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Galilee College

Accounting Principles II Course No. ACC 112

Galilee Corporate Centre • Joe Farrington Road P.O. Box EE 16507 - Nassau, Bahamas – Tel. (242)364-1776 Fax (242)364-1778 Email: [email protected] www.gcollege.org

Accounting Principles II 1 TABLE OF CONTENTS

Chapter 12: Partnerships Chapter 13: Corporations: Paid-in Capital and the Balance Sheet Chapter 14: Retained Earnings, Treasury Stock, and the Income Statement Chapter 15: Long-term Liabilities Chapter 16: Investments and International Operations Chapter 17: The Statement of Cash Flows Chapter 18: Financial Statement Analysis Chapter 19: Introduction to Management Accounting Chapter 20: Job Costing Chapter 21: Process Costing Chapter 22: Cost-Volume-Profit Analysis Chapter 23: The Master Budget and Responsibility Accounting Chapter 24: Flexible Budgets and Standard Costs Chapter 25: Activity-Based Costing and Other Cost Management Tools Chapter 26: Special Business Decisions and Capital Budgeting

Accounting Principles II 2 Chapter 12: Partnerships

Objectives

1. Identify the characteristics of a partnership

2. Account for the partners’ investments in a partnership

3. Allocate profits and losses to the partners

4. Account for the admission of a partner to the business

5. Account for a partner’s withdrawal from the firm

6. Account for the liquidation of a partnership

7. Prepare partnership financial statements

Characteristics of a Partnership:

Partnership agreement - A contract between partners that specifies such items as: (1) the name, location, and nature of the business; (2) the name, capital investment, and duties of each partner; and (3) how profits and losses are to be shared.

Limited life - Life of a partnership is limited by the length of time that all partners continue to own a part of the business. When a partner withdraws from the partnership the partnership must be dissolved.

Mutual agency - Every partner can bind the business to a contract within the scope of the partnership’s regular business operations.

Unlimited personal liability - When a partnership can not pay its debts with the business’ assets, the partners must use their own personal assets to pay off the remaining debt.

Co-ownership of property - All assets that a partner invests in the partnership become the joint property of all the partners.

No partnership income taxes - The partnership is not responsible to the payment of income taxes on the net income of the business. Since the net income is divided among the partners, each partner is personally liable for the income taxes on their share of the business’ net income.

Partners owners equity accounts - Each partner has their own capital and withdraw account.

Accounting Principles II 3 Initial Investment by Partners:

The Asset accounts will be debited for what the partners invests into the partnership and any Liabilities assumed by the partnership from the partners will be credited. Each partner will have their own capital account and it will be credited for the amount that they invested. The journal entry will look similar to the entry below.

Cash Amount invested Asset MV of assets contributed Liabilities MV of liabilities assumed by the partnership Partner A, Capital Total Investment by A Partner B, Capital Total Investment by B

Sharing of Profits and Losses:

The profits or losses are allocated to each partner based on a fraction or percentage stated in the partnership agreement. If there is no method mention in the agreement for the division of profits and losses then they are to be allocated equally to each partner.

Journal entry to record the allocation of Net Income based on percentage:

Income Summary Net Income Partner A, Capital Net Income x 45% Partner B, Capital Net Income x 55%

Accounts would be reversed if the partnership had a Net Loss instead of a Net Income.

Allocation of Net Income based on the capital contributions of the partners:

Step 1: Add the capital account balances for all the partners together to find the total capital of the business

Partner A, Capital $22800 Partner B, Capital 34200 Total Capital $57000

Step 2: Divide each partner’s capital balance by the total capital to find each partner’s investment percentage

Partner A, Capital $22800 (Account Balance) / $57000 (Total Capital) = 40% Partner B, Capital 34200 (Account Balance) / 57000 (Total Capital) = 60%

Step 3: Allocate the net income or loss to each partner by multiplying their investment percentage to the amount of net income or loss

Accounting Principles II 4 Partner A’s share $70000 (Net Income) x 40% = $28000 Partner B’s share 70000 (Net Income) x 60% = 42000 Total $70000

Step 4: Now enter the Journal Entry.

Income Summary $70000 Partner A, Capital $28000 Partner B, Capital 42000

Allocation of Net Income based on Salary allowances and Interest percentage:

Step 1: Allocate Net Income between the partners, as below.

Step 2: Enter amounts in journal entry

Income Summary $96000 Partner A, Capital $51200 Partner B, Capital 44800

Recording the withdraws made by partners:

Accounting Principles II 5 Partner A, Withdraws Amount withdrawn Partner B, Withdraws Amount withdrawn Cash (or other asset) Total withdrawn

Admission of New Partners:

By the purchasing of an existing partners interest:

The new partner gains admission by buying an existing partner’s capital interest with the approval of all other partners. In this situation, the existing partner's capital balance is simply transferred to the new partner's capital account.

Old Partner, Capital Capital balance of old partner New Partner, Capital Capital balance of old partner

By investing into the partnership:

Case 1: The new partner invests assets into the business and receives a capital interest in the partnership that is less than the total market value of the investment. In this case, part of the new partner's investment is given to the existing partners as a bonus.

Step 1: Determine the bonus to the old partners

Partnership capital of existing partners $xxxxx New partner’s investment xxxxx Total partnership capital including new partner $xxxxx New partner’s capital interest (total capital x partnership %) xxxxx Bonus to existing partners (total cap. - new partner) $xxxxx

Step 2: Allocate bonus to existing partners based on percentage

Bonus to existing partners $xxxxx Partner A’s share (Bonus x partnership %) xxxxx Partner B’s share (Bouns x partnership %) xxxxx

Step 3: Record journal entry

Cash Amount invested Partner C, Capital New partner’s interest Partner A, Capital Partner’s share of bonus Partner B, Capital Partner’s share of bonus

Case 2: The new partner invests assets into the business and receives a capital interest that is more than the market value of the assets invested. In this case the existing partners must transfer part of their capital balances to the new partner's account

Accounting Principles II 6 Step 1: Determine the bonus for the new partner

Partnership capital of existing partners $xxxxx New partner’s investment xxxxx Total partnership capital $xxxxx New partner’s capital interest (total part. Cap. x partnership %) xxxxx Bonus to new partner (total cap. - new partner’s interest) $xxxxx

Step 2: Allocate the new partner’s bonus to the old partners

Bonus to new partner $xxxxx Partner A’s share (Bonus x partner's %) xxxxx Partner B’s share (Bonus x partner's %) xxxxx

Step 3: Record journal entry

Cash Amount invested Partner A, Capital Partner’s share of bonus Partner B, Capital Partner’s share of bonus Partner C, Capital Capital interest received

Revaluation of assets before the withdraw of a partner:

If the value of the assets went down:

Partner A, Capital Loss x partner's % Partner B, Capital Loss x partner's % Partner C, Capital Loss x partner's % Asset Amount of Loss in asset value

If the value of the assets went up:

Asset Amount of Gain in asset value Partner A, Capital Gain x partner's % Partner B, Capital Gain x partner's % Partner C, Capital Gain x partner's %

Withdraw of a partner from the business:

Partner withdraws receiving an amount equal to their capital balance:

Accounting Principles II 7 Partner C, Capital Capital balance Cash (or asset received) Amount received

Partner withdraws receiving an amount less than their capital balance:

Partner C, Capital Capital balance Cash Amount received Partner A, Capital Difference x partner's % Partner B, Capital Difference x partner's %

Note: The difference between what the leaving partner receives and what their capital balance was is treated as a bonus to the remaining partners paid by the leaving partner.

Partner withdraws receiving an amount more than their capital balance:

Partner C, Capital Capital balance Partner A, Capital Difference x partner's % Partner B, Capital Difference x partner's % Cash Amount received

Note: The difference between what the leaving partner receives and what their capital balance was is treated as a bonus to the leaving partner paid by the remaining partners.

Steps in the Liquidation of a Partnership:

Step 1: Sell all of the noncash assets - any gain or loss recognized is split between the partners

Journal Entry:

Cash Amount received Noncash Assets Book Value of assets Partner A, Capital Gain x partner’s % Partner B, Capital Gain x partner’s %

Note: If there was a loss on the sale of the noncash assets, then the partner’s capital account would have been debited for their share of the loss instead of credited.

Step 2: Pay off all partnership liabilities.

Journal Entry:

Liabilities Amount owed Cash Amount owed

Step 3: Distribute the remaining cash to the partners.

Accounting Principles II 8 Journal Entry:

Partner A, Capital Partner’s Capital balance Partner B, Capital Partner’s Capital balance Cash Total cash paid to partners

Note: If there was not enough cash to pay off the liabilities, then the partners would have been responsible for investing more cash into the partnership so that the liabilities could be paid off. Below is an example of the journal entry needed to record the additional investment by the partners.

Journal Entry:

Cash Amount of additional cash needed Partner A, Capital Amount Partner A invested Partner B, Capital Amount Partner B invested

The information needed to complete the entries for these steps can be obtained from a liquidation worksheet like the one shown below.

Liquidation Summary Worksheet:

EXERCISE 12-1

Adam Meppen and Bailey Quaid form a partnership, investing $40,000 and $70,000, respectively.

Accounting Principles II 9 Required:

Determine their shares of net income or net loss for each of the following situations:

a. Net loss is $52,000, and the partners have no written partnership agreement.

b. Net income is $77,000, and the partnership agreement states that the partners share profits and losses on the basis of their capital contributions.

c. Net loss is $33,000, and the partnership agreement states that the partners share profits on the basis of their capital contributions.

d. Net income is $98,000. The first $60,000 is shared on the basis of partner capital contributions. The next $30,000 is based on partner service, with Meppen receiving 30% and Quaid receiving 70%. The remainder is shared equally.

PROBLEM 12-1

Rudy Trump, Monica Rivers, and Courtney Jetta have formed a partnership. Trump invested $20,000; Rivers, $40,000; and Jetta, $60,000. Trump will manage the store, Rivers will work in the store three-quarters of the time, and Jetta will not work.

Required:

1. Compute the partners' shares of profits and losses under each of the following plans:

a. Net income is $87,000, and the articles of partnership do not specify how profits and losses are shared.

b. Net loss is $47,000, and the partnership agreement allocates 45% of profits to Trump, 35% to Rivers, and 20% to Jetta. The agreement does not discuss the sharing of losses.

c. Net income is $104,000. The first $50,000 is allocated on the basis of salaries of $34,000 for Trump and $16,000 for Rivers. The remainder is allocated on the basis of partner capital contributions.

d. Net income for the year ended September 30, 20X4, is $86,000. The first $30,000 is allocated on the basis of partner capital contributions, and the next $30,000 is based on service, with $20,000 going to Trump and $10,000 going to Rivers. Any remainder is shared equally.

2. Revenues for the year ended September 30, 20X4, were $572,000, and expenses were $486,000. Under plan (d), prepare the partnership income statement for the year.

Accounting Principles II 10 Chapter 13: Corporations: Paid-in Capital and the Balance Sheet

Objectives

1. Identify the characteristics of a corporation

2. Record the issuance of stock

3. Prepare the stockholders’ equity section of a corporation’s balance sheet

4. Account for cash dividends

5. Use different stock values in decision making

6. Evaluate a company’s return on assets and return on stockholders’ equity

7. Account for the income tax of a corporation

Characteristics of Corporations:

Separate legal entity - a corporation is a distinct entity that exists apart from its owners (stockholders)

Accounting Principles II 11 Continuous life - the life of the corporation continues regardless of changes in the ownership of the corporation’s stock

No mutual agency - a stockholder can not commit the corporation to a contract unless they are also on officer in the corporation.

Limited liability of stockholders - stockholders have no personal obligation for the corporation’s liabilities. The most the stockholders can lose is the amount they invested in the corporation.

Separation of ownership & management - stockholders own the business, but the board of directors manage the business.

Corporate taxation - corporate income is subject to double taxation. Once at the corporate level and then at the stockholder’s level.

Government regulation - corporations are subject to government regulation mainly to ensure that corporations disclose all information that investors and creditors need to have to make informed decisions.

Stockholder’s Equity:

Stockholder’s equity consists of two basic sources:

1. Paid in Capital - investments received from stockholders thru the issuance of stock 2. Retained Earnings - capital that the corporation has earned from operations

Issuance (Sale) of Stock:

If the stock was issued for par:

Cash Number of shares x Par value Common (or Preferred) Stock Number of shares x Par Value

If the stock was issued for more than par:

Cash Number of shares x Sales price Common (or Preferred) Stock Number of shares x Par Value Paid in Capital in excess of par, Common (or Preferred) Difference

If the stock has no par value:

Accounting Principles II 12 Cash Number of shares x Sales price Common Stock Number of shares x Sales price

Note: If the stock has no par value, but does have a stated value, then the stock is recorded in the same manner as par value stock. Any excess capital received above the stated value of the stock is credited to "Paid in Capital in excess of stated value, Common"

If stock is issued for noncash assets:

In addition to issuing stock for cash, a company can issue stock in exchange for other noncash assets like equipment, buildings, and land. When stock is issued for noncash assets, the assets received are debited for their current market value and the stock is credited at its par value (or stated value). If the market value of the assets received is more than the par value of the stock issued, then the difference is credited to the "Paid in Capital in excess of Par, Common" account.

Asset Market Value Common Stock Number of shares x Par value Paid in Capital in excess of Par, Common Difference

Recording Cash Dividends:

The declaration of a cash dividend:

Retained Earnings Total Dividends Dividends Payable, Preferred Preferred Dividends Dividends Payable, Common Common Dividends

The payment of cash dividends:

Dividends Payable, Preferred Preferred Dividends Dividends Payable, Common Common Dividends Cash Total Dividends

Preferred Stock Dividends:

The amount of dividends that are paid to preferred stockholders is determined by Preferred Stock’s dividend preference which is stated as a percentage or as a dollar amount.

6% preferred stock - means that preferred stockholders will receive an annual dividend of 6% of the par value of the stock

Accounting Principles II 13 $6 preferred stock - means that preferred stockholders will receive an annual dividend of $6 for each share of stock

Cumulative Preferred Stock - when preferred stock is cumulative then the preferred stockholders will have dividends in arrears anytime in which their full annual dividend is not paid by the corporation. When this happens the unpaid dividend (dividends in arrears) will be carried forward to the next year until they are paid. Preferred stockholders must receive all dividends for the current year and any dividends in arrears for prior years before the corporation can pay any dividends to the common stockholders.

Allocating Dividends to Preferred and Common:

Total Dividends Declared $xxxx Preferred Stock: Annual Preferred Dividend $xxxx Dividends in Arrears xxxx Total Preferred Stock Dividends xxxx (Can not exceed the total dividends) Common Stock: Total Common Stock Dividends $xxxx (Any remaining dividends)

Calculating Book Value per share:

Book Value - amount of owner’s equity on the corporation’s books for each share of its stock

Redemption Value - a set price that a corporation is required to pay to redeem (retire) the preferred stock from the stockholders

Liquidation Value - the amount a corporation agrees to pay preferred stockholders for each share of stock they own if the corporation liquidates.

Calculating the Book Value for both Preferred and Common Stock is a two step process.

Step 1: Calculate Preferred Stock’s Equity

Redemption (or Call) Value # of shares x Redemption price Cumulative dividends Dividends in arrears Stockholders equity allocated to Preferred Stock Total Book Value per share Total PS Equity / # of shares

Step 2: Calculate Common Stock’s Equity

Total Stockholder’s Equity Total equity Less equity allocated to PS Total PS Equity

Accounting Principles II 14 Equity allocated to Common Stock Remainder allocated to CS Book Value per share Total CS equity / # of shares

Financial Analysis Ratios:

Rate of Return on Assets - represents a company’s success in using its assets to earn income

Average Total Assets is equal to the sum of the beginning and ending total assets for the year divided by 2.

Rate of Return on Equity -

Average Common Stock Equity is equal to the sum of the beginning and ending common stock equity (excluding preferred stock's equity) for the year divided by 2.

Accounting for Income Taxes:

Income Tax Expense = Income before income tax (from Income Statement) x Income tax rate

Income Tax Payable = Taxable income (from tax return) x Income tax rate

Since the income used to calculate the Income Tax Expense and Income Tax Payable for the year are obtained from different statements, the amount will not always be the same. Because of this, another account is needed in order to keep track of the difference between these two accounts. The account is titled "Deferred Tax Liability."

Journal entry to record Income taxes:

Income Tax Expense Taxes on Income Statement Income Tax Payable Taxes on Tax return Deferred Tax Liability Difference Difference

NOTE: In the event that the taxes on the tax return are more than the taxes on the Income Statement, the Deferred Tax Liability would be debited for the difference instead of credited.

EXERCISE 13-1

Gene Shattler, Inc., has the following selected account balances at June 30, 20X2:

Inventory...... $112,0000 Common stock, no-par with

Accounting Principles II 15 Machinery and equipment...... 109,000 $1 stated value, 100,000 Preferred stock, 5%, $20 par, shares authorized and issued...... $100,000 20,000 shares authorized, Accumulated depreciation C 5,000 shares issued...... 100,000 machinery and equipment...... 62,000 Paid-in capital in excess of Retained earnings ...... 119,000 par C preferred stock...... 88,000 Cost of gods sold...... 81,000

Required:

Prepare the stockholders' equity section of the company's balance sheet.

PROBLEM 13-1

Eastern Seaboard Airline Corporation has 5,000 shares of 5%, $10 par value preferred stock and 100,000 shares of $1.50 par common stock outstanding. During a three-year period, Eastern Seaboard declared and paid cash dividends as follows: 20X1, $1,500; 20X2, $15,000; and 20X3, $23,000.

Required:

1. Compute the total dividends to preferred stock and to common stock for each of the three years if:

a. preferred is noncumulative.

b. preferred is cumulative.

2. For case (1.b.) record the declaration of the 20X3 dividends on December 22, 20X3, and the payment of the dividends on January 14, 20X4.

Accounting Principles II 16 Chapter 14: Retained Earnings, Treasury Stock, and the Income Statement

Objectives

1. Account for stock dividends

2. Distinguish stock splits from stock dividends

3. Account for treasury stock

4. Report restrictions on retained earnings

5. Identify the elements of a complex income statement

6. Prepare a statement of stockholders’ equity

Income Statement format:

Multi-Step with Earnings Per Share:

Revenues ...... $xxx,xxx Cost of Goods Sold ...... xxx,xxx Gross Margin ...... xxx,xxx Operating Expenses ...... xxx,xxx Operating Income ...... xxx,xxx Other Gains (losses) ...... xxx,xxx Income from continuing operations before income tax ...... xxx,xxx

Accounting Principles II 17 Income Tax Expense (for continuing operations) ...... xxx,xxx Income from continuing operations ...... xxx,xxx Discontinued Operations ...... xxx,xxx Income before extraordinary items and cumulative effect of change in accounting methods ...... xxx,xxx Extraordinary Items ...... xxx,xxx Cumulative effect of change in accounting methods ...... xxx,xxx Net Income ...... $xxx,xxx

Earnings per share of common stock

Income from continuing operations ($ amount / shares) ...... $x.xx Income from discontinued operations ($ amount / shares) ...... x.xx Income before extraordinary items and cumulative effect of change in accounting methods ($ amount / shares) ...... x.xx Extraordinary Item ($ amount / shares) ...... x.xx Cumulative effect of change in accounting methods ...... x.xx Net Income ($ amount / shares) ...... $x.xx

Earning Per Share:

EPS = (Net Income - Preferred Dividends)/Weighted Average number of common shares outstanding

Weighted Average number of Common Shares Outstanding:

Number of Fraction Weighted Average Common Shares X of = Number of Common Outstanding Year Shares Outstanding

Income Statement format:

Single Step

Revenues and Gains: Sales Revenue ...... $xxx,xxx Gains ...... xx,xxx Total revenues and gains ...... xxx,xxx Expenses and Losses: Cost of goods sold ...... $xxx,xxx Selling expenses ...... xx,xxx General expenses ...... xx,xxx Interest expense ...... xx,xxx Losses ...... xx,xxx

Accounting Principles II 18 Income tax expense ...... xx,xxx Total expenses and losses ...... xxx,xxx Income from continuing operations ...... xx,xxx Discontinued operations Operating Income less income tax ...... xx,xxx Loss (Gain) on sale of discontinued operations less income tax ...... xx,xxx xx,xxx Income before extraordinary items and cumulative effect of change in accounting methods ...... xx,xxx Extraordinary items less income tax ...... xx,xxx Cumulative effect of change in accounting method less income tax ...... x,xxx Net Income ...... $ xx,xxx

Earnings per share: Income from continuing operation ($ Amt / shares) ...... $x.xx Income from discontinued operations ($ Amt / shares) ...... x.xx Income before extraordinary items and cumulative effect of change in accounting methods ($ Amt / shares) ...... x.xx Extraordinary item ($ Amt / shares) ...... x.xx Cumulative effect of change in accounting methods ($ Amt / shares) ...... x.xx Net Income ($ Amt / shares) ...... $x.xx

Stock Dividends:

Small Stock dividend (less than 25%)

Journal Entry on Date of Declaration:

Retained Earnings Shares x Market Value Common Stock Dividend Distributable Shares x Par Value Paid-In Capital in Excess of Par, Common Excess (MV - PV)

Journal Entry on Date of Distribution:

Common Stock Dividend Distributable Par Value Common Stock Par Value

Large Stock dividend (25% or more)

Journal Entry on Date of Declaration:

Retained Earnings Shares x Par Value Common Stock Dividend Distributable Shares x Par Value

Accounting Principles II 19 Journal Entry on Date of Distribution:

Common Stock Dividend Distributable Par Value Common Stock Par Value

Treasury Stock Transactions:

Purchase of Treasury Stock

Treasury Stock, Common Shares x Cost/share Cash Shares x Cost/share

Resale of Treasury Stock at cost:

Cash Shares x Cost/share Treasury Stock, Common Shares x Cost/share

Resale of Treasury Stock above cost: The gain received on the resale of the stock is entered in the Paid in capital account for the treasury stock.

Cash Shares x Sales Price Treasury Stock, Common Shares x Cost/share Paid In Capital from Treasury Stock transactions Excess

Resale of Treasury Stock below cost: The loss on the resale of the stock is first absorbed by any Paid in Capital from previous sales above cost. Once the Paid in Capital has been exhausted, then any remaining loss is deducted from the Retained Earnings account.

Cash Shares x Sales Price Paid In Capital from Treasury Stock transactions Amount up to prior balance Retained Earnings Excess loss Treasury Stock Shares x Cost/share

EXERCISE 14-8

Beauvette Corporation’s accounting records include the following for 20X3:

Sales revenue...... $410,000 Operating expenses (including income tax)...... 106,000 Cumulative effect of change in

Accounting Principles II 20 depreciation method (debit)...... (7,000) Cost of goods sold...... 245,000 Loss on discontinued operations...... 50,000 Income tax expense C extraordinary gain...... 6,000 Income tax saving C change in depreciation method...... 3,000 Income tax saving C loss on discontinued operations...... 20,000 Extraordinary gain...... 15,000

Required:

Prepare a multiple-step income statement for 20X3. Omit earnings per share. Was 20X3 a good year, a fair year, or a bad year for Beauvette Corporation? Explain your answer in terms of the outlook for 20X4.

EXERCISE 14-11

Light Crust, Inc., a bakery, reported a prior-period adjustment in 20X3. An accounting error caused net income of prior years to be overstated by $3.8 million. Retained earnings at December 31, 20X2, as previously reported, stood at $395.3 million. Net income for 20X3 was $111.9 million, and dividends totaled $39.8 million.

Required:

Prepare the company's statement of retained earnings for the year ended December 31, 20X3.

EXERCISE 14-12

The Parisian Hotel Company, a large hotel chain, had retained earnings of $413 million at the beginning of 20X7. The company showed these figures at December 31, 20X7:

($ Millions) Net income...... $141 Cash dividends C preferred...... 2 common...... 85 Decrease in retained earnings due to retirement of preferred stock...... 11

Required:

Accounting Principles II 21 Beginning with net income, prepare a combined statement of income and retained earnings for The Parisian Hotel Company for 20X7.

Chapter 15: Long-term Liabilities

Objectives

1. Account for basic bonds payable transactions by the straight-line amortization method

2. Amortize bond discount and premium by the effective-interest method

3. Account for retirement of bonds payable

4. Account for conversion of bonds payable

5. Show the advantages and disadvantages of borrowing

6. Account for lease liabilities and pension liabilities

Assume the following: A corporation's bond indenture provides for the issuance of $100,000 of bonds for a term of five years. The bonds carry a coupon (a/k/a stated or contract) rate of 10%. The bonds are issued on January 1, which is the same as the date of the bonds, and will pay interest every six months on July 1 and January 1 of each year.

Journal entries related to the issuance of these bonds at FACE VALUE, and to the payment and / or accrual of Bond Interest Expense for the first year of the bond issue:

Cash 100,000

Accounting Principles II 22 If the market rate of interest Bonds Payable 100,000 EQUALS the coupon rate: The bonds are issued at face value. The carrying value through out the life of the bonds will be $100,000. On the July 1 interest payment date: Bond Interest Expense 5,000 Cash 5,000 Note that the amount of cash paid is equal to [Face X Coupon Rate ÷ 2].

(This entry assumes that no adjusting entries for bond interest expense have been made.) On December 31 (the end of the reporting Bond Interest Expense 5,000 year): Bond Interest Payable 5,000 Note that the credit to the liability account Bond Interest Payable is equal to [Face X Coupon Rate ÷ 2]. On the January 1 interest payment Bond Interest Payable 5,000 date: Cash 5,000

Journal entries related to the issuance of bonds at a DISCOUNT, and the payment and / or accrual of Bond Interest Expense:

If the market rate of interest is Cash 96,000 GREATER than the coupon rate: Bond Discount 4,000 Bonds Payable 100,000 The bonds are issued at "96" or 96% of the total face value of the bond issue. The $4,000 difference between the Bonds Payable account (the amount which will be repaid to the bondholders at maturity) and the Cash received is debited to the account Discount on Bonds Payable, or simply Bond Discount. Bond Discount is a CONTRA account which is presented as a reduction to the Bonds Payable account on the balance sheet.

The balance is the Bond Discount account is amortized over the life of the bonds on each interest payment date as an INCREASE to Bond Interest Expense. The carrying value through out the life of the bonds is equal to the balance in the Bonds Payable account LESS the unamortized balance in the Bonds Discount account. i.e. the carrying value of the bonds begins at $96,000 at issuance and rises with each amortization until the Bond Discount is fully amortized (the Bonds Discount balance is ZERO) and the carrying value of the bonds is $100,000. On the July 1 interest payment date: Bond Interest Expense 5,400 Bond Discount 400 Cash 5,000 Note that the amount of cash paid is equal to [Face X Coupon Rate ÷ 2]. HOWEVER, bond interest expense is equal to the cash paid PLUS the discount amortized.

Accounting Principles II 23 (This entry assumes that no adjusting entries for bond interest expense have been made.)

The carrying value of the bonds is now $96,400. On December 31 (the end of the Bond Interest Expense 5,400 reporting year): Bond Discount 400 Bond Interest Payable 5,000 Note that the credit to the liability account Bond Interest Payable is equal to [Face X Coupon Rate ÷ 2]. Again, bond interest expense is equal to the cash paid PLUS the discount amortized.

The carrying value of the bonds is now $96,800. On the January 1 interest payment date: Bond Interest Payable 5,000 Cash 5,000

Journal entries related to the issuance of bonds at a PREMIUM, and the payment or accrual of Bond Interest Expense:

If the market rate of interest is Cash 104,000 LESS than the coupon rate: Bond Premium 4,000 Bonds Payable 100,000 The bonds are issued at "104" or 104% of the total face value of the bond issue. The $4,000 difference between the Bonds Payable account (the amount which will be repaid to the bondholders at maturity) and the Cash received is credited to the account Premium on Bonds Payable, or simply Bond Premium. Bond Premium is an ADJUNCT account which is presented as an addition to the Bonds Payable account on the balance sheet.

The balance in the Bond Premium account is amortized over the life of the bonds on each interest payment date as a DECREASE to Bond Interest Expense. The carrying value through out the life of the bonds is equal to the balance in the Bonds Payable account PLUS the unamortized balance in the Bond Premium account. i.e. the carrying value of the bonds begins at $104,000 at issuance and falls with each amortization until the Bond Premium is fully amortized (the Bonds Premium balance is ZERO) and the carrying value of the bonds is $100,000. On the July 1 interest payment date: Bond Interest Expense 4,600 Bond Premium 400 Cash 5,000 Note that the amount of cash paid is equal to [Face X Coupon Rate ÷ 2]. HOWEVER, bond interest expense is equal to the cash paid LESS the premium amortized.

Accounting Principles II 24 (This entry assumes that no adjusting entries for bond interest expense have been made.)

The carrying value of the bonds is now $103,600. On December 31 (the end of the Bond Interest Expense 4,600 reporting year): Bond Premium 400 Bond Interest Payable 5,000 Note that the credit to the liability account Bond Interest Payable is equal to [Face X Coupon Rate ÷ 2]. Again, bond interest expense is equal to the cash paid LESS the premium amortized.

The carrying value of the bonds is now $103,200. On the January 1 interest payment Bond Interest Payable 5,000 date: Cash 5,000

EXERCISE 15-5

Assume Network Navigator Corp. is authorized to issue $500,000 of 7%, ten-year bonds payable. On January 2, when the market interest rate is 8%, the company issues $300,000 of the bonds and receives cash of $279,615. Network Navigator measures interest expense by the effective-interest method.

Required:

1. Prepare an amortization table for the first four semiannual interest periods.

2. Record the first semiannual interest payment on June 30 and the second payment on December31.

EXERCISE 15-6

On September 30, 20X2, the market interest rate is 7%. Lemon-Blake Software, Inc., issues $200,000 of 8%, 20-year bonds payable at 110 5/8. The bonds pay interest on March 31 and September 30. Lemon-Blake Software measures interest expense by the effective-interest method.

Required:

1. Prepare an amortization table for the first four semiannual interest periods.

Accounting Principles II 25 2. Record issuance of the bonds on September 30, 20X2, the accrual of interest at December 31, 20X2, and the semiannual interest payment on March 31, 20X3.

Chapter 16: Investments and International Operations

Objectives

1. Account for trading investments

2. Account for available-for-sale investments

3. Use the equity method for investments

4. Understand consolidated financial statements

5. Account for long-term investments in bonds

6. Account for transactions stated in a foreign currency

Short-Term Investments SFAS 115 Investments in Debt Securities i. Classify as held-to-maturity ii. Measured at amortized cost in Balance sheet, if a. if there is positive intent & ability to hold to maturity

MARKETABLE EQUITY SECURITY: (Trading or Available-for-Sale) 1. Trading securities (held principally for sale in the near term) i. Report at Fair Value ii. Recognize in earnings unrealized holding gains and losses

2. Available-for-Sale Securities – (Measured at FV on Balance Sheet)  Not expected to be sold in the near term (Noncurrent Asset)

Accounting Principles II 26 i. FV Hedge – Recognize in earnings unrealized holding gains and losses (FV vs. Cost) ii. Non-FV Hedge - Recognize in OCI unrealized holding gains and losses (FV vs. Cost) - Dr. J’s Note: Unless it’s indicated that these are FV Hedge, assume Non- FV and recognize in OCC. - OCI accumulates amounts, and it is a CONTRA SHE account. - Net Income is effected only if there is a realized Gain or Loss iii. If transfer as Held-to-Maturity, continue to report unrealized gain/loss in OCI  BUT, amortize similar to premium or discount * This amortization offsets or mitigate the effect on interest income of the amortization of premium or discount.  Fair Value Accounting may result in a premium or discount whn a debt security is transferred to the held-to-maturity category. iv. If transfer as Trading Security , recognize to earning any unrealized holding g/l v. If write down to FV because of permanent decline, do not reverse if increases occur - Increases will be reported as OCI Investments in Bonds

 If Market Rate increase over Yield Rate – Price of bond will decrease = discount  If Market Rate Decrease over Yield Rate – Price of bond will increase = premium  Discount means that the bonds have decline in Fair Value  Premium means that the bonds have increased in Fair Value

Note: 1. When bond is purchased at a premium its initial carrying value is greater than the maturity value 2. When bond is purchased at a discount its initial carrying value is less than the maturity value

Cash Paid (Premium) Investor pays more than the face value of bonds Premium xx FV of Bonds xx Interest Expense 1since last interest) xx

Cash xx Cash Paid (Discount) Investor pays less than the face value of bonds Interest Expense (since last interest) xx FV of Bonds xx Discount xx Cash xx Note: Carrying value is always higher when purchase at a premium, because the premium is extras that you pay, whereas, the discount is a reduced amount. Please Remember!

Accounting Principles II 27  Effective Interest Method Interest Revenue = (CV at Beg. Of period x yield (int. rate)  Straight-line Method Interest Revenue is equal during the life of the bond, which reduces Carry value faster)

Sinking Funds Sinking fund – To segregate and accumulate assets to pay bond liability  The fund is increased by revenue earned (interest and dividend)  The fund is increased by additional deposits  The fund is decreased by any administration cost

1. If amounts will be accumulated over a period of time, the calculation is (Desired amount divided by the future value of an annuity ordinary/advance)

Equity Method

1. Equity Method - Investor can exercise significant influence over investee  20% or greater  <20% if significant influence is present  If cost is at beg. Of year and additional share is not equity, treat at equity from beginning of year.  >50% by one company = consolidated F/S, unless control is temporary

Entries

Earnings: Dividends Investment xx Cash xx Earnings xx Investment xx 2. Cumulative Preferred Dividend must be deducted whether or not paid 3. Change in fair value has no effect on investment 4. Cash Dividends received decreases investment carrying value = Equals Return of investment  Goodwill = (Cost price – purchase price)

Cost Method  Investments less than 20% should be recorded at original cost  Intercompany receivables should be recorded in full and separately - Eliminated only if ownership increase and entities consolidate.  Dividends are not liabilities until declared.  Liquidating Dividend reduces carrying value of investment (return of investment)

Accounting Principles II 28 Entries

Earnings: Dividends No Entry Cash xx Dividend Income xx

Chapter 17: The Statement of Cash Flows

Objectives

1. Identify the purposes of the statement of cash flows

2. Report cash flows from operating, investing, and financing activities

3. Prepare a statement of cash flows by the direct method

4. Compute the cash effects of a wide variety of business transactions

5. Prepare a statement of cash flows by the indirect method

Accounting Principles II 29 Accounting Principles II 30 Accounting Principles II 31 Accounting Principles II 32 Accounting Principles II 33 PROBLEM 17-1

The comparative balance sheet of Fortis Software Co. at December 31, 20X5, reported the following:

December 31, 20X5 20X4 Current assets: Cash and cash equivalents...... $10,600 $15,500 Accounts receivable...... 28,600 29,300 Inventories...... 51,600 53,000 Prepaid expenses...... 4,200 3,700

Current liabilities: Notes payable (for inventory purchases)...... $ 9,200 $ -0- Accounts payable...... 21,900 28,000 Accrued liabilities...... 11,000 16,800

Fortis’s transactions during 20X5 included the following:

Amortization expense...... $ 5,000 Payment of cash dividends...... 7,000 Cash acquisition of equipment...... 55,000 Issuance of long-term note payable to borrow cash...... 32,000 Retirement of bonds payable by issuing common stock..... 55,000 Cash acquisition of building...... 124,000 Net income...... 28,600 Insurance of common stock for cash...... 105,600 Stock dividend...... 13,000 Sale of long-term investment ...... 6,000 Depreciation expense...... 15,000

Required:

1. Prepare the statement of cash flows for Fortis Software for the year ended December 31, 20X5. Use the indirect method to report cash flows from operating activities. Report noncash investing and financing activities in an accompanying schedule.

2. Evaluate Fortis Software’s cash flows for the year. Mention all three categories of cash flows, and give the reason for your evaluation.

Accounting Principles II 34 PROBLEM 17-2

The 20X3 comparative income statement and comparative balance sheet of Zurich Telecom, Inc., follow:

ZURICH TELECOM, INC. Income Statement for 20X3

Revenues: Sales revenue...... $427,000 Interest revenue...... 11,700 Total revenues...... 438,700 Expenses: Cost of goods sold...... $205,200 Salary expense...... 76,400 Depreciation expense...... 15,300 Other operating expense...... 49,700 Interest expense...... 24,600 Income tax expense...... 16,900 Total expenses...... 388,100 Net income...... $ 50,600

Zurich Telecom had no noncash investing and financing transactions during 20X3. During the year, there were no sales of land or equipment, no issuances of notes payable, no retirements of stock, and no treasury stock transactions.

Accounting Principles II 35 PROBLEM 17-2 Continued

ZURICH TELECOM, INC. Comparative Balance Sheet

December 31, Increase 20X3 20X2 (Decrease) Current assets: Cash and cash equivalents ...... $ 8,700 $ 15,600 $ (6,900) Accounts receivable...... 35,500 43,100 (7,600) Interest receivable...... 600 900 (300) Inventories...... 94,300 89,900 4,400 Prepaid expenses...... 1,700 2,200 (500) Plant assets:...... Land...... 35,100 10,000 25,100 Equipment, net...... 100,900 93,700 7,200 Total assets...... $276,800 $255,400 $21,400 Current liabilities: Accounts payable...... $ 16,400 17,900 $ (1,500) Interest payable...... 6,300 6,700 (400) Salary payable...... 2,100 1,400 700 Other accrued liabilities...... 18,100 18,700 (600) Income tax payable...... 6,300 3,800 2,500 Long-term liabilities: Notes payable...... 55,000 65,000 (10,000) Stockholders= equity: Common stock, no-par...... 131,100 122,300 8,800 Retained earnings...... 41,500 19,600 21,900 Total liabilities and stockholders= equity...... $276,800 $255,400 $ 21,400

Required:

1. Prepare the 20X3 statement of cash flows, formatting operating activities by the direct method.

2. How will what you learned in this problem help you evaluate an investment?

Accounting Principles II 36 Chapter 18: Financial Statement Analysis

Objectives

1. Perform a horizontal analysis of financial statements

2. Perform a vertical analysis of financial statements

3. Prepare common-size financial statements

4. Compute the standard financial ratios

5. Use ratios in decision making

6. Measure economic value added

Financial Statement Analysis:

Horizontal Analysis - This type of analysis studies the changes in the items on the financial statement, in both dollar amount and as percentages, for successive accounting periods. The earliest year is known as the "base year". The base year amounts are what is used to get your percentages.

Amount of change (in dollars) Percent of Change = ------Amount for the base year

Steps in performing a Horizontal Analysis:

Step 1: Compute the dollar amount of change from the base year to the next year by subtracting the base year amount.

Step 2: Compute the percent of change from the base year, using the formula shown above.

Example:

Income Statement Increase (Decrease) 2000 1999 Amount Percent ($) (%) Net Sales 102,500 77,500 25,0001 32.3%2 Cost of Goods Sold 61,500 50,375 11,125 22.1% Gross Profit 41,000 27,125 13,875 51.2% Operating Expenses 27,100 12,125 14,975 123.5% Net Income 13,900 15,000 (1,100) (7.33%)

Accounting Principles II 37 1 ($102,500 - 77,500) = $25,000 2 ($25,000 / 77,500) = 0.3225 = 32.3%

A Horizontal Analysis can also be done for a series of years using "trend percentages." The trend percentages are computed by selecting a year to serve as the base year, usually the earliest year. Then the amounts for every other year are divided by the base year amounts to get a percentage. The percentages for the base year will always be 100%.

Example:

Income Statement 2000 1999 1998 1997 Net Sales 15,065 13,767 11,984 10,571 Cost of Goods Sold 3,965 3,637 3,122 2,717 Gross Profit 11,100 10,130 8,862 7,854 Operating Expenses 8,225 5,310 4,714 3,654 Net Income 2,875 4,820 4,148 4,200

After the amounts are converted to percentages, the Income Statement will look like the one below.

Income Statement 20001 1999 1998 1997 Net Sales 142.5% 130.2% 113.4% 100% Cost of Goods Sold 145.9% 133.9% 114.9% 100% Gross Profit 141.3% 129.0% 112.8% 100% Operating Expenses 225.1% 145.3% 129.0% 100% Net Income 68.5% 114.8% 98.8% 100%

1 Calculations for 2000 15,065 / 10,571 = 1.4251 = 142.5% 3,965 / 2,717 = 1.4593 = 145.9% 11,100 / 7,854 = 1.4132 = 141.3% 8,225 / 3,654 = 2.2509 = 225.1% 2,875 / 4,200 = 0.6845 = 68.5% Vertical Analysis: This type of analysis reveals the relationship of each financial statement item to the base amount. For the Income Statement, the "Net Sales" is used as the base amount and all other items are expressed as a percentage of Net Sales. For the Balance Sheet, the "Total Assets" is used as the base amount.

Accounting Principles II 38 Examples:

Income Statement Amount Percentage1 Net Sales $193,000 100% Cost of Goods Sold 50,759 26.3% Gross Profit $142,241 73.7% Operating Expenses 90,903 47.1% Net Income $51,338 26.6%

1 Calculations to find percentages 193,000 / 193,000 = 1.000 = 100% 50,759 / 193,000 = 0.263 = 26.3% 142,241 / 193,000 = 0.737 = 73.7% 90,903 / 193,000 = 0.471 = 47.1% 51,338 / 193,000 = 0.266 = 26.6%

Balance Sheet Amount Percentage Assets Cash $1,681 11.4% Receivables 2,651 18.1% Inventory 1,669 11.4% ¦ ¦ ¦ Total Assets $14,685 100% Liabilities Account Payable $2,125 14.5% Wages Payable 3,100 21.1% Total Liabilities $5,225 35.6% Owner's Equity Capital 9,460 64.4% Total Liabilities & $14,685 100% Owner's Equity

Accounting Principles II 39 Calculating Financial Ratios:

Measuring a company's ability to pay its current liabilities

1) Working Capital = Current Assets - Current Liabilities

Example: Current Assets are $153,598 and Current Liabilities are $75,935

Working Capital = $153,598 - 75,935 = $77,663

2) Current Ratio = Current Assets / Current Liabilities

This ratio shows the company's ability to pay its current liabilities using their current assets. A ratio of 2.0 or better is considered to be good.

Example: Using same information from the previous example

Current Ratio = $153,598 / 75,935 = 2.02

3) Acid-Test (Quick) Ratio = (Cash + ST Investments + Net Current Receivables) / Current Liabilities

This ratio shows the company's ability to pay its current liabilities if they were to become due immediately. A ratio of 0.9 to 1.0 is considered average.

Example: Cash is $23,975, Short Term Investments are $35,000, Net Current Receivables are $27,800 and Current Liabilities are $75,935.

Acid-Test Ratio = ($23,975 + 35,000 + 27,800) / 75,935 = 86,775 / 75,935 = 1.14 Measuring a company's ability to sell inventory and collect receivables:

1) Inventory Turnover = Cost of Goods Sold / Average Inventory

Shows the number of times a company sells its average inventory during the year. To calculate the average inventory add the beginning and ending inventory balances together and then divide by two. The Inventory Turnover is dependent on the type of business. Businesses (like a grocery store) that sell perishable goods should have a much higher turnover than businesses (like a car dealership) that sells nonperishable goods.

Example: Inventory on December 31, 1999 is $145,000, Inventory on December 31, 2000 is $130,000, and Cost of Goods Sold is $325,000.

Inventory Turnover = $325,000 / [(145,000 + 130,000) / 2]

Accounting Principles II 40 = 325,000 / [275,000 / 2] = 325,000 / 137,500 = 2.36

2) Accounts Receivable Turnover = Net Credit Sales / Average Net Accounts Receivable

Shows a company's ability to collect cash from its credit customers. The average Net Accounts Receivable is calculated the same way as the average inventory was above, (Beginning A/R + Ending A/R) / 2. Generally the higher the turnover the better.

Example: Net Credit Sales were $450,000, Accounts Receivable on December 31, 1999 was $57,900, and Accounts Receivable on December 31, 2000 was $43,876.

Accounts Receivable Turnover = $450,000 / [(57,900 + 43,876) / 2] = 450,000 / [101,776 / 2] = 450,000 / 50,888 = 8.84

3) Days Sales in Receivables = Average Net Accounts Receivable / (Net Sales / 365)

Shows the number of days in which Sales remain in the Accounts Receivable. The lower the number, the better off a company's cash flow will be.

Example: Using the same information from the previous example.

Days Sales in Receivables = [(57,900 + 43,876) / 2] / (450,000 / 365) = [101,776 / 2] / 1232.8767 = 50,888 / 1232.8767 = 41.276 = 41 days

Measuring a company's ability to pay Short and Long Term Debt:

1) Debt Ratio = Total Liabilities / Total Assets

Shows the percentage of the assets which are financed by debt. You do not want this ratio to get too high. A high debt ratio could lead to trouble for the company.

Example: Total Liabilities are $56,000 and Total Assets are $278,500

Debt Ratio = 56,000 / 278,500 = 0.2011 = 20.11%

Accounting Principles II 41 2) Times Interest Earned Ratio = Income from Operations / Interest Expense

Shows the number of times Operating Income can be used to cover the company's Interest Expense. A ratio of 2.0 to 3.0 is considered to be average.

Example: Income from Operations is $120,000 and Interest Expense is $19,500

Times Interest Earned Ratio = $120,000 / 19,500 = 6.15 Measuring a company's profitability:

1) Rate of Return on Net Sales = Net Income / Net Sales

Shows the percentage of each Sales dollar that is earned as Net Income.

Example: Net Income for the year was $111,300 and Net Sales were $1,020,500.

Rate of Return on Net Sales = $111,300 / 1,020,500 = 0.1091 = 10.91%

2) Rate of Return on Assets = (Net Income + Interest Expense) / Average Total Assets

Shows how profitably a company has used its assets.

Example: Net Income for the year is $111,300, Interest Expense is $19,500, Total Assets on December 31, 1999 was $675,000, and Total Assets on December 31, 2000 was $750,000.

Rate of Return on Assets = ($111,300 + 19,500) / [(675,000 + 750,000) / 2] = 130,800 / [1,425,000 / 2] = 130,800 / 712,500 = 0.1836 = 18.36%

3) Rate of Return on Common Stockholders Equity = (Net Income - Preferred Dividends) / (Average Common Stockholders Equity)

Shows how much income was earned with the common stockholder's investment.

Example: Net Income for the year is $111,300 , there are 25,000 shares of 5% Preferred Stock (par value $10) outstanding, Common Stockholder's Equity on December 31, 1999 is $514,000, and Common Stockholder's Equity on December 31, 2000 is $530,000.

First the Preferred Dividends must be calculated:

Accounting Principles II 42 25,000 shares * $10 par value * 5% = $12,500

Now the Rate of Return can be calculated:

Rate of Return on CS Equity = ($111,300 - 12,500) / [(514,000 + 530,000) / 2] = 98,800 / (1,044,000 / 2) = 98,800 / 522,000 = 0.1893 = 18.93%

4) Earnings per Share of Common Stock = (Net Income - Preferred Dividends) / Number of shares of Common Stock outstanding

Shows the Net Income for one share of common stock.

Example: Using the same information as in the previous example and the fact that there are 265,000 shares of common stock outstanding.

Earnings per Share of Common Stock = ($111,300 - 12,500) / 265,000 = 98,800 / 265,000 = $0.37 Measuring a company's stock as an investment:

1) Price/Earnings Ratio = Market Price per share / Earnings per share

This ratio gives you what the market price is for $1 of earnings.

Example: Using the Earnings per share calculated in the previous example and the fact that the current Market Price per share is $10.25

Price/Earning Ratio = $10.25 / $0.37 = 27.70

2) Dividend Yield = Dividends per share / Market Price per share

Shows the percentage of the market price returned to the stockholder's as a dividend.

Example: The current Market Price per share is $10.25 and the Dividends paid per share were $1.50

Dividend Yield = $1.50 / $10.25 = 0.1463 = 14.63%

Accounting Principles II 43 EXERCISE 18-1

The financial statements of Lambert Enterprises, Inc., include the following items:

Current Year Preceding Year

Balance sheet data: Cash...... $ 29,000 $ 22,000 Short-term investments...... 11,000 26,000 Net receivables...... 64,000 73,000 Inventory...... 87,000 71,000 Prepaid expenses...... 6,000 8,000 Total current assets...... 197,000 200,000 Total current liabilities...... 121,000 91,000

Income statement data: Net credit sales...... $480,000 Cost of goods sold...... 260,000

Required:

Compute the following ratios for the current year: (a) current ratio, (b) acid-test ratio, (c) inventory turnover, (d) accounts receivable turnover, and (e) days= sales in average receivables.

PROBLEM 18-1

Assume that you are considering purchasing an investment and have decided to invest in a company in the automotive supply business. You have narrowed the choice to Bowie, Inc., or Drane Corp. and have assembled the following data:

Selected income statement data for current year:

Bowie, Inc. Drane Corp. Net sales (all on credit)...... $497,000 $371,000 Cost of goods sold...... 258,000 209,000 Income from operations...... 138,000 79,000 Interest expense...... 19,000 C Net income...... 72,000 48,000

Selected balance sheet and market price data at end of current year:

Accounting Principles II 44 Bowie, Inc. Drane Corp. Current assets: Cash...... $ 19,000 $ 22,000 Short-term investments...... 18,000 20,000 Current receivables, net...... 46,000 42,000 Inventories...... 100,000 87,000 Prepaid expenses...... 3,000 2,000 Total current assets...... 186,000 173,000 Total assets...... 328,000 265,000 Total current liabilities...... 98,000 108,000 Total liabilities...... 131,000 * 108,000 * Preferred stock: 5%, $100 par...... 20,000 – Common stock, $1 par (10,000 shares)...... 10,000 $2 par (6,000 shares)...... 12,000 Total stockholders' equity...... 197,000 157,000 Market price per share of common stock...... $ 81.50 $ 40.00

*Notes payable: Bowie, Inc., $86,000 Drane Corp., $ 1,000

PROBLEM 18-1 Continued

Selected balance sheet data at beginning of current year:

Bowie, Inc. Drane Corp. Current receivables, net...... $ 48,000 $ 40,000 Inventories...... 88,000 93,000 Total assets...... 270,000 259,000 Preferred stock, 5%, $100 par...... 20,000 – Common stock, $1 par (10,000 shares)...... 10,000 $2 par (6,000 shares)...... 12,000 Total stockholders' equity...... 126,000 118,000

Accounting Principles II 45 Your investment strategy is to purchase the stocks of companies that have low price/earnings ratios but appear to be in good shape financially. Assume that you have analyzed all other factors, and your decision depends on the results of the ratio analysis to be performed.

Required:

1. Compute the following ratios for both companies for the current year, and decide which company's stock better fits your investment strategy:

a. Current ratio b. Acid-test ratio c. Inventory turnover d. Times-interest-earned ratio e. Return on common stockholders' equity f. Earnings per share of common stock g. Book value per share of common stock h. Price/earnings ratio

Accounting Principles II 46 Chapter 19: Introduction to Management Accounting

Objectives

1. Distinguish between financial accounting and management accounting

2. Describe the value chain and classify costs by value-chain function

3. Distinguish direct costs from indirect costs

4. Distinguish among full product costs, inventoriable product costs, and period costs

5. Prepare the financial statements of a manufacturing company

6. Identify major trends in the business environment, and use cost-benefit analysis to make business decisions

7. Use reasonable standards to make ethical judgments

Terms and Definitions:

Cost Object - anything for which a separate measurement of costs is desired

Direct Cost - a cost that can be specifically (directly) traced to a cost object

Indirect Cost - a cost that can not be specifically traced to a cost object

Period Cost - operating costs that are expensed in the period in which they are incurred

Product Cost - all costs relating to the manufacturing of a product that are regarded first as an asset and later expensed (Direct Materials, Direct Labor, and Manufacturing Overhead)

Direct Materials - materials that become a physical part of a finished product and whose costs are separately and conveniently traceable through the manufacturing process to a finished product.

Direct Labor - the compensation of employees who physically convert materials into the company's products; labor costs that are directly traceable to the finished products.

Manufacturing Overhead - all manufacturing costs other than direct materials and direct labor.

Prime Costs = Direct Materials + Direct Labor

Accounting Principles II 47 Conversion Costs = Direct Labor + Manufacturing Overhead

Differences between Product and Period Costs:

Product Costs Period Costs Costs that are initially recorded as an Costs that are expensed in the period asset and not expensed until the incurred and are never considered to inventory is sold be an asset Examples: Salaries of Office Examples: Purchases, Freight In, managers; Utilities, Insurance and Direct Materials, Direct Labor, Property taxes on executive offices; Manufacturing Overhead Advertising Expense

Calculating the Cost of Goods Manufactured:

Below is an example of the format used to calculate the Cost of Goods Manufactured

Schedule of Cost of Goods Manufactured Beginning Work In Process Inventory $38,000 Add: Direct Materials: Beginning Materials Inventory $22,000 Purchases of Direct Materials 78,000 Materials available for use 100,000 Ending Materials Inventory (28,000) Direct Materials used $72,000 Direct Labor 82,000 Manufacturing Overhead: Indirect Materials $15,000 Indirect Labor 9,000 Depreciation, Factory 16,000 Plant Utilities 2,900 Plant Insurance 13,100 Total Manufacturing Overhead costs 56,000 Total Manufacturing Cost 210,000 Total Manufacturing Costs to account for $248,000

Accounting Principles II 48 Less: Ending Work In Process Inventory (30,000) Cost of Goods Manufactured $218,000 EXERCISE 19-1

Required:

Compute the 20X5 cost of goods manufactured and cost of goods sold for Strike Marine Company using the following amounts:

Beginning End of Year of Year Materials inventory...... $22,000 $28,000 Work in process inventory...... 42,000 30,000 Finished goods inventory...... 18,000 25,000 Purchases of raw materials...... 78,000 Direct labor...... 82,000 Indirect labor...... 15,000 Insurance on plant...... 9,000 Depreciation C plant building and equipment...... 16,000 Repairs and maintenance C plant...... 4,000 Marketing expenses...... 77,000 General and administrative expenses...... 29,000 Income tax expense...... 30,000

EXERCISE 19-2

Required:

Prepare the 20X5 income statement for the Strike Marine Company in Exercise 19-1. Assume that it sold 28,000 units of its product at a price of $14 during 20X5.

Accounting Principles II 49 Chapter 20: Job Costing

Objectives

1. Distinguish between job costing and process costing

2. Account for materials and labor in a manufacturer’s job costing system

3. Account for manufacturing overhead in a manufacturer’s job costing system

4. Account for noninventoriable costs in job costing

Product Costing Approaches:

Process Costing - A system for assigning costs to large numbers of identical units that usually proceed in a continuous flow though a series of uniform production steps or processes. (Used when producing a continuous flow of similar units - Example: oil refinery)

Job Costing - A system for assigning costs to a specific unit or to a small batch of products or services that (1) proceeds through the production steps as a distinct identifiable job and (2) can vary considerably in terms of materials, labor, and overhead costs. (Used when producing different units for different jobs - Example: car manufacturer, construction company)

Journal entries to account for the different manufacturing costs:

Note: During this next section it might be helpful to refer back to the flowchart in the notes for Chapter 19, which shows how the costs flow between the different accounts for a manufacturing company.

Requisition of Materials into production:

When materials are introduced into production there are both direct and indirect materials used. The direct and indirect costs must be separated since they are accounted for with different accounts. The direct materials are transferred to the Work In Process Inventory while the indirect materials get transferred to the Manufacturing Overhead account.

General Journal Post. Date Accounts/Explanations Ref. Debit Credit Work In Process Inventory Direct Materials

Accounting Principles II 50 Indirect Manufacturing Overhead Materials Materials Inventory Total Materials Example: $11,000 of materials were requisitioned into production. $9,000 of which were direct materials.

General Journal Post. Date Accounts/Explanations Ref. Debit Credit Work In Process Inventory 9,000 Manufacturing Overhead 2,000 Materials Inventory 11,000

Labor costs incurred:

For a manufacturing company, when labor costs are incurred (or paid) the wages are debited to the Manufacturing Wages account instead of the Wages Expense account, as in a service business.

General Journal Post. Date Accounts/Explanations Ref. Debit Credit Manufacturing Wages Labor Costs Wages Payable (or Cash) Labor Costs

Example: The company has incurred total wages of $120,000 for the current period.

General Journal Post. Date Accounts/Explanations Ref. Debit Credit Manufacturing Wages 120,000 Wages Payable 120,000

Assignment of labor costs to production:

As with the materials used, labor costs used in production must also be separated into their direct and indirect cost components. These costs are then transferred out of the Manufacturing Wages and into the Work In Process Inventory (direct labor) or the Manufacturing Overhead (indirect

Accounting Principles II 51 labor) accounts.

General Journal Post. Date Accounts/Explanations Ref. Debit Credit Work In Process Inventory Direct Labor Manufacturing Overhead Indirect Labor Manufacturing Wages Total Labor

Example: $100,000 of labor costs are entered into production, $75,000 is direct and $25,000 is indirect.

General Journal Post. Date Accounts/Explanations Ref. Debit Credit Work In Process Inventory 75,000 Manufacturing Overhead 25,000 Manufacturing Wages 100,000

Accounting for other Manufacturing Overhead costs incurred:

In addition to indirect materials and indirect labor there are other costs that a manufacturing company incurs during the production process that can not be separated and assigned directly to a specific unit or product in a easy and cost-effective manner. Some of these costs include: Depreciation, Utilities, Insurance, and Property taxes on the factory. It is important to remember that these expenses must be on the factory facilities and not on the administrative offices. If the expenses are for the administrative offices, then the expenses are debited to their normal expense account (Depreciation Expense, Utilities Expense, etc. ).

General Journal Post. Date Accounts/Explanations Ref. Debit Credit Manufacturing Overhead Total OH costs Accumulated Depreciation, Depr. Exp Plant Accounts Payable (or Cash) Utilities costs Expired Prepaid Insurance Insurance Property Tax Payable Property Taxes

Accounting Principles II 52 Example: Expenses incurred for the plant were: Depreciation on the plant was $13,000; Insurance expired was $1,700; and Property Taxes to be paid are $4,200.

General Journal Post. Date Accounts/Explanations Ref. Debit Credit Manufacturing Overhead 18,900 Accumulated Depreciation, 13,000 Plant Prepaid Insurance 1,700 Property Tax Payable 4,200

Applying Overhead to production:

The overhead costs added to the Manufacturing Overhead account must now be applied to the units in the Work In Process Inventory. These overhead costs are applied by using a predetermined overhead rate. This rate is determined by dividing the total estimated overhead costs for the year by the estimated allocation base.

Predetermined Total estimated Manufacturing Overhead costs Manufacturing = ------Overhead Rate Estimated Allocation Base

Allocation Base - is a common denominator that links the indirect costs to the cost objects (products). Examples include: Direct Labor hours, Direct Labor costs, or Machine hours.

When overhead is applied, it is added (debited) to the Work In Process Inventory account and credited to the Manufacturing Overhead account.

General Journal Post. Date Account/Explanations Ref. Debit Credit Work In Process Inventory Applied OH Manufacturing Overhead Applied OH

Example: Manufacturing Overhead is applied based on the predetermined overhead rate of

Accounting Principles II 53 $2.50 per direct labor hour. Total direct labor hours for the period was 100,000 hours.

General Journal Post. Date Accounts/Explanations Ref. Debit Credit Work In Process Inventory 250,000 Manufacturing Overhead 250,000

Transferring of completed goods:

When the products are completed, their costs must be transferred from the Work In Process Inventory and into Finished Goods Inventory.

General Journal Post. Date Accounts/Explanations Ref. Debit Credit Cost of Finished Goods Inventory Units Work In Process Inventory Cost of Units

Sale of Goods:

Accounting for the sale of goods is the same for a manufacturing business as for a merchandising business. There are two journal entries that must be done. The first entry is to record the price that the products were sold for and the second entry is to record the cost of producing those units.

Example:

Accounting for Under-Applied and Over-Applied Overhead:

If the amount is considered to be insignificant, it is closed (transferred) to the Cost of Goods Sold account.

Accounting Principles II 54

If the amount is considered to be significant, then it must be allocated between the Work In Process Inventory, Finished Goods Inventory, and Cost of Goods Sold accounts. The amount of under-applied (or over-applied) overhead is allocated based on the account balances.

Ending

Balance Proration Overhead Allocated Amount Work in Process $120,000 120,000/1,245,000 * 50,000 = 4819 Finished Goods 375,000 375,000/1,245,000 * 50,000 = 15060 Cost of Goods 750,000 750,000/1,245,000 * 50,000 = 30121 Sold 1,245,000 50,000

Accounting Principles II 55 EXERCISE 20-1

Terra Nova, an environmental consulting firm, specializes in advising electric utilities on compliance with recent environmental regulations. Terra Nova uses a job cost system with a predetermined indirect cost allocation rate, computed as a percentage of expected direct labor costs.

At the beginning of 20X5, managing partner Jim Bladen prepared the following plan, or budget, for 20X5:

Direct labor hours (professionals)...... 16,000 hours Direct labor costs (professionals)...... $2,240,000 Office rent...... 350,000 Support staff salaries...... 860,000 Utilities...... 246,000

Northern Electric is inviting several consultants to bid for their work. Jim Bladen estimates that this job will require about 220 direct labor hours.

Required:

1. Compute Terra Nova’s (a) hourly direct labor cost rate, and (b) indirect cost allocation rate.

2. Compute the predicted cost of the Northern Electric job.

3. If Bladen wants to earn a profit that equals 20% of the job=s cost, how much should be bid for the Northern Electric job?

EXERCISE 20-2

At the end of the 20X4 fiscal year, SeaPro’s manufacturing records show the following unadjusted ending account balances:

Work in ProcessFinished Goods Cost of Inventory Inventory Goods Sold Direct materials...... $100,000 $170,000 $ 360,000 Direct labor...... 80,000 250,000 600,000 Manufacturing overhead..... 70,000 310,000 460,000 Total...... $250,000 $730,000 $1,420,000

Accounting Principles II 56 SeaPro’s accountants allocated overhead during the year using a predetermined rate of $48 per machine hour. At year end, they computed the actual rate of $52 per machine hour. The beginning balances of both Work in Process Inventory and Finished Goods Inventory were zero.

Required:

1. How many machine hours did SeaPro use in 20X4?

2. Was manufacturing overhead over or under allocated for the year? By how much?

3. Record the entry to close out the over or under allocated overhead.

PROBLEM 20-1

OneClick is a Web site design and consulting firm. The firm uses a job cost system, where each client is a different “job.” OneClick traces direct labor, licensing costs, and travel costs directly to each job (client). It allocates indirect costs to jobs based on a predetermined indirect cost allocation rate, computed as a percentage of direct labor costs.

At the beginning of 20X4, managing partner Lauren Pearle prepared the following budget:

Direct labor hours (professionals)...... 6,000 hours Direct labor costs (professional)...... $600,000 Support staff salaries...... 70,000 Computer leases...... 34,000 Office supplies...... 11,000 Office rent...... 35,000

In November 20X4, OneClick served several clients. Records for two clients appear here:

Planet Foods Deception Fragrances Direct labor hours...... 675 hours 20 hours Licensing costs...... $ 1,325 $125 Travel costs...... $10,500 C

Required: 1. Compute OneClick=s predetermined indirect cost allocation rate for 20X4. 2. Compute the total cost of each job. 3. If Pearle wants to earn profits equal to 30% of sales revenue, how much (what total fee) should she charge each of these two clients?

4. Why does OneClick assign costs to jobs?

Accounting Principles II 57 Chapter 21: Process Costing

Objectives

1. Distinguish between the flow of costs in process costing and job costing

2. Record process costing transactions

3. Compute equivalent units

4. Assign costs to units completed and to units in ending work in process inventory

5. Account for a second processing department by the FIFO method

6. Account for a second processing department by the weighted average method

Accounting Principles II 58 Accounting Principles II 59 Accounting Principles II 60 Accounting Principles II 61 EXERCISE 21-1

Silicon Semiconductors, Inc., experienced the following activity in its Photolithography Department during December. Materials are added at the beginning of the photolithography process.

Units: Work in process, November 30 (80% of the way through the process)...... 8,000 units Transferred in from Polishing and Cutting Department during December...... 27,000 units Completed during December...... 26,000 units Work in process, December 31 (70% of the way through the process)...... 9,000 units Costs: Work in process, November 30...... $ 60,116 Transferred in from Polishing and Cutting Department during December...... 97,200 Direct materials added during December...... 74,250 Conversion costs added during December...... 90,650

Required:

1. Draw a time line for the Photolithography Department using the FIFO method.

2. Use the time line to help you compute the number of equivalent units of work performed by the Photolithography Department during December. Use the FIFO method.

3. Compute the costs per equivalent unit, and assign total cost to (a) units completed and transferred to Finished Goods Inventory, and (b) units in December 31 work in process inventory.

EXERCISE 21-2

Required:

Repeat Exercise 21-1, using the weighted-average method. The November 30 balance of Work in Process Inventory – Photolithography Department ($60,116) is composed of the following amounts: transferred-in costs, $20,050; direct materials costs, $20,250; and conversion costs, $19,816.

Accounting Principles II 62 PROBLEM 21-1

Cox Carpeting manufactures broadloom carpet in seven processes: spinning, dyeing, plying, spooling, tufting, latexing, and shearing. First, fluff nylon purchased from a company such as DuPont or Monsanto is spun into yarn that is dyed the desired color. The threads of the yarn are joined together, or plied, for added strength. The plied yard is spooled for carpet making. Tufting is the process by which yarn is added to burlap backing. After the backing is latexed to hold it together and make it skid-resistant, the carpet is sheared to give it an even appearance and feel.

At March 31, before recording the transfer of costs out of the Dyeing Department, the Cox Carpeting general ledger included the following account for one of its lines of carpet:

Work In Process Inventory – Dyeing February 28 Balance 9,500 Transferred in from Spinning 23,520 Direct materials 11,760 Direct labor 8,455 Manufacturing overhead 42,900

In the Dyeing Department, direct materials (dye) are added at the beginning of the process. Conversion costs are incurred evenly throughout the process. Work in process inventory of the Dyeing Department on February 28 consisted of 75 rolls that were 50% of the way through the production process. During March, 560 rolls were transferred in from the Spinning Department. The Dyeing Department completed and transferred 500 rolls to the Plying Department in March, and 135 rolls were still in process on March 31. The ending inventory was 80% of the way through the dyeing process. Cox Carpeting uses FIFO process costing.

Required:

1. Prepare a time line for the Dyeing Department.

2. Use the time line to help you compute the equivalent units, cost per equivalent unit, and total costs to account for in the Dyeing Department for March.

3. Assign total Dyeing Department cost to (a) goods transferred from Dyeing to Plying, and (b) Work in Process Inventory – Dyeing on March 31.

Accounting Principles II 63 PROBLEM 21-2

Rule, Inc., manufactures auto roof racks in a two-stage process that includes shaping and plating. Steel alloy is the basic raw material of the shaping process. The steel is molded according to the design specifications of automobile manufacturers (Ford and General Motors). The Plating Department then adds an anodized finish.

At March 31, before recording the transfer of cost from the Plating Department to Finished Goods Inventory, the Rule general ledger included the following account:

Work In Process Inventory – Plating February 28 Balance 30,200 Transferred in from Shaping 36,000 Direct materials 24,200 Direct labor 21,732 Manufacturing overhead 35,388

The direct materials (rubber pads) are added at the end of the plating process. Conversion costs are incurred evenly throughout the process. Work in process of the Plating Department on February 28 consisted of 600 racks that were 30% of the way through the production process. During March, 3,000 racks were transferred in from the Shaping Department. The Plating Department transferred 2,200 racks to Finished Goods Inventory in March, and 1,400 were still in process on March 31. This ending inventory was 50% of the way through the plating process. Rule uses FIFO process costing.

Required:

1. Draw a time line for the Plating Department.

2. Use the time line to help you compute the equivalent units, cost per equivalent unit, and total costs to account for in the Plating Department for March.

3. Assign total Plating Department cost to (a) goods transferred out of the Plating Department and (b) Work in Process Inventory – Plating on March 31.

Accounting Principles II 64 Chapter 22: Cost-Volume-Profit Analysis

Objectives

1. Identify different cost behavior patterns

2. Use a contribution margin income statement to make business decisions

3. Compute breakeven sales and perform sensitivity analyses

4. Compute the sales level needed to earn a target operating income

5. Graph a set of cost-volume-profit relationships

6. Compute a margin of safety

7. Use the sales mix in CVP analysis

8. Compute income using variable costing and absorption costing

Definitions: Variable Costs (VC) - costs that change, in total, in direct proportion to changes in volume of activity Fixed Costs (FC) - costs that do not change, in total, despite changes in production level Mixed Costs (MC) - costs that have a variable part and a fixed part Contribution Margin (CM) - excess of sales revenue over variable expenses Contribution Margin Income Statement Format: Sales Revenue $1,000,000 $725,000 Variable Expenses:

Variable Manufacturing COGS $100,000 Variable Marketing Expenses 75,000

Variable Distribution Expenses 40,000 215,000 Contribution Margin $785,000 $510,000

Fixed Expenses: Fixed Manufacturing Expenses $200,000

Fixed Marketing Expenses 45,000 Fixed Distribution Expenses 65,000 310,000

Operating Income $475,000 $ 200,000

Accounting Principles II 65 Break-Even Analysis:

Break-Even Point - sales level at which operating income is zero. (Total Revenue = Total Expenses)

Formulas

Contribution Margin = Sales - Variable Costs

Contribution Margin Ratio = Contribution Margin Sales

Break-Even Point = Fixed Costs + Operating Income (In Units) CM per unit

Break-Even Point = Fixed Costs + Operating Income (In Dollars) CM ratio

Margin of Safety - is the excess of the expected Sales over the Break Even Sales

Formulas:

Margin of Safety = Expected Sales - Break Even Sales (Can be expressed in units or dollars)

Margin of Safety = Margin of Safety (As a %) Expected Sales

Sales Mix

Sales mix is used for finding break even sales when more than one product is produced or sold. The process of finding the break even point involves three steps.

Step 1 - Find the weighted average Contribution Margin per unit

Product A Product B Total Sales price per unit $10.00 $15.00 Deduct: Variable expense per unit 3.00 10.00 Contribution Margin per unit $ 7.00 $ 5.00 Sales mix in units 5 3 8 Contribution Margin $35.00 $15.00 $50.00 Weighted Average CM per unit $ 6.25 Step 2 - Find the Break Even Sales in total units

Accounting Principles II 66 Fixed Costs + Operating Income 7000 + 5500 Sales in total units = = = 2000 Weighted Average CM per unit 6.25

Step 3 - Find the Break Even Sales for each product

Sales Mix Break Even Total Units (as a fraction) Units Product A 2000 X 5/8 = 1250 Product B 2000 X 3/8 = 750 Total 2000

Sales mix fraction = Units of each Product / Total Units

Product Costing Methods

There are two methods of determining a products cost - the Absorption Costing method and the Variable Costing method. As you can see below the only difference between the two methods is in how the Fixed Manufacturing Overhead (MOH) is treated. Under the Variable Costing method it is treated as a period cost and therefore not included in the cost of the product.

Absorption Costing Variable Costing

Direct Materials Direct Materials Direct Labor Direct Labor Variable MOH Variable MOH Fixed MOH

= Total Product Cost = Total Product Cost

EXERCISE 22-1

Accounting Principles II 67 Riley Watches’ April income statement follows:

RILEY WATCHES

Income Statement For the Month of April 20XX

Sales revenue...... $720,000 Cost of goods sold...... 448,000 Gross profit...... 272,000 Operating expenses: Marketing expense...... $92,000 General and administrative expense 42,000 134,000 Operating income...... $138,000

Riley’s cost of goods is a variable expense. Marketing expense is 30% fixed and 70% variable. General and administrative expense is 60% fixed and 40% variable.

Required:

1. Prepare Riley’s contribution margin income statement for April.

2. Compute the expected increase in operating income to the nearest $1,000 if sales increase by $50,000.

EXERCISE 22-2

For its top managers, Blue Sea Travel formats its income statement as follows: BLUE SEA TRAVEL Contribution Margin Income Statement Three Months Ended March 31, 20XX

Sales revenue...... $320,000 Variable expenses...... 96,000 Contribution margin...... 224,000 Fixed expenses...... 210,000 Operating income...... $ 14,000

Blue Sea’s relevant range is between sales of $250,000 and $360,000.

Accounting Principles II 68 Required:

1. Prepare contribution margin income statements at those volume levels. Also, compute breakeven sales in dollars.

EXERCISE 22-3 Baker Breakfast Co. produces frozen bagels. The company has fixed expenses of $63,000, and variable expenses of $1.10 per package. Each package sells for $2.00.

Required: 1. Compute the contribution margin per package and the contribution margin ratio. 2. Determine the breakeven point in units and in dollars, using the contribution margin approach.

EXERCISE 22-4

Baker Breakfast Co. produces frozen bagels. The company has fixed expenses of $63,000, and variable expenses of $1.10 per package. Each package sells for $2.00.

Required:

1. Compute the contribution margin per package and the contribution margin ratio.

2. Determine the breakeven point in units and in dollars, using the contribution margin approach.

PROBLEM 22-1

The Royal Blue schooner sails in the U.S. Virgin Islands during the winter. The average cruise has 45 tourists on board, and each person pays $75 for a day=s sail. The ship sails 80 days each year.

The Royal Blue has a crew of fifteen. Each crew member earns an average of $95 per cruise. The crew is paid only when the ship sails. Other variable expenses are for refreshments, which average $14 per passenger per cruise. Annual fixed expenses total $66,000.

Required:

1. Compute revenue and variable expenses for each cruise. 2. Use the income statement equation approach to compute the number of cruises the Royal Blue must make each year to break even.

3. Use the contribution margin approach to compute the number of cruises needed each year to earn $85,800. Is this profit goal realistic? Give your reason. 4. Prepare the Royal Blue contribution margin income statement for 80 cruises for the year.

Accounting Principles II 69 Report only two categories of expenses: variable and fixed.

Chapter 23: The Master Budget and Responsibility Accounting

Objectives

1. Identify the benefits of budgeting

2. Prepare an operating budget for a company

3. Prepare the components of a financial budget

4. Use sensitivity analysis in budgeting

5. Distinguish among different types of responsibility centers

6. Prepare a performance report for management by exception

7. Allocate indirect costs to departments

Master Budget - The set of budgeted financial statements and supporting schedules for the entire organization. This includes the operating budget, the capital expenditures budget, and the financial budget.

Operating Budget - This budget sets the expected revenues and expenses for the period. It consists of a Sales budget, Purchases budget, Inventory budget, Cost of Goods Sold budget, Operating Expense budget, and a budgeted Income Statement.

Capital Expenditures Budget - is a company’s plan for purchases of property, plant, and equipment and other long-term assets.

Financial Budget - projects cash inflows and outflows (also known as a cash budget), the period ending Balance Sheet, and the Statement of Cash Flows.

Preparing a Master Budget

Step 1 - Prepare the Sales Budget showing the expected (budgeted) sales for the period

January February March Total

Cash Sales 20,000 27,400 18,000 Credit Sales 34,000 40,600 23,750

Accounting Principles II 70 Total Sales 54,000 68,000 41,750 163,750

Step 2 - Prepare the Purchases, Cost of Goods Sold, and Inventory Budgets January February March Total

COGS 34,000 45,000 24,500 Desired Ending Inv. 5,000 4,000 6,000 Total Inv. 39,000 49,000 30,500 Beginning Inv. (4,000) (5,000) (4,000) Purchases 35,000 44,000 26,500 105,500 Step 3 - Prepare the Operating Expense Budget

January February March Total

Salaries Exp 2,000 2,000 2,000 6,000 Rent Exp 1,500 1,500 1,500 4,500 Depr Exp 1,250 1,750 1,500 4,500

Total Operating Exp 11,750 13,000 9,750 34,500 Step 4 - Prepare the Budgeted Income Statement

Amount Sales Revenue from Sales Budget Cost of Goods Sold from Purchaes, COGS, Inv Budget Gross Margin Sales - COGS Operating Expenses Salaries from Exp Budget Rent Depreciation

Accounting Principles II 71

Operating Income Gross Margin - Op. Exp Interest Expense $ Net Income Op. Income - Int. Exp

Step 5 - Capital Expenditures Budget

January February March Total

Purchase of delivery truck $xxx $xxx $xxx $xxx Purchase of equipment $xxx $xxx Total Capital Expenditures $xxx $xxx $xxx $x,xxx

Step 6 - Prepare the Cash Budget

January February March Beginning Cash Balance $xxxx Jan End. Feb End. Bal Bal Cash Collections: From Customers xxx xxx xxx Interest xxx xxx xxx Cash Available (1) Total Total Total Cash Disbursements: Purchases of Inventory $xxxx $xxxx $xxxx Operating Expenses xxx xxx xxx Capital Expenditures xxxx xxxx xxxx Total Cash Disbursements (2) Total Total Total Ending Cash Balance before

Accounting Principles II 72 financing (3) (1) - (2) (1) - (2) (1) - (2) Minimum Cash Balance desired $xxxx $xxxx $xxxx Cash Excess (Deficiency) Difference Difference Difference Financing of Cash deficiency Borrowing $xxx $xxx $xxx Principal payments (xxx) (xxx) (xxx) Interest Expense (xxx) (xxx) (xxx) Total Effects of financing (4) Total Total Total Ending Cash balance (3) + (4) (3) + (4) (3) + (4)

Step 7 & 8 - Prepare the budgeted Balance Sheet and Cash Flows Statement

Responsibility Accounting

Responsibility accounting - a system for evaluating the performance of each responsibility center and its manager

Responsibility center - a part or subunit of a company whose manager is accountable for specific activities

Types of Responsibility centers

Cost center - a center whose manager is accountable for costs (expenses) only

Revenue center - a center whose manager is accountable for revenues only

Profit center - a center whose manager is accountable for both costs and revenues

Investment center - a center whose manager is accountable for revenues, costs, and investments

Management by exception - a management style which directs management’s attention to important differences between actual and budgeted amounts

Departmental Accounting

Income statements for a business are broken down by departments rather than just showing the revenues and expenses for the company as a whole

Indirect expenses must be allocated to the departments depending on an allocation base

Accounting Principles II 73 Allocation of Indirect Costs

(1) Choose an allocation base for each indirect cost (2) Compute an indirect cost allocation rate

Allocation rate Total Indirect cost Total quantity of allocation base

(3) Allocate the indirect cost

Allocated cost = Quantity of allocation base X Allocation used by the department Rate

Departmental Income Statement Format

Total Dept. A Dept. B Sales Revenue Cost of Goods Sold Gross Margin Operating Expenses

Total Operating Expenses Operating Income

Accounting Principles II 74 EXERCISE 23-1 i-Tote is an e-tailer of women’s accessories. Their sales budget for the nine months ended September 30 follows:

Quarter Ended

Nine-Month March 31 June 30 Sept. 30 Total Cash sales, 30%...... $ 30,000 $ 45,000 $ 37,500 $112,500 Credit sales, 70%...... 70,000 105,000 87,500 262,500 Total sales, 100%...... $100,000 $150,000 $125,000 $375,000

In the past, cost of goods sold has been 70% of total sales. The director of marketing and the financial vice president agree that each quarter=s ending inventory should not be below $20,000 plus 10% of cost of goods sold for the following quarter. Thomas expects sales of $110,000 during the fourth quarter. The January 1 inventory was $22,000.

Required:

Prepare a purchases, cost of goods sold, and inventory budget for each of the first three quarters of the year. Compute cost of goods sold for the entire nine-month period.

EXERCISE 23-2

Harrison Woods, a family-owned gardening store, began October with $7,500 cash. Management forecasts that collections from credit customers will be $9,500 in October and $13,000 in November. The store is scheduled to receive $6,000 cash on a business note receivable in October. Projected cash payments include inventory purchases ($11,000 in October and $14,100 in November) and operating expenses ($3,000 each month).

Harrison’s bank requires a $6,500 minimum balance in the store's checking account. At the end of any month when the account balance dips below $6,500, the bank automatically extends credit to the store in multiples of $1,000. Harrison=s borrows as little as possible and pays back these loans in quarterly installments of $2,000, plus 4.5% interest on the entire unpaid principal. The first payment occurs three months after the loan.

Required:

1. Prepare the store's cash budget for October and November.

Accounting Principles II 75 2. How much cash will Harrison’s borrow in November if collections from customers that month total $9,300 instead of $13,000?

Chapter 24: Flexible Budgets and Standard Costs

Objectives

1. Prepare a flexible budget for the income statement

2. Prepare an income statement performance report

3. Identify the benefits of standard costs

4. Compute standard cost variances for direct materials and direct labor

5. Analyze manufacturing overhead in a standard cost system

6. Record transactions at standard cost

7. Prepare a standard cost income statement for management

Accounting Principles II 76 Accounting Principles II 77 Accounting Principles II 78 Accounting Principles II 79 Accounting Principles II 80 EXERCISE 24-1

GompuGear sells its main product, ergonomic mouse pads, for $10 each. Its variable cost is $4 per pad. Fixed expenses are $200,000 per month for volumes up to 60,000 pads. Above 60,000 pads, monthly fixed expenses are $300,000.

Required:

Prepare a monthly flexible budget for the product, showing sales, variable expenses, fixed expenses, and operating income or loss for volume levels of 40,000, 50,000, and 70,000 pads.

EXERCISE 24-2

Forever Frames, which uses a standard cost accounting system, manufactured 400,000 picture frames during the year, using 1,350,000 board feet of lumber purchased at $1.55 per foot. Production required 9,500 direct labor hours that cost $12.00 per hour. The materials standard was three board feet of lumber per frame, at a standard cost of $1.70 per foot. The labor standard was 0.025 direct labor hour per frame, at a standard cost of $11.50 per hour.

Required:

1. Compute the price and efficiency variances for direct materials and direct labor.

2. Does the pattern of variances suggest Forever Frames’ managers have been making tradeoffs? Explain.

PROBLEM 24-1

Cellular Technologies manufactures capacitors for cellular base stations and other communications applications. The company's static budget income statement for October 20X4 follows. It is based on expected sales volume of 9,000 units.

CELLULAR TECHNOLOGIES Static Budget Income Statement October 20X4

Sales revenue...... $189,000 Variable expenses: Cost of goods sold...... 72,000

Accounting Principles II 81 Sales commissions...... 9,450 Shipping expense...... 4,500 Fixed expenses: Salary expense...... 27,500 Depreciation expense...... 13,250 Rent expense...... 11,250 Insurance expense...... 2,750 Total expenses...... 140,700 Operating income...... $ 48,300

Cellular Technologies’ plant capacity is 95,000 units. If actual volume exceeds 95,000 units, Cellular Technologies must rent additional space. In that case, salaries will increase by 15%, rent will double, and insurance expense will increase by $1,000. Depreciation will be unaffected.

Required:

1. Prepare flexible budget income statements for 7,500, 9,000, and 11,000 units.

2. Graph the behavior of the company’s total costs.

3. Why might Cellular Technologies’ managers want to see the graph you prepared in Requirement 2 as well as the columnar format analysis in Requirement 1? What is the disadvantage of the graphic approach in Requirement 2?

Accounting Principles II 82 Chapter 25: Activity-Based Costing and Other Cost Management Tools

Objectives

1. Describe and develop activity-based costs (ABC)

2. Use ABC data and activity-based management (ABM) to make business decisions

3. Use ABM and value engineering to achieve target costs for target pricing

4. Decide when ABC is most likely to pass the cost-benefit test

5. Compare a traditional production system to a just-in-time (JIT) production system

6. Record manufacturing costs for a just-in-time costing system

7. Contrast the four types of quality costs and use these costs to make decisions

Accounting Principles II 83 Accounting Principles II 84 Accounting Principles II 85 Accounting Principles II 86 EXERCISE 25-1

Wheels, Inc., uses activity-based costing to account for its chrome wheel manufacturing process. Company managers have identified four manufacturing activities: materials handling, machine set-up, insertion of parts, and finishing. The budgeted activity costs for 20X3 and their allocation bases are as follows:

Total Budgeted Activity CostAllocation Base

Materials handling $ 18,000 Number of parts Machine setup 2,800 Number of setups Insertion of parts 24,000 Number of parts Finishing 60,000 Finishing direct labor hours Total $104,800

Wheels, Inc., expects to produce 2,000 chrome wheels during the year. The wheels are expected to use 12,000 parts, require eight setups, and consume 1,000 hours of finishing time.

Required:

1. Compute the cost allocation rate for each activity.

2. Compute the indirect manufacturing cost of each wheel.

PROBLEM 25-1

MacArthur, Inc., manufactures CD racks and uses an activity-based costing system. MacArthur’s activity areas and related data follow:

Budgeted Cost Cost Activity of Activity Allocation Base Allocation Base

Materials handling $ 200,000 Number of parts $ 0.30 Assembling 3,000,000 Direct labor hours 18.00 Finishing 160,000 Number of finished units 5.00

MacArthur produced two styles of CD racks in April – the standard rack and an unfinished rack, which has fewer parts per rack and requires no finishing. The totals for quantities, direct materials costs, and other data follow:

Total Total Direct Total Number Total Assembling

Accounting Principles II 87 Product Units Produced Materials Costs of Parts Direct Labor Hours

Standard CD rack 2,500 $24,000 30,000 3,000 Unfinished CD rack 3,500 27,000 36,000 2,800

Required:

1. Compute the manufacturing product cost per unit of each type of CD rack.

2. Suppose that premanufacturing activities, such as product design, were assigned to the standard CD racks at $4 each and to the unfinished racks at $3 each. Similar analyses were conducted of postmanufacturing activities such as distribution, marketing, and customer service. The postmanufacturing costs were $18 per standard rack and $13 per unfinished rack. Compute the full product costs per unit.

3. Which product costs are reported in the external financial statements? Which costs are used for management decision making? Explain the difference.

4. What price should MacArthur’s managers set for unfinished racks to earn a unit profit of $15?

PROBLEM 25-2

Canyon Creek’s Shelf Department manufactures bookshelves in its Santa Clarita, California, plant. The company uses activity-based costing. Its activities and related data follow:

Budgeted Cost Cost Activity of Activity Allocation Base Allocation Base

Materials handling $ 300,000 Number of parts $ 0.50 Assembling 3,000,000 Direct labor hours 15.00 Painting 170,000 Number of painted bookshelves 6.00

Canyon Creek produced two styles of bookshelves in March – the standard bookshelf and an unpainted bookshelf, which has fewer parts and requires no painting. The totals for quantities, direct materials costs, and other data are as follows:

Total Total Direct Total Number Total Assembling Product Units Produced Materials Costs of Parts Direct Labor Hours

Standard bookshelf 5,000 $90,000 100,000 5,000

Accounting Principles II 88 Unpainted bookshelf 1,000 15,000 15,000 900

Required:

1. Compute the per-unit manufacturing product cost of standard bookshelves and unpainted bookshelves.

2. Premanufacturing activities, such as product design, were assigned to the standard bookshelves at $5 each and to the unpainted bookshelves at $3 each. Similar analyses were conducted of postmanufacturing activities such as distribution, marketing, and customer service. The post-manufacturing costs were $21 per standard bookshelf and $18 per unpainted bookshelf. Compute the full product cost per bookshelf.

3. Which product costs are reported in the external financial statements? Which costs are used for management decision making? Explain the difference.

4. What price should Canyon Creek’s managers set for standard bookshelves to earn a $34.00 profit per bookshelf?

Accounting Principles II 89 Chapter 26: Special Business Decisions and Capital Budgeting

Objectives

1. Identify the relevant information for a special business decision

2. Make five types of short-term special business decisions

3. Explain the difference between correct and incorrect analysis of a particular business decision

4. Use opportunity costs in decision making

5. Use four capital budgeting models to make longer-term investment decisions\

6. Compare and contrast popular capital budgeting methods

General Concepts

Capital Budgeting is the process of planning expenditures for assets whose returns are expected to continue beyond one year. 1. Without proper timing, additional capacity generated by the acquisition of capital assets may not coincide with changes in demand for output, resulting in capacity excess or shortage. a. Accurate forecasting is needed to anticipate changes in product demand so that full economic benefits flow to the firm when the capital asset is available for use.

2. A capital budget usually involves substantial expenditures. The source of these funds become critical. a. Planning for future funds is important because of possible rapid changes in capital markets, inflation, interest rates, and the money supply.

3. Types of costs relevant to capital budgeting analysis a. An incremental cost is the difference in cost resulting from selecting one option instead of another. b. A sunk cost is a past cost that cannot be avoided because an expenditure has been made or an irrevocable decision to incur the cost has been taken. c. Opportunity cost is the maximum benefit forgone by using a scarce resource for a given purpose. It is the benefit that would have been provided by the next best use of that resource. d. Avoidable costs are cost that may be eliminated by not engaging in an activity or by performing it more efficiently. e. An imputed cost is a cost that may not entail a specified dollar outlay formally recognized by the accounting system but that is relevant to establishing the economic reality analyzed in the decision-making process, such as outlay cost or opportunity costs. f. Cost of capital is the interest cost of debt proceeds (net of tax) or the cost of obtaining equity capital to be invested in long-term plant and equipment. g. A common cost is a cost common to all possibilities in question and not clearly allocable to any one of them.

4. Capital budgeting requires choosing among investment proposals, making a ranking procedure necessary. Thus, cash-flow benefits should be related to their cost by using a method to evaluate the investment.

Accounting Principles II 90 Capital Budgeting

A capital expenditure is an outlay of cash for a project that is expected to produce a cash inflow over a period of time exceeding one year. Examples of projects include investments in property, plant, and equipment, research and development projects, large advertising campaigns, or any other project that requires a capital expenditure and generates a future cash flow.

Because capital expenditures can be very large and have a significant impact on the financial performance of the firm, great importance is placed on project selection. This process is called capital budgeting.

Criteria for Capital Budgeting Decisions

Potentially, there is a wide array of criteria for selecting projects. Some shareholders may want the firm to select projects that will show immediate surges in cash inflow, others may want to emphasize long-term growth with little importance on short-term performance. Viewed in this way, it would be quite difficult to satisfy the differing interests of all the shareholders. Fortunately, there is a solution.

The goal of the firm is to maximize present shareholder value. This goal implies that projects should be undertaken that result in a positive net present value, that is, the present value of the expected cash inflow less the present value of the required capital expenditures. Using net present value (NPV) as a measure, capital budgeting involves selecting those projects that increase the value of the firm because they have a positive NPV. The timing and growth rate of the incoming cash flow is important only to the extent of its impact on NPV.

Using NPV as the criterion by which to select projects assumes efficient capital markets so that the firm has access to whatever capital is needed to pursue the positive NPV projects. In situations where this is not the case, there may be capital rationing and the capital budgeting process becomes more complex.

Note that it is not the responsibility of the firm to decide whether to please particular groups of shareholders who prefer longer or shorter term results. Once the firm has selected the projects to maximize its net present value, it is up to the individual shareholders to use the capital markets to borrow or lend in order to move the exact timing of their own cash inflows forward or backward. This idea is crucial in the principal-agent relationship that exists between shareholders and corporate managers. Even though each may have their own individual preferences, the common goal is that of maximizing the present value of the corporation.

Alternative Rules for Capital Budgeting

While net present value is the rule that always maximizes shareholder value, some firms use other criteria for their capital budgeting decisions, such as:

Accounting Principles II 91  Internal Rate of Return (IRR)  Profitability Index  Payback Period  Return on Book Value

A. Capital Budgeting 1. Accounting Rate of Return: A capital budgeting technique i. Increase in Accounting Net Income / Required Investment  reduce increase in accounting net income by the depreciation amount. ii. Ignores the time value of money iii. Emphasis is not on cash flow 2. The Payback Period: Time required for net cash inflows to equal the cost of the initial investment (stated in years) i. Net Investment / Average expected annual cash flow (savings) ii. Depreciation is ignored because it is a noncash expense  Except to the extend that it is included in cashflow related to taxes iii. Ignores the time value of money iv. Time required to cover cashflows 3. The Net Present Value Method: A capital budgeting technique that recognizes time value of money i. by discounting the after-tax cash flows over a project’s life using the company’s minimum desired rate of return. (reinvestment is at this rate) Calculation: PV after-tax cash flows – Initial Investment  Initial investment is reduced by i. the proceeds from the sale of the asset to be replaced. ii. Discount Rate must be determined in advanced. 4. Internal Rate of Return (IRR): Discount rate at which the PV of expected future cash flows is equal to the cost of the investment. i. The interest rate at which the NPV = 0 a. NPV: PV of expected future net cash inflows – cost of investment  Increase in desired return can be adjusted by changing the discount rate Calculation for cost of Investment (PV of 1 x net cash inflows - positive NPV or add negative NPV ii. Residual sales (salvage) value is a cashflow that s/b discounted to determine its PV. iii. Reinvestment is at the IRR iv. Recognizes time value of money v. Depreciation is excluded because it’s a noncash flow

5. The Modified Internal Rate of Return (MIRR) is the interest rate at which the present value of the cash outflows discounted at the cost of capital equals the present value of the terminal value.

Accounting Principles II 92 i. The terminal value is the future value of the cash inlows assuming they are reinvested at the cost of capital.

6. Economic value added (EVA)  Economic value added (EVA)is a more specific version of residual income.  It equals after-tax operating income [earnings before interest and taxes x (1.0 - the tax rate)] minus the product of the after-tax weighted-average cost of capital and an investment base equal to total assets minus current liabilities. EVA represents the business unit's true economic profit primarily because a charge for the cost of equity capital is implicit in the cost of capital.  The cost of equity is an opportunity cost, that is, the return that could have been obtained on the best alternative investment of similar risk.  Hence, the EVA measures the marginal benefit obtained by using resources in a particular way. It is useful for determining whether a segment of a business is increasing shareholder value.

Exercise 26-1 Tam Co. is negotiating to purchase equipment that would cost $100,000, with the expectation that $20,000 per year could be saved in after-tax cash costs if the equipment were acquired. The equipment's estimated useful life is 10 years, with no residual value, and would be depreciated by the straight-line method. Tam's predetermined minimum desired rate of return is 12%. Present value of an annuity of $1 at 12% for 10 periods is 5.65. Present value of $1 due in 10 periods at 12% is .322.

A. What is the Net present value?

B. What is the Payback period?

C. What is the Accrual accounting rate of return based on initial investment?

D. In estimating the internal rate of return, the factors in the table of present values of an annuity should be taken from the columns with entries closest to (select one)

A. 0.65 B. 1.30 C. 5.00 D. 5.65

Exercise 26-2 Doro Co. is considering the purchase of a $100,000 machine that is expected to result in a decrease of $25,000 per year in cash expenses after taxes. This machine, which has no residual value, has an estimated useful life of 10 years and will be depreciated on a straight-line basis. For this machine, what is the accounting rate of return based on initial investment?

Accounting Principles II 93 Exercise 26-3 Major Corp. is considering the purchase of a new machine for $5,000 that will have an estimated useful life of 5 years and no salvage value. The machine will increase Major's after-tax cash flow by $2,000 annually for 5 years. Major uses the straight-line method of depreciation and has an incremental borrowing rate of 10%. The present value factors for 10% are as follows:

Ordinary annuity with five payments 3.79 Annuity due for five payments 4.17 Using the payback method, how many years will it take to pay back Major's initial investment in the machine?

Exercise 26-4 Lin Co. is buying machinery it expects will increase average annual operating income by $40,000. The initial increase in the required investment is $60,000, and the average increase in required investment is $30,000. To compute the accrual accounting rate of return, what amount should be used as the numerator in the ratio?

Exercise 26-5 Pole Co. is investing in a machine with a 3-year life. The machine is expected to reduce annual cash operating costs by $30,000 in each of the first 2 years and by $20,000 in year 3. Present values of an annuity of $1 at 14% are

Period 1 0.88 2 1.65 3 2.32 Using a 14% cost of capital, what is the present value of these future savings?

Accounting Principles II 94

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