CHAPTER 13

Operating Activities
THINKING BEYOND THE QUESTION How do we account for operating activities? Estimation methods can have a major effect on a companys reported revenues and expenses. If appropriate methods are used, the revenues and expenses should be a fair representation of the companys economic activities and should be useful for understanding future revenues and expenses. If methods are selected that do not provide a fair representation, current period profits may be a poor measure of current economic activities. The income statement is divided into recurring and nonrecurring events. Decision makers often place more emphasis on recurring events because they are likely to indicate future results. Nonrecurring events affect future events indirectly. For example, large one-time losses can reduce the amount a company is able to invest in new assets. However, these losses should not continue to occur in the future. Proper distinction among recurring and nonrecurring items should help stockholders and other decision makers evaluate a companys future performance. QUESTIONS Q13-1 Both the income statement and the statement of cash flows report the results of operating activities. The difference is that the income statement reports the accrual-basis consequences of those activities, while the statement of cash flows reports the cash-basis consequences. As we have seen throughout this book, those consequences are often different. Information about both is necessary for managers and outsiders to make decisions regarding the organization. Q13-2 The income statement is organized to highlight certain information that is useful to financial statement users. By breaking out specific items separately, additional information about the workings of the organization are revealed. For example, if the company has material amounts of both sales revenue and service revenue, it is important for readers to know which side of the business contributed most to revenue and whether one side of the business is growing more rapidly than the other. For another

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example, it is important that financial statement users be able to evaluate the ongoing regular activities separately from one-time events. For this reason, gains and losses are reported separately. It is true that all the revenues and all the expenses could each be totaled and then subtracted from each other to determine net income. To do so, however, would obscure important information. To use this approach might make accounting easier to learn, but it would reduce the amount of information provided to financial statement users and the quality of decisions they are able to make. Q13-3 Your friend is partially rightthe income statement is full of estimates, and it does not reveal either the current cash position or the cash flows of the entity. Because cash is what an investor wants from an investment, the income statement may seem irrelevant. But the income statement can also be described as an estimate of the cash flows that will, eventually, go in and out of the company because of the current periods operations. As such, it reveals at least as much about the future cash potential of the company as either of the other statements. Q13-4 Title to goods transfers to the buyer at the point named in the freight terms. Therefore, if goods are sold FOB shipping point, the goods become the property of the buyer when they are loaded onto the truck (or rail car) at the shipping point. Since the buyer owns the goods during shipment, it is logical that the buyer pays the freight to move goods that it owns. Note that this rationale also holds when goods are sold FOB destination. In that situation, the title to the goods does not transfer until the goods reach their destination. Accordingly, the seller owns the goods during transit and is responsible for paying the freight cost on goods it is transporting. Q13-5 There is a large conceptual difference between a reduction of revenue and an expense. While it is true that the effect on net income would be identical, there is more to the issue. Revenue can be defined as the reward that is earned from serving customers. Sales discounts and sales returns are clearly reductions of that reward. Net sales (the amount remaining after sales discounts and sales returns are deducted) is the best measure of the amount that has been earned from customers. Expense, on the other hand, is defined as resources consumed in providing goods and services to those customers. Sales discounts and sales returns do not represent resources consumed. They are, at best, phantom resources: resources the company never had and never expects to have. Accordingly, sales discounts and sales returns cannot be reported as expenses. While the effect on net income is the same regardless of treatment, users of financial statements obtain additional information from having clear measurements presented of the components that make up net income.

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Q13-6 Gross profit is affected by two types of transactions: sales and the transactions that create inventory cost. For a merchandiser, inventory cost derives from just one transaction, a purchase. For a manufacturer, it is more complex; inventory cost is accumulated as a result of all the transactions involving raw materials purchase and use, labor, and overhead. If the sale occurs in a different period from the cash flow, operating cash flow will show the transactions in a different period from the income statement. If the sale occurs before the cash flow, a receivable affects the balance sheet until the cash comes in. If the cash flow occurs first, deferred revenue appears on the balance sheet until the earnings process is completed. If purchase or production of inventory occurs in an earlier period than the sale, inventory appears on the balance sheet. If items involved in inventory are not paid for when purchased, a payable appears in the liability section. Q13-7 Neither receiving nor paying for the raw materials will affect the current-year income statement. The materials will be expensed as part of cost of goods sold when they are used in manufacturing and the resulting products are sold. Since none of the materials have been used (i.e., sold as part of finished goods), no expense has been incurred. Similarly, when the materials are paid for has no effect on net income. Net income is affected only when the raw materials have been transformed into finished products and those products are sold. Q13-8 These goods should not be included as part of Hadleys inventory at December 31 because the firm does not own the goods. The ownership of goods transfers from seller to buyer at the point named in the shipping terms. Since the shipping terms were FOB destination, and the goods had not reached the destination as of December 31, the seller still owns the goods. These goods should appear on the balance sheet of the seller at December 31. Q13-9 Yes and no. It depends on what is meant by the amount of inventory. If the issue is the quantity of inventory on hand, such as number of cases, number of tons, etc., the answer is no. GAAP require a physical count at fiscal year-end to confirm the quantity of goods in inventory. On the other hand, if the issue is the cost of the inventory on hand, the answer is yes. Take a company such as Home Depot. At a balance sheet date it has thousands of hammers of a given type and description on hand. Some may have been purchased at a cost of $5.50, some at $5.75, some at $5.60. When displayed in the stores, however, all of these hammers of different cost are placed on the same display. When a given hammer is sold it is impossible to tell whether it is one that cost $5.50, $5.60, or $5.75. Therefore, a guess must be made about which hammers were sold and

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which hammers are still on display. LIFO, FIFO, and weighted-average methods are based on different assumptions about which hammers have been sold and which hammers are still available for sale. Generally, they all yield different results. Q13-10 Most corporations attempt to maximize reported earnings and cash flows from operating activities. Inventory estimation methods affect reported earnings directly and cash flows indirectly through taxes on corporate profits. If a companys unit inventory costs increase over time, LIFO normally will result in a greater amount of cost of goods sold than FIFO because more recent (higher) costs are matched against revenues. Therefore, reported income and taxable income will be lower. The company can reduce its cash outflow for taxes, but it will also report a lower net income than if it had used FIFO. The cash flow effect is a real economic effect because it affects the companys resources. The effect on net income is not a real economic effect because a companys resources are the same regardless of which method is used. Thus, if the tax effect is material, companies normally will select LIFO. The effect on taxes is not as easy to determine if a companys sales are volatile. If a company sells more units than it produces during a period, it will sell units out of inventory layers that have a lower unit cost than current costs. The unit cost of these earlier layers may be much lower if LIFO has been used than if FIFO has been used because they represent much earlier acquisitions. Therefore, the company may actually record lower cost of goods sold using LIFO than using FIFO, resulting in higher tax payments. Also, some companies unit inventory costs decrease over time, even during periods of general inflation. The costs of computer and electronics items have decreased as technology, production processes, and competition have increased. Therefore, FIFO results in lower reported income and tax payments for companies in these industries because earlier inventory costs are matched against revenues. Inventory cost is a much more important issue for some companies than others. Some companies maintain small amounts of inventory and, therefore, are not affected much by the choice of estimation method. Other companies maintain large amounts of inventory. These companies are particularly sensitive to the choice of estimation method. Q13-11 This is because of the mechanics of the LIFO and FIFO methods. Under LIFO, the most recent costs of inventory purchases are charged off to cost of goods sold. Older costs are reported as ending inventory. When prices are rising, then, this causes the newer, higher costs to be reported as cost of goods sold, which causes net income to be lower. The older, lower costs are reported on the balance sheet as ending inventory. Under FIFO, however, just the opposite effect occurs. The older, lower costs are

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charged off to cost of goods sold and the newer, higher costs are reported as ending inventory. Q13-12 The lower of cost or market rule requires companies to estimate the replacement cost of their inventories. If the replacement cost is below cost, the inventory must be written down to the lower value. The purpose of this rule is to require a company to recognize the loss from a decline in value of inventory in the period in which the decline occurs. The loss reduces reported income and reduces the book value of assets in the period in which the decline is recorded. It has no effect on cash flows. An adjustment is not made if market value exceeds cost. Thus, like general asset impairment reporting, this measurement rule biases reported assets and income downward. It is justified by the concept of conservatism, which results in recording potential losses as soon as they can be estimated but not recording gains until they are realized. This principle is designed to prevent companies from reporting overly optimistic accounting numbers. Q13-13 It is difficult to argue that research and development costs dont provide any benefit to future accounting periods. If this were true, companies would be foolish to make such expenditures. Even casual observation of todays business world reveals massive investments in R&D and a steady stream of advancing technology and new products that result from it. In spite of this, GAAP treat R&D expenditures as if they dont have future value. Mostly this is because it is so difficult to determine the benefit. There's an old line quoted by R&D managers that says I know that half of my R&D expenditures are wasted, I just dont know which half. This illustrates the uncertainty of determining whether any specific R&D project will ever pay off. Many do, but many others (most others?) never result in a viable product and the money turns out to have been wasted. Because of this uncertainty, and the difficult judgments that would have to be made to capitalize some costs and not others, GAAP require immediate write-off. Q13-14 The existence of a difference between the two amounts indicates that the company has preferred stock outstanding. Because of the nature of preferred stock, all preferred dividends must be paid in full before any dividends may be paid on common stock. The difference between net income and net income available for common stockholders ($3.75 million $3.0 million) is the preferred dividends claimed by preferred shareholders ($0.75 million). Q13-15 Earnings per share numbers can be confusing, with both basic and diluted earnings presented and with computations based on income before and after items like discontinued segments, extraordinary items, and effects of changes in accounting principles. Most investors are most interested in

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forecasting the future results of the company. For this purpose, the earnings per share on income from continuing operations may be the most important. The three other earnings per share numbers (related to discontinued operations, extraordinary items, and changes in accounting principles) are special one-time events not expected to recur. Therefore, they are of little help in projecting the future. EXERCISES E13-1 Definitions of all terms are listed in the glossary. E13-2 Hoffman Income Year Ending December 31, 2007 Sales revenue Cost of goods sold Gross profit Selling, general, and administrative expenses* Operating income Interest expense Gain on sale of land Pretax income Income tax expense Net income Earnings per share (10,400 shares) *$9,968 + $13,510 + $9,002 + $59,780 E13-3 Sales are revenues generated from the sale of goods and services during a fiscal period. Other income is income generated by other miscellaneous operating activities. Cost of goods sold includes the cost of materials and labor directly associated with producing the goods sold and the indirect costs of depreciation, supplies, utilities, and labor that were used in the production process. These costs are inventoried until goods are sold, at which time they are expensed. Selling, general, administrative, and other expenses are those resulting from selling and distributing goods and from general management of a company. Costs associated with these activities generally are expensed in the fiscal period in which they occur. Research and development expenses are those associated with the creation and improvement of products and production processes. GAAP require these costs to be expensed in the period in which they occur. Provision for depreciation, depletion, and amortization is the expense associated with the use of plant assets, natural resources, and intangi$260,772 102,690 158,082 92,260 65,822 (1,420) 4,800 69,202 24,221 $ 44,981 $ 4.33 Electric Statement

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ble assets. The costs of these assets are allocated to expense on a systematic basis over their estimated useful lives. Depletion is allocated based on the estimated portion of total assets consumed during a fiscal period. Interest expense is the cost of borrowing. Income from continuing operations before taxes on income is equivalent to pretax income. Provision for taxes on income is the amount of tax a company would owe on its pretax income if this amount of income were reported for tax purposes. Because tax rules differ from accounting rules, the actual amount of tax a company owes often differs from the amount reported on the income statement. (Based on the Other Topics section at the end of the chapter) Minority interests is the portion of income of consolidated subsidiaries attributable to minority stockholders of these subsidiaries. Thus, if Alcoa owns 80% of another company, minority interests represents the portion of the subsidiarys income attributable to the 20% of the stock not owned by Alcoa. Income from continuing operations is after-tax consolidated income of the company and its subsidiaries, less minority interest in subsidiary income. Loss on discontinued operations is the after-tax loss associated with the sale of a business segment. Net income is the after-tax consolidated income of the company and its subsidiaries. Earnings per share is the amount of net income available to common stockholders divided by the average number of common shares outstanding during the fiscal period. Alcoa reports earnings per share as basic and diluted. The diluted value represents earnings available to common shareholders if all convertible securities were exchanged for common stock. Gross profit is computed as follows (in millions): Sales Cost of goods sold Gross profit E13-4 a. $23,478 18,623 $ 4,855

In general, San Miguel should not recognize revenue until: i. It has completed most of the activities necessary to produce and sell the goods or services, ii. It has incurred the costs associated with producing and selling the goods or services, iii. It can objectively measure the amount of revenue it has earned, and iv. It is reasonably sure that it is going to collect cash from the purchaser.

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(continued)

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135

In other words, revenue cannot be recognized until the company has performed those activities that earn it the right to receive payment from the buyer. Also, the amount of revenue and collectibility must be reasonably determinable. The critical point for the sale of equipment appears to be when title passes to the purchaser. At this point, San Miguel has performed those activities necessary to earn the revenue and is reasonably assured of receiving payment (otherwise they wouldnt turn over the equipment). Payment of cash prior to or subsequent to the passage of title normally does not affect revenue recognition unless substantial uncertainty about receipt of the cash exists. b. San Miguels service contracts provide for service over a period of time. Therefore, service revenue should be recognized as time passes. For example, if a three-year contract is sold for $6,000, San Miguel would recognize $2,000 of service revenue during the first year of the contract. Other types of contracts might result in a different recognition process.

E13-5

Amount of gross sales $30,000,000 Sales discounts 900,000 Amount billed 29,100,000 Expected returns* 450,000 Net sales revenue $28,650,000 *25% $30,000,000 gross sales 6% = $450,000 The amount of revenue recognized should be net of discounts and expected returns. The net amount is the amount of cash a company expects to receive eventually from its customers. Only 3 months (25%) worth of sales are still returnable, and of those, 6% are expected to be returned. E13-6 a.
Accounts Accounts Receivable Sales Revenue Cash Accounts Receivable Allowance for Doubtful Accounts Accounts Receivable Doubtful Accounts Expense Allowance for Doubtful Accounts Debits 18,600,000 18,600,000 18,750,000 18,750,000 165,000 165,000 273,000 273,000 273,000 +18,750,000 18,750,000 +165,000 165,000 273,000 Credits A +18,600,000 +18,600,000 = L+ OE CC + RE

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Calculation of doubtful accounts expense: Allowance for doubtful accounts, beginning of 2008 Account written off Balance after write-off Allowance required at end of 2008 ($18,600,000 0.03) Balance after write-off Amount of additional allowance required b. Accounts receivable, net, at 12/31/08: Accounts receivable, 1/1/08 ($3,200,000 + $450,000) Credit sales Cash collected Accounts written off Accounts receivable, 12/31/08 Allowance for doubtful accounts ($18,600,000 0.03) Accounts receivable, net, 12/31/08

$ $ $ $

450,000 (165,000) 285,000 558,000 (285,000) 273,000

$ 3,650,000 18,600,000 (18,750,000) (165,000) $ 3,335,000 (558,000) $ 2,777,000

E13-7

a.

The entire amount should be recognized as a sale in April, when the machine is delivered to the customer and the earnings process is completed. The cost of the components should be recognized in April, as part of cost of goods sold, to match the expense with the recognition of the related revenue. The labor costs, including health and pension benefits, would also become part of cost of goods sold in April, to match the expense with the recognition of the related revenue. The estimated cost of servicing the warranty should be recognized in April, when it is matched with the related revenues. Year 2007 Year 2008 $ 350,000 6,000,000 (5,400,000) (180,000) $ 770,000 (continued) Accounts Receivable: Beginning balance Credit sales during year Collections from customers Accounts written off Ending balance

b.

c.

d. E13-8 a.

0 4,000,000 (3,500,000) (150,000) $ 350,000

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b.

Doubtful Accounts Expense: 2007: $4,000,000 0.05 2008: Proof *Desired ending balance ($770,000 0.08) Balance before adjusting entry: Ending 2007 balance (50,000) Write-offs during 2008 (180,000) Doubtful accounts expense required

$ 200,000 $ 191,600* $ 61,600 130,000 $ 191,600 $ 0 200,000 (150,000) $ 50,000 $ 50,000 191,600 (180,000) $ 61,600

c.

Allowance for Doubtful Accounts: Beginning balance Estimated doubtful accounts expense Write-offs Ending balance

When doubtful accounts expense is based on the ending balance of Accounts Receivable, the amount calculated becomes the desired ending balance of the allowance account ($770,000 0.08 = $61,600). The amount of expense is that which produces the desired ending balance in the Allowance for Doubtful Accounts. E13-9 a. b. c. E13-10 a. b. E13-11
Date 2/27 3/12 4/4 Accounts Merchandise Accounts Payable Accounts Payable Cash Accounts Receivable Cost of Goods Sold Sales Merchandise Cash Accounts Receivable Debits Credits 400 400 400 400 625 400 625 400 625 625 400 +625 400 +625 400 +625 625 A +400 +400 400 = L+ OE CC + RE

Revenue = $700,000 Expenses = $455,000

($2,000,000 35%) ($1,300,000 35%)

Gross profit = $245,000 ($700,000 $455,000) Revenue = $16,000,000 ($40 million 40%)

Expenses = $12,000,000 ($4 million + $6 million + $2 million)

5/15

The net effect on the income statement is a $225 gross profit ($625 $400). This is also the net effect on total assets.

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E13-12 a.
Accounts 1 2 3 4 5 6 7 8 Merchandise Inventory Accounts Payable Accounts Receivable Sales Revenue Cost of Goods Sold Merchandise Inventory Accounts Payable Merchandise Inventory Cash Accounts Receivable Accounts Payable Cash Sales Discounts Accounts Receivable Doubtful Accounts Expense Allowance for Doubtful Accounts Allowance for Doubtful Accounts Accounts Receivable Debits 600,000 600,000 855,000 855,000 491,000 491,000 35,000 35,000 788,000 788,000 565,000 565,000 22,000 22,000 16,000 16,000 12,000 12,000 16,000 +12,000 12,000 22,000 16,000 565,000 22,000 35,000 +788,000 788,000 565,000 491,000 35,000 +855,000 +855,000 491,000 Credits A +600,000 +600,000 = L+ OE CC + RE

b.

Net Income Gross sales revenue Sales discounts Net sales revenue Cost of goods sold Doubtful accounts expense Net income Cash Flow (Direct Method) Cash received from customers Cash paid to suppliers Net operating cash flow Cash Flow (Indirect Method) Net income Increase in net receivables* Increase in merchandise Net operating cash flow

$ 855,000 (22,000) 833,000 (491,000) (16,000) $ 326,000 $ 788,000 565,000 $ 223,000 $ 326,000 (29,000) (74,000) $ 223,000

* Net of balance in the Allowance for Doubtful Accounts: $16,000 estimate less $12,000 write-off.

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E13-13 The income statement recognition of the events would be in March, when the sale took place; the income statement effect in the other months is zero. Both the purchase and the sale should be recorded net of the discount. Saleinvoice price Less discount, 1% Net sale price Purchase price Less discount, 2% Cost of goods sold Gross profit on March income statement E13-14 a. $75,000 750 $74,250 $60,000 1,200 58,800 $ 15,450

b. c. d. e. f. g. h. i.

j.

Always false. Sales discounts are not an expense. They do not represent the use or consumption of resources in generating revenue. Instead, sales discounts are a reduction in the amount of revenue that has been earned. They are similar to other price reductions. In essence, it is revenue that the company never had. Always true. NOTE: Key word here is NET accounts receivable. The reduction in receivables and the allowance offset each other. Generally true. Unless the goods were sold FOB destination (which means the seller is responsible for paying the freight cost). Always false. Manufacturers report these three categories of inventory, not retailers. Generally true. The only exception would be if the retail selling price and the cost on the books were the same. Always true. Always true. NOTE: Not all companies do this, but this is the conceptually preferable method of accounting for inventory. Always false. The cost should be recorded initially in Raw Materials Inventory. Always false. The cost of factory wages should become part of workin-process inventory and, eventually, finished goods inventory. When the goods are sold, the cost of wages (now included in finished goods inventory) is reported on the income statement as cost of goods sold. Always true.

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E13-15 a.

Beginning inventory 100 units Purchased (500 + 400) 900 Sold (880) Ending inventory 120 units Cost of goods available for sale: 100 units @ $8.00 = $ 800 500 units @ $8.30 = 4,150 400 units @ $8.50 = 3,400 Total $8,350 Sales: 880 @ $12 = $10,560 FIFO: Ending inventory = $1,020 (120 $8.50) Cost of goods sold = $7,330 (100 $8.00) + (500 $8.30) + (280 $8.50) Gross profit: $3,230 ($10,560 $7,330) LIFO: Ending inventory = $966 (100 $8.00) + (20 $8.30) Cost of goods sold = $7,384 (400 $8.50) + (480 $8.30) Gross profit = $3,176 ($10,560 $7,384) Weighted-average: Average cost = $8.35 $8,350 1,000 units Ending inventory = $1,002 (120 $8.35) Cost of goods sold = $7,348 (880 $8.35) Gross profit = $3,212 ($10,560 $7,348)

b.

The highest gross profit results from FIFO because the oldest, lowest costs go into cost of goods sold. LIFO yields the lowest gross profit because the newest, highest costs are in cost of goods sold.

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E13-16 (In millions) FIFO LIFO Excess of FIFO over LIFO costs Increase in inventory ($562 $294) = $268 Beginning Inventory $ 2,015 1,721 $ 294 Ending Inventory $ 2,575 2,013 $ 562

Because ending inventory would have been higher under FIFO, cost of goods sold would have been lower. On a FIFO basis, the company would have reported $268 million less of cost of goods sold than on a LIFO basis. Therefore, income taxes would have been $93.8 million higher ($268 0.35) and net income would have been $174.2 million higher ($268 $93.8) if FIFO had been used. You can also use knowledge of the accounting equation (assets = liabilities + owners equity) to address this exercise. The higher FIFO ending inventory on the left side (under assets) is balanced by a higher net income, under FIFO, on the right side (in owners equity). If net income is higher under FIFO, then taxes are higher. E13-17 a. Income Sales revenue Less: Cost of goods sold Other expenses Pretax income Income tax expense (30%) Net income b. As reported via FIFO $60,000,000 42,000,000 12,000,000 6,000,000 1,800,000 $ 4,200,000 If LIFO had been used $60,000,000 44,000,000 12,000,000 4,000,000 1,200,000 $ 2,800,000 If LIFO had been used $60,000,000 45,000,000 12,000,000 1,200,000 $ 1,800,000

As reported Cash flow via FIFO Sales (all collected in cash) $60,000,000 Cash paid for purchases of inventory* 45,000,000 Other expenses (all paid in cash) 12,000,000 Cash paid for taxes (30%) 1,800,000 Cash flow from operations $ 1,200,000

* This assumes all purchases of inventory were for cash. c. No. Cost of goods sold would have been $2 million higher using LIFO rather than FIFO. As a result, the companys net income would have been $1.4 million ($4,200,000 $2,800,000) less if it had used LIFO. Therefore, it would have incurred $600,000 ($1,800,000 $1,200,000) less income taxes if it had used LIFO. As a result, the companys net cash flow from operating activities would have been $600,000 greater

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if it had used LIFO. This is a common reason to use LIFO. It generally postpones the payment of cash for taxes. Over time, the total amount of cash paid for taxes is the same regardless of method. In the short run, cash can usually be conserved by using the LIFO method. This is beneficial from a time value of money perspective. This is a good example of a financial reporting choice that management must make. To save cash, the company must report less net income. E13-18 a. b. c. d. e. f. g. h. i. j. E13-19 a. Goods were sold to customers on credit. Company records cost of goods sold and decrease of inventory. Cash was collected from customers' credit purchases. Inventory was purchased on credit. Some of the inventory purchased on credit was returned to the vendor, or a purchase discount was given. The company estimated its doubtful accounts expense for the period. Doubtful accounts were written off. Customer pays within the discount period and is allowed the sales discount. Company estimates possible returns by customers. Company estimates cost of warranty repairs. Total units sold = 70 + 60 + 60 = 190 Total units in ending inventory = 100 + 50 + 100 190 = 60 FIFO ending inventory = (60 15) = $900 FIFO cost of goods sold = (100 12) + (50 14) + (40 15) = $2,500 LIFO ending inventory = (60 12) = $720 LIFO cost of goods sold = (100 15) + (50 14) + (40 12) = $2,680 Total cost of goods available for sale = 1,200 + 700 + 1,500 = $3,400 Total units available for sale = 100 + 50 + 100 = 250 Weighted average cost per unit = 3,400 250 = $13.60 Weighted average ending inventory = 60 $13.60 = $816 Weighted average cost of goods sold = 190 $13.60 = $2,584 Total units sold = 8,000 + 2,000 + 5,000 = 15,000 Total units in ending inventory = 9,000 + 3,000 + 10,000 15,000 = 7,000 FIFO ending inventory = (7,000 14) = $98,000 FIFO cost of goods sold = (9,000 10) + (3,000 12) + (3,000 14) = $168,000 (continued)

b. c.

E13-20 a.

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b.

LIFO ending inventory = (7,000 10) = $70,000 LIFO cost of goods sold = (10,000 14) + (3,000 12) + (2,000 10) = $196,000 Total cost of goods available for sale = 90,000 + 36,000 + 140,000 = $266,000 Total units available for sale = 9,000 + 3,000 + 10,000 = 22,000 Weighted average cost per unit = $266,000 22,000 = $12.09 Weighted average ending inventory = 7,000 $12.09 = $84,630 Weighted average cost of goods sold = $266,000 goods available for sale $84,630 ending inventory = $181,370 (Alternatively, cost of goods sold could be calculated as 15,000 $12.09 = $181,350; then ending inventory would be $266,000 $181,350 = $84,650. The $20 difference in the solution is due to rounding.) Merchandise Inventory $ 165,000 30,500 (90,000) 186,000 (152,000) $ 139,500 Merchandise Inventory $ 165,000 30,500 (90,500) 186,000 (155,000) $ 136,000 Cost of Goods Sold $ 90,000 152,000 $242,000 Cost of Goods Sold

c.

E13-21 January 1 balance (550 @ 300) January 5 Purchases (100 @ 305) January 7 Sales (300 @ 300) January 10 Purchases (600 @ 310) January 31 Sales (250 @ 300) + (100 @ 305) + (150 @ 310) Ending balance E13-22 January 1 balance (550 @ 300) January 5 Purchases (100 @ 305) January 7 Sales (100 @ 305) + (200 @ 300) January 10 Purchases (600 @ 310) January 31 Sales (500 @ 310) Ending balance

$ 90,500 155,000 $ 245,500

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E13-23 a.

Earnings per share data distinguish the effect of an extraordinary item so that the investor has the option of concentrating on the effects of the normal and recurring items in the income statement. These items are more useful in predicting the future of the company. Effects of discontinued segments and cumulative effects of changes in accounting principle are also separated in earnings per share computations. Basic and diluted earnings per share are the categories specified by Statement of Financial Accounting Standards No. 128. Basic earnings per share includes no dilutive securities, so the weighted-average number of shares can be calculated by dividing the relevant income amount by any of the three numbers given (with small rounding differences): Income Amount $3,487 644 2,843 EPS $1.16 0.21 0.95 Shares 3,006 3,067 2,993

b.

(Thousands except per share) Before extraordinary item Extraordinary item Net income

(Number of shares actually used in the computation was 3,000.) For diluted earnings per share, the denominator is slightly higher; again, there are rounding differences: (Thousands except per share) Before extraordinary item Extraordinary item Net income Income Amount $3,487 644 2,843 EPS $1.00 0.19 0.81 Shares 3,487 3,389 3,510

(The denominator actually used in the computation was 3,500.) c. The extra 500 would come from some kind of security that could turn into common stock, such as convertible preferred stock, convertible bonds, or employee stock options.

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E13-24 A complete income statement is shown below with each of the requirements keyed by letter. Net operating revenues Cost of goods sold Selling and administrative expenses Research and development expenses Operating income Net interest expense Income from continuing operations, before taxes Provision for income taxes Income before discontinued operations Discontinued operations: Current period loss, net of tax benefit Loss from sale of discontinued operations, net of tax benefit Net income Less: Preferred dividends Net income available for common shareholders Earnings per share: Continuing operations [($182,580 $48,000) 25,000 shares] Discontinued operations [($24,000 $89,000) 25,000 shares] Net income [($69,580 $48,000) 25,000 shares] Income from continuing operations, before taxes Income tax expense (provision for taxes) Income before special items Discontinued operations: Current period loss, net of $3,150 tax effect Gain from sale of discontinued operations, net of tax of $975 Extraordinary itemHurricane damages, net of tax effect of $6,300 Net income $ 956,000 (312,000) (245,000) (122,000) 277,000 (8,500) 268,500 (85,920) 182,580 (24,000) (89,000) $ 69,580 (48,000) $ 21,580 $ $ 5.38 (4.52) 0.86

A. B. C.

D. E. F. G. H. E13-25 a.

$250,000 (75,000) 175,000 (7,350) 2,275 (14,700) $ 155,225

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b.

Earnings per share: Income before special items Discontinued operations, net Extraordinary item Net income

$2.18 (0.06) (0.18) $1.94

($175,000 80,000) ($5,075 80,000) ($14,700 80,000) ($155,225 80,000)

E13-26 a. b. c. d.

Inventory is expensed as cost of goods sold when it is sold; so this would be expensed in 2008 rather than 2007. Estimated warranty costs should be expensed in the year of sale, to match expenses with the related revenues; so these should be expensed in 2007. Like estimated warranty costs, estimated bad debts should be expensed in the year of sale to match expenses with the related revenues; so these should be expensed in 2007. U.S. accounting standards require expensing research and development costs in the year incurred, although they are designed to produce better products in the future. These should be expensed in 2007.

PROBLEMS P13-1 Leafy Green Income For the Month of January 2007 Sales Expenses: Salad ingredients Depreciation on delivery vehicle1 Other operating expenses Interest expense2 Net income Earnings per share3
1 2

Corp. Statement $16,500

$8,500 200 6,000 56 14,756 $ 1,744 $ 1.34

$7,200 36 months = $200 ($8,400 loan 8%) 12 months = $56 3 $1,744 net income 1,300 shares P13-2 In general, revenues are recognized in the income statement when the following four criteria have been met: 1. The selling company has completed most of the activities necessary to produce and sell the goods or services. 2. The selling company has incurred the costs associated with producing and selling the goods or services or can reasonably estimate those costs. 3. The selling company can measure objectively the amount of revenue it has earned.

Operating Activities

147

4. The selling company is reasonably sure that it is going to collect cash from the purchaser. For the situations listed, application of these criteria would result in the following recognition: a. The dishwasher sale would be recognized in February, when the delivery was made, because title transferred at that point. b. Each month 1/24 of the subscription price would be recognized. c. Each month 1/60 of the service contract revenue would be recognized. d. Because returns can be estimated, the sale price of the wallpaper can be recognized at the time of sale, reduced by an estimated amount for returns (about 0.12 rolls per customer). e. An estimate of the percentage of completion can be used under these conditions: an estimate would be made of the proportion of the contract completed; that fraction of the total estimated gross profit would be recognized each month. P13-3 Revenue recognition involves decisions about when revenue is recorded for financial reporting purposes. This is an important decision because it affects the amount of revenue reported in specific fiscal years. Revenue should be recognized when it has been earned. The earnings process typically has been completed when a company has completed all the activities necessary to obtain the right to receive payment from the buyer. Usually, the process is completed when goods are transferred or services are provided. Unisys engages in several types of revenue-generating activities. Completion of the earnings process for these types of revenues is associated with different events. The company has earned its sales when goods are shipped or when they are made available for use by the customer. Service revenue is earned during the period that customers contract for these services. For large, multiyear contracts, estimates of total revenues and expenses, and of the portion of the contract completed, would be necessary if any profit is to be shown in the earlier years of the contract. P13-4 A. Accounts receivable, 1/1/2008 ($16.5 million + $1.8 million) Sales on credit Collected from customers Accounts written off in 2008 Accounts receivable, end of 2008 Ending balance in allowance for doubtful accounts ($14,920,000 10%) B. $ 18,300,000 56,500,000 (57,900,000) (1,980,000) $ 14,920,000 $ 1,492,000 1,800,000 (1,980,000) (1,492,000) 1,672,000

Allowance for doubtful accounts, beginning of 2008 $ Accounts written off as uncollectible Desired ending balance in allowance account Doubtful accounts expense for 2008 $

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C.

Balance sheet presentation Accounts receivable, gross Less: Allowance for doubtful accounts Accounts receivable, net

$14,920,000 1,492,000 $13,428,000

D.

Companies estimate uncollectible accounts to match these expected costs with the revenues that are expected to produce the uncollectible accounts. If expenses were not recorded until actual accounts were written off, revenues often would be recorded in one period and related expenses would be recorded in another. The accrual basis of accounting attempts to match revenues and expenses in the period in which the economic activity that produced the revenues or expenses occurred. An increase in this percentage would indicate that a company is having greater difficulty collecting its receivables. A rapid increase might suggest that a companys customers are facing financial difficulties and are having problems paying their debts. Therefore, a companys cash flows may be affected adversely. Companies sometimes change their credit policies. They may relax their policies, permitting credit sales to more risky customers. The net result of this policy might be to increase the percentage of uncollectible accounts. On the other hand, if the policy provides for larger amounts of sales, a company may be better off with a higher percentage of uncollectibles. Therefore, both the total amount of sales and the amount of uncollectibles should be examined.

E.

P13-5 Computation of Manufacturing Inventory Costs: Raw materials inventory: Beginning balance Materials purchased during the year Materials used in production Ending balance Work-in-process inventory: Beginning balance Materials used in production Labor costs Overhead costs Cost of goods completed* Ending balance

850,000 3,550,000 (3,720,000) $ 680,000 $ 1,400,000 3,720,000 2,490,000 1,380,000 (7,110,000) $ 1,880,000

*Work completed for the year must be calculated: Beginning balance + work completed cost of goods sold = ending balance $620,000 + work completed $7,200,000 = $530,000 Work completed = $530,000 $620,000 + $7,200,000 = $7,110,000 (continued)

Operating Activities

149

Finished goods inventory: Beginning balance Cost of goods completed Cost of goods sold Ending balance P13-6 Part of the cost of goods manufactured, or expense? expense cost of goods expense cost of goods cost of goods expense cost of goods cost of goods cost of goods cost of goods cost of goods cost of goods expense expense expense cost of goods expense

620,000 7,110,000 (7,200,000) $ 530,000

a. Salaries of sales office staff b. Electric utilities for the factory area c. Office supplies d. Paint and miscellaneous plastic parts e. Depreciation on factory equipment f. Depreciation on delivery vans g. Salaries of factory foremen h. Miscellaneous factory supplies i. Steel rods used for chair frames j. Plastic sheets used for table tops k. Salaries of furniture assemblers l. Insurance on the factory m. Insurance on the administrative offices n. Advertising in trade magazines o. Lawn furniture sold to retailers p. Rental of storage facilities for materials q. Rental of storage facilities for finished goods

Materials, labor, or overhead? overhead materials/O.H .* overhead overhead overhead materials materials labor overhead overhead

*Depends on how significant they are. With regard to manufacturing costs, it is relatively easy to distinguish among materials and labor on the one hand, and factory overhead on the other. Materials includes the principal parts of the finished product, either by size or cost. Labor includes the "hands-on" work done by the factory

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employees. Factory overhead includes all other costs that are involved in manufacturing of the finished product. Items treated as expense generally benefit one accounting period only. While these items benefit the company as a whole, they are not related to the manufacturing process. Any costs incurred after the manufacturing is completed would probably be treated as expense, such as that related to delivery vans or storage of the product. Of course, when finished goods are sold, the cost immediately becomes an expense. P13-7 A. Raw materials and parts are the physical components that will become part of the firms finished products. Work in process is costs of partially completed products, including purchased parts, labor, and overhead. Finished goods is costs of completed but unsold goods, again including purchased parts, labor, and overhead. In all cases, these inventories become the expense cost of goods sold when they are part of a completed product that is sold. The inventory decrease is added to net income on the statement of cash flows because cash was not used to replace this inventory. Therefore, purchases were lower than the cost of goods sold that was subtracted in calculating income. LIFO saves taxes only in an industry in which prices are rising. In this industry, prices tend to move downward rather than upward.

B.

C.

Operating Activities

151

P13-8 A.
Accounts 1 2 Merchandise Accounts Payable Accounts Receivable Cost of Goods Sold a Sales Revenue Merchandise Accounts Payable Merchandise Cash Cost of Goods Sold b Sales Revenue Merchandise Sales Revenue Merchandise Accounts Receivable Cost of Goods Sold c Accounts Payabled Cash Cashe Sales Discounts Accounts Receivable Accounts Receivablef Cash Cost of Goods Sold g Sales Revenue Merchandise Warranty Expenseh Warranty Obligation Doubtful Accounts Expense Allowance for Doubtful Accounts
a

Debits 32,000

Credits 32,000

A +32,000

L+ +32,000

OE CC + RE

8,400 4,900 8,400 4,900 400 400 12,000 9,300 12,000 9,300 636 371 636 371 31,600 31,600 7,609 155 7,764 15,600 5,200 12,747 20,800 12,747 3,280 3,280 344 344

+8,400 4,900 +8,400 4,900 400 400 +12,000 9,300 +12,000 9,300 636 +371 636 +371 31,600 31,600 +7,609 155 7,764 +15,600 +5,200 12,747 +20,800 12,747 3,280 +3,280 344 344

3 4

6 7

9 10

(700 units @ $7) [(300 units @ $7) + (900 units @ $8)] c (53 $7) d [$32,000 $400 of goods previously returned to vendor] e [(700 units 53 units previously returned by customers) $12 98%] f [(1,600 units @ $13) 75%] g [(53 7) + (1,547 8)] h [10% ((1,200 units @ $10) + (1,600 units @ $13))]
b

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Chapter 13

B.

Culture Music Income Month of October

Company Statement

Net Sales ($8,400 + $12,000 + $20,800 $636 $155) $40,409 Cost of goods sold ($4,900 $371 + $9,300 + $12,747) 26,576 Gross profit 13,833 Operating expenses: Warranty expense $3,280 Doubtful accounts expense 344 Other operating expenses 2,500 6,124 Income before taxes 7,709 Provision for income taxes ($7,709 35%) 2,698 Net income $ 5,011 C. $616 Cost of goods sold under: Sale #1 Sale #2 Return Sale #3 Total FIFO $4,900 $9,300 ($371) $12,747 $26,576 LIFO (700 @ $8) 5,600 ($424) (1,200 @ $8) 9,600 (1,600 @ $8) 12,800 27,576 Excess of LIFO expense over FIFO expense $ 1,000 Reduction in income before tax $ 1,000 Reduction in taxes due (35%) (350) Reduction in net income if LIFO is used $ 650 D. $350 The only change in cash flow if LIFO is used instead of FIFO is the cash paid for taxes, which results in $350 additional cash from operations. This assumes, of course, that the same accounting method is used for financial reporting as for preparing the tax return.

Operating Activities

153

P13-9 A.
Accounts 1 Debits Credits A +6,300 9,000 +6,300 60,000 60,000 60,000 20,000 20,000 100,000 10,300 100,000 10,300 10,300 5,960 5,960 5,960 +20,000 100,000 = L+ OE CC + RE 9,000

2 3 4 5 6 7

Sales Returns 9,000 a Merchandise 6,300 Accounts Receivable Cost of Goods Sold Accounts Payable 60,000 Merchandise No entry necessaryb Warranty Expense 20,000c Warranty Obligations Service Contracts 100,000 Accounts Receivable Sales Returns 10,300 Allowance for Returns Doubtful Accounts Expense 5,960 Allowance for Doubtful Accounts
a b

9,000 6,300

Based on a 30% gross profit ($9,000 70% = $6,300 cost of goods sold) Title to the goods transferred at the shipping point. Therefore, the goods were correctly included as part of last years ending inventory. $75,000 $55,000 = $20,000

B.

$248,440 Schedule: Net sales $1,835,7001 Service contracts 692,0002 Total revenue Cost of goods sold Less: Operating expenses: Wages $ 537,3004 Rent 60,0004 Advertising 282,0004 Doubtful accounts 5,960 Depreciation 26,8004 Warranties 75,0005 Total operating expenses Operating income
1 2

$2,527,700 1,292,2003

987,060 $ 248,440

[$1,855,000 ($9,000 + $10,300 sales returns)] ($792,000 $100,000) 3 ($1,298,500 $6,300) 4 (no change) 5 ($55,000 + $20,000)

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P13-10 A.

Method A = Weighted-average Method B = FIFO Method C = LIFO NOTE: No computations are necessary to answer this part of the problem. Because prices are rising, LIFO will yield the highest cost of goods sold (and lowest ending merchandise inventory). FIFO yields the opposite result, and weighted-average, by the very nature of its name will yield a result in between LIFO and FIFO. Based on this alone, it is determined that Method A is weighted-average, Method B is FIFO, and Method C is LIFO. Merchandise Cost of Method A: Weighted average Inventory Goods Sold March 11 sale 73,500 73,500 [($90,000 + $36,000) 12,000 = $10.50] [$10.50 7,000 units] Method B: FIFO March 11 sale (7,000 @ $10) Merchandise Cost of Inventory Goods Sold 70,000 70,000

B.

Merchandise Cost of Method C: LIFO Inventory Goods Sold March 11 sale (3,000 @ $12) + (4,000 @ $10) 76,000 76,000 P13-11 A. Units Sold 20,000 24,000 Revenue 20,000 $55 = $1,100,000 24,000 $55 = $1,320,000 Cost of Goods Sold 20,000 $36 = $720,000 20,000 $36 = $720,000 2,000 $34 = $68,000 2,000 $32 = $64,000 $852,000 20,000 $36 = $720,000 2,000 $34 = $68,000 2,000 $32 = $64,000 4,000 $23 = $92,000 $944,000 20,000 $36 = $,720,000 2,000 $34 = $,68,000 2,000 $32 = $,64,000 4,000 $23 = $,92,000 8,000 $22 = $,176,000 $1,120,000 Gross Profit $380,000 $468,000 Gross Profit per Unit $19.00 $19.50

28,000

28,000 $55 = $1,540,000

$596,000

$21.29

36,000

36,000 $55 = $1,980,000

$860,000

$23.89

Operating Activities

155

B.

To minimize the effect of taxes: produce 36,000 units If Rousseau produced 36,000 units during the current year, it would report gross profit of $684,000. (Sales of $1,980,000 from the table in Part A less production costs of $1,296,000 [36,000 $36]). All units sold would have the highest possible cost of $36 each, which would minimize gross profit. To maximize the effect of taxes: produce 20,000 units By producing only 20,000 units, Rousseau would be forced to sell off all its beginning inventory which has a lower cost basis than current production. This would maximize gross profit and taxes at $860,000 (sales of $1,980,000 less beginning inventory of $400,000 less this years production costs of $720,000).

C.

Gross profit can be adjusted by controlling the number of units produced during the current year. The more units produced (up to 36,000), the lower gross profit will be because of the layers of beginning inventory. As production decreases below 36,000, units from beginning inventory will be included in cost of goods sold, increasing gross profit. One type of standard that would prevent this type of manipulation would be a requirement that all units of inventory be reported at their replacement cost at the end of the fiscal year. Adjusting the inventory value to its current cost would eliminate the disparity in unit costs for different levels of inventory observed in this problem. Or, of course, a standard could require the use of FIFO. Current Methods $12,000,000 3,500,000 1,200,000 3,000,000 7,700,000 4,300,000 1,290,000 $ 3,010,000 Alternate Methods $12,000,000 4,300,000 1,700,000 3,000,000 9,000,000 3,000,000 900,000 $ 2,100,000

P13-12 A. Sales revenue Cost of goods sold Depreciation expense Other expenses Total operating expenses Pretax income Income taxes Net income B.

The only cash flow effect of the choice in accounting methods is the effect on income taxes. Net cash flow from operating activities would be $390,000 higher ($1,290,000 $900,000) if the alternate methods were used for tax purposes than if the current methods were used.

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P13-13 A.

Sold = 5,200 units Ending inventory = 900 units Proof: Beginning units in inventory Purchase Purchase Total units available for sale Less: units sold (4,000 + 1,200) Ending inventory 1,000 3,500 1,600 6,100 5,200 900 Periodic $65,400 $ 9,000

B. Cost of Goods Sold Ending inventory

Perpetual $63,800 $10,600

Proof of perpetual system amounts (cost is determined separately for each sale): Cost of goods sold: First sale: 3,500 units @ $12 = $42,000 + 500 units @ $10 = 5,000 4,000 units sold = $47,000 Second sale: 1,200 units @ $14 = 16,800 Cost of goods sold = $63,800 Ending inventory: 500 units @ $10 (remaining after first sale) 400 units @ $14 (remaining after second sale) $ 5,000 5,600 $10,600

Proof of periodic system amounts (cost is determined only at the end of year): Cost of goods sold: Under LIFO, the cost of goods sold is the cost of the 5,200 units most recently purchased September 12 1,600 units @ $14 = $22,400 March 15 3,500 units @ $12 = 42,000 January 1 100 units @ $10 = 1,000 Total cost of goods 5,200 units sold $65,400 Ending inventory: 900 units @ $10 = $9,000 C. Net income when the perpetual method is used would be: Sales Revenue $ 85,000 Cost of Goods Sold (63,800) Other Expenses (5,600) Net Income $ 15,600 (continued)

Operating Activities

157

Net income when the periodic method is used would be: Sales Revenue $ 85,000 Cost of Goods Sold (65,400) Other Expenses (5,600) Net Income $ 14,000 For the two methods, net income differs by $1,600 and is lower if the periodic method is used. This happens because when determining the cost of goods sold, only the latest costs are used; i.e., the highest costs. If using the perpetual method, cost of goods sold is determined after each sale, and may include some of the earlier, lower costs. D. Advantages of the perpetual method are that more timely information is available. Also, if there are any inventory losses during the year, this can be determined by comparing the accounting records with a physical inventory. This comparison is not available if the periodic method is used. A disadvantage would be that the perpetual method is time consuming and more expensive to use. Advantages of the periodic method are that it is simpler and less expensive. The disadvantages would be that, as mentioned above, determination of inventory losses would not be possible as there would be nothing to which to compare a year-end physical inventory. Also, inventory information would not be timely.

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P13-14

Lawson Company Income Statement For the Year Ended December 31, 2007 (In millions) Sales revenue Cost of goods sold Gross profit Operating expenses: Selling expenses General and administrative expenses Total operating expenses Income from operations Other revenues and expenses: Interest expense Interest income Gain on sale of securities Income from continuing operations before taxes Provision for income taxes (35%) Income from continuing operations Discontinued operations (net of tax effect of $4.3) Extraordinary item (net of tax of $6.8) Cumulative effect of accounting change (net of tax effect of $1.4) Net income Earnings per share: Income from continuing operations Discontinued operations Extraordinary item Cumulative effect of accounting change Net income

$ 318.6 173.2 145.4 28.5 73.3 101.8 43.6 (10.0) 5.7 7.4 46.7 16.3 30.4 (8.0) 12.6 (2.6) $ 32.4 $ 12.16 (3.20) 5.04 (1.04) $ 12.96

P13-15 A.

B.

The gross profit on product sales is $806 million ($3,355 $2,549). On service sales, it is $1,010 million ($2,941 $1,931). Showing these separately allows creditors and other investors to evaluate these components of the company separately, comparing them with other industries engaged in sales of similar products or services. A provision for restructuring is the estimated cost of a plan that may involve elimination of certain products, closing of facilities, or selling off nonproductive assets. A discontinued segment may involve some of the same kinds of charges, but it involves closing an entire line of business, not just scaling back an existing line. The restructuring provision is in operating income because it involves the continuing business of the company. The discontinued segment, on the other hand, is presented separately because it would be of little help to the investor trying to predict the future of the entity. (continued)

Operating Activities

159

C. D.

E.

F.

G.

Yes, moving interest expense below would have made income from operations positive in 2008 and 2007, but not in 2006. Income taxes is a positive number because it represents savings from carrying the 2007 loss back (or forward) against the taxes from some former (or future) more profitable years. Worldwide may have received a refund of taxes from some previous years. The cumulative effect of a change in accounting principle is the effect that the new principle would have had on income had it always been used. This, too, is presented separately to allow the investor to see the normal impact of the years transactions. Income from operations probably assists more in assessing the future of the company. The discontinued operations have nothing to do with the future of the company; the accounting change is a onetime event. The discontinued segment and the change in accounting principle are presented net of tax in part to show the net impact of the event or change on the company. But, perhaps more important, this also means that the income tax line is associated only with the income from continuing operations. Thus it presents a more normal picture of the relationship between income and tax for this company. Pelican Income Statement Year Ended June 30, 2007 Sales revenue Service revenue Total operating revenues Cost of goods sold Gross profit Selling, general, and administrative expenses* Operating income Interest expense Interest revenue Loss on sale of old machinery Pretax income Income tax expense (30%) Income before extraordinary item Extraordinary gain on extinguishment of debt, net of $12 tax Net income (In Enterprises thousands) $ 6,930 3,382 10,312 3,660 6,652 2,727 3,925 (124) 44 (255) 3,590 1,077 2,513 28 $ 2,541

P13-16 A.

*General and administrative expenses = $1,224 + $102 + $546 + $855 = $2,727

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Earnings per share: Income before extraordinary Extraordinary gain Net income B.

$2.77 [($2,513 $21**) 900 shares] 0.03 [$28 900 shares] $2.80 [($2,541 $21) 900 shares]

**Preferred dividends = 7% $300 = $21 No. The closing entries have not been made because the revenue and expense accounts still have nonzero balances. Once the closing entries have been entered and processed, the revenue and expense accounts all have zero balances. $2,520 The first claim on net income is by the preferred stockholders. Their dividend claim must be satisfied before any resources (dividends) can flow to the common stockholders. Therefore, in this problem, the first $21,000 of net income is claimed by the holders of preferred stock ($300,000 7% = $21,000). Net income of $2,541,000 $21,000 = $2,520,000 is available to common stockholders.

C.

D.

Each of these stops along the income statement reports additional information that would not be available if all the information were just added together and a single number reported. When you start combining items and netting them against each other, eventually all you have left is one line titled net income. Readers of financial statements need more than just a single summary number. They want to know the components that made up net income. For example, they want to know the portion of income that was generated by operating activities (i.e., operating income) versus nonoperating activities and nonrecurring items (e.g., extraordinary items). As another example, gross profit is an important target that users evaluate because if a firm cant sell its goods at a price above cost, it doesnt matter how efficient the firm is in controlling its operating expenses. There will not be a profit. The income statement attempts to maximize the information provided without overwhelming the reader with minutiae and detail.

Operating Activities

161

P13-17

Sales revenue Cost of goods sold1 Doubtful accounts expense2 Depreciation expense3 Amortization expense4 Other operating expenses Interest expense Total expenses Income before taxes Income tax expense Income before cumulative effect of accounting change 116,622 Cumulative effect of accounting change net of tax savings of $374,000 (726,000) Net income (loss) $ (609,378) $ Earnings per share: Income before cumulative effect of accounting change $ 0.23 Cumulative effect of accounting change (1.45) Net income $ (1.22)
1

A. Minimum Net Income $13,680,000 3,930,000 400,000 2,348,300 120,000 6,245,000 460,000 13,503,300 176,700 60,078

B. Maximum Net Income $13,680,000 3,710,000 300,000 718,143 30,000 6,245,000 460,000 11,463,143 2,216,857 753,731 1,463,126 0 1,463,126

$2.93 0.00 $2.93

Cost of goods sold: LIFO: 150,000 units at $11.50 $1,725,000 210,000 units at $10.50 2,205,000 Cost of goods sold $3,930,000 FIFO: 140,000 units at $10.00 $1,400,000 220,000 units at $10.50 2,310,000 Cost of goods sold $3,710,000 2 Doubtful accounts expense: Maximum expense 4% $10 million = $400,000 Minimum expense 3% $10 million = $300,000 3 Depreciation expense: Maximum Double-declining balance over minimum life expense: $3,375,000 0.50 $1,687,500 $8,260,000 2 25 660,800 Depreciation expense $2,348,300 Minimum Straight-line over maximum life expense: $3,375,000 7 years $ 482,143 $8,260,000 35 years 236,000 Depreciation expense $ 718,143 4 Amortization expense for intangibles: Maximum expense: $1,200,000 10 years $ 120,000 Minimum expense: $1,200,000 40 years $ 30,000

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C.

The results of parts (a) and (b) suggest that one must be very careful when comparing the net incomes of two or more companies. The numbers (and comparisons) may be meaningless unless one is aware of the different accounting choices that were made in obtaining the numbers. NOTE: This is why GAAP require that the first note to the financial statements be a summary of significant accounting policies. This would be the first place to check on equivalence of accounting choices. Additional information about the effects of such choices can be found in the other notes. Merchandise was sold to customers at a price of $18,000. The cost to the seller of the merchandise sold was $14,600. Merchandise the company had purchased on credit for $33,000 was returned to the supplier. Cash was received from a customer in payment on account. The customer had been granted a 3% sales discount, probably for paying within a restricted number of days ($135 $4,500 = 3%). An $1,100 uncollectible account was written off against the allowance for doubtful accounts. The company paid $2,500 on its accounts payable. Goods that had been sold for $6,000 were returned by customers and put back into inventory for sale to others. The cost of the goods that the customers returned was $4,200. Production was completed on goods having a cost of $13,000. The cost of these goods was transferred out of Work-in-Process Inventory and placed in Finished Goods Inventory. The estimated cost of warranties granted on goods sold during the period was $15,750. That amount was recorded as expense and also added to the related liability account. The amount of sales returns that the company expects from goods sold this period is $8,300. It is likely that some of this periods credit sales or receivables will not be collected. The company estimates this at $3,740. At the end of the period, the cost of certain inventory items exceeds its market cost. Accordingly, a loss has been recognized to reduce the carrying cost of inventory.

P13-18 a. b. c. d. e. f. g. h. i. j. k.

Operating Activities

163

P13-19 A.

This disclosure reveals that Half Moon Inc. has an investment in the common stock of Able Company and that the size of the investment is sufficient to give Half Moon significant influence. The investment is not large enough for Half Moon to control Able Company, only to have significant influence. The $40,000 amount is Half Moons prorata share of Ables net income. For example, assume that Half Moon owns 25% of Able Company. This would mean that 25% of Ables net income was $40,000 and that Ables total net income for the period was $160,000 ($40,000 25% = $160,000). This disclosure reveals that Half Moon controls Baker Company. Usually this means that Half Moon owns a majority of Bakers common stock. Further, this disclosure reveals that Half Moon does not own all of Bakers common stock. There are one or more minority shareholders. Therefore, not all of the income earned by Baker Company can be claimed by Half Moon. Some of the earnings of Baker Company are claimed by other holders of Baker Company stock: the minority shareholders. Therefore, a portion of Baker Companys earnings must be deducted from net income. If Baker Company had suffered a loss during the period, the minority share of loss would have been added. Projected benefit obligation: The amount of pension benefits earned by employees as of the balance sheet date. Fair value of plan assets: The market value of assets that Half Moon has set aside to provide the benefits that have been promised. Pension liability: The difference between the companys obligation for pension benefits that employees have earned to date and the fair value of assets that have been put aside to meet that obligation. The company is obligated to make up any shortfall between benefits promised and the assets set aside to fund them. Service cost: The amount of pension benefits that employees have earned during the current fiscal period. Return on plan assets: The earnings during the current fiscal period on pension plan assets that have been set aside previously. Net pension expense: The cost of the pension plan to the company during the period.

B.

C.

D.

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P13-20

The Inventory of August 31, 2007

Book Webster's

Wermz Dictionary

FIFO Basis
Cost of Goods Sold Date Purchased 12-Apr-07 3-May-07 24-Jul-07 Totals Units Available Cost per Unit 245 $27.00 360 29.00 1000 32.00 1605 Units 245 360 842 1447 Cost $ 6,615.00 10,440.00 26,944.00 $43,999.00 Ending Inventory Units 0 0 158 158 Cost $5,056.00 $5,056.00

LIFO Basis
Cost of Goods Sold Date Purchased 12-Apr-07 3-May-07 24-Jul-07 Totals Units Available 245 360 1000 1605 Cost per Unit $27.00 29.00 32.00 Units 87 360 1000 1447 Cost $ 2,349.00 10,440.00 32,000.00 $44,789.00 Ending Inventory Units 158 0 0 158 Cost $4,266.00 $4,266.00

Tax Savings from LIFO LIFO Cost $ 44,789.00 FIFO Cost 43,999.00 $ 790.00 Tax Rate 0.35 Tax Savings $ 276.50 If 545 units were purchased in April and the May purchase cost $31.00 per unit: FIFO Basis
Cost of Goods Sold Date Purchased 12-Apr-07 3-May-07 24-Jul-07 Totals Units Available 545 360 1000 1905 Cost per Unit $27.00 31.00 32.00 Units 545 360 542 1447 Cost $14,715.00 11,160.00 17,344.00 $43,219.00 Ending Inventory Units 0 0 458 458 Cost $14,656.00 $14,656.00

(continued)

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LIFO Basis
Cost of Goods Sold Date Purchased 12-Apr-07 3-May-07 24-Jul-07 Totals Units Available 545 360 1000 1905 Cost per Unit $27.00 31.00 32.00 Units 87 360 1000 1447 Cost $ 2,349.00 11,160.00 32,000.00 $45,509.00 Ending Inventory Units 458 0 0 458 Cost $12,366.00 $12,366.00

Tax Savings from LIFO LIFO Cost $45,509.00 FIFO Cost 43,219.00 $ 2,290.00 Tax Rate 0.35 Tax Savings $ 801.50 P13-22 1 d CASES C13-1 A. About 72% ($765 million out of $1,063 million total) of General Mills inventories were valued at LIFO at May 30, 2004. The LIFO reserve at that date is $41 million; the prior year reserve was $27 million. Note 6 indicates LIFO decreased 2004 earnings by $0.02 per share and had a negligible impact on fiscal 2003 and 2002 earnings. The allowance for doubtful accounts declined from $28 million in 2003 to $19 million in 2004. The ratio of year-end allowance to sales is 0.3% ($28 10,506 = 0.003) and 0.2% ($19 11,070 = 0.002) for 2003 and 2004, respectively. Thus, the allowance for bad debts has declined as a percentage of sales. From the statement of cash flows, we learn that General Mills recorded depreciation and amortization of $399 million. This, however, does not represent a cash outlay. Depreciation and amortization were deducted from revenues in determining net income, but involved no cash flow. Therefore, these expenses were added back when calculating cash flow from operating activities. The company recorded $508 million in interest expense, as reported on the 2004 Consolidated Statements of Earnings. However, note 13 indicated cash payments for interest totaled $490 in 2004. 2 a 3 b 4 b 5 a 6 c 7 b 8 a 9 b 10 b 11 a 12 c 13 b

B.

C.

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Chapter 13

C13-2 (NOTE: There are many different solution approaches that students might take. The discussion and numerical information provided below are illustrative. The most important lesson of this case is that different accounting procedures and methods lead to different results, even when the underlying economic circumstances are the same. Failure to understand the effects of these differences can lead to poor decisions.) While a superficial review of the respective income statements seems to show that Moonbeam was the more successful and profitable firm, the notes to the financial statements indicate there is apples-and-oranges accounting involved. The two companies have used different accounting methods and procedures to prepare their respective income statements. Therefore, a direct comparison of the bottom lines (net income) may not be very useful. To better understand and compare the results of the two companies, it is necessary to apply the same accounting methods and procedures to each firm. That step is particularly appropriate here because the two firms operate in the same industry, sell the same products, and have many of the same customers. While either firms income statement might be held constant and the other modified to conform using the same accounting methods, it probably makes the most sense here to hold Sunlights income statement constant and modify Moonbeams. This is because at least two of Moonbeams accounting choices are questionable. First, Moonbeam recorded no allowances for sales discounts or sales returns. Some might believe it laudable that they preferred not to make any estimate rather than a poor one. At the same time, however, the amounts are unlikely to be zero and even a rough estimate is probably better than none. Second, Moonbeams revenue recognition procedure is suspect. It recognizes revenue when an order is received. This is highly unusual. The more common (and acceptable) practice is to recognize revenue when the goods are shipped (or delivered) to customers. On two other choices, Moonbeam simply made different estimates. Regarding uncollectible accounts, Moonbeam thought they would be low; Sunlight thought they would be higher. Regarding warranty costs, Moonbeam thought they would be immaterial, Sunlight thought differently. With the companies being in the same line of business, selling the same products, and having many of the same customers, it is hard to understand how their estimates could be so different. Maybe management of Sunlight is just more cautious and conservative by nature. Nevertheless, these differences in accounting choice have caused the financial statements to tell incomparable stories. If Moonbeams income statement is restated using the same methods and procedures as used by Sunlight, it would appear as follows in column c on the following page. (continued)

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Income Statements for Year 2007 Sales revenue* Cost of goods sold** Gross profit Operating expenses: Depreciation Insurance Supplies Uncollectible accounts*** Warranties**** Wages Total operating expenses Operating income Interest expense Pretax income Income tax expense Net income Earnings per share Proofs of restated items *Sales revenue:

(a) Sunlight Inc. $ 31,000 20,000 $ 11,000 1,100 550 1,300 1,240 620 1,500 6,310 4,690 900 3,790 1,298 $ 2,492 $ 1.25

(b) Moonbeam (as reported) $ 31,000 18,600 $ 12,400 1,100 610 1,300 310 -01,570 4,890 7,510 900 6,610 2,314 $ 4,296 $ 2.15

(c) Moonbeam (restated) $ 26,542 16,700 $ 9,842 1,100 610 1,300 1,240 620 1,570 6,440 3,402 900 2,502 876 $ 1,626 $ 0.81

Originally $31,000 Less: allowance for sales discounts 113 allowance for sales returns 1,345 goods not qualifying as a sale (100 units @ $30) 3,000 Restated sales revenue $26,542 **Cost of goods sold: Originally $18,600 Less: cost of goods not sold ($100 units @ $19) 1,900 Restated cost of goods sold $16,700 *** Uncollectible accounts expense: Assumed similar to Sunlight's since Moonbeam sells to the same customers. ****Warranty expense: Assumed similar to Sunlights since Moonbeam sells the same products. When the financial results of the two companies are prepared using the same set of assumptions, a very different picture appears. It is Sunlight Incorporated that is the more profitable firm (at least during the first year). In fact, it is half again as profitable as Moonbeam ($2,492 versus $1,626), even without changing Moonbeams cost of goods sold to the LIFO method. This illustrates the importance of the choices that management makes when applying accounting procedures and methods. It also illustrates the importance of the notes to the financial statements. To read the financial statements of these two firms without reading the notes might lead one to a faulty conclusion.