalculatethepresentvaluebysummingupthepresentvalueofeachpaymentasfollows:
RecordCapitalLeaseLiability
Onceweknowthepresentvalueoftheleasepayments,wecanrecordthevalueoftheleasedassetandliability.
Let'slookattheinitialjournalentriesandthetransferofthejournalentriestotheledgeraccounts
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CapitalLeasePayments
Thesecondstepinaccountingfortheillustrationcapitalleaseistogeneratethecapitalleaseobligationamortizationscheduleandrelatedjournalentries.Remember
accountingviewsthisobligationasbeingsimilartoaninstallmentloan.Therefore,eachrentalpaymentwillconsistoftwocomponents.Namely,a10%interestpaymenton
theoutstandingbalanceoftheloanandarepaymentofpartoftheloan'soutstandingbalance.
Belowisthecapitalleaseobligationamortizationscheduleandtherelatedjournalentries.
CapitalLeaseAssetDepreciation
Thelaststepinaccountingfortheillustrationcapitalleaseistogeneratethedepreciationscheduleandrelatedjournalentriesfortheleasedasset.Thedepreciation
schedulefollowsthecompany'sstraightlinedepreciationpolicy.Theannualdepreciationiscalculatedusingthethreeyearleaseterm.Sincetheleasedassetmustbe
returnedtothelessorattheendofthelease,itdoesnothaveanyresidualvaluetothelessee.
Belowistheannualdepreciationscheduleandtherelatedjournalentries.
OperatingLeaseAccounting
Ifaleaseisnotacapitallease,itisclassifiedasanoperatinglease.Theaccountingforanoperatingleaseisstraightforward.Theperiodicleasepaymentsaresimplyrecordedas
aleaseexpenseeachyear.Neitheraliabilitynoranassetisrecognized.
Toillustrateoperatingleaseaccounting,assumeyouleasedanewcarfor3yearsforanannualrentalpaymentof$3,000underanoperatinglease.
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Exercise10.7
Youhavemadethefirstyearleaserentalpayment.Whatarethefirstyearjournalentriesfora3yearoperatingleaserequiringanannualleaserentalpaymentof$6,000?
GlobalGrocerLease
Now,let'sturntoyourGlobalGrocerleaseaccountingdecision(youmaywanttoreviewthe"CapitalLeaseCriteria"screenbeforeproceedingtoanalyzethetermsoftheGlobal
Grocerleaseagreement).
TheleasedmachinerywasdeliveredandinstalledbythelessoronJanuary31.Overthepriorweek,youlearnedthefollowingabouttheproposedmachinerylease.
Youhavetodecidewhethertheleasesatisfiesthecriteriaforacapitallease,orwhetheritisanoperatinglease.Whatisyourdecision?
Watchthevideoforthecorrectanswer.
Theleaseisacapitallease.Theleaseterm(5years)ismorethan75%oftheleasedassetseconomiclife(6years).5/6=83.3%
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HavingdecidedtheGlobalGrocerleaseisacapitallease,youmustnowpreparetherelatedjournalentries.Yourfirststepistodeterminethepresentvalueoftheleases'five
$5,000annualrentalpaymentsusingGlobalGrocers'10percentborrowingrate.
Usetheannuitytabletomakeyourcalculation.
Enteryourcalculatedpresentvalueamounthere:
InitialEntry
Nowthatyouhavedeterminedthatthepresentvalueofthe5yearstreamofannual$5,000leasepaymentstobemadebyGlobalGroceris$18,955,youcanmakethe
January31journalentrytorecordGlobalGrocer'scapitalleaseobligationandasset.
BalanceSheetEffect
ThenextstepinyourinitialaccountingforthecapitalleaseistodisplaythecapitalleaseobligationcorrectlyintheJanuary31balancesheet.
Sincethecapitalleaseobligationisviewedasaformofdebt,whentheobligationisdisplayedinthebalancesheetitmustbepresentedintwoparts.Thenextyear'sprincipal
reductionportioninthenextannualleasepaymentisshownasacurrentliabilityinthecurrentperiod'sbalancesheet.Theobligationremainingafterthecurrentportionis
deductedfromthetotalendofperiodobligationandisreportedasanoncurrentliability.
CurrentvsNonCurrent
TodetermineGlobalGrocers'currentvsnoncurrentbalancesheetpresentationoftheinitialcapitalleaseobligationyoupreparedthefirsttwoyearsofitsfiveyearlease
obligationamortizationscheduleshownbelow.
Thefirstlineoftheamortizationscheduleindicates$1,896ofthefirstannual$5,000leasepaymentisinterestontheinitial$18,955leaseobligation.Theremaining$3,104
ofthis$5,000leasepaymentrepresentsareductionoftheleaseobligation.Thatis,$3,104ofthe$18,955initialvaluationofthecapitalleaseobligationwillbereturnedas
partofthe$5,000leasepaymenttothelessorwhenthefirstannualleasepaymentismade.Accordingly,whenthecapitalleaseobligationisdisplayedintheJanuary31
balancesheet,$3,104willbelistedasacurrentliabilitysinceitwillbepaidwithinthenext12months.The$15,851remainingbalanceoftheobligationwillbereportedasa
noncurrentliability.
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ContingentLiabilities
Asnotedearlier,inJanuaryGlobalGrocerdiscoversthatitswarehousewasbuiltnearanoldchemicalwastedump.Thewarehouselandmaybepolluted.Ifthisisthecase,Global
Grocerfacesapotentialenvironmentalcleanupcost.Itmaybesubstantial.
Accountantsrefertothepotentialchemicalwastecleanupcostasalosscontingency.Thatis,theobligationinvolvesuncertaintyastothepossiblecostwhichwillonlyberesolved
bysomefutureeventthatmayormaynothappen.
TheaccountingchallengenowfacingyouandGlobalGrocerisshouldthislosscontingencyberecognizedasaliability.
RequiredConditions
Thedeterminationofwhetherornotalosscontingencyshouldberecordedasaliabilityrequiresjudgment.
Alosscontingencyisrecognizedasaliabilitywhenbothofthefollowingconditionsaremet.
Informationavailablepriortotheissuanceofthefinancialstatementsindicatesthatitisprobablethatanassethasbeenimpairedoraliabilityhasbeenincurred(That
is,thethreeliabilitycriteriahavebeenmet).
Theamountofthelosscanbereasonablyestimated.
FutureEvents
Implicitinthefirstrequiredconditionforrecognitionisthatismustbeprobablethatafutureeventwilloccurconfirmingthefactoftheloss.Inmakingthisjudgment,
accountantsrecognizethelikelihoodofthefutureeventthatwillconfirmthelosshasoccurredcanrangefromprobabletoremote.
Asnotedearlier,inordertorecognizealosscontingencyasaliability,itmustbeprobablethatthefutureconfirmingeventoreventswilloccur.Thatis,thefutureeventor
eventsarelikelytooccur.
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Exercise10.8
TheEastCompany'sglassdivisionhadacontracttoinstallallofthewindowsinanew50storyseethroughofficebuilding.Thebuilding'scompletiondatewasdelayedfor
nearlyayearduetoproblemsassociatedwiththeinstallationofthewindows.Eventually,thebuildingownerssuedEastfor$10millionclaiminglossofrentalrevenues.
Concurrently,East'slawyerrecommendedEastsettlethelitigation.Anysettlementwouldnotbereimbursedbyinsurance.
WhenshouldEastrecordaliabilityforthelosscontingencyarisingfromthedefectivewindowinstallations?
Accounting
Toillustratetheaccountingrecognitionofalosscontingentassumethefollowing:TheAllenCompanyreachestheconclusionthata$100,000litigationlosscontingencyshould
berecognizedasaliabilityandacurrentexpense.Subsequently,oneyearlaterthelitigationisresolvedandtheactualcashlitigationlossis$70,000,ratherthantheoriginal
estimated$100,000.
Let'snowrecordthejournalentryfortheseevents.
GlobalGrocer
ItisnowJanuary31andyouhavetodecidewhetherornottorecordacontingentliabilityforGlobalGrocer'spossiblechemicalwastecleanupcost.
Sofaryouhavegatheredthefollowingfacts:
Thepotentialsourceofanycontaminationofthewarehousepropertyislocatednearlyahalfmileaway
Thedegreeofcontaminationofthepotentialsourceisstillunderinvestigation
Itisbelieved,butitisnotconfirmed,thatgroundwaterflowsfromthecontaminationsiteinthegeneraldirectionofthewarehouseproperty
Alocalenvironmentalcleanupcompanyhasestimatedthat,dependingontheextentofcontaminationthecostofcleaningupthewarehousepropertymightrangefrom
$30,000to$70,000.Insurancewouldnotcoveranyofthiscost.
Whatisyourdecision?ShouldGlobalGrocerrecordachemicalwastecleanupcostliabilityonJanuary31?(Decideonyouranswerbeforegoingtothenextscreen).
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AccountingDecision
NoteDisclosure
GlobalGrocerhasdecidedtofollowthemajority'saccountinganddisclosurelosscontingencydecision.Theabovenotewillbeincludedaspartofthecompany'sJanuary31,
2015financialstatementpresentation.
IFRS
IFRSreferstothosecontingentliabilitiesthatGAAPrecognizesonthebalancesheetas"provisions",not"contingentliabilities".Theterm"contingentliability"isreservedto
describethoseunrecognizedcontingentliabilitiesthatunderGAAPandIFRSmayormaynothavetobedisclosed.
DebtRatings
Theinvestmentqualityofthedebtofcompaniesmayberatedbydebtratingservices.Forexample,Moody's,aleadingdebtratingservice,issuesratingsthatareexpressedin
termssuchasAAA(thehighestrating)allthewaydowntoC(thelowestrating).Theratingrepresentsthelikelihoodthedebtorwillpaythedebt'sprincipalandinterestontime.
Forthemostpart,thehigherthedebtrating,theloweristherequiredrateofreturnofinvestors.DebtratedtripleBorbetterisconsideredtobeof"investmentgrade."Itis
consideredtobearelativelysafeinvestment.Aninvestmentgraderatingisconsidereddesirablesincemanyfinancialinstitutionsbyregulationorpolicycannotholddebtrated
lessthaninvestmentgrade.Manyunratedandlessthaninvestmentgradedebtarereferredtoas"junkbonds."
InterestCoverageRatio
EBITDACoverageRatio=EBITDA
Totalinterestcharges
Ratingservicesusemanyoftheratiosyouhavereviewedinearlierchapterstoreachtheirratingdecision.Inadditiontotheseratios,anextremelyimportantclassofratios
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knownasinterestcoverageratiosisemployed.Theseratiosaredesignedtomeasurehowadequatelycreditorsareprotectedbyfundsgeneratedbythedebtor'soperations.One
ofthemostpopularinterestcoverageratiosisshownabove.Thenumeratorofthisratioisreferredtoasacompany's"EBITDA."Generally,thehighertheEBITDAcoverage
ratio,thehigherisacompany'sdebtrating.
Examples
GlobalGrocer'sEBITDA
GlobalGrocer'sDecember31incomestatementanditsaccompanyingDepreciationandAmortizationnoteareshownbelow.WhatisGlobalGrocer'sDecemberEBITDAto
totalinterestratio?
UseyourmousetoidentifyonebyonethelineitemsintheincomestatementandnotethatyouwillusetocomputeGlobalGrocer'sDecemberEBITDAtototalinterestratio.
Recap
Thischapterhasextendedyourknowledgeofaccountingforliabilities.Inparticularyoulearned
Generally,executorycontractsdonotgiverisetoliabilities,buttherearesomeexceptions.
Zerocoupondebtisinitiallyrecognizedasaliabilityattheamountreceivedbytheborrower.Overitslife,theinterestonzerocoupondebtisaccruedasanoncash
expenseandasanadditiontotherelatedliability.
Leasesareclassifiedaseithercapitaloroperatingleases.Capitalleasesareaccountedforasiftheyareapurchaseofanassetfinancedbyaninstallmentloan.
Operatingleaserentalsareanoperatingexpense.Neitheranassetoraliabilityisrecordedbythelessee.
Losscontingenciesarerecordedasaliabilitywhen1)itisprobablythatanassethasbeenimpairedoraliabilityhasbeenincurredand2)theamountofthelosscan
bereasonablyestimated.Gaincontingenciesarenotrecognizeduntilrealized
EBITDAinterestcoverageratiomeasuresaborrower'sabilitytomeetinterestpaymentsfromoperatingfunds.
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InvestmentsandInvestmentIncome
Inthischapteryouwilllearnabouthowtoaccountforinvestmentsinothercompaniesandtorecordinvestmentincome.Keymanagementchallengesyouwillcoverinclude:
Howtorecordtheacquisitionofshortterminvestmentsinstocksandbondsthathavebeenpurchasedasanalternativetoholdingcashatthebank.
Howtorecordgainsandlossesondifferenttypesofshortterminvestments
Howtorecordalongterminvestmentthatresultsintheacquirergainingcontrolovertheothercompanyandintegratingthetwobusinesses
Asinpreviouschapters,youwilllearntheaccountingforthesetypesoftransactionsbydoingtheaccountingforGlobalGrocer.
Challenges
AsGlobalGrocerenterstheendofitsfirstsixmonthsofoperations,youencounterthefollowingnewreportingchallengesrelatingtoinvestmentsinothercompanies:
$15,000ofexcesscash,whichhadbeenputintomarketablesecurities,hadincreasedinvalueto$16,500.Howshouldtheinvestmentbevaluedinthebalancesheet?
Shouldanygainontheinvestmentbereflectedintheincomestatement?
Youdecidetoacquireoneofyourcompetitors,InternationalSpecialtiesfor$$1,184,350.Initsownbooks,InternationalSpecialtiesvaluesitsequityat$224,435.How
shouldtheacquisitionberecorded?
Severalfactorsaffectthewaythatthesetransactionsarerecorded:themotivationsforundertakingtheinvestmentinthefirstplace,andtheextenttowhichwehavecontrol
overthefirminwhichwehaveinvested.
InvestmentMotivations
Firmsacquirethedebtandequitysecuritiesofotherfirmsforavarietyofreasons.
Theymayusethesetypesofinvestmentsasaconvenientwaytoparkexcesscashneededtofundworkingcapitalorlongtermassetsinthenearfuture.Investingin
othercompanydebtorequityisexpectedtoprovideahigherreturnthancouldbeearnedbykeepingtheexcesscashinthebank.
Managersalsomakeinvestmentsinothercompaniesforstrategicpurposes.Thesetypesofinvestmentstypicallyinvolveacquisitionofamajorityoftheequityof
anothercompany.Theacquiringcompany'smanagementthenhascontrolovertheacquiredcompany,enablingitintegrateitintoitsownoperationsortotakeother
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actionsthatimprovetheperformanceofthenewlycreatedcombinedfirm.
Sincethemotivationforthesetypesoftransactionsisverydifferent,werecordthetwoverydifferently.
Control
Accountingdistinguishesbetweeninvestmentsthatenableonefirmtocontrolanother,andinvestmentswherethereisnosuchtransferofcontrol.Onefirmcontrolsanotherif
itownsamajority(i.e.morethan50%)ofitscommonequity.Asnotedabove,managerstypicallyviewcontrollinginvestmentsaslongtermandstrategic.Thesetypesof
investmentsarecalledbusinessacquisitionsorcombinationsandareaccountedforusingthepurchasemethod.
Incontrast,thereisnoissueofcontrolwhenafirmacquiresonlyasmallpercentageofthecommonequityofanotherfirm.Investmentsincorporatedebtorequitystakesof
lessthan20%areusuallyviewedasnotinvolvingcontrol.Thesetypesofinvestmentsarisewhenafirmisusingtheinvestmentasaconvenienttemporaryplacetoparkexcess
cash.Theseinvestmentsarecalledmarketablesecuritiesandareaccountedforusingeitherthecostormarketmethod.
Investmentsintheequityofanothercompanythatare20%ormore,butlessthanmajorityownershiparelikelytoprovidetheacquiringfirmwithsomeinbetweenlevelof
control.Thesetypesofinvestmentsarecalledequityinvestmentsorinvestmentsinassociatedcompaniesandaccountedforusingtheequitymethod.Discussionof
thesetypesofinvestmentsisbeyondthescopeofthischapter.
MarketableSecurities
MarketableSecuritiesareshownascurrentassetsonthebalancesheet.Theyareinvestmentsthatare
Readilymarketable
Expectedtobeconvertedtocashwithinayear.
Havenocontrolimplicationsforthecompanywhosesecuritiesareacquired
Popularmarketablesecurityinvestmentsincludecommercialpaperandtreasurybills.Commercialpaperisthenamegiventoatypeofshortterminterestbearingnoteissued
bycorporations.TreasurybillsareinterestpayingshorttermobligationssoldbytheU.S.Treasury.Otherformsofmarketablesecuritiesincludethemarketablecommonstock
ofothercompanies,corporatepromissorynotesandcorporatebonds.
Investmentsthatarenotmarketableorthataregoingtobeheldforlongerthanayear,butwhichdonotprovidetheownerwithanycontrolrights,arelistedaslongterm
investmentsratherthanmarketablesecuritiesonthebalancesheet.Theseinvestmentsareaccountedforattheircost.
Exercise11.1
Whichoneofthefollowingreadilymarketablesecuritiesisnotamarketablesecurityforaccountingpurposes?
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Intent
Asnotedearlier,marketablesecuritiesarerecordedusingeitherthecostormarketmethods.Theinvestmentintentionoftheinvestorinacquiringmarketablesecurities
determineswhichofthesemethodsisused.Therefore,thefirststepinthemarketablesecurityaccountingdecisionistodeterminetheinvestor'sintent.
Accountingclassifiesaninvestor'sintentinoneofthreecategories.Theyare:
Holdtomaturity
Trading
Availableforsale
HoldtoMaturity
Holdtomaturitymarketablesecuritiesaredebtsecuritiesthattheinvestorintendstoholdtomaturity.Thesetypesofmarketablesecuritiesareaccountedforonthebalance
sheetattheircost.
Trading
Tradingsecuritiesaredebtandequitysecuritiesthattheholderintendstosellintheneartermaspartofaplantoearnprofitsfromshorttermmovementsinthesecurity's
price.
Tradingsecuritiesareaccountedforattheirmarketvalue.Thatis,ateachbalancesheetdatetheyarereportedattheircurrentmarketvalue.Anyunrealizedgainorlosssince
thelastbalancesheetdateisincludedintheincomestatementasinvestmentincome.Whenthesecurityiseventuallysold,anyadditionalgainsorlossisalsorecordedinthe
incomestatementasinvestmentincome.
Forexample,consideranequitysecurityboughtneartheendofthemonthfor$1,000.Theintentistoprofitfromashorttermupwardmovementinitsprice.Attheendof
themonth,whenthecompanypreparesitsfinancialstatements,thesecurityisstillownedbutitsmarketpricehasincreasedto$1,100.Twodaysintothenextmonththe
securityissoldfor$1,050.
Sincetheinvestorintendstoprofitfromashorttermmovementinthesecurity'sprice,theinvestmentisclassifiedasatradingsecurity.
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TheUnrealizedGainof$100andLossonSaleof$50areincludedintheincomestatementfortheappropriateperiodaspartofInvestmentIncome.
AvailableforSale
Availableforsalesecuritiesaredebtandequitysecuritiesthatdonotfallintoeithertheholdtomaturityortradingsecuritycategories.
Liketradingsecurities,availableforsalesecuritiesarereportedonthebalancesheetattheirmarketvalue.However,unlikethecaseoftradingsecurities,unrealizedgains
andlossesonavailableforsalesecuritiesarenotshownasInvestmentIncome.Insteadtheyaredirectlycredited/debitedtoaspecialshareholders'equityaccountcalled
UnrealizedgainsandlossesonAvailableforSaleSecurities.Whenthesecurityissoldandanactualgainorlossisrealized,anyrelatedunrealizedgainorloss
recognizedtodateiseliminatedfromowners'equityandtheactualgainorlossisrecordedintheincomestatement.
Let'sseehowthisworksinpractice.Considerthefollowingexample.Acompanyacquiressecuritiesthatareavailableforsalefor$50,000atthebeginningofthemonth.At
theendofmonththesecuritieshadamarketvalueof$52,300.Duringthefollowingmonththesecuritiesweresoldfor$54,000,arealizedagainof$4,000overtheoriginal
costofthesecurities.
Attheendofthepurchasemonth,theUnrealizedgainonAvailableforSaleSecuritiesof$2,300isincludedinthebalancesheetaspartofShareholder'sEquity.Whenthe
securitiesaresoldinthefollowingmonth,thedebittoUnrealizedgainonAvailableforSaleSecuritiesof$2,300eliminatesthisaccountintheOwners'Equitysegmentof
thebalancesheet.TherealizedGainonSaleofAvailableforSaleSecuritiesisshownonthesalemonthincomestatementaspartofInvestmentIncome.
Exercise11.2
Whichstatementisfalse?
GlobalGrocer
Let'srecordthetransactionsinvolvingmarketablesecuritiesforGlobalGrocer.
GlobalGrocerinvested$15,000ofexcesscashinthecommonstockofalargewelltradedpubliccompanyatthebeginningofFebruary.Itanticipatedthatthisinvestment
wouldgenerateahigherreturnthanwouldbeearnedbyinvestinginthebank.However,itdidnotintendspeculatingonshorttermmovementsinthestock'sprice.Atthe
endoftheyear,thestockwasvaluedat$16,500.
Howshouldthisinvestmentberecorded?
HowwouldthesemarketablesecuritiesbeclassifiedbasedonGlobalGrocer'sintensions?
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Whatisthejournalentrytorecordthepurchaseofthestockfor$15,000?
BusinessAcquisitions
Abusinessacquisitionisatransactionwhereoneentitygainscontrolovertheassetsandoperationsofanother.Lateintheyear,youbecomeawarethattheownerof
InternationalSpecialties,acompetingbusiness,isconsideringretiringandisinterestedinsellingherbusinesstoyou.
PurchasePrice
YouhireabrokertohelpyoutodeterminewhatInternationalSpecialtiesisworth.Afterreviewingthefollowinglastannualfinancialstatementsforthecompany,thebroker
suggeststhatyouproposeacquiringthebusinessfor$1,184,350andfinancetheacquisitionusingalongtermbankloan.
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Businessacquisitionsarerecordedusingtheacquisitionmethodofaccounting.Underthismethod,theacquiringcompanyrecordsonitsbalancesheetthefairvalueofthe
netassets(thatistheassetsnetofanyliabilities)thatitacquires.Fairvalueistheamountawillingbuyerandsellerwouldexchangeforanassetorliabilityinacurrent
transaction,otherthanaforcedorliquidationsale.
Ifthepurchasepriceisgreaterthanthefairvalueofthenetassetsacquired,theexcesspurchasepriceisrecordedasanassetcalledgoodwill,andisreportedasanintangible
assetonthebalancesheet.Netassetsacquiredisthedifferencebetweenthevalueoftheacquiredassetsexcludinganygoodwillandthevalueoftheacquiredliabilities.
PurchasePrice=Fairvalueofassetsacquired+Fairvalueofliabilitiesassumed+Goodwill
NetAssetsFairValue
AmongthefinancialinformationprovidedbythebusinessbrokeryouhiredtohelpvalueInternationalSpecialtiesisanestimateofthefairvaluesofthefirm'sassets.
CalculatingGoodwill
IfGlobalGrocerboughtInternational'sassetslistedonthepreviousscreen(fairvalue$711,400)aswellasitscontinuingbusinessfor$1,184,350and,inaddition,assumed
International'sliabilities(fairvalue$233,050),howmuchwouldGlobalGrocerrecordasgoodwill?
Isyourcalculatedgoodwillamountanassetoraliability?
InterpretingGoodwill
Goodwillisacommonbalancesheetaccount.Workingfromtheeverydaydictionarydefinitionofgoodwill,itreflectsthevalueofacompany'sintellectualcapital,product
strength,goodreputationandothervaluableintangibleattributesoftheacquiredcompany.Itisimportanttorecognizethatgoodwillonlyappearsonthebalancesheetwhen
acompanypurchasesanothercompanyformorethanthefairvalueofitsnetassets.Basedontheacquirers'purchaseprice,goodwillcanbethoughtofrepresentingthevalue
oftheacquiredcompany'searningpowerinexcessoftheearningpoweroftheacquirednetassetsstandingalone.
Asnotedearlier,goodwillisanintangibleasset.However,theaccountingforgoodwilldiffersfromthatofmostotherintangiblessinceitisnotamortized.Instead,itistested
annuallyforimpairmentand,ifimpaired,thedeclineinthevalueoftheassetisreflectedonthebalancesheetandanexpensefortheamountoftheimpairmentappearson
theincomestatement.
RecordingAcquisition
YouarrangeforalongtermbankloantofinancetheacquisitionofInternationalSpecialties.TheowneragreestoyourofferandthetransactioniscompletedinearlyMarch.
Let'spreparethejournalentrytorecordGlobalGrocer'sacquisitionofInternationalSpecialties.
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IncomeEffects
HowwillacquiringInternationalSpecialtiesaffectGlobalGrocer'sfutureearnings?Sincethetwofirmsarenowviewedasacombinedentity,theincomestatementforthe
newfirmgoingforwardwillincludetherevenues,costofsales,andotherexpensesofbothfirmstogether.
Inaddition,asdiscussedabove,eachyearGlobalGrocerwillestimatethefairvalueofthegoodwillrelatedtotheInternationalSpecialtiesacquisition.Iftheassetis
impaired,itwillhavetorecordanexpenseforthewritedown,andreducetheasset'svalueonitsbalancesheet.
Exercise11.3
VerityGreetingCardshasofferedtoacquireFriendlyFacesCardsfor$2,300,000,payableinVerityGreetingCardscommonstock.FriendlyFace'sassetsandliabilitiesare
asfollows:
WhatvaluewillVerityGreetingCardsplaceongoodwill?
PreparethejournalentrytorecordVerityGreetingCardsacquisitionofFriendlyFacesCardsfor$2,300,000instock.FriendlyFace'sassetsandliabilitiesareasfollows:
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Recap
Inthischapteryoucoveredhowtorecordtheacquisitionandincomefrominvestments.Youlearnedthat
Marketablesecuritiesareshortterminvestmentsindebtorequitysecuritiesthatafirmusesasanalternativetodepositingsurpluscashinthebank.
Marketablesecuritiesmustbeclassifiedinoneofthreecategories,dependingontheintentoftheinvestingfirm.Theaccountingforeachcategoryisdifferent.
Businesscombinationsarisewhenonefirmacquiresmorethan50%ofthecommonstockofanotherfirm.
Businesscombinationsareaccountedforusingtheacquisitionmethod,whichvaluestheassetsacquiredandliabilitiesassumedattheirestimatedfairvalues.
Anydifferencebetweenthepurchasepriceforabusinessacquisitionandthefairvalueofthenetassetsotherthangoodwillisrecordedasagoodwillassetonthe
acquirer'sbalancesheet.Goodwillisnotamortized,butisreviewedforimpairmenteachyearand,ifimpaired,writtendownthroughachargetoearningstoitsnew
fairvalue.
Sincethemotivationforeachofthetypesofinvestmentsdiscussedinthischapterareverydifferent,weaccountforthemdifferently.
DeferredTaxesandTaxExpense
Inthischapteryouwilllearnaboutaccountingforincometaxes.Inparticular,youwilllearn
Thatthemethodsusedtoprepareafirm'staxableincomeandestimatethetaxesthatitowesthegovernmentcandifferfromthoseusedtopreparethefinancialreports
usedbymanagersandinvestorstoevaluateperformance.
Thatdifferencesinafirm'spretaxearningsfortaxandfinancialreportingpurposescangiverisetoadeferredtaxliabilityordeferredtaxasset,anaccrualthatappears
onthebalancesheet.
Howtorecordthetaxexpenseintheincomestatementandanydeferredtaxassetorliabilitybalancesheetaccountstoreflectanydifferencesintaxandfinancial
reportingaccounting.
Asinpreviouschapters,youwilllearntheaccountingforthesetypesoftransactionsbydoingtheaccountingforGlobalGrocer.
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ManagementChallenges
GlobalGrocerisconcludingitsfirstyearofoperation.Yourealizethatyouhavetoprepareataxreturntodeterminetheamountoftaxesthatthefirmowesthegovernment.To
helpyouwiththistaskyouhireataxaccountantwhoinformsyouthattaxableearningsonyourtaxreturnwillbedifferentthantheearningsbeforetaxamountshowninthe
financialstatementsyouhavealreadyprepared.Thisdifferencearisesbecausetheaccountingmethodsforrecordingtransactionsusedfortaxreportingarenotalwaysthe
sameasthoseusedforfinancialreporting.
AsyoureflectonyourconversationwiththetaxaccountantyouwonderhowyoushouldrecordtaxesinGlobalGrocer'sfinancialstatements.How,ifatall,shoulddifferences
betweentheaccountingmethodsusedtocomputeearningsforthetaxauthorityandforfinancialreportingberecordedinGlobalGrocer'sbooks?
TaxvsFinancialReporting
Inmanycountriestheaccountingmethodsthatthegovernmentrequiresorallowscompaniestousefortaxreturnpreparationdifferfromthoseusedforfinancialreporting
purposes.
Governmentshavedifferentobjectivesandinformationneedsthanafirm'sinvestors.Forexample,thegovernmentoftenpermitsfirmstouseshortereconomiclivesandmore
accelerateddepreciationofnewequipmentfortaxpurposestomeetitseconomicgoalsofencouraginginvestmentinnewcapitalandcreatingadditionalemployment.
Governmentsputapremiumonobjectivityinmeasuringtaxableincomewhereas,aswehaveseen,investorsvaluetherelevanceofinformation.Asaresult,governmentsoften
disallowtaxdeductionsforexpensesthatareestimatesoffuturelosses,suchasestimatedbaddebtexpenses.Instead,theselossesarereportedfortaxpurposeswhenalosshas
actuallyoccurred.
Thedifferencesinmethodsusedtoreportincomefortaxpurposesandforfinancialreportingleadmanyfirmstoeffectivelyhavetwodifferentsetsofaccountingrecordstheir
taxaccountingrecords(sometimesreferredtoas"TaxBooks")andtheirfinancialreportingrecords(sometimesreferredtoas"FinancialReportingBooks").
Example
Tounderstandhowdifferencesbetweentaxandfinancialreportingbooksarise,let'slookatasimpleexample.
PascoeInc.,whichhasearningsbeforedepreciationof$2,000forfinancialreportingandtaxpurposesinyears1and2,buysa2yeardepreciableassetatthebeginningof
year1for$1,000.Forfinancialreportingpurposestheassetisdepreciatedusingthestraightlinemethod(at$500peryear).Fortaxreturnpurposes,Pascoetakestheentire
$1,000purchasepriceasataxdeductionintheacquisitionyear.Pascoepaystaxesonitstaxableincomeata40%taxrate.Itstaxreturnandincomestatementinthe
financialreportingbookswouldlookasfollows:
TaxExpensevsTaxesDue
Itwouldbeconvenienttosimplyshowthetaxexpenseinthefinancialreportingbooksastheamountthecompanyowesthegovernmentbasedonitstaxreturn.ForthePascoe
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Inc.example,thiswouldimplythattheIncomeTaxExpensewouldbe$400and$800inyears1and2.
Underthisapproach,theincomestatementinPascoe'sfinancialreportingbookswouldshowearningsbeforetaxesbasedonthefinancialreportingaccountingmethodsandthe
taxexpensebasedonthemethodsusedforthetaxbooks.
However,standardsettershaveconcludedthatthispresentsamisleadingpictureofthecompany'sfinancialperformanceforthetwoannualperiods.Pascoe'snetincomein
year's1and2wouldbe$1,110and$700respectively.Theseamountsdiffereventhoughincomebeforetaxesisidenticalat$1,500inbothyears.Inaddition,year1'snetincome
wouldbeamisleadingindicatorofnetincomeinyear2,sincethefirm'soperatingperformancedoesnotchange.
DeferredTaxAccruals
Howthenshouldwerecordthetaxexpense?Inparticular,whatshouldwedotoreflecttheeffectofdifferencesinaccountingmethodsusedinthefirm'sfinancialreporting
andtaxbooks?
StandardsettershavedealtwiththeseaccountingdifferencesbyrequiringthatthetaxexpensebebasedonIncomeBeforeTaxesinthefinancialreportingbooksratherthan
TaxableIncomeinthetaxbooks.Thisleadstothecreationofadeferredtaxaccrualtoreflectthetaxeffectofanyaccountingmethoddifferencesthatexistbetweenthetwosets
ofbooks.Asyouwilllearn,theaccountingeffectofmostoftheseaccountingdifferencesreverseinsomefutureperiod.Consequently,accountantsrefertotheseaccounting
differencesas"temporaryaccountingdifferences".
ThedeferredtaxaccrualisconsistentwiththematchingconceptsinceitmatchesthetaxexpenseineachyearwithIncomeBeforeTaxesinthefinancialreportingbooks.The
taxaccrualcanappearasaliabilityoranassetonthefirm'sbalancesheet.
FinancialReportingBooks
TaxBooks
=TemporaryAccountingDifferences
XTaxRate
=DeferredTaxAccrual
TimingDifferences
Deferredtaxaccountingisusedwhenthefollowingthreeconditionshold:
Atransactionoreventisaccountedfordifferentlyinanentity'sfinancialreportsandincometaxreturns.
Theaccountingeffectofthedifferenceinaccountingpoliciesistemporaryinthattheearlyperiodeffectsofthedifferencearereversedinlaterperiods.
Theaccountingdifferencehastaxconsequences.
Whentheseconditionsholdthereisadifferenceinthetimingoffinancialreportingandtaxableincome.
Let'sreturntotheexampleofPascoeInc.,whichusedaccelerateddepreciationforitstaxbooksandstraightlinedepreciationforitsfinancialreportingbooks.Wecansee
thatthedepreciationdifferencemeetsallthreeoftheaboveconditionsrequiredforusingdeferredtaxaccounting.
Theaccelerateddepreciationmethodleadstohigherdepreciationchargesthanthestraightlinemethodintheearlyyearsofanasset'slife,resultinginalowertaxable
incomeinthoseyears.
Theeffectistemporarysinceatsomepointintheasset'sdepreciablelifetheaccountingeffectofthetwodepreciationmethodsreverses.Thisoccursinthelateryears
oftheasset'sdepreciablelifewhenfinancialreportingstraightlinedepreciationchargesarehigherthanthetaxreturnaccelerateddepreciationcharges.
Thedifferenceintheuseofthetwodepreciationmethodshastaxconsequences.Thehigherearlyyeartaxdeductionsfordepreciationleadtolowertaxableincome
thanifthecompanyusedstraightlinedepreciationfortaxreturnpurposes.Inthelateryearsoftheasset'sdepreciablelifethissituationisreversed.
PermanentDifferences
Notalldifferencesbetweenfinancialandtaxreturnaccountingresultintherecognitionofadeferredtaxaccrual.Theseexceptionsoccurwhenthereisapermanentrather
thanatemporarydifferencebetweenacompany'sfinancialandtaxaccounting.Permanentdifferencesoccurwheneitherrevenueorexpensesarerecognizedfortaxreturn
purposesbutneverforfinancialreportingpurposesorexpensesorrevenuesarerecognizedforfinancialreportingpurposesbutneverfortaxreturnpurposes.Inother
words,permanentdifferencesareaccountingdifferencesthatdonotreverseinfutureperiods.
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Exercise12.1
Isthefollowingstatementtrueorfalse:AretailcompanyisrequiredbyGAAPtorecognizeforfinancialreportingpurposesthefullprofitonitsinstallmentsaleswhenthe
saleismade.Incontrast,initsincometaxreturnthecompanyreportsthesameinstallmentsaleprofitproportionallyaseachinstallmentpaymentismadeoverthelifeofthe
installmentcontract.Isthisasituationthatmayrequiredeferredtaxaccounting?
Isthefollowingstatementoneofthethreeconditionsrequiringdeferredtaxaccounting:Thecompanyaccountsdifferentlyforthesametransactionsinitsfinancial
statementsandtaxreturns.
Isthefollowingstatementoneofthethreeconditionsrequiringdeferredtaxaccounting:Thedifferentaccountingpoliciesleadtoadifferentpatternofprofitsbeing
recognizedforfinancialreportingandtaxreturnpurposesovertime,butintheendthesesdifferencesaretemporarysincethetotalprofitisthesameunderbothaccounting
policies.
Isthefollowingstatementoneofthethreeconditionsrequiringdeferredtaxaccounting:Generally,GAAPdoesnotpermittheuseofthecompany'sinstallmentsaletax
accountingpolicyinitsfinancialstatements.
Isthefollowingstatementoneofthethreeconditionsrequiringdeferredtaxaccounting:Thedifferentaccountingpolicieshaveincometaxconsequencessincethetaxreturn
profitrecognitionaccountingpolicypushesthepaymentoftaxesonsomeoftheprofitrecognizedforfinancialreportingpurposesintofutureperiods.
DeferredTaxLiabilities
Toseehowadeferredtaxliabilityiscreated,let'sreturntotheexampleofPascoeInc.,whosetaxandfinancialreportingbooksdifferbecauseofadifferenceinthemethod
usedtodepreciatea$1000fixedasset.Recallthatthetaxesduewere$400inyear1and$800inyear2reflectingthehigherdepreciationexpensepermittedbythetax
authorityinyear1.Yetintheincomestatementincomebeforetaxesareidenticalinbothyearsasthedepreciationexpenseiscomputedonastraightlinebasis.
Accounting
Let'sseehowthecreationofaDeferredTaxLiabilityisrecordedinacompany'sfinancialreportingbooks.AswesawinthePascoeInc.depreciationexample,thecompany
owed$400intaxesinyear1and$800inyear2,yetitstaxexpenseinthefinancialreportingbookswas$600forbothyears.
PressPlaytoseePascoe'sdeferredtaxliabilityandexpensejournalentries.
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Definition
Asyoucansee,adeferredtaxliabilityisanunusualliability.Unlikemostliabilities,itisnotapresentobligationtotransferresourcestoanotherentity.
Instead,itislittlemorethanabalancingcreditentrytotheliabilitysectionofthebalancesheettooffsetadebitentrymadetotheincomestatement.Thisdebitentryis
madesothattheincomestatementisnotmisleading.
Definition:
Adeferredtaxliabilityisthefuturetaxconsequencesattributabletotemporaryaccountingdifferencesbetweenfinancialandtaxaccountingpolicieswherethefuturetax
consequencesresultinhigherfuturetaxes.
DeferredTaxLiability=FutureHigherTaxConsequencesofaTemporaryAccountingDifference
DeferredTaxAssets
Asnotedabove,thedeferredtaxaccrualcanalsobeanasset.Toillustratehowthiscanarise,let'sconsiderthefinancialreportingandtaxbooksofColaCompany.Attheendof
year1(itsfirstyearofoperation),Colareportedgrossprofitsof$8,000.Forfinancialreportingpurposes,Cola'sonlyoperatingexpensewasa$500BadDebtExpensefor
expectedcustomerdefaultsonits$10,000ofaccountsreceivable.Inyear2,Cola'sgrossprofitswere$9,000.Duringyear2,actuallossesoncustomerdefaultsamountedto
$500,butnoaccountsreceivablewereoutstandingatyearendsonobaddebtexpensewasneeded.
InCola'staxbooks,abaddebtdeductionwouldnotberecordedinyear1sincethetaxauthoritydoesnotrecognizeestimatedlossesandallowscompaniestodeductonlyactual
customerdefaultsthatoccurredduringtheyearintheirtaxbooks.Cola'staxrateis40%.Cola'sincomestatementinitstaxandfinancialreportingbooksisasfollows:
Accounting
Let'sseehowthecreationofaDeferredTaxAssetisrecordedinColaCompany'sfinancialreportingbooks.RecallthatColaowed$3200intaxesinyear1and$3400inyear
2,comparedtothetaxexpenseinitsfinancialreportingbooksof$3000and3600forthesameyears.Thisseriesofeventsisrecordedasfollows:
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Definition
Deferredtaxassetsaretheoppositeofdeferredtaxliabilities.Deferredtaxassetsarisewhentemporarydifferencesbetweenacompany'sfinancialandtaxaccountingresult
infuturelowertaxes.
Deferredtaxassetsandtheirrelateddeferredtaxbenefitsareonlyrecognizedinthebalancesheetandincomestatementifmanagementbelievesitis"morelikelythannot"
(abetterthan5050chance)thatthefuturetaxbenefitwillbeusedtolowerthetaxpaymentsinsubsequentyears.Thislastconditionconformstotheconservativeconcept.
DeferredTaxAsset=MoreLikelyThanNotFutureLowerTaxConsequencesofaTemporaryAccountingDifference
LossCarryforwards
Deferredtaxassetscanarisealsoiftherearenotemporarydifferencesinreportingmethodsusedfortaxandfinancialreportingbooks,butthefirmreportslossesfortax
purposes.
UndertheUStaxcode,companiesthatreportlossesontheirtaxreturnscancarryforwardtheselossesfortaxreturnpurposesfor20yearsandapplythemasanoffsettoany
futuretaxableincome.Ifthecurrentlossisexpectedtoresultinlowerfuturetaxpayments,thetaxequivalentofthelossisrecordedasadeferredtaxassetandadeferredtax
benefitasrecognizedintheincomestatement.Theamountofthepastlossescarriedforwardtooffsetfuturetaxableincomeiscalleda"taxlosscarryforward."
TheUStaxcodealsoprovidesfor"taxlosscarrybacks."Thisprovisionofthecodespermitscompaniestousetheircurrenttaxreturnlossestooffsettaxableincomereported
inpriorperiods.Thismayresultinarefundofpriorperiodtaxpayments.
Exercise12.2
Afteritsfirstyearofoperation,KryptonCo.recordsalossof$2,500inbothitsfinancialreportingandtaxbooks.Managementexpectsthatthecompanywillearnaprofit
of$5,000inyear2.Thecompany'staxrateis40%.Recordthetaxexpenseinthefinancialstatements.
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Exercise12.3
FinancialAccounting
BuyerCompanycapitalizessomeofitssoftwaredevelopmentcostsforfinancialreportingpurposes,buttreats100%ofthecostsincurredduringtheyearasadeductionfortax
purposes.Inthecurrentyear,thefinancialreportingexpenseforsoftwaredevelopmentis$3,600,000,whereasthetaxdeductionis$4,200,000.Thecompany'staxrateis
40%.
Doesthisdifferenceleadtothecreationofa:
WhatamountisrecordedinBuyerCompany'sfinancialreportingbooksforDeferredTaxLiabilitythisyear?Therearenootheraccountingmethoddifferences.
CurrentandDeferredTaxExpense
Thetaxexpenseinafirm'sincomestatementcanbedividedintotwocomponents,thecurrentportionandthedeferredportion.
Thecurrentportionisthetaxduetothetaxauthoritythatperiod.
Thedeferredportionisthetaxaccrualrequiredtoreflectanytemporaryaccountingdifferencesbetweenfinancialandtaxaccountingpolicies.
Forexample,recallthatforPascoe,whichhadadifferenceintaxableandfinancialreportingasaresultofdifferencesindepreciationmethods,thefulltaxexpenseinyear1was
$600.Ofthis,$400istaxesdue,andiscalledthecurrenttaxexpense.Theother$200isthedeferredtaxexpenseandreflectsthetaxeffectofthedifferencein
acceleratedandstraightlinedepreciationusedinthetaxandfinancialreportingbooks.
Example
SpiritCo.hasincomebeforedepreciationof$5,000forfinancialreportingandtaxpurposesinyears1and2.Atthebeginningofyear1thefirmacquiresadepreciableasset
witha2yearlifeandnoresidualvaluefor$800.Theassetisdepreciatedforfinancialreportingpurposesusingthestraightlinemethodovera2yearperiod.Forincome
taxreturnpurposes,thecompanytakestheentire$800purchasepriceasataxdeductionintheacquisitionyear.Therearenootherdifferencesbetweenthecompany's
financialreportingandtaxreturnaccounting.Thecompanypaystaxesata40%taxrate.
Exercise12.4
Preston'sInc.'sdeferredtaxliabilityattheendofyear1increasesby$2,000andthendecreasesby$2,000inthefollowingyearduetothereversalofthetemporary
differencebetweenthecompany'sfinancialreportingandtaxreturndepreciationaccounting.Whatistheeffectonthecompany'syear1deferredtaxexpense?
GlobalGrocer
Nowthatwehavecovereddeferredtaxaccounting,let'sreturntoGlobalGrocerandrecorditsentryforthecurrentyear'staxexpense.Yourfinancialreportingrecordsindicate
thatGlobalGrocer'searningsbeforetaxesfortheyearwere$641,000.Afterexaminingyourrecords,thetaxaccountanthasdeterminedthattaxableincomewas$570,000.The
followingtableshowswherethesedifferencesarise:
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TaxesDue
GlobalGrocer'staxrateis40%.UsetheinformationfromGlobalGrocer'staxandfinancialreportingbookstoestimatethetaxesitowesthegovernmentfortheyear.
TaxesExpense
GlobalGrocer'staxrateis40%.UsetheinformationfromGlobalGrocer'staxandfinancialreportingbookstoestimatethetaxexpenseinitsfinancialreportingbooksforthe
year.
Accounting
AssumeGlobalGrocers'taxrateis40%.WewillnowusetheinformationfromGlobalGrocer'staxandfinancialreportingbookstorecordthejournalentryfortheyear'stax
expense.Wewillfollowtheaccountingrequirementthatdeferredtaxassetsanddeferredtaxliabilitiesbeshowngross(i.e.,not"netted")onthebalancesheet.
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Recap
Inthischapteryouhavebeenintroducedtoaccountingfortaxes.Youhavelearnedthat
Afirm'staxableincomeanditsearningsbeforetaxesforfinancialreportingfrequentlydiffer.Thisarisesbecausetheobjectivesofthegovernment,whichsetsrulesfor
taxreporting,differfromthoseofinvestorswhousefinancialreportinginformationtoallocateresources.Asaresult,inmanycounties,firmshaveseparatesetsofbooks
fortaxandfinancialreportingpurposes.
Deferredtaxaccountingisusedinafirm'sfinancialreportingbookstorecordanaccrualforthetaxeffectofanytemporarydifferencesinearningsthatarisefromusing
differentaccountingmethodsinthefirm'staxandfinancialreportingbooks.
Adeferredtaxliabilityiscreatedtorecordthefuturetaxconsequencesoftemporaryaccountingdifferencesbetweenfinancialandtaxaccountingpoliciesthatleadto
higherfuturetaxes.
Deferredtaxassetsarisewhentemporarydifferencesbetweenacompany'sfinancialandtaxaccountingresultinfuturelowertaxes.
Deferredtaxassetscanalsoariseifafirmusesthesameaccountingpoliciesfortaxandfinancialreporting,butgeneratestaxlosscarryforwards.
Thetaxexpensecanbedividedintotwopiecesthecurrenttaxexpense(whichrepresentsthefirm'sobligationtothegovernmentforthecurrentyear)andthe
deferredtaxexpense(whichrepresentstheadjustmentneededtoreflecttaxeffectsoftemporarydifferencesinaccountingpoliciesfortaxandfinancialreporting
incomeduringtheyear.)
Owners'Equity
Inthischapteryouwilllearnaboutowners'equityandanumberofequitytransactions.Theseinclude:
Paidincapital
Parvalue
Issuesofpreferredstock,
Stockrepurchases,
Dividenddistributions,
Stocksplits
Stockoptions
Comprehensiveincome
Youwillalsolearnaboutakeyindicatoroffinancialperformanceforowners.Asinpreviouschapters,youwilllearntheaccountingforthesetypesoftransactionsbydoingthe
accountingforGlobalGrocer.
ManagementChallenges
AsGlobalGrocerenterstheendofitsfirstyearofoperations,youencounterseveralnewreportingchallengesrelatedtoowners'equity:
Asyouweregoingthroughyourfiles,youcameacrossanotefromthelawyerinvolvedinsettingupGlobalGrocerthatmentionedthatGlobalGrocer'scommonstock
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hadaparvalueof$0.50pershare.Youwereunsurewhatthismeantorhowitshouldbereportedinthefinancialstatements.
YouruncleapproachesyouaboutinvestinginGlobalGrocer.Heproposesinvesting$20,000andinreturnwouldlikeyoutoissuehimpreferredstock.Whatisthe
differencebetweenpreferredandcommonstock,andhowshouldthenewissueberecorded?
Afterasuccessfulfirstyear,youdecidetoissueacashdividendoftencentspershare.Howshouldthisberecorded?
Afterreadinganarticleonstocksplitsinthebusinesssectionofthelocalnewspaper,youwonderwhetheritmakessenseforGlobalGrocertosplititsstock,andifso
howsuchatransactionwouldberecorded.
OneoftheearlyinvestorsinGlobalGrocerisretiringandwouldliketosellhissharesinthecompany.Youoffertorepurchasethestockatapriceof$5pershare.
LateintheyearyoudecidetohireJaneMcDermottasaseniormanagertohelpyourunGlobalGrocer.Inherpreviousposition,Janereceivedstockoptions.Toattract
hertoGlobalGroceryouwillprobablyhavetoofferherstockoptionsinGlobalGrocer.Youhaveheardmuchaboutstockoptionsbutarenotsurewhattheyreallyentail
andhowtheyshouldbereportedinGlobalGrocer'sbooks.
Youwererecentlysenttheannualreportforapubliccompanywhosestockyouown.Asyouwereflippingthroughthereportyounoticedthatitpresenteda
ComprehensiveIncomeStatementinadditiontoitsIncomeStatement.YouwonderedhowComprehensiveIncomediffersfromregularNetIncome,andhowthey
differforGlobalGrocer.
CommonStock
Whenacompanyissuescommonstock,itfrequentlyidentifiesanominalvalueofthestockasitsparvalue.Assigningaparvaluetoastockisahistoricalpracticethattodayhas
littlepracticalsignificance.Bylaweachstockcertificatehasadollarvalueprintedonitsface.Thisamountisitsparorstatedvalue.Parvaluedoesnotindicateastock'sworth,
butitdoeshavealegalsignificance.Ifashareholderbuysstockdirectlyfromtheissuingcompanyandpayslessthantheparvalue,theshareholdercouldbeliabletopaythe
differenceifcalleduponbythecompany'screditors.Today,thiscouldnothappen.Moststatesprohibittheissuanceofcommonstockatlessthanitsparvalueortheparvalueis
setatanominalamountwellbelowtheissuanceprice.
Forstockthathasaparvalue,thebalancesheetshowsthevalueofthestockatitsparvalue.Ofcourse,thestockisrarelyissuedatparvalue.Usuallyitisissuedatamuch
higheramount.ThedifferencebetweentheissueamountandtheparvalueiscalledAdditionalPaidinCapital.Italsoappearsonthebalancesheetintheowners'equity
section.
ThesumoftheparvalueandadditionalpaidincapitalforcommonstockiscalledPaidinCapital.
GlobalGrocer
Let'slookatGlobalgrocer'spaidincapitalfromcommonstock.Thecompanyhadissued55,000sharesofcommonstockfor$110,000.Giventhelawyer'snotethatparvalue
was$0.50,wecannowbreakdownGlobalGrocer'spaidincapitalintoitsparvalueandadditionalpaidincapitalcomponents.
WhatisthetotalparvalueofGlobalGrocer'scommonstock?
Whatisthetotaladditionalpaidincapital?
ThebalancesheetpresentationofcommonstockforGlobalGrocerwillshowboththeparvalueandadditionalpaidincapitalcomponentsasfollows:
Example
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InternationalFood'sissued150,000newcommonshareswithaparvalueof$0.10atapriceof$5pershare.Hereisthejournalentrytorecordthenewshareissue.
PreferredStock
Commonstockisthemostpopularformofequityinvestmentyouwillencounter.Butsomecompaniesalsoissueotherclassesofstock,notablypreferredstock.Thereareseveral
importantdifferencesbetweenpreferredstockandcommonstock.
Preferredstockislessriskythancommonstocksinceithashigherpriorityinreceivingdividendpaymentsandreturnofcapitalintheeventofaliquidationofthe
company.
Preferredstockdoesnothavevotingrights.
Preferredstockistypicallyentitledtoafixeddividendrate,comparabletofixedinterestdebt.Incontrast,commonstockisnotentitledtoanyspecifieddividend
payment.
Types
Therearemanydifferenttypesofpreferredstock:
CumulativePreferredStock:specifiesthatifthecompanyisunabletopaythepreferreddividendsinagivenyear,itcannotpayanycommonstockdividendsuntilthe
preferreddividendsinarrearsarefullypaid.
ConvertiblePreferredStock:specifiesthatthepreferredstockcanbeconvertedintocommonstockatadefinedexchangerateattheoptionofthepreferredstockowner.
RedeemablePreferredShares:specifythattheissuingcompanymustbuybackthepreferredsharesatadefinedpricewithinadefinedtimeperiod.
GlobalGrocer
Attheendofyourfirstyearofoperations,youruncleapproachesyouaboutinvestinginGlobalGrocerandproposesinvesting$20,000.Sinceheiselderly,hewouldpreferto
receiveafixedreturnonhisinvestment,andsuggeststhatyouissuehimpreferredratherthancommonstock.Youagreetoissuethepreferredstockata6.5%dividendrate.
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RecordtheissueofthepreferredstockinGlobalGrocer'sbooks:
FinancialAccounting
StockRepurchases
Sometimescompaniesbuybacktheirowncommonstock.Thispurchasedstockiscalledtreasurystock.
Stockrepurchasesareverysimilartodividends,inthattheyresultincashbeingdistributedtoshareholders.
However,whereasdividendsaretypicallytaxedatordinaryincomerates,stockrepurchasesenablesomeinvestorstoreceivecashinaformthatleadstoacapitalgain,whichis
typicallytaxedatcapitalgainsratethatislowerthantherateusedtotaxordinaryincome.Thistaxdifferencehasledmanycompaniestomakedistributionstoshareholdersin
theformofastockrepurchaseratherthanadividend.
Accounting
Stockrepurchasesarereportedasanegativeowners'equityaccountinthebalancesheet.Thestockrepurchasevalueisequaltothepricepaidtoacquirethestock.
Forexample,considerthefollowingsimplifiedbalancesheetforGraphicInc.
OnJanuary4,thecompanyrepurchased$15,000ofitsownstock.Let'sseehowwewouldrecordthisevent.TheTreasuryStockaccountisdeductedfromshareholder's
equity.Asaresult,therevisedbalancesheetisasfollows:
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Ifthecompanysubsequentlyreissuestreasurystock,anygainorlossistreatedasanadjustmenttoadditionalpaidincapital.Againorlossonthesaleoftreasurystockis
neverincludedinthedeterminationofnetincome.
GlobalGrocer
Attheendoftheyear,oneoftheearlyinvestorsinGlobalGrocerannouncedthathewasretiringandwouldliketosellhissharesinthecompany.GlobalGrocerrepurchased
his2,000sharesatapriceof$5pershare.Showthejournalentrytorecordtherepurchase.
Dividends
Firmscandecidetopayoutcashtoshareholdersintheformofadividend.Typically,firmsavoidpayingdividendsiftheyaregrowingandcanreinvestcashgeneratedfrom
operatingthebusinessprofitablyinnewequipmentortosupportworkingcapitalneeds.
However,maturefirmsthatproducemorecashfromoperationsthantheyneedforfundingfuturegrowthmaydecidetopayoutexcesscashtoshareholdersintheformofa
dividend.
Thestocksoffirmsthatpaydividendsarecalledincomestocks,andtendtoattractadifferentclassofinvestorthanthosethatavoiddividendstofocusongrowth.Investors
attractedtoincomestocksinclude:
Retiredinvestorswhowantasteadystreamofincome,and
Institutionsthatdonotpaytaxesondividends.
Restrictions
Dividendsaredeclaredbyafirm'sboardofdirectors.Insettingafirm'sdividendpolicy,thedirectorsfaceanumberofrestrictions.
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Statelawsprohibitacompanyfrompayingdividendsoutofcapital,thatisoutoffundsraisedfromissuingstock.Dividendscanthereforeonlybepaidbyfirmsthathave
positiveretainedearnings.Thisformofrestrictionisintendedtoprecludeafirmfromliquidatingitsassets,payingstockholdersaliquidatingdividend,andleaving
creditorswiththecompanyshell.
Contractswithcreditorsalsofrequentlyspecifylimitstodividends,typicallybyrequiringthefirmtomaintainminimumdebttoequityratiosorbylimitingdividendstobe
paidonlywhenretainedearningsarepositive.
GlobalGrocer
Attheendofitsfirstyearofoperation,GlobalGrocerearnedprofitsof$397,420.Youdecidetopayadividendoftencentspershare.GlobalGrocerhasissued55,000shares.
Ofthattotal,2,000sharesareheldasTreasurystock,leaving53,000sharesoutstanding.Dividendsareonlypaidonsharesoutstanding,notonTreasurystock.Howshould
thedividendberecordedwhenitisdeclared?Whathappenswhenthedividendisactuallypaid?
Thedeclarationofadividendcreatesabindingcommitmenttoshareholderfromthecompany.Theamountofthecommitmentis$5,300(or53,000sharestimestencents
pershare).Thecommitmentisshownasacurrentliability,usuallycalledDividendsPayable.TheothersideofthetransactionistoreduceRetainedEarnings,indicatingthat
thedecisiontodistributeearningstoshareholdersasadividend,ratherthantoreinvestearnings.Thejournalentryforthistransactionisasfollows:
Whenthedividendissubsequentlypaid,thecompanyeliminatesitsobligationtoshareholdersandreducescash,bothforthefulldividendamountof$5,300.Thejournal
entryforthistransactionisasfollows:
Exercise13.1
RumbleCorp.earned$365,000fortheyear.OnMarch1itdeclaredadividendequalto50%ofannualprofits.ThedividendwaspaidonMarch31.Recordthedividend
declarationandpayment.
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StockSplits
Companiessometimessplittheirstockbyincreasingthenumberofsharesoutstanding.Asplitchangesthenumberofsharesownedbyitscurrentshareholders,butdoesnot
changethebookvaluesofthefirm'sassets,liabilities,oritsowners'equity.
Forexample,considerPilotInc.thathas10,000sharesoutstandingandastockpriceof$5,implyingthatitsmarketcapitalizationis$50,000(10,000*$5).A2for1stocksplit
wouldincreasethenumberofsharesoutstandingbyafactorof2,to20,000.Butsincethesplithasnotchangedthefirm'sbusinessfundamentals,itsmarketcapitalization
shouldnotchange.Forthistohappenthestockpricewouldhavetodropby50%to$2.50.Thefirmwouldnowhave20,000sharesoutstandingandastockpriceof$2.50,and
continuetohaveamarketcapitalizationof$50,000(20,000*$2.50).
Somearguethatstocksplitsactuallyleadtohighermarketcapitalizationsforthesplittingfirmsbecausetheysignalthatmanagementconfidenceinthefirm'sfutureprospects,
orbymakingitlesscostlyforsmallinvestorstoownsmallparcelsofshares.
Accounting
Accountingforstocksplitsisstraightforward.Ifthefirm'sstockhasaparvalue,asplitchangestheparvalueofthestockbutnottheaggregatebookvalueofpaidincapital.
Torecordthischange,stockwiththeoldparvalueneedtoberemovedfromthebooksandstockwiththenewparvaluerecordedalongwithanadjustmenttothestock'spar
value.
Forexample,recallthatPilotInc.2for1stocksplitincreaseditsharesoutstandingfrom10,000to20,000.Iftheformerparvalueoftheseshareswas$1.00,thenewpar
valuewoulddeclineby50%to$0.50.Torecordthistransactionthefollowingjournalentrywouldbemade:
NoticethattheaggregatebookvalueofCommonstockatparvaluewouldnotchange,leavingthebookvalueofequitythesame.Butnow,thebalancesheetwouldshowa
differentparvaluepershare.
Sometimescompaniesdonotchangetheparvaluewhentheysplittheirstock.Inthesecases,acreditequaltotheparvalueofthestockissuedismadetocommonstock.A
debitforthesameamountismadetoretainedearnings.
Stocksplitsthatresultinanissuanceofnewsharesthatintotalarelessthan2025percentoftheoutstandingsharesarecalledastockdividend.Inthiscase,adebitentry
equaltothemarketvalueofthesharesissuedismadetoretainedearnings.Acompoundcreditentryismadetocommonstockfortheparvalueoftheissuedstockalongwith
anentrytoadditionalpaidincapitalforthedifferencebetweenthestock'smarketvalueanditsparvalue.
GlobalGrocer
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Attheendofitsfirstyearofoperation,youdecidethatGlobalGrocershouldmakea2for1stocksplit,alongwithanadjustmenttothestock'sparvalue,earlyinitssecond
yearofoperation.Giventhecurrent$0.50parvalueofGlobalGrocer'sstock,whatwillbethevalueofitsrevisedparvaluewhenthesplittakesplace?
StockOptions
Stockoptionshavebecomeapopularwayforcompaniestorewardandmotivatetheirtopmanagers.Ifacompanygrantsastockoptiontoamanager,themanagerhastheright
tobuythestockfromthecompanyataspecifiedprice,calledtheexerciseorstrikeprice,withinaspecifiedperiod,calledtheexerciseperiod.
Forexample,acompanywhosestockpriceiscurrentlyworth$20persharemightgrantstockoptionstoamanageratanexercisepriceof$20withanexerciseperiodof5
years.Ifduringthenextfiveyearsthestockappreciatesinvaluetosay$40,themanagercanbenefitfrombuyingthestockfromthecompanyat$20andsellingat$40.
However,ifthestockdeclinesandneverrisesabove$20duringtheexerciseperiod,themanagerwouldchoosenotexercisetheoption,sincenogaincouldberealized.The
optionisthensaidtobe'outofthemoney'meaningthatthevalueofthestockislowerthantheoption'sexerciseprice.
BenefitsandCosts
Stockoptionsgrantedtotopmanagementhaveanumberofbenefits:
Theymotivatethemanagerstomakedecisionsthatincreasethevalueofthecompany'sstock,consistentwiththeinterestsofthecompany'sshareholders
Theyareanoncashformofcompensationwhichcanbebeneficialforcashconstrainedyoungcompanies.
Sincestockoptionsaretypicallyforfeitedifthemanagerleavesthecompany,stockoptionsprovideawaytoreducemanagementturnover.
Theyattractmanagerswhoareentrepreneurialandriskseeking.
However,stockoptionsalsocanhavecostsfortheorganization:
Ifthestockpricefallssignificantlyafterstockoptionsaregranted,sothattheoptionsarewell'outofthemoney'theyarelikelytohavelimitedpositiveemployee
motivationbenefit.
Optionshavebeenlinkedtoearningsmanagementandfraudasmanagersatsomecompanieshavesoughttoboosttheirfirms'stockprice.
Accounting
Accountingforstockoptionshasproventobeahighlycontroversialissue.Stockoptionsarecertainlyavaluableformofcompensationforemployeesthatreceivethem.
However,opinionshavevariedoverhowtheyshouldbevaluedandreported.
Priorto2005,mostoptiongrantsdidnothavetoberecordedasacompensationexpense,eitherwhentheoptionwasgrantedorwhenitwasexercised.However,sincethen,
standardsettershaverequiredcompaniestoestimatethefairvalueofoptiongrantsandtoamortizethatfairvalueovertheserviceperiod.Theserviceperiodistypically
definedastheperiodfromoptiongrantdatetotheoptionvestingdate(whenthemanagerofficiallyownsandhastherighttoexercisetheoptions).Thefairvalueofan
optionisdeterminedbyacomplexequationthatisbeyondthescopeofthistutorial.However,inpracticeitiseasilydetermined,sincemosthandheldbusinesscalculators
areprogrammedtomakethefairvaluecalculation.
Forexample,consideracompanywhosestockpriceiscurrentlyworth$20persharewhogrants5,000stockoptionstotopmanagementatanexercisepriceof$20witha
vestingperiodof2years.Thefairvalueofeachoptionisestimatedtobe$5.Thecompanywouldthenmakethefollowingjournalentriestorecordtheinitialgrant,
amortizationandexerciseoftheoptions.
GrantDate
Noentryisneeded,sincenoservicehasyetbeenprovidedbytopmanagement.
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Endoffirstandsecondplanyears
Acompensationexpenseneedstobereportedsincethemanagementhasprovidedaportionoftheservice.Thetotalcostoftheplanis$25,000($5*5,000)andtheservice
periodistwoyears(fromdateofgranttodateofvesting).Theannualcompensationcostistherefore$12,500,andwillbereflectedasadebittocompensationexpense.The
offsettingcreditismadetoanowners'equityaccountcalledAdditionalpaidincapital:Stockoptions,reflectingthevalueofcapitalrecognizedtodatefromstockoption
capital.
AtExercise
Assumethatthecompany'sstockpriceaftertwoyearswas$30.Themanagerswouldthenelecttoexercisetheoptions.Let'sseehowthiseventgetsrecorded.Wehaveto
recordtheinflowofcashfromtheexercise(for5,000optionsat$20,or$100,000).Wewillalsoeliminatethe$25,000alreadycreditedtoAdditionalpaidincapital:Stock
optionsandreplaceitwithcommonstock(reflectinganyparvalueandadditionalpaidincapital).Ifthestockhasaparvalueof$1,wewillcreditCommonstockatparvalue
for$5,000(5,000sharesat$1)andcreditthebalanceof$120,000toAdditionalpaidincapital.
Optionsexpireoutofthemoney
Let'snowassumethataftertwoyearsthestockclosesat$15andtheoptionsexpireoutofthemoney.Howisthiseventrecorded?Wewillhavetotransfertheamountofthe
AdditionalPaidInCapital:StockOptionsrecognizedtodatetothegeneralAdditionalPaidinCapitalaccount.Thisrequiresthefollowingjournalentry.
GlobalGrocer
LateintheyearyouhiredJaneMcDermottasaseniormanagertohelpyourunGlobalGrocer.Inherpreviousposition,Janereceivedstockoptions.ToattracthertoGlobal
Groceryoudecidetoofferher1,000optionstobuyGlobalGrocerstockatanexercisepriceof$5pershare.Theoptionsexpireinfiveyears,vestafterthreeyears,anda
friendwithfinancebackgroundestimatesthattheyarewortharound$12,000.
Whatentrywillyoumakeatthegrantoftheoptions:
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HowmuchCompensationexpensewillyouhavetorecordfortheoptionsafterthefirstyearofJane'semployment?
ComprehensiveIncome
Youwererecentlysenttheannualreportforapubliccompanywhosestockyouown.AsyouwereflippingthroughthereportyounoticedthatitpresentedaComprehensive
IncomeStatementinadditiontoitsIncomeStatement.YouwonderedhowComprehensiveIncomediffersfromregularNetIncome,andhowtheydifferforGlobalGrocer.
Aswehaveseen,therearesomegainsorlossesthatarenotrecordedaspartofNetIncome.Forexample,inthechapterdiscussingavailableforsalesecurities,wesawthatsuch
investmentswererevaluedtotheirfairvalueeachaccountingperiod.However,thesegainswerenotreportedaspartofNetIncome.Instead,theywereshownasaseparate
owners'equityaccountcalledUnrealizedGainonAvailableforSaleMarketableSecurities.
BecausetheIncomeStatementdoesnotincludeallchangesinOwners'Equity,standardsettersnowrequirefirmstoprepareaComprehensiveIncomeStatementtoprovide
investorswithsuchareconciliation.
TheComprehensiveIncomeStatementshowschangesinshareholdersequityarisingfromallchangesotherthannewinvestmentsbyordistributionstoowners,andinthecase
ofGlobalGrocerincludes:
NetIncome,and
Unrealizedgainsandlossesonavailableforsalesecurities
GlobalGrocer
Theonlyowners'equitychangeforGlobalGrocerthatwasnotrecordedintheIncomeStatementwasanunrealizedgainonavailableforsalesecurities.Givenitsnetincome,
GlobalGrocer'sComprehensiveIncomeStatementwouldbeasfollows:
Thestatementshowsthat,afterincludingunrealizedgainsonavailableforsalesecurities,GlobalGrocer'sComprehensiveIncomeactuallyexceededitsNetIncome,although
thedifferenceisrelativelymodest.
GlobalGrocer'sEquity
BelowisarevisedBalancesheetforGlobalGrocer,providingthedetailsofShareholder'sEquityafterthetransactionsinthisandtheearlierchaptershavebeenrecordedand
posted.
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NoticethattheOwners'Equityincludes(a)theequityeffectofthepreferredstockissue,(b)thecommonstockatparvalueaswellasAdditionalpaidincapital,(c)theadditional
paidincapital:Stockoptionamountresultingfromrecordingastockoptionexpense,(d)thereductioninShareholders'EquityfromtherepurchaseofTreasuryStock,(e)the
ComprehensiveIncomeentryforUnrealizedgainonavailableforsalesecurities,and(f)theretainedearningswhichincludestheyear'sNetIncomeof$397,420lessthe$5,300
dividend.
EquityRatios:ROE
Akeyratiousedbyinvestorstoevaluateafirm'sperformanceisReturnonEquityorROE.ThisratioissimplyNetIncomedividedbyOwners'Equity.
TheReturnonEquityshowshowmuchreturnthecompanywasabletogeneratefromtheinvestmentthatshareholdersmadeinthecompany(boththeirinvestmentofcapital
andthereinvestmentofearnings).Shareholderscanthenevaluatewhetherthefirm'smanagershavebeenabletogenerateareturnthatcompensatesthemsufficientlyforthe
riskstheybearinowningthecompany'sstockandrelativetotheperformanceavailablefromotherfirms.
ReturnonEquity=NetIncome
Owners'Equity
ROEDrivers
Afirm'sReturnonEquitycanbedecomposedintothreekeycomponentsordrivers:
NetIncomeMargin=NetIncome
Sales
AssetTurnover=Sales
TotalAssets
FinancialLeverage=TotalAssets
Owners'Equity
ThisimpliesthatafirmcanimproveitsROEby(a)increasingnetincomemarginsthoughimprovedpricingorcostcontrols,(b)increasingassetturnover,byreducingits
workingcapitalneedsormakinglongtermassetsworkmoreproductively,or(c)byincreasingthefirm'sfinancialleveragebytakingonadditionaldebtfinancing.
ReturnonEquity=NetIncomeXSalesXTotalAssets
SalesTotalAssetsOwners'Equity
GlobalGrocer
SinceGlobalGrocerhasonlybeeninbusinessforasingleyear,itprobablymakessensetolookatitsROEcomputedusingendingOwners'Equity(sincebeginningequitywas
zero).
RatioCalculation
Let'slookatGlobalGrocer'sROEandthedriversofROE.BelowyouwillseehoweachratioiscomputedfromthesummaryfinancialstatementsforGlobalGrocer.
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Exercise13.2
EstimateRatios
ThefollowingfinancialstatementsareavailableforSuperiorCorp.andAverageCorp.,twofirmsthatoperatehardwarestores,forthelatestfiscalyear:
EstimatethefollowingratiosforAverage&Superior.Enteryouranswerswithonedecimalplaceanddonotround.
Benchmarks&Interpretation
Whichofthefollowingstatementsisinconsistentwiththeaboveratios?
Recap
Inthischapteryoucoveredsomeadvancedaccountingtopics.Youlearned:
Owners'equitymayincludemoreaccountsthanjustcommonstockandretainedearnings
Thecommonstockaccountconsistsoftwoaccountscommonstockatparandadditionalpaidincapital
Inadditiontoissuingcommonstock,firmscanissuePreferredStock,whichhashigherpriorityinbankruptcyandusuallyhasaspecifieddividendrate.
Aformofcashdistributiontoshareholdersisastockrepurchase,whichleadstothecreationofTreasuryStock,anegativelineiteminOwners'Equity.
Dividenddistributionsresultinthepayoutofcashtoshareholders,andreducereinvestedprofits.
Stocksplitschangethenumberofsharesoutstandingandtheparvalueoftheshares,buttheydonotaffectthebookvaluesoftotalassets,liabilitiesandequity.
Stockoptionsaredesignedtohelplinkmanagers'incentiveswiththoseofshareholders.Theirestimatedvalueatdateofgrantistypicallyrecordedasacompensation
expenseovertheperiodduringwhichtheoptionsvest.
Somegainsandlosses,suchasunrealizedgainsandlossesonavailableforsalesecuritiesaredeliberatelyexcludedfromNetIncome,butareincludedina
ComprehensiveIncomeStatementandseparatelyreportedinOwners'Equity.
ReturnonEquity(ROE)isausefulmeasureofthereturnthatafirmgeneratesduringtheperiodonowners'equity.Itisdrivenbythreefactors:operatingperformance
representedbynetprofitmargins,assetmanagementrepresentedbyassetturnover,andthefirm'scapitalstructurerepresentedbyitsfinancialleverage.
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Congratulations
NowthatyouhavecompletedthetutorialandpreparedGlobalGrocers'endoffirstyearbalancesheet,youshouldhavetheabilitytoprepare,read,interpretandevaluate
reasonablycomplexfinancialstatements.Youwillfindthesetobevaluableskills.CongratulationsandgoodluckinthefuturetoyouandGlobalGrocer.
WelcometotheadvancedmaterialfinalexamfortheFinancialAccountingOnlineCourse.Thistestwillallowyoutoassessyourknowledgeofmoreadvancedfinancialreporting
topicscoveredinchapters713.
Navigation:
Toadvancefromonequestiontothenext,selectoneoftheanswerchoicesor,ifapplicable,completewithyourownchoiceandclicktheSubmitbutton.Aftersubmittingyour
answer,youwillnotbeabletochangeit,somakesureyouaresatisfiedwithyourselectionbeforeyousubmiteachanswer.Youmayalsoskipaquestionbypressingtheforward
advancearrow.PleasenotethatyoucanreturntoskippedquestionsusingtheJumptounansweredquestionselectionmenuorthenavigationalarrowsatanytime.Although
youcanskipaquestion,youmustnavigatebacktoitandansweritallquestionsmustbeansweredfortheexamtobescored.
IMPORTANT:Takethisexamonlyaftertakingthepreviousfinalassessmentexams.Therearethreefinalassessmentexams.Thus,ifyoudidnotreceivea
passingscoreonthefirstorsecond,itiscriticalthatyoureviewthecoursematerialcarefullybeforetakingthisexam.
GoodLuck!
CopyrightHarvardBusinessSchoolPublishing.Copyingorpostingisaninfringementofcopyright.Permissions@hbsp.harvard.eduor6177837860.
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