Financial Accounting: Tools for Business Decision Making, 10th Edition [10 ed.] 9781119783091

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AUTHENTIC PRODUCT

>aul Kimmel's ~ccounting Course Design ~ith WileyPLUS JI Kimmel, author of several Wiley courses, teaches at The University i/Visconsin-Madison and uses WileyPLUS in a flipped classroom mat.

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ided Learning

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Information Retention

Personalized Practice

Just-in-Time Homework Help

1MPLE:

EXAMPLE:

EXAMPLE :

EXAMPLE:

I sets up his learning path to 1light and structure pregnments, post-assignments discussions, adaptive gnments, exam practice, and :zing.

Paul assigns Interactive Tutorial Assignments ahead of pre-l ecture activities so students come to class ready to actively participate.

Paul uses Adaptive Assignments as a capstone activity at the end of each week t o improve retention.

Paul assigns post-assignment problem s supported by Solution Walkthrough Videos.

Interactive Tutorial Assignments provide students with self-paced lecture walkthroughs of each chapter. Broken into smaller chunks with Knowledge Check questions and Do lt!s, students must watch the videos and respond to associated questions correctly or exhaust attempts before moving on, enhancing the retention of information. Trying to solve a problem before being taught the solution is frustrating but improves retention.

Adaptive Assignments effectively close knowledge gaps through personalized adaptive experiences that provide just-inti me instruction, immediate feedback, and remediation to previous learning objectives. To improve learning, employ dynamic (adaptive) testing rather than static testing. Without feedback, students often overestimate their competence and don't see a need to try to improve.

lided learning path enables to control what your students when they see it, and in what ~r. This makes it very clear fo r Jents to understand what /'re supposed to complete. This ;pecially vital for online classes. •ing a clear path to learning uces the risk of"losing" ~ents, keeping them engaged I on track in your course.

Solution Walkthrough Videos provide students with 24/7 just-in-time homework support and enable you to assign more difficult homework questions. Longer, multi-learning objective problems with video support help students consolidate their understanding.

WILEY

Paul Kimmel's Accountin g Course Design with WileyPLUS Course Design Suggestions from Make It Stick*

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Trying to solve a problem before being taught the solution improves retention. Testing (active retrieval) doesn't just measure learning, it strengthens memory. Spaced "testing" results in greater retention. Providing feedback strengthens learning more than testing alone.

*Make It Stick; Brow n, Ro edige r, an d McD ani el , 2014.

Online

Complete first pre-assignment. Due Monday before class.

In Class

Students do at least two exercises in class on blank sheet (i.e., conditions faced in a test).

Online

Complete second pre-assignment . Due Wednesday before class.

In Class

Students do at least two exercises in class on blank sheet.

Online

Complete post-assignment. Due Friday night.

Online

Complete adaptive assignment. Due Saturday night.

Financial Accounting Tools for Business Decision Makin§

Tenth Edition

PAUL D. KIMMEL PhD, CPI University of Wisconsin-Madisor Madison, Wisconsir

JERRY J. WEYGANDT PhD, CPI University of Wisconsin-Madisor Madison, Wisconsir

JILL E. MITCHELL MS, MEd, CII Northern Virginia Community CollegE Annandale, Virginie

WILE)'

DEDICATED TO Our spouses, Enid, Merlynn, and Sean, for their love, support, and encouragement. VICE PRESIDENT, EDITORIAL PRODUCT MANAGEMENT ASSOCIATE EDITORIAL DIRECTOR SENIOR COURSE CONTENT DEVELOPER INSTRUCTIONAL DESIGNER SENIOR PRODUCT MARKETING MANAGER EDITORIAL SUPERVISOR PROGRAM ASSISTANT SENIOR MANAGER, COURSE DEVELOPMENT AND PRODUCTION EXECUTIVE MANAGING EDITOR SENIOR PRODUCTION EDITOR SENIOR DESIGNER COVER IMAGE

Michael McDonald Zoe Craig Jenny Welter Matt Origoni Christina Koop Minarik Terry Ann Tatro Natalie Munoz Ed Brislin Karen Staudinger Rachel Conrad Jon Boylan Paul Kimmel

This book was set in 9.5/12 STIX Two Text by Lumina Datamatics, Inc. Founded in 1807, John Wiley & Sons, Inc. has been a valued source of knowledge and understanding for more than 200 years, helping people around the world meet their needs and fulfill their aspirations. Our company is built on a foundation of principles that include responsibility to the communities we serve and where we live and work. In 2008, we launched a Corporate Citizenship Initiative, a global effort to address the environmental, social, economic, and ethical challenges we face in our business. Among the issues we are addressing are carbon impact, paper specifications and procurement, ethical conduct within our business and among our vendors, and community and charitable support. For more information, please visit our website: www.wiley.com/go/ citizenship. Copyright © 2022 John Wiley & Sons, Inc. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc. 222 Rosewood Drive, Danvers, MA 01923, website www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030-5774, (201)748-6011, fax (201)748-6008, website http://www.wiley.com/go/permissions. ISBN-13: 978-1-119-78309-1 The inside back cover will contain printing identification and country of origin if omitted from this page. In addition, if the ISBN on the back cover differs from the ISBN on this page, the one on the back cover is correct. Printed in America. SKY10030060_092421

Brief Contents 1

Introduction to Financial Statements

2

A Further Look at Financial Statements

3

The Accounting Information System

4

Accrual Accounting Concepts

5

Merchandising Operations and the Multiple-Step Income Statement 5-1

6

Reporting and Analyzing Inventory

7

Fraud, Internal Control, and Cash

8

Reporting and Analyzing Receivables

9

Reporting and Analyzing Long-Lived Assets

1-1 2-1

3-1

4-1

6-1 7-1

s-1 9-1

10

Reporting and Analyzing Liabilities

11

Reporting and Analyzing Stockholders' Equity

12

Statement of Cash Flows

13

Financial Analysis: The Big Picture

APPENDIX A

10-1 11-1

12-1 13-1

Specimen Financial Statements: Apple Inc.

A-1

APPENDIX

s

Specimen Financial Statements: Columbia Sportswear Company B-1

APPENDIX

c

Specimen Financial Statements: Under Armour, Inc.

APPENDIX D

Specimen Financial Statements: Amazon.com, Inc.

APPENDIX E

Specimen Financial Statements: Walmart Inc.

APPENDIX F

Time Value of Money

APPENDIX G

Reporting and Analyzing Investments

COMPANY INDEX SUBJECT INDEX

1-1 1-5

RAPID REVIEW: CHAPTER CONTENT

F-1

G-1

E-1

c-1 0 -1

From the Authors Dear Student, Why This Course? Remember your biology course in high school? Did you have one of those "invisible man" models (or maybe something more high-tech than that) that gave you the opportunity to look "inside" the human body? This accounting course offers something similar. To understand a business, you have to understand the financial insides of a business organization. A financial accounting course will help you understand the essential financial components of businesses. Whether you are looking at a large multinational company like Apple or Starbucks or a single-owner software consulting business or coffee shop, knowing the fundamentals of financial accounting will help you understand what is happening. As an employee, a manager, an investor, a business owner, "Whether you are looking at a large multinaor a director of your own personal finances-any of which roles you will tional company like Apple or Starbucks or have at some point in your life-you will make better decisions for having a single-owner software consulting business taken this course. or coffee shop, knowing the fundamentals of financial accounting will help you underWhy This Text? Your instructor has chosen this text for you because of stand what is happening." its trusted reputation. We have worked hard to provide instructional material that is engaging, timely, and accurate. How to Succeed? We've asked many students and many instructors whether there is a secret for success in this course. The nearly unanimous answer turns out to be not much of a secret: "Do the homework." This is one course where doing is learning. The more time you spend on the homework assignments-using the various tools that this text provides-the more likely you are to learn the essential concepts, techniques, and methods of accounting. Good luck in this course. We hope you enjoy the experience and that you put to good use throughout a lifetime of success the knowledge you obtain in this course. We are sure you will not be disappointed. Paul D. Kimmel Jerry J. Weygandt Jill E. Mitchell

vi

Author Commitmen·

PAUL D. KIMMEL, PhD, CPA , received his bachelor's degree from the University of Minnesota and his doctorate in accounting from the University of Wisconsin. He was an Associate Professor at the University of Wisconsin-Milwaukee for more than 25 years and is now a Senior Lecturer at the University of Wisconsin-Madison. He has public accounting experience with Deloitte & Touche (Minneapolis). He was the recipient of the UWM School of Business Advisory Council Teaching Award and the Reggie Taite Excellence in Teaching Award, and a three-time winner of the Outstanding Teaching Assistant Award at the University of Wisconsin. He is also a recipient of the Elijah Watts Sells Award for Honorary Distinction for his results on the CPA exam. He is a member of the American Accounting Association and the Institute of Management Accountants and has published articles in Accounting Review, Accounting Horizons, Advances in Management Accounting, Managerial Finance, Issues in Accounting Education, and Journal of Accounting Education, as well as other journals. His research interests include accounting for financial instruments and innovation in accounting education.

JERRY J. WEYGANDT, PhD, CPA , is Arthur Andersen Alumni Emeritus Professor of Accounting at the University of Wisconsin-Madison. He holds a Ph.D. in accounting from the University of Illinois. Articles by Professor Weygandt have appeared in The Accounting Review, Journal of Accounting Research, Accounting Horizons, Journal of Accountancy, and other academic and professional journals. These articles have examined such financial reporting issues as accounting for price-level adjustments, pensions, convertible securities, stock option contracts, and interim reports. Professor Weygandt is author of other accounting and financial reporting texts and is a member of the American Accounting Association, the American Institute of Certified Public Accountants, and the Wisconsin Society of Certified Public Accountants. He has served on numerous committees of the American Accounting Association and as a member of the editorial board of the Accounting Review; he also has served as President and Secretary-Treasurer of the American Accounting Association. In addition, he has been actively involved with the American Institute of Certified Public Accountants and has been a member of the Accounting Standards Executive Committee (AcSEC) of that organization. He has served on the FASB task force that examined the reporting issues related to accounting for income taxes and served as a trustee of the Financial Accounting Foundation. Professor Weygandt has received the Chancellor's Award for Excellence in Teaching and the Beta Gamma Sigma Dean's Teaching Award. He is on the board of directors of M & I Bank of Southern Wisconsin. He is the recipient of the Wisconsin Institute of CPA's Outstanding Educator's Award and the Lifetime Achievement Award. In 2001 he received the American Accounting Association's Outstanding Educator Award.

JILL E. MITCHELL, MS, MEd, CIA, is a Profi sor of Accounting at Northern Virginia C01 munity College (NOVA), where she has taug face-to-face, hybrid, and online courses sin 2008. Since 2009, she has been an adjunct i structor at George Mason University (GMl She is a past president of the Washingtc D.C. Chapter of the Accounting and Financ Women's Alliance (AFWA), and she serv on the board of directors of the Virginia So ety of CPAs (VSCPA). She is a member oft American Accounting Association (AAA) a1 the Institute of Internal Auditors. Jill sen on the AAA Education Committee and is t co-chair for the Conference on Teaching a1 Learning in Accounting (CTLA). Prior joining the faculty at NOVA, Jill was a seni auditor with Ernst & Young's Business Ri Services practice in Miami, Florida. She is certified internal auditor and earned an MS Accountancy from the University of Virgir and a BBA in Management Information S) terns from the University of Georgia hone program. Recently, she earned an MEd Instructional Design Technology from GM Jill is a recipient of the Outstanding Facul Award, the Commonwealth's highest hon for faculty of Virginia's universities and collE es presented by the State Council of Higher E ucation for Virginia; the Virginia Commurn College System Chancellor's Award for Teac ing Excellence; the AFWA's Women Wi Count Award; the AAA 1\vo-Year Colle Educator of the Year Award; and the AAA Michael and Mary Anne Cook/Deloitte Fou dation Prize, the foremost recognition of : individual who consistently demonstrates t attributes of a superior teacher in the discipli of accounting.

New to This Edition: Data Anal tics The authors carefully considered how to thoughtfully and meaningfully integrate data analytics into the financial accounting course, and are pleased to provide the following data analytics resources.

Data Analytics and Decision-Making The text provides numerous discussions on how decision-makers are increasingly relying on data analytics to make decisions using accounting information.

Accounting software systems collect vast amounts of data about a company's economic events as well as its suppliers and customers. Business decision-makers take advantage of this wealth of data by using data analytics to gain insights and therefore make more informed business decisions.

• Data analytics involves analyzing data, often employing both software and statistics, to draw inferences. • As both data access and analytical software improve, the use of data analytics to support decisions is becoming increasingly common at virtually all types of companies.

Data Analytics in the Real World Real-world examples that illustrate engaging situations in companies are provided throughout the text.

Data Analytics Insight

Netflix

Using Data Science to Create Art Technology provides decision-makers and problem-solvers with access to a large volume of information called "big data." And Netflix, the world's leading subscription streaming entertainment service, is tapping into this big data as part of its efforts to ramp up its original content production. In a recent year, Netflix planned to spend $8 billion on content creation. Producing content involves a blend of creativity, technology, and business decisions, all of which result in costs. And by analyzing the large amounts of data from past productions, such as filming locations and production

Bogdan Glisik/ Shutterstock.com

viii

schedules, Netflix can more precisely estimate costs for future productions. Further, consider that the production of a TV show or film involves hundreds of tasks. Here again, Netflix uses data science, in this case to visualize where bottlenecks might occur or where opportunities might exist to increase the efficiency of the production process. Source: Based on Ritwik Kumar et. al., "Data Science and the Art of Producing Entertainment at Netflix," The Netflix Tech Blog (March 26, 2018).

How can "big data" improve decision-making? (Answer is available at the end of the chapter.)

NEW TO THIS EDITION: DATA ANALYTICS

Data Analytics in Action Data Analytics in Action problems provide students with the opportunity to see how to use data analytics to help solve realistic business problems. Excel templates for each Data Analytics in Action problem provide students a framework for solving the problem. Data Analytics in Excel videos provide students with step-by-step guidance to perform the Excel skills they need to solve these problems.

Using Data Visua lization to Analyze Changes over Time DA6.1 Data visualization can be used to analyze company changes over time. Example: Recall the Feature Story "Where Is That Spare Bulldozer Blade?"' presented in the chapter. Caterpillar continues to enhance its inventocy management by improving its product sustainability in two ways. First. it is rebuilding used parts to like-new condition. Second, the company is remanufacturing usable inventory parts when customers trade-in or dispose of their used equipment These actions not only reduce inventory costs but also enable Caterpillar to participate in the circular economy, where manufacturers take responsibility for their products at the end of the product lives. As noted in its 2019 sustainability report, Caterpillar has a goal of 20% growth in both rebuilding and remanufacturing. Has Caterpillar reached this goal? A line chart can help you visualize the company's progress over time. What information can you obtain by examining the following chart?

Caterpillar Remanufacturing and Rebuilding Changes 25%

20 15 10

Percentage Changes

--·-----·- ·- -- ---

-5

-

-

-

-

-

------ --- - ---- - · --

-

-

--

-

--·- --- ------

-···- - - - -·- -·- -·- -·-·-

---

-15 2016 - - Goal 20%

2017 -

2018

Remanufacturing % change from 2013

2019 -

Rebuild% change from 2013

Source: "ESG Data Center," Caterpillar 2019 Sustainability Report.

The chart indicates that while Caterpillar's goal has remained at 20%, the remanufacturing and rebuilding businesses are growing. The biggest increase in the growth of rebuilding occurred from 2016 to 2017. There was a decline from 2018 to 2019 in these initiatives as Caterpillar may have reached a peak that is leveling off due to new production that is more sustainable. For this case, you will look more closely at specific Caterpillar data regarding its end-of-life returned materials and the percentage usable for recycling. You will create and analyze a combination column and line chart to determine how Caterpillar can increase its gross profit as it relates to these end-of-life materials. Go to Wiley Course Resources for complete case details and instructions.

Using Dat a Analytics to Compare Companies' Inventory Turnover DA6.2 Inventory turnover shows the number of times during the period a firm sells the entire dollar amount of its inventory. It is advantageous to turn over inventory more quickly to reduce the risk of obsolescence and spoilage. As such, companies often have a goal of increasing inventory turnover. For this case, you will use inventory turnover data for Costco, Walmart, Target, and Amazon to create and analyze scatter plots, as well as to calculate days' sales in inventory, to determine which company is managing its inventory levels most effectively.

@ml

Go to Wiley Course Resources for complete case details and instructions.

Data Visualization Homework Assignments PowerBI and Tableau visualizations accompanied by assignable questions are available with most chapters. PowerBI and Tableau visualizations allow students to interpret visualizations and think critically about data.

Data Analytics Module An accounting-specific data analytics module with interactive lessons, case studies, and videos is part of the Wiley online course. The module has been prepared using industryvalidated content to help students develop the professional competencies needed for the rhimP-inP- workfnrrP

New to This Edition: Cha ter-b -Cha ter Chan Chapter 1: Introduction to Financial Statements • NEW discussions of hybrid forms of organization and critical audit matters. • NEW section on overview of data analytics, including Data Analytics Insight box on how Netflix relies on data science to streamline production costs on content creation.

• EXPANDED discussion of FOB shipping/ destination for improved student understanding. • ADDED discussion of new technology, such as use of artificial intelligence and algorithms, to Data Analytics and Credit Sales section.

• NEW DO IT!s on using financial information and components of annual reports.

• UPDATED People, Planet, and Profit Insight box to focus on REI, for greater continuity throughout chapter.

• NEW chapter appendix on career opportunities in accounting.

• MOVED discussion of the comprehensive income statement to Chapter 13.

• ADDED Questions, Do It's, Exercises, and Ethics Case to end-of-chapter (EOC) problem material.

• ADDED Exercises, Ethics Case, and Data Analytics in Action to EOC problem material.

Chapter 2: A Further Look at Financial Statements

Chapter 6: Reporting and Analyzing Inventory

• MOVED discussion of free cash flow/using a statement of cash flows to Chapter 12.

• ADDED separate DO IT's after each cost flow method discussion.

• NEW discussion of why receivables are considered more liquid than inventory.

• NEW illustration on the impact on cost flow assumptions when costs change.

• DELETED partial balance sheet illustrations showing classifications for more streamlined presentation.

• NEW discussion of how companies can use data analytics when determining NRV of products.

• NEW Investor Insight box, on reliability of investor bulletin board postings.

• NEW Data Analytics Insight box on value of dashboards.

• UPDATED definitions of materiality and the full disclosure principle per recent FASB actions. • NEW illustrations on (1) world view of the standard-setting environment, (2) enhancing qualities of accounting information, and (3) summary of the conceptual framework. • ADDED Exercises to EOC problem material. Chapter 3: The Accounting Information System • NEW discussion of recent technologies used, such as cloud-based storage and data automation tools. • NEW DO IT! on accounts, debits, and credits. • ADDED Practice Brief Exercise, DO IT!, Exercises, and Ethics Case to EOC problem material. Chapter 4: Accrual Accounting Concepts • NEW discussion of recent technologies used, such as the use of robotic process automation (RPA) in the closing process. • NEW illustration of a post-closing trial balance. • ADDED Exercises and Problem to EOC problem material.

X

Chapter 5: Merchandising Operations and the MultipleStep Income Statement

• ADDED Exercises, Critical Thinking Case, and Data Analytics in Action to EOC problem material. Chapter 7: Fraud, Internal Control, and Cash • UPDATED discussion and illustrations of cash receipts controls, to reflect current practices and technology. • NEW section on electronic banking. • NEW illustration on how to determine outstanding checks in a bank reconciliation. • ADDED Real-World Focus Case and Data Analytics in Action to EOC problem material. Chapter 8: Reporting and Analyzing Receivables • NEW Data Analytics Insight box on how companies are making increasingly more sophisticated credit decisions using data analytics. • NEW illustration on the use of Tableau dashboards to provide tracking and analysis of a company's receivables. • ADDED Exercises Data Analytics in Action to EOC problem material.

NEW TO THIS EDITION: CHAPTER-BY-CHAPTER CHANGES

Chapter 9: Reporting and Analyzing Long-Lived Assets • UPDATED People, Planet, and Profit Insight box to now focus on Nike's sustainability report. • ADDED Exercises, Critical Thinking Case, and Data Analytics in Action to EOC problem material. Chapter 10: Reporting and Analyzing Liabilities • NEW Investor Insight box on how Ford issued bonds to raise cash for operations and new products. • ADDED Tesla as comparative company in analyzing the liquidity and solvency of General Motors. • ADDED Critical Thinking Case to EOC problem material. Chapter 11: Reporting and Analyzing Stockholders' Equity • UPDATED People, Planet, and Profit Insight box to highlight latest information on corporate social responsibility proposals. • ADDED new discussion of liquidating dividends. • NEW Investor Insight box on stock dividends. • ADDED Exercises, Critical Thinking Case, and Data Analytics in Action to EOC problem material.

Chapter 12: Statement of Cash Flows • ADDED Data Analytics in Action to EOC problem materic: Chapter 13: Financial Analysis: The Big Picture • NEW presentation of discontinued operations on the i1 come statement (previously on the statement of compn hensive income) as well as discussion and format of ti: statement of comprehensive income. • ADDED Critical Thinking Case to EOC problem materia Appendix F: Time Value of Money (previously AppendixG) • NEW discussion of using Excel function to solve time va ue of money problems. Appendix G: Reporting and Analyzing Investments (previously Appendix H) • NEW DO IT!s added to appendix discussion as well c: end-of-chapter material. NEW Review and Practice section includes multiplt choice questions followed by annotated solutions, pra, tice brief exercises with solutions, practice exercises wit solutions, and a practice problem with solution.

New to This Edition in Your Wiley Course Lecture Videos Lecture Videos, narrated by an accounting instructor for every section in the text, talk through the PowerPoint slides, including embedded application videos where applicable, providing support for online courses, flipped classrooms, and student study and review.

Interactive Tutorial Assignments Interactive Tutorial Assignments provide students a guided walkthrough and review of the chapter content and topics, including Chapter Overview Videos, Lecture Videos for each learning objective, and selected Real World Videos. Interactive Knowledge Check and Do It! questions in the assignments check student understanding and knowledge acquisition. In applicable questions, values change algorithmically, to support student practice and integrity. The Interactive Tutorial Assignments are available to students as practice, and may be separately customized and assigned by instructors.

Animations Short, animated videos engage students and simplify major concepts in the text, making the concepts easier to understand. They offer an alternative approach to understanding the written material.

Brief Exercise Solution Walkthrough Videos Additional Solution Walkthrough Videos developed for this edition, now also including selected Brief Exercises, continue to build scaffolding for student understanding and 24/7 problem-solving support.

ical Features

Proven Peda

When you think of accounting, you probably don't think of athletics. So why do we have a photo of a cyclist on our cover? It's because this image represents active learning that's best accomplished through full engagement, commitment, and practice. In this new edition, all content has been carefully reviewed and revised to ensure maximum student understanding. At the same time, the time-tested features that have proven to be of most help to students have been retained, such as the following.

lnfographic Learning Over half of the text is visual, providing students alternative ways of learning about accounting. ILLUSTRATION 6.4

Specific identification method

_ _ _ _6 ,_ _ __

+

$800

➔

Cost of goods sold= $700 + $800 = $1,500 Ending inventory= $750

Real-World Decision-Making Real-world examples, which illustrate engaging situations in companies, are provided throughout the text. Answers to the critical thinking questions posed to readers within the real-world examples are now available at the end of each chapter.

People, Planet, and Profit Insight Got Junk? Do you have an old computer or two in your garage? How about an old TV that needs replacing? Many people do. Approximately 163,000 computers and televisions become obsolete each day. Yet, in a recent year, only 11 % of comnjgphoto/Getty Images puters were recycled. It is estimated that 75% of all computers ever sold are sitting in storage somewhere, waiting

xii

to be disposed of. Each of these old TVs and computers is loaded with lead, cadmium, mercury, and other toxic chemicals. If you have one of these electronic gadgets, you have a responsibility, and a probable cost, for disposing of it. Companies have the same problem, but their discarded materials may include lead paint, asbestos, and other toxic chemicals.

What accounting issue might this cause for companies? (Answer is available at the end of the chapter.)

PROVEN PEDAGOGICAL FEATURES

xii

DO IT! Exercises DO IT! Exercises in the body of the text prompt students to stop and review key concepts. They outline the Action Plan necessary to complete the exercise as well as show a detailed solution.

ACTION PLAN

DO IT! 2a I Cost Flow Methods-FIFO Method

• Understand the periodic inventory system.

The accounting records of Shumway Ag Implements show the following data.

• Allocate costs between goods sold and goods on hand (ending inventory) for the FIFO method. • Compute cost of goods sold for the FIFO method.

Beginning inventory Purchases Sales

4,000 units at $3 6,000 units at $4 7,000 units at $12

Determine the cost of goods sold during the period under a periodic inventory system using the FIFO method.

Solution Cost of goods available for sale = (4,000 x $3) + (6,000 x $4) = $36,000 Ending inventory= 10,000 - 7,000 = 3,000 units Cost of goods sold FIFO: $36,000- (3,000 x $4) = $24,000 Related exercise material: BE6.3, BE6.4, BE6.5, BE6.6, DO IT! 6.2, E6.5, E.6.6, E6.7, and E6.8.

Decision Tools Accounting concepts that are useful for management decision-making are highlighted throughout the text. A summary of Decision Tools is included in each chapter as well as a practice exercise and solution called Using the Decision Tools. USING THE DECISION TOOLS I Eastman Chemical Eastman Chemical is a global specialty materials company that produces a broad range of products found in items people use every day. Eastman employs approximately 14,500 people around the world and serves customers in more than 100 countries. The company is headquartered in Kingsport, Tennessee. Here is the inventory note taken from recent financial statements.

Eastman Chemical Company Notes to the Financial Statements

(In millions) $ 576 220 1,114

Total inventories-at FIFO or average cost Less: LIFO reserve

1,910 248

Inventories-net (as reported on balance sheet)

$1,662

Eastman determines the cost of most raw materials, work in process, and finished goods inventories in the United States and Switzerland by the LIFO method. The cost of all other inventories is determined by the average-cost method, which approximates the FIFO method. Additional facts (amounts in millions): Current liabilities Current assets (as reported)

Cost of goods sold Beginning inventory

a. Eastern Chemical is a manufacturer, so it purchases raw materials and makes them into finished products. At the end of each period, it has some goods that have been started but are not yet complete (work in process). By reporting all three components of inventory, a company reveals important information about its inventory position. For example, if amounts of raw materials have increased significantly compared to the previous year, we might assume the company is planning to step up production. On the other hand, if levels of finished goods have increased relative to last year and raw materials have declined, we might conclude that sales are slowing down-that the company has too much inventory on hand and is cutting back production. b. Companies are free to choose different cost flow assumptions for different types of inventory. A company might choose to use FIFO for a product that is expected to decrease in price over time. One common reason for choosing a method other than LIFO is that many foreign countries do not allow LIFO; thus, the company cannot use LIFO for its foreign operations.

Inventories: The components of inventories are summarized as follows: Inventories-gross: Raw materials Work in process Finished goods

Solution

$1,789 3,321 7,039 1,583

Instructions Answer the following questions. a. Why does the company report its inventory in three components? b. Why might the company use three methods (LIFO, FIFO and average-cost) to account for its inventory? c. Perform each of the following. 1. Calculate the inventory turnover and days in inventory using the LIFO inventory. 2. Calculate the current ratio using LIFO and the current ratio using FIFO. Discuss the difference.

c. I. inventory turnover= CoSt of goods sold Average inventory

$7,039 ($1,583 + $1,662) + 2

4.3times

Days in _ 365 = 365 == 84 .9 days inventory Inventory turnover 4.3 2. Current ratio LIFO

FIFO

=

Current assets = $3,321 = 1. 86 :l $3,321 + $248 l.99:1 $1,789 Current liabilities $1,789 This represents a 7% increase in the current ratio [(1.99 - 1.86) + 1.86].

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PROVEN PEDAGOGICAL FEATURES

Review and Practice Each chapter concludes with a Review and Practice section which includes a review of learning objectives, Decision Tools review, key terms glossary, practice multiple-choice questions with annotated solutions, practice brief exercises with solutions, practice exercises with solutions, and a practice problem with a solution.

Revi ew and Practice Practice Brief Exercises Determine ending inventory amount.

1. (LO 1) Fylus Company took a physical inventory on December 31 and determined that goods

costing $180,000 were on hand. Not included in the physical count were $18,000 of goods purchased from Rake Corporation, FOB destination, and $27,000 of goods sold to Shovel Company for $40,000, FOB destination. Both the Rake purchase and the Shovel sale were in transit year-end. What amount should Fylus report as its December 31 inventory?

Solution 1. Physical inventory

Add: Goods sold to Shovel

$180,000 27,000

Fylus ending inventory

$207,000

The $18,000 of goods purchased from Rake are excluded from ending inventory because the terms are FOB destination which means Fylus takes title at the time the goods are received. Goods sold to Shovel FOB destination means that the goods are still Fylus's until delivered.

•

ital Tools

Digital study tools in Wiley's online course include the following.

Lecture Videos Lecture Videos, narrated by an accounting instructor for every section in the text, talk through the PowerPoint slides, including embedded application videos where applicable, providing support for online courses, flipped classrooms, and student study and review.

Lea rn ing Objective: 6.1 Discuss how t o classify and determine inventory.

6.1 Classifying and Determining Inventory: Classifying Inventory - Lecture Video (2 min) lectur@

Video

Wiitch this video. t hen answer the questions that follow t o check your understanding_

Video: C1-issifyinc Inventory

I

Reporting Inventory Two ~leps .ill the end of the accountint period cornptete 2

Determ1n

6.1 Classifying and Determining Inventory: Classifying Inventory - Knowl edge Check Knowledge Check Answer the following questions. If you would like to review the video or transcr ipt_ click here

l Work in process is a type at inventory for

compilnies

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2. Companies using a

3 Companies take a physical inventory at the

Question 1

:: merch.tndising

:: manufacturi ng

of the ac counting period

Question2

:: periodic

:: perpetual

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Interactive Tutorial Assignments Interactive Tutorial Assignments provide students with guided instruction of the chapter content and topics, including Chapter Overview Videos, Lecture Videos for each learning objective, and selected Real World Videos. Knowledge Check questions in the assignments check student understanding and knowledge acquisition. The Interactive Tutorial Assignments are available to students as practice, and may be separately customized and assigned by instructors.

xvi

ENGAGING DIGITAL TOOLS

Animations Short, animated videos engage students and simplify major concepts in the text, making the concepts easier to understand. They offer an alternative approach to understanding the written material.

During Class

ffl

Real-World Company Videos Real-world company videos feature both small businesses and larger companies to help students apply content and see how business owners apply concepts from the text in the real world. Many of the videos have associated questions available to be assigned.

Source: YouTube.

ENGAGING DIGITAL TOOLS

Solution Walkthrough Videos Solution Walkthrough Videos are available as question assistance and to help students develop problem-solving techniques. These videos walk students through solutions step-by-step and are based on the most regularly assigned exercises and problems in the text.

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Source: YouTube.

Gradable Excel Questions Gradable Excel questions for each chapter provide students an opportunity to practice Excel skills in the context of solving accounting problems.

I

I

• A B _c______l ~ _D_ _+---E-+--_ 1 i Function: IF; Formula: Subtract, Multiply; Cell Referencing

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2

3 • Brief Exercise - Using Excel to Determine Variances

PROBLEM

4

Student Work Area Required: Provide input into cells shaded in yellow in th is templat e. Use cell references to the Problem area with

5

In October, Pine Company wa s determining its overhead

6

variance. Its predetermined overh ead rate is based on

mathematical formulas in the input cells. In the last input

7

direct labor hours. The fo llowing

field, input an IF function with cell references to your work area.

8 9

Manufacturing overhead costs incurred

10 i

Actual direct labor hours

21,000

Overhead applied

Standard hours allowed for work done

20,600

Total overhead variance

I~~ i I~! : i

Predetermined overhead rate

$ 118,000

Actu al overhead

6.00 Nature of variance

Answer Field 15.4% of your score. Formula: Mult iply; Celt reference. Use a mathematical formula and cell referencing to the Problem area to determine the overhead applied.

Compute the amount of the t otal overhead variance and

15 i designate if the va riance is favorable or unfavorable using

! 16 , Excel's IF function.

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xvi i

xviii

ENGAGING DIGITAL TOOLS

Data Visualization Homework Assignments PowerBI and Tableau visualizations accompanied by questions are available with most chapters. PowerBI and Tableau visualizations allow students to interpret visualizations and think critically about data.

Other Learning Opportunities Other learning opportunities in Wiley's online course include the following. • Accounting-Specific Data Analytics Module offers interactive lessons, case studies, and videos. The module has been prepared using industry-validated content to help students develop the professional competencies needed for the changing workforce. • Cookie Creations is a continuing case that spans across chapters and offers students the opportunity to see how a small business might use financial accounting to operate effectively. • Wiley Accounting Updates (wileyaccountingupdates.com) provide faculty and students with weekly curated news articles and suggested discussion questions. • Flashcards and Crossword Puzzles help students study and master basic vocabulary and concepts. • Student Practice quickly and effectively assesses student understanding of the material they have just covered. • Adaptive Assignments encourage students to persist so that they can succeed in this course and beyond. By continuously adapting to each student's needs and providing achievable goals with just-in-time instruction, Adaptive Assignments close knowledge gaps to accelerate learning.

Contents 1 Introduction to Financial Statements

3 The Accounting Information System

1-1

Knowing the Numbers: Columbia Sportswear Company

1-1

1.1 Business Organization and Accounting Information Uses 1-2 Forms of Business Organization 1-3 Users and Uses of Financial Information 1-4 Data Analytics 1-6 Ethics in Financial Reporting 1-7 1.2 The Three Types of Business Activity 1-8 FinancingActivities 1-9 Investing Activities 1-9 OperatingActivities 1-10 1.3 The Four Financial Statements 1-11 Income Statement 1-12 Retained Earnings Statement 1-13 Balance Sheet 1-14 Statement of Cash Flows 1-16 Interrelationships of Statements 1-17 Elements of an Annual Report 1-20

Appendix lA: Career Opportunities in Accounting "Show Me the Money" 1-24

2 A Further Look at Financial Statements

2-1

Just Fooling Around?: The Motley Fool 2-2 2.1 The Classified Balance Sheet 2-3 Current Assets 2-3 Long-Term Investments 2-5 Property, Plant, and Equipment 2-5 Intangible Assets 2-5 Current Liabilities 2-7 Long-Term Liabilities 2-7 Stockholders' Equity 2-7 2.2 Analyzing the Financial Statements Using Ratios 2-8 Ratio Analysis 2-8 Using the Income Statement 2-9 Using a Classified Balance Sheet 2-10 2.3 Financial Reporting Concepts 2-14 The Standard-Setting Environment 2-14 Qualities of Useful Information 2-16 Assumptions in Financial Reporting 2-17 Principles in Financial Reporting 2-18 Cost Constraint 2-18

1-23

3-1

Accidents Happen: MF Global Holdings Ltd 3-1 3.1 Using the Accounting Equation to Analyze Transactions 3-3 Accounting Transactions 3-3 Analyzing Transactions 3-4 Summary ofTransactions 3-10 3.2 Accounts, Debits, and Credits 3-11 Debits and Credits 3-11 Debit and Credit Procedures 3-12 Stockholders' Equity Relationships 3-15 Summary of Debit/Credit Rules 3-16 3.3 Using a Journal 3-17 The Recording Process 3-17 The Journal 3-18 3.4 The Ledger and Posting 3-20 The Ledger 3-20 Chart of Accounts 3-21 Posting 3-21 The Recording Process Illustrated 3-22 Summary Illustration of Journalizing and Posting 3.5 The Trial Balance 3-30 Limitations of a Trial Balance 3-31

4 Accrual Accounting Concepts

3-28

4-1

Keeping Track of Groupons: Groupon 4-1 4.1 Accrual-Basis Accounting and Adjusting Entries 4-2 The Revenue Recognition Principle 4-3 The Expense Recognition Principle 4-4 Accrual versus Cash Basis of Accounting 4-5 The Need for Adjusting Entries 4-5 Types of Adjusting Entries 4-6 4.2 Adjusting Entries for Deferrals 4-7 Prepaid Expenses 4-7 Unearned Revenues 4-12 4.3 Adjusting Entries for Accruals 4-15 Accrued Revenues 4-15 Accrued Expenses 4-17 Summary of Basic Relationships 4-20 4.4 The Adjusted Trial Balance and Closing Entries 4-23 Preparing the Adjusted Trial Balance 4-23 Preparing Financial Statements 4-24 Quality of Earnings 4-24 Closing the Books 4-27 xix

xx

CONTENTS

Summary of the Accounting Cycle 4-30 Appendix 4A: Using a Worksheet 4-34

S Merchandising Operations and the Multiple-Step Income Statement 5-1 Buy Now, Vote Later: REI

5-1 5.1 Merchandising Operations and Inventory Systems 5-2 Operating Cycles 5-3 Flow of Costs 5-4 5.2 Recording Purchases Under a Perpetual System 5-6 Freight Costs 5-8 Purchase Returns and Allowances 5-9 Purchase Discounts 5-10 Summary of Purchasing Transactions 5-11 5.3 Recording Sales Under a Perpetual System 5-11 Sales Returns and Allowances 5-13 Sales Discounts 5-14 Data Analytics and Credit Sales 5-15 5.4 Preparing the Multiple-Step Income Statement 5-16 Single-Step Income Statement 5-16 Multiple-Step Income Statement 5-17 5.5 Cost of Goods Sold Under a Periodic System 5-21 5.6 Gross Profit Rate and Profit Margin 5-23 Gross Profit Rate 5-23 Profit Margin 5-24 Appendix SA: Periodic Inventory System 5-27 Recording Merchandise Transactions 5-27 Recording Purchases of Merchandise 5-28 Freight Costs 5-28 Recording Sales of Merchandise 5-28 Comparison of Entries-Perpetual vs. Periodic 5-29 Appendix SB: Adjusting Entries for Credit Sales with Returns and Allowances 5-30 Data Analytics in Action 5-52

6 Reporting and Analyzing Inventory

G-1

"Where Is That Spare Bulldozer Blade?": Caterpillar

Lower-of-Cost-or-Net Realizable Value 6-17 Financial Analysis and Data Analytics 6-18 Adjustments for LIFO Reserve 6-21 Appendix GA: Inventory Cost Flow Methods in Perpetual Inventory Systems 6-24 First-In, First-Out (FIFO) 6-24 Last-In, First-Out (LIFO) 6-25 Average-Cost 6-26 Appendix GB: Effects of Inventory Errors 6-27 Income Statement Effects 6-27 Balance Sheet Effects 6-28 Data Analytics in Action 6-49

7 Fraud, Internal Control, and Cash

1-1

Minding the Money in Madison: Barriques

7-1 7.1 Fraud and Internal Control 7-3 Fraud 7-3 The Sarbanes-Oxley Act 7-3 Internal Control 7-4 Principles of Internal Control Activities 7-5 Data Analytics and Internal Controls 7-10 Limitations of Internal Control 7-11 7.2 Cash Controls 7-12 Cash Receipts Controls 7-12 Cash Disbursements Controls 7-14 Petty Cash Fund 7-16 7.3 Control Features of a Bank Account 7-17 Electronic Banking 7-18 Bank Statements 7-18 Reconciling the Bank Account 7-20 7.4 Reporting Cash 7-25 Cash Equivalents 7-26 Restricted Cash 7-26 Managing and Monitoring Cash 7-27 Cash Budgeting 7-29 Appendix 7A: Operation of a Petty Cash Fund 7-32 Establishing the Petty Cash Fund 7-33 Making Payments from the Petty Cash Fund 7-33 Replenishing the Petty Cash Fund 7-34 Data Analytics in Action 7-56

6-1

6.1 Classifying and Determining Inventory 6-2 Classifying Inventory 6-2 Determining Inventory Quantities 6-4 6.2 Inventory Methods and Financial Effects 6-7 Specific Identification 6-7 Cost Flow Assumptions 6-8 Financial Statement and Tax Effects of Cost Flow Methods 6-13 Using Inventory Cost Flow Methods Consistently 6-15 6.3 Inventory Presentation and Analysis 6-17 Presentation 6-17

8 Reporting and Analyzing Receivables

8-1

What's Cooking?: Nike 8-1 8.1 Recognition of Accounts Receivable 8-3 Types of Receivables 8-3 Recognizing Accounts Receivable 8-3 8.2 Valuation and Disposition of Accounts Receivable Valuing Accounts Receivable 8-5 Disposing of Accounts Receivable 8-13

8-5

CONTENTS

8.3 Notes Receivable 8-15 Determining the Maturity Date 8-16 Computing Interest 8-16 Recognizing Notes Receivable 8-17 Valuing Notes Receivable 8-17 Disposing of Notes Receivable 8-17 8.4 Receivables Presentation and Management 8-20 Financial Statement Presentation of Receivables 8-20 Managing Receivables 8-21 Evaluating Liquidity of Receivables 8-23 Accelerating Cash Receipts 8-24 Data Analytics and Receivables Management 8-25 Data Analytics in Action 8-46

9 Reporting and Analyzing Long-Lived Assets

9-1

9-1 9-3 Determining the Cost of Plant Assets 9-3 Expenditures During Useful Life 9-6 To Buy or Lease? 9-7 9.2 Depreciation Methods 9-8 Factors in Computing Depreciation 9-9 Depreciation Methods 9-9 Revising Periodic Depreciation 9-14 Impairments 9-15 9.3 Plant Asset Disposals 9-16 Sale of Plant Assets 9-16 Retirement of Plant Assets 9-18 9.4 Intangible Assets 9-19 Accounting for Intangible Assets 9-19 Types of Intangible Assets 9-20 Research and Development Costs 9-22 9.5 Statement Presentation and Analysis 9-23 Presentation 9-23 Analysis 9-25 Appendix 9A: Other Depreciation Methods 9-30 Declining-Balance Method 9-30 Units-of-Activity Method 9-31 Data Analytics in Action 9-55

A Tale of Two Airlines: American Airlines 9.1 Plant Asset Expenditures

Stockholders' Equity Oh Well, I Guess I'll Get Rich: Facebook

10-1

And Then There Were Two: Maxwell Car Company 10-3

10.1 Accounting for Current Liabilities What Is a Current Liability? 10-3 Notes Payable 10-3 Sales Taxes Payable 10-4 Unearned Revenues 10-5 Current Maturities of Long-Term Debt 10-6 Payroll and Payroll Taxes Payable 10-6

10.2 Characteristics of Bonds 10-9 Types of Bonds 10-9 Issuing Procedures 10-10 Bond Trading 10-10 Determining the Market Price of a Bond 10-11 10.3 Accounting for Bond Transactions 10-14 Issuing Bonds at Face Value 10-14 Discount or Premium on Bonds 10-14 Issuing Bonds at a Discount 10-15 Issuing Bonds at a Premium 10-17 Redeeming Bonds at Maturity 10-19 Redeeming Bonds Before Maturity 10-19 10.4 Presentation and Analysis 10-20 Presentation 10-20 Analysis 10-22 Appendix l0A: Straight-Line Amortization 10-26 Amortizing Bond Discount 10-26 Amortizing Bond Premium 10-28 Appendix 108: Effective-Interest Amortization 10-29 Amortizing Bond Discount 10-29 Amortizing Bond Premium 10-31 Appendix l0C: Accounting for Long-Term Notes Payable 10-32

11 Reporting and Analyzing

10 Reporting and Analyzing Liabilities

xxi

10-1

11-1 11-1

11.1 Corporate Form of Organization 11-3 Characteristics of a Corporation 11-3 Forming a Corporation 11-6 Stockholder Rights 11-7 Stock Issue Considerations 11-8 Corporate Capital 11-10 11.2 Accounting for Common, Preferred, and Treasury Stock 11-12 Accounting for Common Stock 11-12 Accounting for Preferred Stock 11-13 Accounting for Treasury Stock 11-14 11.3 Accounting for Dividends and Stock Splits 11-16 Cash Dividends 11-16 Dividend Preferences 11-19 Stock Dividends 11-21 Stock Splits 11-22 11.4 Presentation and Analysis 11-24 Retained Earnings 11-24 Retained Earnings Restrictions 11-25 Balance Sheet Presentation of Stockholders' Equity 11-26 Analysis of Stockholders' Equity 11-28 Debt versus Equity Decision 11-29 Appendix llA: Entries for Stock Dividends 11-32 Data Analytics in Action 11-55

xxii

CONTENTS

12

Statement of Cash Flows

12-1

Got Cash?: Microsoft

12-2 12.1 Usefulness and Format of the Statement of Cash Flows 12-3 Usefulness of the Statement of Cash Flows 12-3 Classification of Cash Flows 12-3 Significant Noncash Activities 12-4 Format of the Statement of Cash Flows 12-5 12.2 Preparing the Statement of Cash FlowsIndirect Method 12-6 Indirect and Direct Methods 12-7 Indirect Method-Computer Services Company 12-7 Step 1: Operating Activities 12-9 Summary of Conversion to Net Cash Provided by Operating Activities-Indirect Method 12-12 Step 2: Investing and Financing Activities 12-13 Step 3: Net Change in Cash 12-15 12.3 Analyzing the Statement of Cash Flows 12-17 The Corporate Life Cycle 12-17 Free Cash Flow 12-19 Appendix 12A: Statement of Cash Flows-Direct Method 12-22 Step 1: Operating Activities 12-24 Step 2: Investing and Financing Activities 12-28 Step 3: Net Change in Cash 12-30 Appendix 12B: Worksheet for the Indirect Method 12-30 Preparing the Worksheet 12-31 Appendix 12C: Statement of Cash Flows-T-Account Approach 12-35 Data Analytics in Action 12-61

13

Financial Analysis: The Big Picture 13-1

It Pays to Be Patient: Warren Buffett

13-2 13.1 Sustainable Income and Quality of Earnings 13-3 Sustainable Income 13-3 Quality of Earnings 13-7 13.2 Horizontal Analysis and Vertical Analysis 13-9 Horizontal Analysis 13-10 Vertical Analysis 13-12 13.3 Ratio Analysis 13-15 Liquidity Ratios 13-16 Solvency Ratios 13-17 Profitability Ratios 13-17 Financial Analysis and Data Analytics 13-18 Comprehensive Example of Ratio Analysis 13-18 APPENDIX A

APPEND IX

B

Specimen Financial Statements: Apple Inc. A-1

Specimen Financial Statements: Columbia Sportswear Company B-1

APPEND Ix c

Specimen Financial Statements: Under Armour, Inc. C-1

APPEND Ix D

Specimen Financial Statements: Amazon.com, Inc. D-1

APPENDIX E

Specimen Financial Statements: Walmart Inc. E-1

APPENDIX F

Time Value of Money

F-1

F.l Interest and Future Values F-2 Nature of Interest F-2 Future Value of a Single Amount F-3 Future Value of an Annuity F-5 F.2 Present Values F-8 Present Value Variables F-8 Present Value of a Single Amount F-9 Present Value of an Annuity F-11 Time Periods and Discounting F-13 Present Value of a Long-Term Note or Bond F.3 Capital Budgeting Situations F-16 F.4 Using Technological Tools F-18 Present Value of a Single Sum F-19 Present Value of an Annuity F-20 Future Value of a Single Sum F-21 Future Value of an Annuity F-22 Internal Rate of Return F-22 Useful Applications F-23 APPENDIX G

F-13

Reporting and Analyzing Investments G-1

G.l Accounting for Debt Investments G-2 Why Corporations Invest G-2 Accounting for Debt Investments G-2 G.2 Accounting for Stock Investments G-4 Holdings of Less Than 20% G-5 Holdings Between 20% and 50% G-6 Holdings of More Than 50% G-7 G.3 Reporting Investments in Financial Statements Debt Securities G-9 Equity Securities G-12 Balance Sheet Presentation G-13 Presentation of Realized and Unrealized Gain or Loss G-14 Company Index Subject Index

1-1 1-5

Rapid Review: Chapter Content

G-9

Ac kn owled Financial Accounting has benefitted greatly from the input of focus group participants, manuscript reviewers, those who have sent

comments by letter or e-mail, ancillary authors, and proofers. We greatly appreciate the constructive suggestions and innovative ideas of reviewers and the creativity and accuracy of the ancillary authors and checkers. Dennis Avola Northeastern University

Mingcherng Deng Baruch College

Ellen Bartley Farmingdale State College

Kathy Dunne Rider University

Thomas Bednarcik Robert Morris University Illinois Linda Bell Park University Martin Blaine Columbus State Community College Bradley Blaylock Oklahoma State University Isaac Bonaparte Towson University Gary Bower Community College of Rhode Island Robert Braun Southeastern Louisiana University Lou Bravo North Lake College Myra Bruegger Southeastern Community College Barry Buchoff Towson University Brian Bunce Bellevue University Jacqueline Burke Hofstra University Matthew Calderisi Fairleigh Dickinson University Julia Camp Providence College Marian Canada Ivy Tech Community College at Franklin James Chiafery University of Massachusetts-Boston Bea Chiang The College of New Jersey Carolyn Christesen Westchester Community College Colleen Chung Miami Dade College Shifei Chung Rowan University Tony Cioffi Lorain County Community College Leslie Cohen University of Arizona Jim Coughlin Robert Morris University Patricia Crenny Villanova University Dori Danko Grand Valley State University

Barbara Durham University of Central Florida Jeanne Eibes Creighton University David Emerson Salisbury University Caroline Falconetti Nassau Community College Nancy Fan California State Polytechnic University, Pomona Magdy Farag California State Polytechnic University, Pomona Linda Flaming Monmouth University Joseph Fournier University of Rhode Island Chad Frawley Viterbo University AmyGeile University of Arizona Alan Glaser Franklin & Marshall College J. D. Golub Northeastern University Liz Grant Northern Illinois University Rita Grant Grand Valley State University Steve Groves Ivy Tech Community College Konrad Gunderson Missouri Western State University Marcye Hampton University of Central Florida Deborah Hanks Cardinal Stritch University Qian Hao Wilkes University Jacory Hickerson University of Phoenix Huong Higgins Worcester Polytechnic Institute Yongtao Hong North Dakota State University Jana Hosmer Blue Ridge Community College Robert Hurst Franklin University

Wayne Ingalls University of Maine K. Harold Jackson Tarrant County College Jennifer Joe University of Delaware James B. Johnson Community College of Philadelphia Patricia Johnson Canisius College Jordan Kanter University of Rhode Island Ann Galligan Kelley Providence College Robert Kenny The College of New Jersey Emil Koren Saint Leo University Leah Kratz Eastern Mennonite University Faith Lamprey Providence College Claudia Larocque Manchester Community College Gary Laycock Ivy Tech Community College Charles Leflar University of Arkansas Jennifer Lesure Ivy Tech Community College Claudia Lubaski Lorain County Community College Susan Lynn University of Baltimore Yuanyuan Ma University of Minnesota Don McFall Hiram College Allison McLeod University of North Texas Don Minyard University of Alabama-Tuscaloosa Maha Mitrelis Providence College Louella Moore Washburn University Sia Nassiripour William Paterson University Joseph Nesi Monmouth University Judith Pagnette Bellevue College Glenn Pate Palm Beach State College

xxiii

ACKNOWLEDGMENTS

xxiv

Suzy Pearse Clemson University Rachel Pernia Essex County College Bob Picard Idaho State University George Psaras Aurora University Smrity Randhawa University of Southern California Patrick Reihing Nassau Community College John Ribezzo Community College of Rhode Island Barbara Rice Gateway Community and Technical College Vernon Richardson University of Arkansas Patrick Rogan Consumnes River College Juan Roman Saint Leo University John Rude Bloomsburg University Martin Rudnick William Paterson University August Saibeni Consumnes River College Barbara Sandler Queens College Barbara Scofield Washburn University Chris Severson Franklin University Suzanne Seymoure Saint Leo University Abdus Shahid The College of New Jersey Mike Shapeero Bloomsburg University Todd Shawver Bloomsburg University Eileen Shifflett James Madison University Kathy Simmons Bryant University Ladd Simms Mississippi Valley State University Doug Stives Monmouth University Diane Tanner University of North Florida

Karen Tower Ivy Tech Community College

Heidi Hansel Kirkwood Community College

Daniel Tschopp Saint Leo University Mark Ulrich St. John's University Ski Vanderlean Delta College Andrea Weickgenannt Xavier University Nancy Wilburn Northern Arizana University Wayne W. Williams Community College of Philadelphia Leon Wlazlo SUNY Broome Community College Hannah Wong William Paterson University Kenneth Zheng University at Buffalo

Coby Harmon University of California-Santa Barbara

Ancillary Authors, Contributors, Proofers, and Accuracy Checkers Ellen Bartley St. Joseph's College LuAnn Bean Florida Institute of Technology Jack Borke University of Wisconsin-Platteville Ann K. Brooks University of New Mexico Melodi Bunting Edgewood College Bea Chiang The College of New Jersey Lawrence Chui University of St. Thomas (Minnesota) Laura De Luca Fanshawe College Judy Dewitt Central Michigan University Dina El Mahdy Morgan State University James Emig Villanova University Larry Falcetto Emporia State University Michael P. Griffin University of Massachusetts Dartmouth

We appreciate the exemplary support and commitment given to us by associate director Zoe Craig, marketing manager Carolyn Wells, course content developer Jenny Welter, editorial supervisor Terry Ann Tatro, designer Wendy Lai, senior production editor Rachel Conrad, and Julie Perry at Lumina. All of these professionals provided innumerable services that helped the text take shape. We also thank Margaret Shackell of Forsyth Technical Community College and Diane Tanner of University of North

Lisa Hewes Northern Arizona University Kimberly J. Hurt Central Community College Derek Jackson St. Mary's University of Minnesota Craig Krenek Elmhurst College Cynthia Lovick Austin Community College Lisa L. Ludlum Western Illinois University Kirk Lynch Sandhills Community College Susanna Matson Southern New Hampshire University Jill Misuraca University of Tampa Barbara Muller Arizana State University Linda Mullins Georgia State University-Perimeter College Yvonne Phang Borough of Manhattan Community College David Polster Oakton Community College Laura Prosser Black Hills State University Alice Sineath Forsyth Technical Community College Teresa Speck St. Mary's University of Minnesota Lynn Stallworth Appalachian State University Diane Tanner University of North Florida Sheila Viel University of Wisconsin-Milwaukee Dick Wasson Southwestern College Catherine Wyatt Lumina Datamatics Lori Grady Zaher Bucks County Community College Aleksandra Zimmerman Florida State University

Florida for their creativity and efforts in the development of the Data Analytics in Action problems. Finally, we appreciate suggestions and comments from users-instructors and students alike. We welcome your thoughts and ideas about the text. Paul D. Kimmel

Jerry J. Weygandt

Jill E. Mitchell

Cedarburg, Wisconsin

Madison, Wisconsin

Annandale, Virginia

Introduction to Financial Statements Chapter Preview If you own a business, how do you determine whether it is making or losing money? How should you finance expansion-should you borrow, should you issue stock, should you use your own funds? How do you convince banks to lend you money or investors to buy your stock? Success in business requires making countless decisions, and decisions require financial information. The purpose of this chapter is to show you what role accounting plays in providing financial information.

Feature Story Knowing the Numbers Many students who take this course do not plan to be accountants. If you are in that group, you might be thinking, "If I'm not going to be an accountant, why do I need to

The Chapter Preview describes the purpose of the chapter and highlights major topics. The Feature Story helps you picture how the chapter topic relates to the real world of accounting and business.

know accounting?" Well, consider this quote from Harold Geneen, the former chairman of IT&T: "To be good at your business, you have to know the numbers-cold." In business, accounting financial statements are the means for communicating the numbers. If you don't know how to read financial statements, you can't really know your business. 1-1

1-2

CHAPTER 1

Introduction to Financial Statements

Knowing the numbers is sometimes even a matter of corporate survival. Consider the story of Columbia Sportswear Company, headquartered in Portland, Oregon. Gert Boyle's family fled Nazi Germany when she was 13 years old and then purchased a small hat company in Oregon, Columbia Hat Company. In 1971, Gert's husband, who was then running the company, died suddenly. Gert took over the small, struggling company with help from her son Tim, who was then a senior at the University of Oregon. Somehow, they kept the

Chapter Outline

company afloat. Today, Columbia has more than 4,000 employees and annual sales in excess of $1 billion. Its brands include Columbia, Mountain Hardwear, Sorel, and Montrail. Employers such as Columbia Sportswear generally assume that managers in all areas of the company are "financially literate." To help prepare you for that, in this text you will learn how to read and prepare financial statements, and how to use key tools to evaluate financial results using basic data analytics.

The Chapter Outline presents the chapter's topics and subtopics, as well as practice opportunities.

REVIEW

LEARNING OBJECTIVES

LO 1 Identify the forms of business

• Forms of business organization

organization and the uses of accounting information.

• Users and uses of financial information

PRACTICE

DO IT! la Business Organization

Forms

lb Using Financial Information

• Data analytics • Ethics in financial reporting LO 2 Explain the three principal

• Financing activities

types of business activity.

• Investing activities

DO IT! 2 Business Activities

• Operating activities LO 3 Describe the four financial

• Income statement

statements and how they are prepared.

• Retained earnings statement • Balance sheet • Statement of cash flows

DO IT! 3a Financial Statements:

Parts 1-4 3b Components of Annual

Reports

• Interrelationships of statements • Elements of an annual report Go to the Review and Practice section at the end of the chapter for a targeted summary and practice applications with solutions. Visit Wiley Course Resources for additional tutorials and practice opportunities.

1 -1

Business Organization and Accounting Information Uses LEARNING OBJECTIVE 1

Identify the forms of business organization and the uses of accounting information.

Suppose you graduate with a business degree and decide you want to start your own business. But what kind of business? You enjoy working with people, especially teaching them new skills. You spend most of your free time outdoors, kayaking, backpacking, skiing, rock climbing, and mountain biking. You think you might successfully combine your teaching skills and outdoor interest by starting an outdoor guide service.

1.1 Business Organization and Accounting Information Uses

1-3

Forms of Business Organization What organizational form should you choose for your business? You have three choices-sole proprietorship, partnership, or corporation.

Sole Proprietorship

Sole Proprietorship

• Simple to establish • Owner-controlled • Tax advantages

You might choose the sole proprietorship form for your outdoor guide service. • A business owned by one person is a sole proprietorship. • It is simple to set up and gives you control over the business.

Partnership

Small owner-operated businesses such as barber shops, law offices, and auto repair shops are often sole proprietorships, as are farms and small retail stores.

Partnership Another possibility is for you to join forces with other individuals to form a partnership. • A business owned by two or more persons associated as partners is a partnership. • Partnerships often are formed because one individual does not have enough economic resources or other unique skills or resources to initiate or expand the business. You and your partners should formalize your duties and contributions in a written partnership agreement. Retail and service-type businesses, including professional practices (lawyers, doctors, architects, and certified public accountants), often organize as partnerships.

• • • •

Simple to establish Shared control Broader skills and resources Tax advantages

Corporation

Corporation As a third alternative, you might organize as a corporation. • A business organized as a separate legal entity owned by stockholders is a corporation. • Investors in a corporation receive shares of stock to indicate their ownership claim. Buying stock in a corporation is often more attractive than investing in a partnership because shares of stock are easy to sell (transfer ownership). Selling a proprietorship or partnership interest is much more involved. Also, individuals can become stockholders by investing relatively small amounts of money (see Alternative Terminology). Therefore, it is easier for corporations to raise funds compared to sole proprietorships or partnerships. Successful corporations often have thousands of stockholders, and their stock is traded on organized stock exchanges like the New York Stock Exchange. Many businesses start as sole proprietorships or partnerships and eventually incorporate. Other factors to consider in deciding which organizational form to choose are taxes and legal liability. Sole proprietorships or partnerships, generally receive more favorable tax treatment than corporations. However, proprietors and partners are personally liable for all debts and legal obligations of the business; corporate stockholders are not. In other words, corporate stockholders generally pay higher taxes but have no personal legal liability. We will discuss these issues in more depth in a later chapter.

Hybrid Forms of Organization Finally, while sole proprietorships, partnerships, and corporations represent the main types of business organizations, hybrid forms are now allowed in all states. • Hybrid business forms combine the tax advantages of partnerships with the limited liability of corporations. • Probably the most common among these hybrid types are limited liability companies (LLCs) and subchapter S corporations (these forms are discussed extensively in business law classes). The combined number of proprietorships and partnerships in the United States far exceeds the number of corporations. However, the revenue produced by corporations is many times greater. Most of the largest businesses in the United States-for example, Apple, Google, Verizon, Visa, and Microsoft-are corporations. Because the majority of U.S. business is done bv corporations, the emphasis in this text is on the corporate form of organization.

• Easier to transfer ownership • Easier to raise funds • No personal liability

ALTERNAT IV E TERMINOLOGY

Stockholders are sometimes called shareholders. Alternative Terminology notes present synonymous terms that you may come across in practice.

1-4

CHAPTER 1

Introduction to Financial Statements DO IT! exercises prompt you to stop and review the key points you have just studied. The Action Plan offers you tips about how to approach the problem.

ACTION PLAN

• Knowwhich organizational form best matches the business type, size, and preferences of the owner(s).

DO IT! la i Business Organization Forms In choosing the organizational form for your outdoor guide service, you should consider the pros and cons of each. Identify each of the following organizational characteristics with the organizational form or forms with which it is associated (sole proprietorship, partnership, or corporation).

1. Easier to raise funds.

4. Tax advantages.

2. Simple to establish.

5. Easier to transfer ownership.

3. No personal legal liability.

Solution 1. Easier to raise funds: Corporation. 2. Simple to establish: Sole proprietorship and partnership. 3. No personal legal liability: Corporation.

4. Tax advantages: Sole proprietorship and partnership. 5. Easier to transfer ownership: Corporation.

Related exercise material: BEl.l, DO IT! 1.la, and El.2.

!

____________________ _________________,_j

Users and Uses of Financial Information The purpose of financial information is to provide inputs for decision-making. • Accounting is the information system that identifies, records, and communicates the economic events of an organization to interested users. • Users of accounting information can be divided broadly into two groups: internal users and external users.

Internal Users Internal users of accounting information are managers who plan, organize, and run a business. These include marketing managers, production supervisors, finance directors, and company officers. In running a business, managers must answer many important questions, as shown in Illustration 1.1. ILLUSTRATION 1.1 Questions that internal users ask

Questions Asked by Internal Users

Is cash sufficient to pay dividends to our stockholders?

Finance

What price should we charge for our newest smartphone model to maximize the company's net income?

Marketing

Can we afford to give our employees pay raises this year?

Human Resources

Which product line is th e most profitable? Should any product lines be eliminated ?

Management

1.1 Business Organization and Accounting Information Uses

1-5

To answer these and other questions, you need detailed information on a timely basis. For internal users, accounting provides internal reports, such as financial comparisons of operating alternatives, projections of income from new sales campaigns, and forecasts of cash needs for the next year. In addition, companies present summarized financial information in the form of financial statements. Accounting Across the Organization boxes show applications of accounting information in various

business functions.

Accounting Across the Organization

Clif Bar & Company

Owning a Piece of the Bar The original Clif Bar® energy bar was created in 1990 after six months of experimentation by Gary Erickson and his mother in her kitchen. Today, the company has approximately 1,000 employees and was named one of Landor's Breakaway Brands®. One of Clif carterdayne/Getty Images Bar & Company's proudest moments was the creation of an employee stock ownership plan (ESOP). This plan

gives its employees 20% ownership of the company. The ESOP also resulted in Clif Bar enacting an open-book management program, including the commitment to educate all employee-owners about its finances. Armed with basic accounting knowledge, employees are more aware of the financial impact of their actions, which leads to better decisions.

What are the benefits to the company and to the employees of making the financial statements available to all employees? (Answer is available at the end of the chapter.)

External Users There are several types of external users of accounting information. Investors (owners) use accounting information to make decisions to buy, hold, or sell stock. Creditors, such as suppliers and bankers, use accounting information to evaluate the risks of selling on credit or lending money. Some questions that investors and creditors may ask about a company are shown in Illustration 1.2. Questions Asked by External Users

ls Apple earning satisfactory income?

How does Apple compare in size and profitability with Samsung?

II

Headquarters

ILLUSTRATION 1.2 Questions that external users ask

Will Apple be able to pay its debts as they come due?

1111111 1111111 1111111 lllllllt

l■l■IL

The information needs and questions of other external users vary considerably. • Taxing authorities, such as the Internal Revenue Service, want to know whether the company complies with the tax laws. • Customers are interested in whether a company like Tesla will be able to honor product warranties and otherwise support its product lines. • Labor unions, such as the Major League Baseball Players Association, want to know whether the owners have the ability to pay increased wages and benefits. • Regulatory agencies, such as the Securities and Exchange Commission or the Federal Trade Commission, want to know whether the company is operating within prescribed rules.

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CH A PT ER 1

Introduction to Financial Statements

For example, Enron, Dynegy, Duke Energy, and other big energy-trading companies reported record profits at the same time as California was paying extremely high prices for energy and suffering from blackouts. This disparity caused regulators to investigate the energy traders to make sure that the profits were earned by legitimate and fair practices.

Data Analytics

Helpful Hints further clarify concepts being discussed.

HELPFUL HINT Throughout this text, we will highlight examples where accounting information is used to support business decisions using data analytics.

Accounting software systems collect vast amounts of data about a company's economic events as well as its suppliers and customers. Business decision-makers take advantage of this wealth of data by using data analytics to gain insights and therefore make more informed business decisions. • Data analytics involves analyzing data, often employing both software and statistics, to draw inferences. • As both data access and analytical software improve, the use of data analytics to support decisions is becoming increasingly common at virtually all types of companies (see Helpful Hint). Illustration 1.3 shows the four most common types of data analytics that help answer questions ranging from what happened and why did it happen, to what is likely to happen and what should we do about it? Analytics range from simple analysis that can be performed using spreadsheets with tools like pivot tables and graphs, to complex statistical software and even artificial intelligence. More complex analysis provides greater value to the business. Four Types of Data Analytics

ILLUSTRATION 1.3

Four types of data analytics

Future Prescriptive

Greater Predictive

What should we do about it?

What is likely to happen?

Past Diagnostic Value

Why did it happen? Descriptive

What happened?

Hindsight

Less Less

Greater Complexity

Insight boxes provide examples of business situations from various perspectives-ethics, investor, international, corporate social responsibility, and data analytics.

Data Analytics Insight

Netflix

Using Data Science to Create Art

Bogdan Glisik/ Shutterstock.com

Technology provides decision-makers and problem-solvers with access to a large volume of information called "big data." And Netflix, the world's leading subscription streaming entertainment service, is tapping

into this big data as part of its efforts to ramp up its original content production. In a recent year, Netflix planned to spend $8 billion on content creation. Producing content involves a blend of creativity, technology, and business decisions, all of which result in costs. And by analyzing the large amounts of data from past productions, such as filming locations and production schedules,

1.1 Business Organization and Accounting Information Uses

Netflix can more precisely estimate costs for future productions. Further, consider that the production of a TV show or film involves hundreds of tasks. Here again, Netflix uses data science, in this case to visualize where bottlenecks might occur or where opportunities might exist to increase the efficiency of the production process.

1-7

Source: Based on Ritwik Kumar et. al., "Data Science and the Art of Producing Entertainment at Netflix," The Netjli.x Tech Blog (March 26, 2018).

How can "big data" improve decision-making? (Answer is available at the end of the chapter.)

Ethics in Financial Reporting People won't gamble in a casino if they think it is "rigged." Similarly, people won't "play" the stock market if they think stock prices are rigged. At one time, major financial scandals at Enron, WorldCom, HealthSouth, and AIG led to a mistrust of financial reporting in general. A Wall Street Journal article noted that "repeated disclosures about questionable accounting practices have bruised investors' faith in the reliability of earnings reports, which in turn has sent stock prices tumbling." Imagine trying to carry on a business or invest money if you could not depend on the financial statements to be honestly prepared. Information would have no credibility. A well-functioning economy depends on accurate and reliable financial reporting. U.S. regulators and lawmakers were very concerned that the economy would suffer if investors lost confidence in corporate accounting because of unethical financial reporting.

ETHICS NOTE Circus-founder P.T. Barnum is alleged to have said, "Trust everyone, but cut the deck." What Sarbanes-Oxley does is to provide measures that (like cutting the deck of playing cards) help ensure that fraud will not occur.

• Congress passed the Sarbanes-Oxley Act (SOX) to reduce unethical corporate behavior and decrease the likelihood of future corporate scandals (see Ethics Note). • As a result of SOX, top management must now certify the fairness of financial information. • In addition, penalties for fraudulent financial activity are much more severe. • Also, SOX increased both the independence of the outside auditors who review the accuracy of corporate financial statements and the oversight role of boards of directors.

Ethics Notes help sensitize you to some of the ethica l issues in accounting.

Effective financial reporting depends on sound ethical behavior. When analyzing ethics cases and your own ethical experiences, you should apply the three steps outlined in Illustration 1.4.

ILLUSTRATION 1.4

Steps in analyzing ethics cases

Solving an Ethical Dilemma

➔

0

➔

Recognize an ethical situation and the ethical issues involved.

Identify and analyze the principal elements in the situation.

Use your personal ethics to identify ethical situations and issues. Some businesses and professional organizations provide written codes of ethics for guidance in some business situations.

Identify the stakeholderspersons or groups who may be harmed or benefited. Ask the question: What are the responsibilities and obligations of the parties involved?

Identify the alternatives, and weigh the impact of each alternative on various stakeholders. Select the most ethical alternative, considering all the consequences. Sometimes there will be one right answer. Other situations involve more than one right solution; these situations require you to evaluate each alternative and select the best one.

1-8

CHAP T ER 1

lntroductiontoFinancialStatements

Ethics Insight

Dewey & LeBoeuf LLP

I Felt t he Pressure-Would You?

Alliance Images/

Shutterstock.com

"I felt the pressure." That's what some of the employees of the now-defunct law firm of Dewey & LeBoeuf LLP indicated when they helped to overstate revenue and use accounting tricks to hide losses and cover up cash shortages. These employees worked for the former finance director and former chief financial officer (CFO) of the firm. Here are some of their comments:

• "I was instructed by the CFO to create invoices, knowing they would not be sent to clients. When I created these invoices, I knew that it was inappropriate." • "I intentionally gave the auditors incorrect information in the course of the audit."

ACTION PLAN • Review forms of busin ess organization, users of fin ancial information, approach to et hical dilemmas, and definition of data analytics.

What happened here is that a small group of lower-level employees over a period of years carried out the instructions of their bosses. Their bosses, however, seemed to have no concern about unethical practices as evidenced by various e-mails with one another in which they refe rred to their financial manipulations as accounting tricks, cooking the books, and fake income.

Sources: Ashby Jones, "Guilty Pleas of Dewey Staff Detail the Alleged Fraud," Wall Street Jou rnal (March 28, 2014); and Sara Randazzo, "Dewey CFO Escapes Jail Time in Fraud Case Sentencing," Wall Street Journal (October 10, 2017). Why did these employees lie, and what do you believe should be their penalty for these lies? (Answ er is available at the end of the chapter.)

DO IT! lb I Using Financial Information There are a variety of users and uses of financial information. Match each of the following terms with its definition, classification type, or associated phrase.

a. __ Data analytics.

1. Marketing managers, finance directors.

b.

Internal users of financial information. 2. Management must certify the fairness of financial information. c. __ Element of Sarbanes-Oxley Act. External users of financial information. 3. Often employs both software and statistics to d. draw inferences. e. __ Steps in solving an ethical dilemma. 4. Identify the alternatives and weigh the impact of each alternative on various stakeholders. 5. Investors, labor unions.

Solution a.3 b. 1 c.2 d.5 e.4 Related exercise material: BEl.2, DO IT! I.lb, and El.3.

1.2

The Three Types of Business Activity LEARNING OBJECTIVE 2

Explain the three principal types of business activity.

Businesses engage in three types of activity-financing, investing, and operating. For example, consider Gert Boyle's parents, the founders of Columbia Sportswear. 1. The Boyles obtained cash through financing (from personal savings and outside sources like banks) to start and grow their business.

1.2 The Three Types of Business Activity

2. The family then invested the cash in equipment to run the business, such as sewing equipment and delivery vehicles. 3. Once this equipment was in place, they began the operating activities of making and

selling clothing. The accounting information system keeps track of the results of each of the various business activities-financing, investing, and operating. Let's look at each type of business activity in more detail.

Financing Activities It takes money to make money. Financing activities involve raising money from outside sources. The two primary sources of outside funds for corporations are borrowing money (debt financing) and issuing (selling) shares of stock in exchange for cash (equity financing). Columbia Sportswear may borrow money in a variety of ways. For example, it can take out a loan at a bank or borrow directly from investors by issuing debt securities called bonds. Persons or entities to whom Columbia owes money are its creditors.

The Stock Exch ange

Equity Financing

• Amounts owed to creditors-in the form of debt and other obligations-are called liabilities. • Specific names are given to different types of liabilities, depending on their source. Columbia may have a note payable to a bank for the money borrowed to purchase delivery trucks. • Debt securities sold to investors that must be repaid at a particular date some years in the future are bonds payable.

Debt Financing

Corporations also obtain funds by selling shares of stock to investors. Common stock is the term used to describe the total amount paid in by stockholders for the shares they purchase. The claims of creditors differ from those of stockholders. If you loan money to a company, you are one of its creditors. In lending money, you specify a payment schedule (e.g., payment at the end of three months). As a creditor, you have a legal right to be paid at the agreed time. In the event of nonpayment, you may legally force the company to sell property to pay its debts. In the case of financial difficulty, creditor claims must be paid before stockholders' claims. Stockholders, on the other hand, have no claim to corporate cash until the claims of creditors are satisfied. Suppose you buy a company's stock instead of loaning it money. You have no legal right to expect any payments from your stock ownership until all of the company's creditors are paid amounts currently due. However, many corporations make payments to stockholders on a regular basis as long as there is sufficient cash to cover required payments to creditors. These cash payments to stockholders are called dividends.

Investing Activities Once the company has raised cash through financing activities, it uses that cash in investing activities. Investing activities involve the purchase of the resources a company needs in order to operate. Resources owned by a business are called assets. A growing company purchases many assets, such as computers, delivery trucks, furniture, and buildings. • Different types of assets are given different names; Columbia Sportswear's sewing equipment is a type of asset referred to as property, plant, and equipment (see Alternative Terminology). • Cash is one of the more important assets owned by Columbia or any other business.

ALTERNATIVE TERMINOLOGY

• If a company has excess cash that it does not need for a while, it might choose to invest in securities (stocks or bonds) of other corporations, a type of asset referred to as investments.

Property, plant, and equipment is sometimes calledf,xed assets.

Investing

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CH A PT ER 1

Introduction to Financial Statements

Operating Activities Once a business has the assets it needs to get started, it begins operating activities. Operating activities are the day-to-day actions taken by a company to produce and sell a product, or provide a service. Columbia Sportswear is in the business of selling outdoor clothing and footwear. It sells TurboDownjackets, Millennium snowboard pants, Sorel' snow boots, Bugaboo ts™, rainwear, and anything else you might need to protect you from the elements. We call amounts earned from the sale of these products revenues.

Operating

• Revenue is the increase in assets or decrease in liabilities resulting from the sale of goods or the performance of services in the normal course of business; Columbia records revenue when it sells a footwear product. • Revenues arise from different sources and are identified by various names depending on the nature of the business; Columbia's primary source of revenue is the sale of sportswear (but it also generates interest revenue on debt securities held as investments). • Sources of revenue common to many businesses are sales revenue, service revenue, and interest revenue. The company purchases its longer-lived assets through investing activities as described earlier. Other assets with shorter lives, however, result from operating activities. • Supplies are assets used in day-to-day operations (rather than sold to customers). • Goods available for future sales to customers are assets called inventory. • The right to receive money in the future is called an account receivable. If Columbia sells goods to a customer and does not receive cash immediately, then the company has a right to expect payment from that customer in the near future. Before Columbia can sell a single Sorel' boot, it must purchase wool, rubber, leather, metal lace loops, laces, and other materials. It then must process, wrap, and ship the finished product. It also incurs costs like salaries, rents, and utilities. All of these costs, referred to as expenses, are necessary to produce and sell the product. • In accounting language, expenses are the cost of assets consumed or services used in the process of generating revenues. • Expenses take many forms and are identified by various names depending on the type of asset consumed or service used. For example, Columbia keeps track of these types of expenses: cost of goods sold (such as the cost of materials), selling expenses (such as the cost of salespersons' salaries), marketing expenses (such as the cost of advertising), administrative expenses (such as the salaries of administrative staff, and telephone and heating costs incurred at the corporate office), interest expense (amounts of interest paid on various debts), and income tax expense (corporate taxes paid to the government). Columbia may also have liabilities arising from these expenses. • For example, Columbia may purchase goods on credit from suppliers. The obligations to pay for these goods are called accounts payable. • Additionally, Columbia may have interest payable on the outstanding amounts owed to the bank. • It may also have wages payable to its employees and sales taxes payable, property taxes payable, and income taxes payable to the government. Columbia compares the revenues of a period with the expenses of that period to determine whether it earned a profit. When revenues exceed expenses, net income results. When expenses exceed revenues, a net loss results.

1.3 The Four Financial Statements 1-11

DO IT! 2

I

Business Activities

Classify each item as an asset, liability, common stock, revenue, or expense. 1. Cost of renting property.

4. Issuance of ownership shares.

2. Truck purchased.

5. Amount recorded from performing services.

3. Notes payable.

6. Amounts owed to suppliers.

ACTION PLAN

• Classify each item based on its economic characteristics. Proper classification of items is critical if accounting is to provide useful information.

Solution 1. Cost of renting property: Expense.

2. 3. 4. 5. 6.

Truck purchased: Asset. Notes payable: Liability. Issuance of ownership shares: Common stock. Amount recorded from performing services: Revenue. Amounts owed to suppliers: Liability.

Related exercise material: BEl.3, DO IT! 1.2, and El.7.

1.3

The Four Financial Statements

LEARNING OBJECTIVE 3

Describe the four financial statements and how they are prepared.

Assets, liabilities, expenses, and revenues are of interest to users of accounting information. This information is arranged in the format of four different financial statements, which form the backbone of financial accounting: 1. Income statement. Shows how successfully your business performed during a period of time, by subtracting expenses from revenues. 2. Retained earnings statement. Indicates how much of previous income was distributed to owners of your business in the form of dividends, and how much was retained in the business to allow for future growth. 3. Balance sheet. Presents a picture at a point in time of what your business owns (its assets) and what it owes (its liabilities). 4. Statement of cash flows. Shows where your business obtained cash during a period of time and how that cash was used. To introduce you to these statements, we have prepared the financial statements for your outdoor guide service, Sierra Corporation, after your first month of operations (see International Note). To summarize, you officially started your business in Truckee, California, on October 1, 2025. Sierra provides guide services in the Lake Tahoe area of the Sierra Nevada mountains. Its promotional materials describe outdoor day trips, such as rafting, snowshoeing, and hiking, as well as multi-day backcountry experiences. To minimize your initial investment, your customers either bring their own equipment or rent equipment through local outfitters. The financial statements for Sierra's first month of business are provided in the following pages.

International Note The primary types of financial statements required by International Financial Reporting Standards (IFRS) and U.S. generally accepted accounting principles (GAAP) are the same. However, in practice, some format differences do exist in presentations commonly employed by IFRS companies as compared to GAAP companies.

International Notes highlight differences between U.S. and international accounting standards.

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CH APT ER 1

Introduction to Financial Statements

Income Statement HELPFUL HINT

The financial statement heading identifies the company, the type of statement, and the time period covered.

The income statement reports a company's revenues and expenses and resulting net income or loss for a period of time (see Decision Tools). To indicate that its income statement reports the results of operations for a specific period of time, Sierra Corporation dates the income statement "For the Month Ended October 31, 2025." The income statement lists the company's revenues followed by its expenses. Finally, Sierra determines the net income (or net loss) by deducting expenses from revenues. Sierra's income statement is shown in Illustration 1.5 (see Helpful Hint). Congratulations, you are already showing a profit!

Sierra Corporation

ILLUSTRATION 1.S

Sierra Corporation's income statement

Decision Tools The income statement helps users determine if the company's operations are profitable. Decision Tools that are useful

for business decision-making are highlighted throughout the text. A summary of the Decision Tools is also provided in each chapter.

Income Statement For the Month Ended October 31, 2025

Revenues Service revenue Expenses Salaries and wages expense Supplies expense Rent expense Interest expense Insurance expense Depreciation expense Total expenses Net income

$10,600 $5,200 1,500 900

so so 40

Why are financial statement users interested in net income?

• Investors are interested in a company's past net income because it provides useful information for predicting future net income. Investors buy and sell stock based on their beliefs about a company's future performance. If investors believe that Sierra will be successful in the future and that this will result in a higher stock price, they will buy its stock. ETHICS NOTE When companies find errors in previously released income statements, they restate those numbers. Perhaps because of the increased scrutiny shortly after Sarbanes-Oxley was implemented, companies filed a record 1,195 restatements.

• Creditors use the income statement to predict future earnings. When a bank loans money to a company, it believes that it will be repaid in the future. If it didn't think it would be repaid, it wouldn't loan the money. Therefore, prior to making the loan the bank loan officer uses the income statement as a source of information to predict whether the company will be profitable enough to repay its loan. Thus, reporting a strong profit will make it easier for Sierra to raise additional cash either by issuing shares of stock or borrowing. Amounts received from issuing stock are not revenues, and amounts paid out as dividends are not expenses. As a result, they are not reported on the income statement. For example, Sierra Corporation does not treat as revenue the $10,000 of cash received from issuing new stock (see Illustration 1.8), nor does it regard as a business expense the $500 of dividends paid (see Illustration 1.6) (see Ethics Note).

r~-~:::,:~:-==----- - ~~ ~; • I

I. I

i

I

i

!

and expenses for a period of time in an income statement.

3a Pa;~ -: Financial Stat:;;;;~~-The Income Statement

Part 1: CSU Corporation began operations on January 1, 2025. The following information is available for CSU on December 31, 2025. Accounts receivable Accounts payable Rent expense Notes payable Common stock

$ 1,800 2,000 9,000 5,000 10,000

Prepare an income statement.

Retained earnings Equipment Insurance expense Service revenue Supplies

$

0

16,000 1,000 17,000 4,000

Supplies expense Cash Dividends

$ 200 1,400 600

1.3 The Four Financial Statements

1-1:

Solution

CSU Corporation Income Statement For the Year Ended December 31, 2025

Revenues Service revenue Expenses Rent expense Insurance expense Supplies expense Total expenses Net income

$17,000 $9,000 1,000 200 10,200 $ 6,800

Related exercise material: BEl.6, BEl.7, BEl.8, DO IT! 1.3a, El.9, El.10, El.14, El.15, El.16, El.18, andEl.19.

Retained Earnings Statement If Sierra Corporation is profitable, at the end of each period it must decide what portion of profits to pay to shareholders in dividends. In theory, it could pay all of its current-period profits, but few companies do this. Why? Because they want to retain part of the profits to allow for further expansion. High-growth companies, such as Google and Facebook, often pay no dividends. Retained earnings is the net income retained in the corporation. The retained earnings statement shows the amounts and causes of changes in retained earnings for a specific time period (see Decision Tools). The time period is the same as that covered by the income statement. The beginning retained earnings amount appears on the first line of the statement. Then, the company adds net income and deducts dividends to determine the retained earnings at the end of the period. If a company has a net loss, it deducts (rather than adds) that amount in the retained earnings statement. Illustration 1.6 presents Sierra's retained earnings statement (see Helpful Hint).

Sierra Corporation's retained earnings statement

Retained Earnings Statement For the Month Ended October 31, 2025

Less: Dividends Retained earnings, October 31

HELPFUL HINT

The heading of this statement identifies the company, the type of statement, and the time period covered by the statement.

ILLUSTRATION 1.6

Sierra Corporation

Retained earnings, October 1 Add: Net income

Decision Tools The retained earnings statement helps users determine the company's policy toward dividends and growth.

$

0

2,860 2,860 500 $2,360

By monitoring the retained earnings statement, financial statement users can evaluate dividend payment practices. • Some investors seek companies, such as Dow Chemical, that have a history of paying high dividends. • Other investors seek companies, such as Amazon.com, that reinvest earnings to increase the company's growth instead of paying dividends. • Lenders monitor their corporate customers' dividend payments because any money paid in dividends reduces a company's ability to repay its debts.

1-14

CHAPTER 1

Introduction to Financial Statements

ACTION PLAN

• Show the amounts and causes (net income and dividends) of changes in retained earnings during the period in the retained earnings statement.

Part 2: CSU Corporation began operations on January 1, 2025. The following information is available for CSU on December 31, 2025.

Accounts receivable Accounts payable Rent expense Notes payable Common stock

$ 1,800 2,000 9,000 5,000 10,000

Retained earnings Equipment Insurance expense Service revenue Supplies

0 $ 16,000 1,000 17,000 4,000

$ 200 1,400 600

Supplies expense Cash Dividends

Prepare a retained earnings statement. Refer to DO IT! 3a Part 1 for net income.

Solution

CSU Corporation Retained Earnings Statement For the Year Ended December 31, 2025

Retained earnings, January 1 Add: Net income Less: Dividends Retained earnings, December 31

$

0

6,800 6,800 600 $6,200

Related exercise material: BEl.7, BEl.10, DO IT! 1.3a, El.9, El.IO, El.13, El.16, El.17, and El.18.

Balance Sheet Decision Tools The balance sheet helps users determine whether the company relies on debt or stockholders' equity to finance its assets.

The balance sheet reports assets and claims to assets at a specific point in time (see Decision Tools). Claims to assets are subdivided into two categories: claims of creditors and claims of owners. As noted earlier, claims of creditors are called liabilities. The owners' claim to assets is called stockholders' equity. Illustration 1.7 shows the relationship among the categories on the balance sheet in equation form. • This equation is referred to as the basic accounting equation. • This relationship is where the name "balance sheet" comes from. Assets must balance with the claims to assets.

ILLUSTRATION 1.7

Assets= Liabilities+ Stockholders' Equity

Basic accounting equation HELPFUL H INT

The heading of a balance sheet must identify the company, the statement, and the date. ALTER NATI VE TERMINOLO GY

Liabilities are also referred to as debt.

As you can see from looking at Sierra Corporation's balance sheet in Illustration 1.8, the balance sheet presents the company's financial position as of a specific date-in this case, October 31, 2025 (see Helpful Hint). It lists assets first. Assets are listed in the order of their liquidity, that is, how quickly they could be converted to cash. Assets are followed by liabilities and stockholders' equity (see Alternative Terminology). Stockholders' equity is comprised of two parts: (1) common stock and (2) retained earnings. As noted earlier, common stock results when the company sells new shares of stock;

1.3 The Four Financial Statements

1-1

retained earnings is the net income retained in the corporation. Sierra has common stock of $10,000 and retained earnings of $2,360, for total stockholders' equity of $12,360.

ILLUSTRATION 1.8

Sierra Corporation

Sierra Corporation's balance sheet

Balance Sheet October 31, 2025

Assets Cash Accounts receivable Supplies Prepaid insurance Equipment, net Total assets

$15,200 200 1,000 550 4,960 $21,910

Liabilities and Stockholders' Equity Liabilities Notes payable $ 5,000 Accounts payable 2,500 Unearned service revenue 800 Salaries and wages payable 1,200 Interest payable 50 Total liabilities Stockholders' equity Common stock 10,000 Retained earnings 2,360 Total stockholders' equity Total liabilities and stockholders' equity

$ 9,550

12,360 $21,910

Creditors analyze a company's balance sheet to determine the likelihood that they will be repaid. • Creditors carefully evaluate the nature of the company's assets and liabilities. • In operating Sierra's guide service, the balance sheet will be used to determine whether cash on hand is sufficient for immediate cash needs. • The balance sheet will also be used to evaluate the relationship between debt and stockholders' equity to determine whether the company has a satisfactory proportion of debt and common stock financing. .,

DO IT! 3a Part 3

Financial Statements-The Balance Sheet

Part 3: CSU Corporation began operations on January 1, 2025. The following information is avail-

able for CSU on December 31, 2025. Accounts receivable $ 1,800 2,000 Accounts payable 9,000 Rent expense 5,000 Notes payable 10,000 Common stock

Retained earnings Equipment Insurance expense Service revenue Supplies

0 $ 16,000 1,000 17,000 4,000

Supplies expense Cash Dividends

$ 200 1,400 600

Prepare a balance sheet. Refer to DO IT! 3a Part 2 for the ending balance in Retained Earnings.

,

_________

ACTION PLAN

• Present the assets and claims to those assets (liabilities and equity) at a specific point in time in the balance sheet.

1-16

CHAPTER 1

Introduction to Financial Statements

Solution

CSU Corporation Balance Sheet December 31, 2025

Assets $ 1,400

Cash Accounts receivable Supplies Equipment Total assets

1,800 4,000 16,000 $23,200

Liabilities and Stockholders' Equity

Liabilities Notes payable Accounts payable Total liabilities Stockholders' equity Common stock Retained earnings Total stockholders' equity Total liabilities and stockholders' equity

$ 5,000 2,000 $ 7,000 10,000 6,200 16,200 $23,200

Related exercise material: BEl.5, BEl.6, BEl.7, BEl.8, BEl.9, BEI.10, DO IT! 1.3a, El.12, El.16, El.17, and El.22.

Statement of Cash Flows Decision Tools The statement of cash flows helps users determine if the company generates enough cash from operations to fund its investing activities. HELPFUL HINT The heading of this statement identifies the company, the type of statement, and the time period covered by the statement. Negative numbers are shown in parentheses.

ILLUSTRATION 1.9

Sierra Corporation's statement of cash flows

The primary purpose of a statement of cash flows is to provide financial information about the cash receipts and cash payments of a business for a specific period of time (see Decision Tools). To help investors, creditors, and others in their analysis of a company's cash position, the statement of cash flows reports the cash effects of a company's operating, investing, and financing activities. In addition, the statement shows the net increase or decrease in cash during the period, and the amount of cash at the end of the period. Users are interested in the statement of cash flows because they want to know what is happening to a company's most important resource. The statement of cash flows provides answers to these simple but important questions: • Where did cash come from during the period? • How was cash used during the period? • What was the change in the cash balance during the period? The statement of cash flows for Sierra Corporation, in Illustration 1.9, shows that cash increased $15,200 during the month (see Helpful Hint). This increase resulted because operating activities (services to clients) increased cash $5,700, and financing activities increased cash $14,500. Investing activities used $5,000 of cash for the purchase of equipment.

Sierra Corporation Statement of Cash Flows For the Month Ended October 31, 2025

Cash flows from operating activities Cash receipts from operating activities Cash payments for operating activities Net cash provided by operating activities

$11 ,200 (5,500) $ 5,700

1.3 The Four Financial Statements

Cash flows from investing activities Purchased office equipment Net cash used by investing activities Cash flows from financing activities Issuance of common stock Issuance of note payable Payment of dividend Net cash provided by financing activities Net increase in cash Cash at beginning of period Cash at end of period

1-1

ILLUSTRATION 1.9

(5,000)

(continued)

(5,000) 10,000 5,000

--120days

$314,086

56.7%

635

Total Overdue Amount

Overdue Amount%

Overdue invoices {not cleared) $4,327,5.,

Top Debtors Customer3437 = = =~ Customer 2422

Customer5145 Customerl760 Customer5395 Customer 2002 Customer5680 Customer3236

$18,S45 SH,846 $13,526 S11,256 -$11,050 -$10,574 Total Overdue Amount

919%

100.0% 100.0%

lll!a $18,545 -

-

$14,846

sn,110

•

s11,140

95.6%

• sn,oso

"·""

Total Outstanding Amount

Overdue Amount%

Outstanding 11voices

------ . .................

·•

.,

100.0d

1,407

115.7%

$15,790

•

•

100.0%

$26,298 • $24,788

•$26,298 $23,267

-

~'>&iif.K,;S l7 8 47 Tod•y

Overdue Invoices (Not ((eared)

SOO.Od

1,000.0d

Outstanding Invoices

.

2117.2d

/

m.sy '~

/

,I.pf

Oct

M,rAprMay.llJnJulAug~pOct~ovOt'C F, b

Today

-Juf1 ---- Au,

339.lld

CK

Ftb

Source: Tableau website.

Keeping an Eye on Cash A lot of companies report strong sales growth but have cash flow problems. How can this be? The reason for the difference is timing: Sales revenue is recorded when goods are delivered even if cash is not received until later. For example, Nike had sales of $34,350 million during 2017. Does that mean it received cash of $34,350 million from its customers? Most likely not. So how do we determine the amount of cash related to sales revenue that is actually received from customers? We analyze the changes that take place in Accounts Receivable. To illustrate, suppose Bestor Corporation started the year with $10,000 in accounts receivable. During the year, it had credit sales of $100,000. At the end of the year, the balance in accounts receivable was $25,000. As a result, accounts receivable increased $15,000 during the year. How much cash did Bestor collect from customers during the year? Using the following T-account, we can determine that collections were $85,000.

Beginning balance Sales Ending balance

Accounts Receivable 10,000 85,000 100,000 25,000

ACTION PLAN • Review the formula to compute the accounts receivable turnover. • Make sure that both the beginning and ending accounts receivable are considered in the computation. Review the formula to compute the average collection period in days.

As shown, the difference between sales and cash collections is explained by the change in Accounts Receivable. Accounts Receivable increased by $15,000. Therefore, since credit sales were $100,000, cash collections were only $85,000. To illustrate another situation, let's use Nike. Recall that it had net credit sales of $34,350 million. Its ending receivables balance was $3,677 million, and its beginning receivables balance was $3,241 million-an increase of $436 million. Given this change, we can determine that the cash collected from customers during the year was $33,914 million ($34,350 - $436). This is shown in the following T-account.

Beginning balance Sales Ending balance

Accounts Receivable 3,241 33,914 34,350 3,677

Collections

Collections

DO IT! 4

I

Analysis of Receivables

In 2025, Lebron James Company had net credit sales of $923,795 for the year. It had a beginning accounts receivable (net) balance of $38,275 and an ending accounts receivable (net) balance of $35,988. Compute Lebron James Company's (a) accounts receivable turnover and (b) average collection period in days.

Solut ion a. Net credit sales $923,795

Average net accounts receivable $38,275 + $35,988 2

Accounts receivable turnover 24.9 times

I

l

Using the Decision Tools

T

b.

Days in year 365

Accounts receivable turnover

Average collection period in days

24.9 times

14.7 days

Related exercise material: BES.11, BES.12, DO IT! 8.4, ES.18, and ES.19.

USING THE DECISION TOOLS I adidas Suppose the following information was taken from the financial statements of adidas. Similar to Nike and Skechers, adidas sells shoes as well as other products. adidasAG Selected Financial Information (in millions)

€14,534 1,809 1,946 7,347 4,378

Net credit sales Beginning accounts receivable (net) Ending accounts receivable (net) Total current assets Total current liabilities

Instructions Comment on adidas' accounts receivable management and liquidity relative to that of Nike, using (a) the current ratio and (b) the accounts receivable turnover and average collection period. Assume Nike's current ratio was 2.80:1, its accounts receivable turnover was 9.9 times, and its average collection period was 36.9 days.

Solution a. Here is the current ratio (Current assets.;. Current liabilities) for each company. Nike

2.80:1

adidas

$7,347 - - = 1.68:1 $4,378

Based on the assumed information for adidas, Nike's current ratio far exceeds that of adidas. In fact, Nike's might be excessive. A company of its size would not normally want to have so much capital tied up in current assets. b. The accounts receivable turnover and average collection period for each company are: Nike

adidas

Accounts receivable turnover

9.9 times

$14,534 - - - - - - - = 7.7 times ($1,946 + $1,809)/2

Average collection period

36.9 days

365 n=47.4days

Based on the assumed information for adidas, its accounts receivable turnover of 7.7 compared to Nike's 9.9, and its average collection period of 47.4 days versus Nike's 36.9 days, suggest that adidas is able to collect from its customers slightly less quickly. It is important to note, however, that adidas is a German company. It reports under IFRS. A thorough comparison of adidas and Nike would require consideration of differences in the treatment of accounts receivable under IFRS and GAAP.

8-2i

8-28

CHA PT ER 8

Reporting and Analyzing Receivables

Review and Practice Learning Objectives Review

1

Explain how companies recognize accounts receivable.

Receivables are frequently classified as accounts, notes, and other. Accounts receivable are amounts customers owe on account. Notes receivable represent claims that are evidenced by formal instruments of credit. Other receivables include nontrade receivables such as interest receivable, loans to company officers, advances to employees, and income taxes refundable. Companies record accounts receivable when they perform a service on account or at the point-of-sale of merchandise on account. Sales returns and allowances and cash discounts reduce the amount received on accounts receivable. 2

Describe how companies value accounts receivable and

record their disposition. The two methods of accounting for uncollectible accounts are the allowance method and the direct write-off method. Under the allowance method, companies estimate uncollectible accounts as a percentage of receivables. It emphasizes the cash realizable value of the accounts receivable. An aging schedule is frequently used with this approach. 3

Explain how companies recognize, value, and dispose of

notes receivable.

at which time the borrower (maker) pays the face value plus accrued interest and the payee removes the note from the accounts. In many cases, however, similar to accounts receivable, the holder of the note speeds up the conversion by selling the receivable to another party. In some situations, the maker of the note dishonors the note (defaults), and the note is written off. Describe the statement presentation of receivables and the principles of receivables management.

4

Companies should identify each major type of receivable in the balance sheet or in the notes to the financial statements. Short-term receivables are considered current assets. Companies report the gross amount of receivables and the allowance for doubtful accounts. They report bad debt and service charge expenses in the income statement as operating (selling) expenses, and interest revenue as other revenues and gains in the nonoperating section of the statement. To properly manage receivables, management must (a) determine to whom to extend credit, (b) establish a payment period, (c) monitor collections, (d) evaluate the liquidity of receivables, and (e) accelerate cash receipts from receivables when necessary. The accounts receivable turnover and the average collection period both are useful in analyzing management's effectiveness in managing receivables. The accounts receivable aging schedule also provides useful information. If the company needs additional cash, management can accelerate the collection of cash from receivables by selling (factoring) its receivables or by allowing customers to pay with bank credit cards.

The formula for computing interest is Face value of note x Annual interest rate x Time in terms of one year. Notes can be held to maturity,

Decision Tools Review

Decision Checkpoints

Info Needed for Decision

Tool to Use for Decision

How to Evaluate Results

Is the amount of past due accounts increasing? Which accounts require management's attention?

List of outstanding receivables and their due dates

Prepare an aging schedule showing the receivables in various stages: outstanding 0-30 days, 31- 60 days, 61-90 days, and over 90 days.

Accounts in the older categories require follow-up: letters, phone calls, and possible renegotiation of terms.

Is the company's credit risk increasing?

Customer account balances and due dates

Accounts receivable aging schedule

Compute and compare the percentage of receivables over 90 days old.

Does the company have significant concentrations of credit risk?

Note to the financial statements on concentrations of credit risk

If risky credit customers are identified, the financial health of those customers should be evaluated to gain an independent assessment of the potential for a material credit loss.

If a material loss appears likely, the potential negative impact of that loss on the company should be carefully evaluated, along with the adequacy of the allowance for doubtful accounts. (continues)

Practice Multiple-Choice Questions

8-29

(continued)

Decision Checkpoints Are collections being made in a timely fashion?

Info Needed for Decision Net credit sales and average net accounts receivable balance

Tool to Use for Decision

How to Evaluate Results

Net credit Accounts receivable= _ _ _s_al_e_s_ __ Average net turnover accounts receivable Average collection = - -3-6-S_d_a~ys _ __ Accounts period receivable turnover

Average collection period should be consistent with corporate credit policy. An increase may suggest a decline in financial health of customers.

Glossary Review Accounts receivable Amounts customers owe on account. (p. 8-3). Accounts receivable turnover A measure of the liquidity of accounts receivable, computed by dividing net credit sales by average net accounts receivable. (p. 8-23). Aging the accounts receivable A schedule of customer balances classified by the length of time they have been unpaid. (p. 8-10). Allowance method A method of accounting for bad debts that involves estimating uncollectible accounts at the end of each period. (p. 8-7). Average collection period The average amount of time that a receivable is outstanding, calculated by dividing 365 days by the accounts receivable turnover. (p. 8-23). Bad Debt Expense An expense account to record losses from extending credit. (p. 8-6). Cash (net) realizable value The net amount a company expects to receive in cash from receivables. (p. 8-7). Concentration of credit risk The threat of nonpayment from a single large customer or class of customers that could adversely affect the financial health of the company. (p. 8-22). Direct write-off method A method of accounting for bad debts that involves charging receivable balances to Bad Debt Expense at the time receivables from a particular company are determined to be uncollectible. (p. 8-6).

Factor A finance company or bank that buys receivables from businesses for a fee and then collects the payments directly from the customers. (p. 8-13).

Maker The party in a promissory note who is making the promise to pay. (p. 8-15). Notes receivable Written promise (as evidenced by a formal instrument) for amounts to be received. (p. 8-3). Other receivables Nontrade receivables that generally do not result from the operations of the business such as interest receivable and income taxes refundable. (p. 8-3) Payee The party to whom payment of a promissory note is to be made. (p. 8-15). Percentage-of-receivables basis A method of estimating the amount of bad debt expense whereby management establishes a percentage relationship between the amount of receivables and the expected losses from uncollectible accounts. (p. 8-9 ). Promissory note A written promise to pay a specified amount of money on demand or at a definite time. (p. 8-15). Receivables Amounts due from individuals and companies that are expected to be collected in cash. (p. 8-3 ). Trade receivables Notes and accounts receivable that result from sales transactions. (p. 8-3).

Dishonored (defaulted) note A note that is not paid in full at maturity. (p. 8-18).

Practice Multiple-Choice Questions 1. (LO 1) A receivable that is evidenced by a formal instrument

c. accounts receivable and general receivables.

and that normally requires the payment of interest is:

d. accounts receivable, notes receivable, and other receiv-

a. an account receivable. b. a trade receivable. c. a note receivable. d. a classified receivable. 2. (LO 1) Receivables are frequently classified as:

a. accounts receivable, company receivables, and other receivables.

b. accounts receivable, notes receivable, and employee receivables.

ables. 3. (LO 1) Kersee Company on June 15 sells merchandise on account to Eng Co. for $1,000, terms 2/10, n/30. On June 20, Eng Co. returns merchandise worth $300 to Kersee Company. On June 24, payment is received from Eng Co. for the balance due. What is the amount of cash received? a. $700.

c. $686.

b. $680.

d. None of the answer choices is correct.

8-30

CHAPTER 8

Reporting and Analyzing Receivables

4. (LO 2, 4) Accounts and notes receivable are reported in the cur-

10. (LO 2) A company can accelerate its cash receipts by all of the

rent assets section of the balance sheet at:

following except:

a. cash (net) realizable value

a. offering discounts for early payment.

b. net book value.

b. accepting national credit cards for customer purchases.

c. lower-of-cost-or-market value.

c. selling receivables to a factor.

d. invoice cost.

d. writing off receivables.

5. (LO 2) Net credit sales for the month are $800,000. The accounts receivable balance is $160,000. The allowance is calculated as 7.5% of the receivables balance using the percentage-of-receivables basis. If Allowance for Doubtful Accounts has a credit balance of $5,000 before adjustment, what is the balance after adjustment? a. $12,000.

c. $17,000.

b. $7,000.

d. $31,000.

6. (LO 2) In 2025, Patterson Wholesale Company had net cred-

it sales of $750,000. On January 1, 2025, Allowance for Doubtful Accounts had a credit balance of $18,000. During 2025, $30,000 of uncollectible accounts receivable were written off. Past experience indicates that the allowance should be 10% of the balance in receivables (percentage-of-receivables basis). If the accounts receivable balance at December 31 was $200,000, what is the required adjustment to Allowance for Doubtful Accounts at December 31, 2025? a. $20,000.

c. $32,000.

b. $75,000.

d. $30,000.

$800,000 50,000

c. $800,000.

b. $750,000.

d. $735,000.

65,000

8. (LO 2) Which of these statements about Visa credit card sales is incorrect? a. The credit card issuer conducts the credit investigation of the customer. b. The retailer is not involved in the collection process. c. The retailer must wait to receive payment from the issuer. d. The retailer receives cash more quickly than it would from individual customers. 9. (LO 2) Good Stuff Retailers accepted $50,000 of Citibank Visa credit card charges for merchandise sold on July 1. Citibank charges 4% for its credit card use. The entry to record this transaction by Good Stuff Retailers will include a credit to Sales Revenue of $50,000 and a debit(s) to: a. Cash $48,000 and Service Charge Expense $2,000. b. Accounts Receivable $48,000 and Service Charge Expense $2,000. C.

Cash $50,000.

d. Accounts Receivable $50,000.

c. $60,000. d. $65,000.

12. (LO 2) Use the same information as in Question 11, except that Hughes has a debit balance of $5,000 in its Allowance for Doubtful Accounts before any adjustments are made at the end of the year. In this situation, the amount of bad debt expense that should be reported for the year is: a. $5,000.

C.

$60,000.

b. $55,000.

d. $65,000.

incorrect? a. The party making the promise to pay is called the maker. b. The party to whom payment is to be made is called the payee. c. A promissory note is not a negotiable instrument.

What is the cash realizable value of the accounts receivable at December 31, after adjustment? a. $685,000.

a. $5,000. b. $55,000.

13. (LO 3) Which of these statements about promissory notes is

7. (LO 2) An analysis and aging of the accounts receivable of Raja Company at December 31 reveal these data: Accounts receivable Allowance for doubtful accounts per books before adjustment (credit) Amounts expected to become uncollectible

11. (LO 2) Hughes Company has a credit balance of $5,000 in its Allowance for Doubtful Accounts before any adjustments are made at the end of the year. Based on review and aging of its accounts receivable at the end of the year, Hughes estimates that $60,000 of its receivables are uncollectible. The amount of bad debt expense which should be reported for the year is:

d. A promissory note is more liquid than an account receivable. 14. (LO 3) Michael Co. accepts a $1,000, 3-month, 12% promissory

note in settlement of an account with Tani Co. The entry to record this transaction is: a. Notes Receivable Accounts Receivable

1,030

b. Notes Receivable Accounts Receivable

1,000

c. Notes Receivable Sales Revenue

1,000

d. Notes Receivable Accounts Receivable

1,020

1,030 1,000 1,000 1,020

15. (LO 3) Schleis Co. holds Murphy Inc.'s $10,000, 120-day, 9% note. The entry made by Schleis Co. when the note is collected, assuming no interest has previously been accrued, is: a. Cash Notes Receivable

10,300

b. Cash Notes Receivable

10,000

C.

Accounts Receivable Notes Receivable Interest Revenue

d. Cash Notes Receivable Interest Revenue

10,300 10,000 10,300 10,000 300 10,300 10,000 300

Practice Multiple-Choice Questions

16. (LO 4) If a company is concerned about extending credit to a risky customer, it could do any of the following except:

a. require the customer to pay cash in advance. b. require the customer to provide a letter of credit or a bank guarantee. c. contact references provided by the customer, such as banks and other suppliers.

d. provide the customer a lengthy payment period to increase the chance of paying. 17. (LO 4) Eddy Corporation had net credit sales during the year of $800,000 and cost of goods sold of $500,000. The balance in receiva-

Solutions 1. c. A note receivable represent claims for which formal instru-

ments of credit are issued as evidence of the debt. The note normally requires the payment of the principal and interest on a specific date. Choices (a) account receivable, (b) trade receivable, and (d) classified receivable rarely require the payment of interest if paid within a 30-day period. 2. d. Receivables are frequently classified as accounts receivable, notes receivable, and other receivables. The other choices are incorrect because receivables are not frequently classified as (a) company receivables, (b) employee receivables, or (c) general receivables. 3. c. Because payment is made within the discount period of 10 days, the amount received is $700 ($1,000 - $300 return) minus the discount of $14 ($700 x 2%), for a cash amount of $686, not (a) $700 or (b) $680. Choice (d) is wrong as there is a correct answer. 4. a. Accounts and notes receivable are reported in the current assets

section of the balance sheet at cash (net) realizable value, not (b) net book value, (c) lower-of-cost-or-market value, or (d) invoice cost. 5. a. The ending balance required in the allowance account is 7.5% x $160,000, or $12,000. Since there is already a balance of $5,000 in Allowance for Doubtful Accounts, the difference of $7,000 should be added, resulting in a balance of $12,000, not (b) $7,000, (c) $17,000, or (d) $31,000. 6. c. After the write-offs are recorded, Allowance for Doubtful Accounts will have a debit balance of $12,000 ($18,000 credit beginning balance combined with a $30,000 debit for the write-offs). The desired balance, using the percentage-of-receivables basis, is a credit balance of $20,000 ($200,000 x 10%). In order to have an ending balance of $20,000, the required adjustment to Allowance for Doubtful Accounts is $32,000, not (a) $20,000, (b) $75,000, or (d) $30,000. 7. d. The cash realizable value of the accounts receivable is Accounts Receivable ($800,000) less the expected ending balance in Allowance for Doubtful Accounts after adjustments ($65,000) = $735,000, not (a) $685,000, (b) $750,000, or (c) $800,000. 8. c. There is no wait for payment. The retailer receives payment

at the time the credit card is accepted from the customer. The other choices are true statements. 9. a. The entry includes a credit to Sales Revenue for $50,000, a $48,000 debit to Cash, and a debit to Service Charge Expense for $2,000. The other choices are therefore incorrect.

8-31

bles at the beginning of the year was $100,000 and at the end of the year was $150,000. What was the accounts receivable turnover and average collection period in days?

a. 4.0 and 91.3 days.

c. 6.4 and 57 days.

b. 5.3 and 68.9 days.

d. 8.0 and 45.6 days.

18. (LO 4) Prall Corporation sells its goods on terms of 2/10, n/30.

It has an accounts receivable turnover of 7. What is its average collection period (days)?

a. 2,555.

c. 52.

b. 30.

d. 210.

10. d. Writing off receivables will result in a company failing to col-

lect any money. Instead, choices (a) offering discounts for early payment, (b) accepting national credit cards for customer purchases, and (c) selling receivables to a factor will all allow a company to accelerate its cash receipts. 11. b. By crediting Allowance for Doubtful Accounts for $55,000, the new balance will be the required balance of $60,000. This adjusting entry debits Bad Debt Expense for $55,000 and credits Allowance for Doubtful Accounts for $55,000, not (a) $5,000, (c) $60,000, or (d) $65,000.

12. d. By crediting Allowance for Doubtful Accounts for $65,000, the new balance will be the required balance of $60,000. This adjusting entry debits Bad Debt Expense for $65,000 and credits Allowance for Doubtful Accounts for $65,000, not (a) $5,000, (b) $55,000, or (c) $60,000. 13. c. Promissory notes are negotiable instruments, meaning if sold,

the seller can transfer to another party by endorsement. The other choices are true statements. 14. b. On the date Michael accepts the note, Notes Receivable is deb-

ited for $1,000 and Accounts Receivable is credited for $1,000. Interest is accrued only with the passage of time. The other choices are therefore incorrect. 15. d. When Schleis receives payment, it will increase cash, reduce

the notes receivable account, and recognize interest earned for the term of the note. Interest= $10,000 x 9% x 120/360 = $300. Total cash received = $10,000 + $300 = $10,300. The other choices are therefore incorrect. 16. d. A longer payment period will increase the chances the cus-

tomer will not pay. The other choices are incorrect as companies might require risky customers to (a) pay cash in advance, (b) provide letters of credit or bank guarantees, or (c) ask for references from banks and suppliers to determine their payment history. 17. c. Accounts receivable turnover= Net credit sales ($800,000).;. Average net accounts receivable [($100,000 + $150,000)/2] = 6.4. The average collection period in days = (365.;. 6.4) = 57 days. The other choices are therefore incorrect. 18. c. Average collection period = Number of days in the year (365) .;. Accounts receivable turnover (7) = 52 days, not (a) 2.555, (b) 30, or (d) 210.

8-32

CHAPTER 8

Reporting and Analyzing Receivables

Practice Brief Exercises Record basic accounts receivable transactions.

1. (LO 1) Record the following transactions on the books of Gonzalez Co. (Omit cost of goods sold

entries.)

a. On August 1, Gonzalez Co. sold merchandise on account to Miguel Inc. for $15,500, terms 1/10, n/30. b. On August 8, Miguel Inc. returned merchandise worth $3,100 to Gonzalez Co. c. On August 11, Miguel Inc. paid for the merchandise.

Solution 15,500

1. a. Accounts Receivable

15,500

Sales Revenue 3,100

b. Sales Returns and Allowances

3,100

Accounts Receivable C.

Prepare entry using percentage-ofreceivables method.

12,276 124

Cash ($12,400 - $124) Sales Discounts ($12,400 x 1%) Accounts Receivable ($15,500 - $3,100)

12,400

2. (LO 2) Sanchez Co. uses the percentage-of-receivables basis in 2025 to record bad debt expense. It estimates that 3% of accounts receivable will become uncollectible. Sales revenues are $900,000 for 2025, and sales returns and allowances are $50,000 at December 31, 2025. Accounts receivable has a balance of $139,000, and the allowance for doubtful accounts has a credit balance of $3,000. Prepare the adjusting entry to record bad debt expense in 2025.

Solution 2. Bad Debt Expense [($139,000 x 3%) - $3,000] Allowance for Doubtful Accounts

Prepare entry for notes receivable exchanged for account receivable.

1,170 1,170

3. (LO 3) On January 20, 2025, Carlos Co. sold merchandise on account to Carson Co. for $20,000, n/30. On February 19, Carson Co. gave Carlos Co. an 8% promissory note in settlement of this account. Prepare the journal entry to record the sale and the settlement of the account receivable.

Solution 3. Jan. 20

I Accounts Receivable

20,000

Sales Revenue Feb. 191 Notes Receivable Accounts Receivable

20,000 20,000 20,000

Practice Exercises Journalize entries to record bad debt expense using two different bases.

1. (LO 2) The ledger of J.C. Cobb Company at the end of the current year shows Accounts Receivable

$150,000, Sales Revenue $850,000, and Sales Returns and Allowances $30,000.

Instructions a. If J.C. Cobb uses the direct write-off method to account for uncollectible accounts.journalize the adjusting entry at December 31, assuming J.C. Cobb determines that M. Jack's $1,500 balance is uncollectible.

Practice Exercises

8-33

b. If Allowance for Doubtful Accounts has a credit balance of $2,400 in the trial balance, journalize the adjusting entry at December 31, assuming bad debts are expected to be 10% of accounts receivable. c. If Allowance for Doubtful Accounts has a debit balance of $200 in the trial balance, journalize the adjusting entry at December 31, assuming bad debts are expected to be 6% of accounts receivable. Solution 1. a.

b.

Dec. 31 Dec. 31

c. Dec. 31

Bad Debt Expense Accounts Receivable

1,500

Bad Debt Expense Allowance for Doubtful Accounts [($150,000 X 10%)- $2,400]

12,600

Bad Debt Expense Allowance for Doubtful Accounts [($150,000 X 6%) + $200]

9,200

1,500

12,600

9,200

2. (LO 3) Troope Supply Co. has the following transactions related to notes receivable during the last

3 months of 2025. Loaned $16,000 cash to Juan Vasquez on a 1-year, 10% note. Sold goods to A. Palmer, Inc., receiving a $6,750, 90-day, 8% note. Received a $6,400, 6-month, 9% note in exchange for J. Nicholas's outstanding accounts receivable. Accrued interest revenue on all notes receivable.

Oct. 1 Dec. 11 16 31

Instructions

a. Journalize the transactions for Troope Supply Co. b. Record the collection of the Vasquez note at its maturity in 2026. Solution 2025

2. a. Oct.

1

Dec. 11 Dec. 16

Notes Receivable Cash

16,000

Notes Receivable Sales Revenue

6,750

Notes Receivable Accounts Receivable

6,400

16,000 6,750 6,400 454

Interest Receivable Interest Revenue*

31

454

*Calculation of interest revenue:

Vasquez's note: Palmer's note: Nicholas's note: Total accrued interest

$16,000 6,750 6,400

10% 8% 9% X

3/12 = $400 30 20/360 24 X 15/360 = $454

X

X

X

X

2026

b. Oct.

1

Cash Interest Receivable Interest Revenue** Notes Receivable

.. $16,000 X 10% X 9/12

17,600 400 1,200 16,000

Journalize entries for notes receivable transactions.

8-34

CHAPTER 8

Reporting and Analyzing Receivables

Practice Problem Prepare entries for various receivables transactions.

(LO 1, 2, 3) Presented here are selected transactions related to B. Dylan Corp.

Sold $20,000 of merchandise to Potter Company, terms 2/10, n/30. Received payment in full from Potter Company for balance due on existing accounts receivable. Accepted Juno Company's $20,000, 6-month, 12% note for balance due on outstanding account receivable. Made B. Dylan Corp. credit card sales for $13,200. Made Visa credit sales totaling $6,700. A 5% service fee is charged by Visa. Sold accounts receivable of $8,000 to Harcot Factor. Harcot Factor assesses a service charge of 2% of the amount of receivables sold. Received collections of $8,200 on B. Dylan Corp. credit card sales. Wrote off as uncollectible $16,000 of accounts receivable. (B. Dylan Corp. uses the percentage-of-receivables basis to estimate bad debts.) The balance in accounts receivable at the end of the first 6 months is $200,000. The company estimates that 10% of accounts receivable will become uncollectible. At June 30, the credit balance in the allowance account prior to adjustment is $3,500. Recorded bad debt expense. One of the accounts receivable written off in May pays the amount due, $4,000, in full.

Mar. 1 11 12 13 15 Apr. 11 13 May 10 June 30

July 16 Instructions

Prepare the journal entries for the transactions. (Cost of goods sold entries are omitted here as well as in homework material.) Solution Mar. 1

I

11

12

131 15

Apr.

11

13

I May

June

10

30

I

Accounts Receivable Sales Revenue (To record sales on account)

20,000

Cash Sales Discounts (2% x $20,000) Accounts Receivable (To record collection of accounts receivable)

19,600 400

Notes Receivable Accounts Receivable (To record acceptance of Juno Company note)

20,000

Accounts Receivable Sales Revenue (To record company credit card sales)

13,200

20,000

20,000

20,000

13,200

Cash Service Charge Expense (5% x $6,700) Sales Revenue (To record credit card sales)

6,365 335

Cash Service Charge Expense (2% x $8,000) Accounts Receivable (To record sale of receivables to factor)

7,840 160

Cash Accounts Receivable (To record collection of accounts receivable)

8,200

Allowance for Doubtful Accounts Accounts Receivable (To record write-off of accounts receivable)

16,000

Bad Debt Expense Allowance for Doubtful Accounts [($200,000 X 10%) - $3,500] (To record estimate of uncollectible accounts)

16,500

6,700

8,000

8,200

16,000

16,500

Questions July

16

Accounts Receivable Allowance for Doubtful Accounts (To reverse write-off of accounts receivable)

4,000

Cash Accounts Receivable (To record collection of accounts receivable)

4,000

8-l!i

4,000

4,000

Brief Exercises, DO IT! Exercises, Exercises, Problems, Data Analytics Activities, A Look at IFRS, and many additional resources are available for practice in Wiley Course Resources.

Questions 1. What is the difference between an account receivable and a note receivable? 2. What are some common types of receivables other than accounts receivable or notes receivable? 3. What are the essential features of the allowance method of accounting for bad debts? 4. Lance Morrow cannot understand why the cash realizable value

does not decrease when an uncollectible account is written off under the allowance method. Clarify this point for Lance. 5. Sarasota Company has a credit balance of $2,200 in Allowance for Doubtful Accounts before adjustment. The estimated uncollectibles under the percentage-of-receivables basis is $5,100. Prepare the adjusting entry.

14. Compute the missing amounts for each of the following notes.

Principal (a) $60,000 $50,000 $30,000

Annual Interest Rate 6%

(b) 11% 8%

Time

Total Interest

60 days 5 months (c) 3 years

$ 270 $2,500 $2,750 (d)

15. Mendosa Company dishonors a note at maturity. What are the options available to the lender?

16. General Motors Company has accounts receivable and notes receivable. How should the receivables be reported on the balance sheet?

6. What types of receivables does Apple report on its balance sheet? Does it use the allowance method or the direct write-off method to account for uncollectibles?

17. What are the steps to good receivables management?

7. How are bad debts accounted for under the direct write-off method? What are the disadvantages of this method?

19. What is meant by a concentration of credit risk?

8. Tawnya Dobbs, the vice president of sales for Tropical Pools and

Spas, wants the company's credit department to be less restrictive in granting credit. "How can we sell anything when you guys won't approve anybody?" she asks. Discuss the pros and cons of "easy credit." What are the accounting implications? 9. JCPenney Company accepts both its own credit cards and national credit cards. What are the advantages of accepting both types of cards?

18. How might a company monitor the risk related to its accounts receivable?

20. The president of Ericson Inc. proudly announces her company's improved liquidity since its current ratio has increased substantially from one year to the next. Does an increase in the current ratio always indicate improved liquidity? What other ratio or ratios might you review to determine whether or not the increase in the current ratio is an improvement in financial health?

10. An article in the Wall Street Journal indicated that companies are selling their receivables at a record rate. Why do companies sell their receivables?

21. Since hiring a new sales director, Tilton Inc. has enjoyed a 50% increase in sales. The CEO has also noticed, however, that the company's average collection period has increased from 17 days to 38 days. What might be the cause of this increase? What are the implications to management of this increase?

11. Calico Corners decides to sell $400,000 of its accounts receivable to Fast Cash Factors Inc. Fast Cash Factors assesses a service charge of 3% of the amount of receivables sold. Prepare the journal entry that Calico Corners makes to record this sale.

22. Assume The Coca-Cola Company's accounts receivable turnover was 9.05, and its average amount of net receivables during the period was $3,424 million. What is the amount of its net credit sales for the period? What is the average collection period in days?

12. Your roommate is uncertain about the advantages of a promisso-

ry note. Compare the advantages of a note receivable with those of an account receivable.

23. Douglas Corp. has experienced tremendous sales growth this year, but it is always short of cash. What is one explanation for this occurrence?

13. How may the maturity date of a promissory note be stated?

24. How can the amount of collections from customers be determined?

8-36

CHAPTER 8

Reporting and Analyzing Receivables

Brief Exercises Identify different types of receivables.

BES.I (LO 1), C Presented below are three receivables transactions. Indicate whether these receivables are reported as accounts receivable, notes receivable, or other receivables on a balance sheet. a. Advanced $10,000 to an employee. b. Received a promissory note of $34,000 for services performed. c. Sold merchandise on account for $60,000 to a customer.

Record basic accounts receivable transactions.

BES.2 (LO 1), AP Record the following transactions on the books of Jarvis Co. (Omit cost of goods sold entries.) a. On July 1, Jarvis Co. sold merchandise on account to Stacey Inc. for $23,000, terms 2/10, n/30. b. On July 8, Stacey Inc. returned merchandise worth $2,400 to Jarvis Co. c. On July 11, Stacey Inc. paid for the merchandise.

Prepare entry for write-off, and determine cash realizable value.

BES.3 (LO 2), AP At the end of 2024, Safer Co. has accounts receivable of $700,000 and an allowance for doubtful accounts of $25,000. On January 24, 2025, it is learned that the company's receivable from Madonna Inc. is not collectible and therefore management authorizes a write-off of $4,300. a. Prepare the journal entry to record the write-off.

b. What is the cash realizable value of the accounts receivable (1) before the write-off and (2) after the write-off? Prepare entries for collection of bad debt write-off.

BES.4 (LO 2), AP Assume the same information as BE8.3 and that on March 4, 2025, Safer Co. receives payment of $4,300 in full from Madonna Inc. Prepare the journal entries to record this transaction.

Prepare entry using percentage-ofreceivables method.

BES.5 (LO 2), AP Byrd Co. uses the percentage-of-receivables basis to record bad debt expense and concludes that 2% of accounts receivable will become uncollectible. Accounts receivable are $400,000 at the end of the year, and the allowance for doubtful accounts has a credit balance of $2,800. a. Prepare the adjusting journal entry to record bad debt expense for the year. b. If the allowance for doubtful accounts had a debit balance of $900 instead of a credit balance of $2,800, prepare the adjusting journal entry for bad debt expense.

Prepare entry using the percentage-ofreceivables method.

BES.6 (LO 2), AP Bayfiew Corp uses the percentage-of-receivables basis to record bad debt expense. Accounts receivable (ending balance) Allowance for doubtful accounts (unadjusted)

$550,000 (debit) 4,200 (debit)

The company estimates that 3% of accounts receivable will become uncollectible. a. Prepare the adjusting journal entry to record bad debt expense for the year. b. What is the ending (adjusted) balance in Allowance for Doubtful Accounts? c. What is the cash (net) realizable value? Prepare entries for credit card sale and sale of accounts receivable.

BES. 7 (LO 2), AP Consider these transactions: a. Tastee Restaurant accepted a Visa card in payment of a $200 lunch bill. The bank charges a 3% fee. What entry should Tastee make? b. Martin Company sold its accounts receivable of $65,000. What entry should Martin make, given a service charge of 3% on the amount of receivables sold?

Compute interest and determine maturity dates on notes.

Determine maturity dates and compute interest and rates on notes.

BES.S (LO 3), AP Compute interest and find the maturity date for the following notes. Date of Note a. June 10 b. July 14 c. April 27

Principal $S0,000 $50,000 $12,000

Interest Rate(%) 6% 7% 8%

Terms 60 days 90 days 75 days

BES.9 (LO 3), AN Presented below are data on three promissory notes. Determine the missing amounts. Date of Note a. April 1 b. July 2 c. March 7

Terms 60 days 30 days 6 months

Maturity Date ? ? ?

Principal $600,000 90,000 120,000

Annual Interest Rate 9% ? 10%

Total Interest ? $600 ?

DO IT! Exercises

8-37

BES.IO (LO 3), AP On January 10, 2025, Masterson Co. sold merchandise on account to Tompkins for $8,000, terms n/30. On February 9, Tompkins gave Masterson Co. a 7% promissory note in settlement of this account. Prepare the journal entry to record the sale and the settlement of the accounts receivable. (Omit cost of goods sold entries.)

Prepare entry for note receivable exchanged for accounts receivable.

BE8.11 (LO 2, 4), AP During its first year of operations, Fertig Company had credit sales of $3,000,000, of which $400,000 remained uncollected at year-end. The credit manager estimates that $18,000 of these receivables will become uncollectible.

Prepare entry for estimated uncollectibles and classifications, and compute ratios.

a. Prepare the journal entry to record the estimated uncollectibles. (Assume an unadjusted balance of zero in Allowance for Doubtful Accounts.) b. Prepare the current assets section of the balance sheet for Fertig Company, assuming that in addition to the receivables it has cash of $90,000, merchandise inventory of $180,000, and supplies of $13,000. c. Calculate the accounts receivable turnover and average collection period. Assume that average net accounts receivable were $300,000. Explain what these measures tell us. BE8.12 (LO 4), AP Suppose the 2025 financial statements of 3M Company report net sales of $23.1 billion. Accounts receivable (net) are $3.2 billion at the beginning of the year and $3.25 billion at the end of the year. Compute 3M's accounts receivable turnover. Compute 3M's average collection period for accounts receivable in days.

Analyze accounts receivable.

BE8.13 (LO 4), AP Kennewick Corp. had a beginning balance in accounts receivable of $70,000 and an ending balance of $91,000. Credit sales during the period were $598,000. Determine cash collections.

Determine cash collections.

DO IT! Exercises DO IT! 8.1 (LO 1), AP On March 1, Lincoln sold merchandise on account to Amelia Company for $28,000, terms 1/10, net 45. On March 6, Amelia returns merchandise with a sales price of $1,000. On March 11, Lincoln receives payment from Amelia for the balance due. Prepare journal entries to record the March transactions on Lincoln's books. (Ignore cost of goods sold entries and explanations.)

Prepare entries to recognize accounts receivable.

DO IT! 8.2a (LO 2), AP Mantle Company has been in business several years. At the end of the current year, the unadjusted trial balance shows:

Prepare entry for uncollectible accounts.

Accounts Receivable Sales Revenue Allowance for Doubtful Accounts

$ 310,000 Dr. 2,200,000 Cr. 5,700 Cr.

Bad debts are estimated to be 7% of receivables. Prepare the entry to adjust Allowance for Doubtful Accounts. DO IT! 8.2b (LO 2), AP Neumann Distributors is a growing company whose ability to raise capital has not been growing as quickly as its expanding assets and sales. Neumann's local banker has indicated that the company cannot increase its borrowing for the foreseeable future. Neumann's suppliers are demanding payment for goods acquired within 30 days of the invoice date, but Neumann's customers are slow in paying for their purchases (60-90 days). As a result, Neumann has a cash flow problem.

Prepare entry for factored accounts.

Neumann needs $160,000 to cover next Friday's payroll. Its balance of outstanding accounts receivable totals $800,000. To alleviate this cash crunch, the company sells $170,000 of its receivables. Record the entry that Neumann would make. (Assume a 2% service charge.) DO IT! 8.3 (LO 3), AP Buffet Wholesalers accepts from Gates Stores a $6,200, 4-month, 9% note dated May 31 in settlement of Gates' overdue account. The maturity date of the note is September 30. What entry does Buffet make at the maturity date, assuming Gates pays the note and interest in full at that time?

Prepare entries for notes receivable.

DO IT! 8.4 (LO 4), AP In 2025, Bismark Company has net credit sales of $1,600,000 for the year. It had a beginning accounts receivable (net) balance of $108,000 and an ending accounts receivable (net) balance of $120,000. Compute Bismark Company's (a) accounts receivable turnover and (b) average collection period in days.

Compute ratios for receivables.

8-38

CHAPTER 8

Reporting and Analyzing Receivables

Exercises Prepare entries for recognizing accounts receivable.

E8.1 (LO 1), AP On January 6, Jacob Co. sells merchandise on account to Harley Inc. for $9,200, terms 1/10, n/30. On January 16, Harley pays the amount due. Instructions

Prepare the entries on Jacob Co.'s books to record the sale and related collection. (Omit cost of goods sold entries.) Prepare entries for recognizing accounts receivable.

E8.2 (LO 1), AP On January 10, Molly Amise uses her Lawton Co. credit card to purchase merchandise from Lawton Co. for $1,700. On February 10, Molly is billed for the amount due of $1,700. On February 12, Molly pays $1,100 on the balance due. On March 10, Molly is billed for the amount due, including interest at 1% per month on the unpaid balance as of February 12. Instructions

Prepare the entries on Lawton Co.'s books related to the transactions that occurred on January 10, February 12, and March 10. (Omit cost of goods sold entries.) Journalize receivables transactions.

E8.3 (LO 1, 2), AP At the beginning of the current period, Rose Corp. had balances in Accounts Receivable of $200,000 and in Allowance for Doubtful Accounts of $9,000 (credit). During the period, it had net credit sales of $800,000 and collections of $763,000. It wrote off as uncollectible accounts receivable of $7,300. However, a $3,100 account previously written off as uncollectible was recovered before the end of the current period. Uncollectible accounts are estimated to total $25,000 at the end of the period. (Omit cost of goods sold entries.) Instructions a. Prepare the entries to record sales and collections during the period.

b. Prepare the entry to record the write-off of uncollectible accounts during the period.

c. Prepare the entries to record the recovery of the uncollectible account during the period. d. Prepare the entry to record bad debt expense for the period.

e. Determine the ending balances in Accounts Receivable and Allowance for Doubtful Accounts. f. What is the net realizable value of the receivables at the end of the period?

Journalize receivables transactions.

E8.4 (LOl,2), AP On January 1, 2025, Budd Corporation started the year with a balance in Accounts Receivable of $145,000 and a credit balance in Allowance for Doubtful Accounts of $7,950. During 2025, the company had total sales of $600,000; 75% of these sales were credit sales. Collections (not including the cash sales) during the period were $480,000. Budd wrote off as uncollectible accounts receivable of $8,100. In addition, an account of $840 that was previously written off as uncollectible was recovered during the year. Uncollectible accounts are estimated to be 5% of the end-of-year Accounts Receivable balance. (Omit cost of goods sold entries.) Instructions

a. Prepare the entries to record sales and collections during the period. b. Prepare the entry to record the write-off of uncollectible accounts during the period. c. Prepare the entries to record the recovery of the uncollectible account during the period. d. Determine the ending balance in Accounts Receivable. e. Determine the ending balance in Allowance for Doubtful Accounts. f. Prepare the entry to record bad debt expense for the period.

g. What is the net realizable value of the receivables at December 31, 2025? Journalize receivables transactions.

E8.5 (LO 1, 2), AP Assume the following information for Larry Corp. Accounts receivable (beginning balance) Allowance for doubtful accounts (beginning balance) Net credit sales Collections Write-offs of accounts receivable Collections of accounts previously written off

$142,000 11,360 945,000 910,000 5,200 1,900

Uncollectible accounts are expected to be 8% of the ending balance in accounts receivable.

Exercises Instructions

a. Prepare the entries to record sales and collections during the period. b. Prepare the entry to record the write-off of uncollectible accounts during the period. c. Prepare the entries to record the recovery of the uncollectible account during the period. d. Determine the ending balance in Accounts Receivable and the unadjusted balance in Allowance for Doubtful Accounts. e. Prepare the entry to record bad debt expense for the period. f. Determine the ending (adjusted) balance in Allowance for Doubtful Accounts. E8.6 {LO 2), AP The ledger of Macarty Company at the end of the current year shows Accounts Receivable $78,000, Credit Sales $810,000, and Sales Returns and Allowances $40,000.

Prepare entries to record bad debt expense.

Instructions

a. If Macarty uses the direct write-off method to account for uncollectible accounts, journalize the entry if on July 7 Macarty determines that Matisse Company's $900 balance is uncollectible. b. Assume Macarty uses the allowance method to account for uncollectible accounts. If Allowance for Doubtful Accounts has a credit balance of $1,100 in the trial balance.journalize the adjusting entry at December 31, assuming bad debts are expected to be 10% of accounts receivable. c. Assume Macarty uses the allowance method to account for uncollectible accounts. If Allowance for Doubtful Accounts has a debit balance of $500 in the trial balance, journalize the adjusting entry at December 31, assuming bad debts are expected to be 8% of accounts receivable. E8.7 (L02), AP The following represent different scenarios for Emma Company. Prior to any year-end adjusting entries, Emma Company had a balance in Accounts Receivable of $130,000. Credit sales during the period were $730,000, and Sales Returns and Allowances were $18,000.

Prepare entries to record bad debt expenses.

Instructions Record the following independent events.

a. If Emma Company uses the direct write-off method to account for uncollectible accounts, journalize the entry if on May 8 Emma determined that Randal Company's $450 balance is uncollectible. b. If Emma Company uses the allowance method to account for uncollectible accounts, journalize the entry if on May 8 Emma determined that Randal Company's $450 balance is uncollectible. c. Assume Emma Company uses the allowance method to account for uncollectible accounts. If Allowance for Doubtful Accounts has a debit balance of $890 in the trial balance, journalize the adjusting entry at December 31, assuming bad debts are expected to be 9% of Accounts Receivable. d. Assume Emma Company uses the allowance method to account for uncollectible accounts. If

Allowance for Doubtful Accounts has a credit balance of $1,090 in the trial balance, journalize the adjusting entry at December 31, assuming bad debts are expected to be 7% of Accounts Receivable. E8.8 {LO 2), AP Godfreid Company has accounts receivable of $95,400 at March 31, 2025. Credit terms are 2/10, n/30. At March 31, 2025, there is a $2,100 credit balance in Allowance for Doubtful Accounts prior to adjustment. The company uses the percentage-of-receivables basis for estimating uncollectible accounts. The company's estimates of bad debts are as shown below.

Balance, March 31 Age of Accounts Current 1-30 days past due 31-90 days past due Over 90 days past due

2025 --$65,000 12,900 10,100 7,400 $95,400 ---

2024 --$75,000 8,000 2,400 1,100 $86,500

Estimated Percentage Uncollectible 2% 5 30

so

Instructions

a. Determine the total estimated uncollectibles at March 31, 2025. b. Prepare the adjusting entry at March 31, 2025, to record bad debt expense. c. Discuss the implications of the changes in the aging schedule from 2024 to 2025.

Determine bad debt expense, and prepare the adjusting entry.

8-39

8-40

CHAPTER 8

Reporting and Analyzing Receivables

Prepare entry for estimated uncollectibles, write-off, and recovery.

E8.9 (LO 2), AP On December 31, 2024, when its Allowance for Doubtful Accounts had a debit balance of $1,400, Dallas Co. estimates that 9% of its accounts receivable balance of $90,000 will become uncollectible and records the necessary adjustment to Allowance for Doubtful Accounts. On May 11, 2025, Dallas Co. determined that B. Jared's account was uncollectible and wrote off $1,200. On June 12, 2025, Jared paid the amount previously written off. Instructions Prepare the journal entries on December 31, 2024, May 11, 2025, and June 12, 2025.

Prepare entry for sale of accounts receivable.

ES.IO (LO 2), AP On March 3, Plume Appliances sells $710,000 of its receivables to Western Factors Inc. Western Factors Inc. assesses a service charge of 4% of the amount of receivables sold. Instructions Prepare the entry on Plume Appliances' books to record the sale of the receivables.

Prepare entry for credit card sale.

E8.ll (LO 2), AP On May 10, Keene Company sold merchandise for $4,000 and accepted the customer's Best Business Bank MasterCard. At the end of the day, the Best Business Bank MasterCard receipts were deposited in the company's bank account. Best Business Bank charges a 3.8% service charge for credit card sales. Instructions Prepare the entry on Keene Company's books to record the sale of merchandise. (Omit cost of goods sold entries.)

Prepare entry for credit card sale.

E8.12 (LO 2), AP On July 4, Mazie's Restaurant accepts a Visa card for a $250 dinner bill. Visa charges a 4% service fee. Instructions Prepare the entry on Mazie's books related to the transaction.

Prepare entries for notes receivable transactions.

E8.13 (LO 3), AP Moses Supply Co. has the following transactions related to notes receivable during the last 2 months of the year. The company does not make entries to accrue interest except at December 31. Nov. 1 Dec. 11 16 31

Loaned $60,000 cash to C. Bohr on a 12-month, 7% note. Sold goods to K. R. Pine, Inc., receiving a $3,600, 90-day, 8% note. Received a $12,000, 180-day, 9% note to settle an open account from A. Murdock. Accrued interest revenue on all notes receivable.

Instructions Journalize the transactions for Moses Supply Co. (Omit cost of goods sold entries.) Journalize notes receivable transactions.

E8.14 (LO 3), AP These transactions took place for Bramson Co. 2024 May

1

Dec. 31 2025 May

1

Received a $5,000, 12-month, 6% note in exchange for an outstanding account receivable from R. Stoney. Accrued interest revenue on the R. Stoney note.

Received principal plus interest on the R. Stoney note. (No interest has been accrued since December 31, 2024.)

Instructions Record the transactions in the general journal. The company does not make entries to accrue interest except at December 31. Prepare entries for notes receivable transactions.

E8.15 (LO 3), AP Vandiver Company had the following select transactions.

Apr. 1, 2025 July Dec. Apr. Apr.

1, 2025 31, 2025 1, 2026 1, 2026

Accepted Goodwin Company's 12-month, 6% note in settlement of a $30,000 account receivable. Loaned $25,000 cash to Thomas Slocombe on a 9-month, 10% note. Accrued interest on all notes receivable. Received principal plus interest on the Goodwin note. Thomas Slocombe dishonored its note; Vandiver expects it will eventually collect.

Instructions Prepare journal entries to record the transactions. Vandiver prepares adjusting entries once a year on December 31.

Exercises

E8.16 (LO 4), AP Eileen Corp. had the following balances in receivable accounts at October 31, 2025 (in thousands): Allowance for Doubtful Accounts $52, Accounts Receivable $2,910, Other Receivables $189, and Notes Receivable $1,353.

8-41

Prepare a balance sheet presentation of receivables.

Instructions

Prepare the balance sheet presentation of Eileen Corp.'s receivables in good form. E8.17 (LO 4), K The following is a list of activities that companies perform in relation to their receivables.

Identify the principles of receivables management.

1. Selling receivables to a factor. 2. Reviewing company ratings in The Dun and Bradstreet Reference Book of American Business. 3. Collecting information on competitors' payment period policies.

4. Preparing monthly accounts receivable aging schedule and investigating problem accounts.

5. Calculating the accounts receivable turnover and average collection period. Instructions

Match each of the activities listed above with a purpose of the activity listed below. a. Determine to whom to extend credit.

b. Establish a payment period. c. Monitor collections. d. Evaluate the liquidity of receivables. e. Accelerate cash receipts from receivable when necessary. E8.18 (LO 4), AN Suppose the following information was taken from the 2025 financial statements of FedEx Corporation, a major global transportation/delivery company. (in millions) Accounts receivable (gross) Accounts receivable (net) Allowance for doubtful accounts Sales revenue Total current assets

2025

2024

$ 3,587 3,391 196 35,497 7,116

$ 4,517 4,359 158 37,953 7,244

Compute ratios to evaluate a company's receivables balance.

Instructions

Answer each of the following questions.

a. Calculate the accounts receivable turnover and the average collection period for 2025 for FedEx. b. Is accounts receivable a material component of the company's total current assets? c. Evaluate the balance in FedEx's allowance for doubtful accounts. Evaluate liquidity.

E8.19 (LO 4), AN The following ratios are available for Ming Inc.

Current ratio Accounts receivable turnover Inventory turnover

2025

2024

1.3:1 12 times 11 times

1.5:1 10 times 9 times

Instructions

a. Is Ming's short-term liquidity improving or deteriorating in 2025? Be specific in your answer, referring to relevant ratios. b. Do changes in turnover ratios affect profitability? Explain. c. Identify any steps Ming might have taken, or might wish to take, to improve its management of its accounts receivable and inventory turnovers. E8.20 (LO 4), C In a recent annual report, Office Depot, Inc. notes that the company entered into an agreement to sell all of its credit card program receivables to financial service companies.

Identify reason for sale of receivables.

Instructions

Explain why Office Depot, a financially stable company with positive cash flow, would choose to sell its receivables. E8.21 (LO 4), AN Bailey Corp. significantly reduced its requirements for credit sales. As a result, sales during the current year increased dramatically. It had receivables at the beginning of the year of $38,000 and ending receivables of $191,000. Credit sales were $380,000.

Determine cash flows and evaluate quality of earnings.

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CHAPTER 8

Reporting and Analyzing Receivables

Instructions a. Determine cash collections during the period.

b. Discuss how your findings in part (a) would affect Bailey Corp.'s quality of earnings ratio. (Do not compute.) c. What concerns might you have regarding Bailey's accounting? E8.22 (LO 1, 2, 3, 4), K The following words and phrases were discussed in this chapter.

Identify key terms.

1. Notes receivable.

6. Dishonored (defaulted) note.

2. Cash (net) realizable value.

7. Concentration of credit risk.

3. Accounts receivable turnover.

8. Allowance method.

4. Aging the accounts receivable.

9. Direct write-off method. 10. Factor.

5. Percentage-of-receivables basis. Instructions

Match each word or phrase with its description below.

a. ____ Written promise (as evidenced by a formal instrument) for amounts to be received.

b. ____ A method of accounting for bad debts that involves estimating uncollectible accounts at the end of each period. c. ____ A measure of the liquidity of accounts receivable, computed by dividing net credit sales by average net accounts receivable.

d. ____ A method of accounting for bad debts that involves charging receivable balances to Bad Debt Expense at the time receivables from a particular company are determined to be uncollectible. e. ____ A finance company or bank that buys receivables from businesses for a fee and then collects the payments directly from the customers. f. ____ The net amount a company expects to receive in cash from receivables.

g.

The threat of nonpayment from a single large customer or class of customers that could adversely affect the financial health of the company.

h. ____ A note that is not paid in full at maturity. i. ____ A method of estimating the amount of bad debt expense whereby management establishes a percentage relationship between the amount of receivables and the expected losses from uncollectible accounts.

j. ____ A schedule of customer balances classified by the length of time they have been unpaid.

Problems Journalize transactions related to bad debts.

P8.l (LO 2), AP Rianna.com uses the allowance method of accounting for bad debts. The company produced the following aging of the accounts receivable at year-end.

Number of Days Outstanding

Accounts receivable % uncollectible

Total

0-30

31-60

61-90

91-120

Overl20

$377,000

$222,000

$90,000

$38,000

$15,000

$12,000

1%

4%

5%

8%

10%

Estimated bad debts Instructions a.

Tot. est. bad debts

a. Calculate the total estimated bad debts based on the above information. $10,120

b. Prepare the year-end adjusting journal entry to record the bad debts using the aged uncollectible accounts receivable determined in (a). Assume the unadjusted balance in Allowance for Doubtful Accounts is a $4,000 debit. c. Of the above accounts, $5,000 is determined to be specifically uncollectible. Prepare the journal entry to write off the uncollectible account. d. The company collects $5,000 subsequently on a specific account that had previously been determined to be uncollectible in (c). Prepare the journal entry(ies) necessary to restore the account and record the cash collection.

Problems

8-43

e. Comment on how your answers to (a)-(d) would change if Rianna.com used 3% of total accounts receivable, rather than aging the accounts receivable. What are the advantages to the company of aging the accounts receivable rather than applying a percentage to total accounts receivable? PS.2 (LO 2, 4), AP At December 31, 2024, Suisse Imports reported this information on its balance sheet. Accounts receivable Less: Allowance for doubtful accounts

$600,000 37,000

Prepare journal entries related to bad debt expense, and compute ratios.

During 2025, the company had the following transactions related to receivables. 1. Sales on account

$2,500,000

2. Sales returns and allowances

50,000

3. Collections of accounts receivable

2,200,000

4. Write-offs of accounts receivable deemed uncollectible

41,000

5. Recovery of bad debts previously written off as uncollectible

15,000

Instructions a. Prepare the journal entries to record each of these five transactions. Assume that no cash discounts were taken on the collections of accounts receivable. (Omit cost of goods sold entries.) b. Enter the January 1, 2025, balances in Accounts Receivable and Allowance for Doubtful Accounts,

b. A/R bal.

$809,000

post the entries to the two accounts (use T-accounts), and determine the balances. c. Prepare the journal entry to record bad debt expense for 2025, assuming that aging the accounts receivable indicates that estimated bad debts are $46,000. d. Compute the accounts receivable turnover and average collection period. PS.3 (LO 2), AP Presented below is an aging schedule for Bryan Company at December 31, 2024.

Customer

Total

Aneesh Bird Cope DeSpears Others

$ 24,000 30,000 50,000 38,000 120,000 $262,000

Not Yet Due

$ 9,000 $ 30,000 5,000

5,000

72,000

35,000

$107,000

$49,000

3% $ 42,400

Number of Days Past Due 31-60 61-90 Over90

@ml

$15,000 $40,000 $38,000

Estimated percentage uncollectible Total estimated bad debts

1-30

Journalize transactions related to bad debts.

$

3,210

13,000 $28,000

$40,000

$38,000

7%

12%

24%

60%

$ 3,430

$ 3,360

$ 9,600

$22,800

---

At December 31, 2024, the unadjusted balance in Allowance for Doubtful Accounts is a credit of $8,000. Instructions a. Journalize and post the adjusting entry for bad debts at December 31, 2024. (Use T-accounts.)

a. Bad Debt Exp.

b. Journalize and post to the allowance account these 2025 events and transactions: 1. March 1, a $600 customer balance originating in 2024 is judged uncollectible.

2. May 1, a check for $600 is received from the customer whose account was written off as uncollectible on March 1. c. Journalize the adjusting entry for bad debts at December 31, 2025, assuming that the unadjusted balance in Allowance for Doubtful Accounts is a debit of $1,400 and the aging schedule indicates that total estimated bad debts will be $36,700. P8.4 (LO 2), AP

ijfiffiffj

Here is information related to Morgane Company for 2025.

Total credit sales Accounts receivable at December 31 Bad debts written off

$1,500,000 840,000 37,000

Instructions a. What amount of bad debt expense will Morgane Company report if it uses the direct write-off method of accounting for bad debts?

Compute bad debt amounts.

$34,400

8-44

CHAPTER 8

Reporting and Analyzing Receivables

b. Bad Debt Exp.

$30,600

b. Assume that Morgane Company uses the percentage-of-receivables basis to record bad debt expense and concludes that 4% of accounts receivable will become uncollectible. What amount of bad debt expense will the company record if Allowance for Doubtful Accounts has a credit balance of $3,000?

c. Assume the same facts as in part (b), except that there is a $1,000 debit balance in Allowance for Doubtful Accounts. What amount of bad debt expense will Morgane record? d. What is a weakness of the direct write-off method of reporting bad debt expense? Journalize entries to record transactions related to bad debts.

P8.5 (LO 2), AP rnutfljj At December 31, 2025, the trial balance of Malone Company contained the following amounts before adjustment. Debit Credit Accounts Receivable Allowance for Doubtful Accounts Sales Revenue

$180,000 $ 1,500 875,000

Instructions

a. Prepare the adjusting entry at December 31, 2025, to record bad debt expense, assuming that the aging schedule indicates that $10,200 of accounts receivable will be uncollectible. b. Bad Debt Exp.

$11,700

b. Repeat part (a), assuming that instead of a credit balance there is a $1,500 debit balance in Allowance for Doubtful Accounts. c. During the next month, January 2026, a $2,100 account receivable is written off as uncollectible. Prepare the journal entry to record the write-off. d. Repeat part (c), assuming that Malone Company uses the direct write-off method instead of the allowance method in accounting for uncollectible accounts receivable. e. What are the advantages of using the allowance method in accounting for uncollectible accounts as compared to the direct write-off method?

Journalize various receivables transactions.

P8.6 (LO 1, 3),AP On January 1, 2025, Harvee Company had Accounts Receivable of $54,200 and Allowance for Doubtful Accounts of $3,700. Harvee Company prepares financial statements annually. During the year, the following selected transactions occurred. Jan. Feb.

5 2 12

26 5 12 June 2 15

Apr.

Sold $4,000 of merchandise to Rian Company, terms n/30. Accepted a $4,000, 4-month, 9% promissory note from Rian Company for balance due. Sold $12,000 of merchandise to Cato Company and accepted Cato's $12,000, 2-month, 10% note for the balance due. Sold $5,200 of merchandise to Malcolm Co., terms n/10. Accepted a $5,200, 3-month, 8% note from Malcolm Co. for balance due. Collected Cato Company note in full. Collected Rian Company note in full. Sold $2,000 of merchandise to Gerri Inc. and accepted a $2,000, 6-month, 12% note for the amount due.

Instructions Explain the impact of transactions on ratios.

Journalize the transactions. (Omit cost of goods sold entries.) P8.7 (LO 4), C The president of Mossy Enterprises asks if you could indicate the impact certain transactions have on the following ratios. Accounts Average Current Receivable Collection Ratio Turnover Period (2:1) Transaction (lOX) (36.5 days) 1. Received $5,000 on cash sale. The

cost of the goods sold was $2,600. 2. Recorded bad debt expense of $500 using allowance method. 3. Wrote off a $100 account receivable as uncollectible (Uses allowance method.) 4. Recorded $2,500 sales on account. The cost of the goods sold was $1,500. Instructions

Complete the table, indicating whether each transaction will increase (I), decrease (D), or have no effect (NE) on the specific ratios provided for Mossy Enterprises.

Comprehensive Accounting Cycle Review

PS.8 (LO 1, 2, 3, 4), AP Milton Company closes its books on its July 31 year-end. The company does not make entries to accrue for interest except at its year-end. On June 30, the Notes Receivable account balance is $23,800. Notes Receivable include the following.

Date April 21 May25 June 30

Maker

Face Value

Term

Coote Inc. Brady Co. BMGCorp.

$ 6,000 7,800 10,000

90 days 60 days 6 months

Maturity Date

8-45

Prepare entries for various credit card and notes receivable transactions.

Interest Rate

July 20 July 24 December 31

8% 10% 6%

During July, the following transactions were completed. July 5 14 20 24

Made sales of $4,500 on Milton credit cards. Made sales of $600 on Visa credit cards. The credit card service charge is 3%. Received payment in full from Coote Inc. on the amount due. Received payment in full from Brady Co. on the amount due.

Instructions

a. Journalize the July transactions and the July 31 adjusting entry for accrued interest receivable (interest is computed using 360 days) (omit cost of goods sold entries.) b. Enter the balances at July 1 in the receivable accounts and post the entries to all of the receivable accounts. (Use T-accounts.)

b. A/R bal.

$ 4,500

c. Show the balance sheet presentation of the receivable accounts at July 31.

c. Tot. receivables

$14,550

PS.9 (LO 4), AN Suppose the amounts presented here are basic financial information (in millions) from the 2025 annual reports of Nike and adidas.

Sales revenue Allowance for doubtful accounts, beginning Allowance for doubtful accounts, ending Accounts receivable balance (gross), beginning Accounts receivable balance (gross), ending

Nike

adidas

$19,176.1 78.4 110.8 2,873.7 2,994.7

€10,381 119 124 1,743 1,553

Calculate and interpret various ratios.

Instructions Calculate the accounts receivable turnover and average collection period for both companies. Comment on the difference in their collection experiences.

Continuing Case Cookie Creations (Note: This is a continuation of the Cookie Creations case from Chapters 1 through 7.) CCS One of Natalie's friends, Curtis Lesperance, runs a coffee shop where he sells specialty coffees and prepares and sells muffins and cookies. He is eager to buy one of Natalie's fine European mixers, which would enable him to make larger batches of muffins and cookies. However, Curtis cannot afford to pay for the mixer for at least 30 days. He asks Natalie if she would be willing to sell him the mixer on credit. Natalie comes to you for advice. leungchopan/ Shutterstock.com

Go to Wiley Course Resources for complete case details and instructions.

Comprehensive Accounting Cycle Review ACRS Hudson Corporation's balance sheet at December 31, 2024, is presented below.

Hudson Corporation Balance Sheet December 31, 2024 Cash Accounts receivable Allowance for doubtful accounts Inventory

$13,100 19,780 (800) 9,400 $41,480

Accounts payable Common stock Retained earnings

$ 8,750 20,000 12,730 $41,480

8-46

CHAPTER 8

Reporting and Analyzing Receivables

During January 2025, the following transactions occurred. Hudson uses the perpetual inventory method. Hudson accepted a 4-month, 8% note from Betheny Company in payment of Betheny's $1,200 account. Hudson wrote off as uncollectible the accounts of Walter Corporation ($450) and Drake Company ($280). Hudson purchased $17,200 of inventory on account. Hudson sold for $25,000 on account inventory that cost $17,500. Hudson sold inventory that cost $700 to Jack Rice for $1,000. Rice charged this amount on his Visa First Bank card. The service fee charged Hudson by First Bank is 3%. Hudson collected $22,900 from customers on account. Hudson paid $16,300 on accounts payable. Hudson received payment in full ($280) from Drake Company on the account written off on January 3. Hudson purchased advertising supplies for $1,400 cash. Hudson paid other operating expenses, $3,218.

Jan. 1 3 8 11 15 17 21 24 27 31

Adjustment data:

1. Interest is recorded for the month on the note from January 1. 2. Bad debts are expected to be 6% of the January 31, 2025, accounts receivable. 3. A count of advertising supplies on January 31, 2025, reveals that $560 remains unused. 4. The income tax rate is 30%. (Hint: Prepare the income statement up to Income before taxes and multiply by 30% to compute the amount; round to whole dollars.) Instructions (You may want to set up T-accounts to determine ending balances.)

a. Prepare journal entries for the transactions listed above and adjusting entries. (Include entries for cost of goods sold using the perpetual inventory system.) b. Prepare an adjusted trial balance at January 31, 2025. c. Prepare an income statement and a retained earnings statement for the month ending January 31,

2025, and a classified balance sheet as of January 31, 2025.

Data Analytics in Action Using Data Visualization to Understand Accounts Receivable and Bad Debts over Time DAS.I Data visualization can be used to understand accounts receivable and bad debts. Example: Many stakeholders are interested in bad debt information. Under transparency rules, cities, states, and other governments publicize financial data. Using data visualization, we can see trends in the data from the city of Austin, Texas, regarding energy revenue and bad debt, as the following chart shows.

Bad Debts as a Percent of Total Revenue

2%

l

Bad Debt Expense over Time-Austin Energy

s2,ooo

: JI I I I rfN I I I Jt :· 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Fiscal Year

I ■ Revenue Source: City of Austin open data portal.

Bad debts to revenue% I

000

T;~~,:::;·

Expand Your Critical Thinking

The chart indicates a steady increase in bad debt expense as a percent of total revenue from 2008 to 2011, followed by a steep peak in 2014. The expense percentage declined sharply in 2015, followed by a slight increase in 2016 and a decline to the lowest level in 2019. Over the entire 12-year period, revenue increased steadily. However, the trend in revenue does not explain the spike in bad debt expense, so there is likely some other cause of the increase in bad debt expense from 2012 to 2013. What conclusions can we make about the city of Austin's ability to collect amounts owed by energy customers? Except for the peak in 2013 and 2014, Austin appears to be efficient in collecting amounts due. While the highest percent uncollectible is 1.51%, this amount is relatively low compared to many industries, which experience higher rates of uncollectibility. Austin's lower bad debt expense rate may be due to the nature of the industry-providing service-viewed by most people as essential. Customers are more likely to pay their energy bills while foregoing payments to other obligations they may owe. In this case, you will use the data to calculate the relationships of accounts receivable to revenue and assets, and prepare a combo column and line chart to visualize those relationships for each of the largest revenue-producing companies in the United States. Go to Wiley Course Resources for complete case details and instructions.

Using Data Analytics to Understand Notes Receivable over Ti me DA8.2 Banks have large loan portfolios that result from loans to customers. Analytics can help us understand the proportion of these notes receivables to the bank's total assets. For this case, you will use the assets section of JP Morgan Chase's balance sheet for 2 years to (1) calculate the proportion of each asset as a percent of total assets for both years (this is often called common size financial statements), (2) create pie charts, and (3) analyze the differences. Go to Wiley Course Resources for complete case details and instructions.

Expand Your Critical Thinking Financia l Reporti ng Pro blem: Apple Inc. CT8.l Refer to the financial statements of Apple Inc. in Appendix A. Instructions

a. Calculate the accounts receivable turnover and average collection period for 2020. (Assume all sales were credit sales.) b. Did Apple have any potentially significant credit risks in 2020? c. What conclusions can you draw from the information in parts (a) and (b)?

Comparative An alysis Problem : Columbia Sportswear Company vs. Under Armour, Inc. CT8.2 The financial statements of Columbia Sportswear Company are presented in Appendix B. Financial statements of Under Armour are presented in Appendix C. Instructions

a. Based on the information contained in these financial statements, compute the following 2020 values for each company. 1. Accounts receivable turnover.

2. Average collection period for accounts receivable. b. What conclusions concerning the management of accounts receivable can be drawn from these data?

Comparative Analysis Problem: Amazon.com, Inc. vs. Walmart Inc. CT8.3 The financial statements of Amazon.com, Inc. are presented in Appendix D. Financial statemPnts of Wlllmllrt Inc,_ '"" nrPsPntPrl in Annf'nrlix R.

8-47

8-48

CHAPTER 8

Reporting and Analyzing Receivables

Instructions a. Based on the information contained in these financial statements, compute the following values for

each company for the most recent fiscal year provided. 1. Accounts receivable turnover. (For Amazon.com, use "Net product sales." Assume all sales were

credit sales.) 2. Average collection period for accounts receivable. b. What conclusions concerning the management of accounts receivable can be drawn from these data?

Interpreting Financial Statements CT8.4 Suppose the information below is from the 2025 financial statements and accompanying notes of The Scotts Company, a major manufacturer of lawn-care products. 2024

(in millions)

2025

---

Accounts receivable Allowance for uncollectible accounts Sales revenue Total current assets

$ 270.4 10.6 2,981.8 1,044.9

$ 259.7 11.4 2,871.8 999.3

The Scotts Company Notes to the Financial Statements

Note 19. Concentrations of Credit Risk Financial instruments which potentially subject the Company to concentration of credit risk consist principally of trade accounts receivable. The Company sells its consumer products to a wide variety of retailers, including mass merchandisers, home centers, independent hardware stores, nurseries, garden outlets, warehouse clubs, food and drug stores and local and regional chains. Professional products are sold to commercial nurseries, greenhouses, landscape services and growers of specialty agriculture crops. Concentrations of accounts receivable at September 30, net of accounts receivable pledged under the terms of the New MARP Agreement whereby the purchaser has assumed the risk associated with the debtor's financial inability to pay ($146.6 million and $149.5 million for 2025 and 2024, respectively), were as follows.

Due from customers geographically located in North America Applicable to the consumer business Applicable to Scotts LawnService®, the professional businesses (primarily distributors), Smith & Hawken® and Morning Song® Top 3 customers within consumer business as a percent of total consumer accounts receivable

2025

2024

53% 61 %

52% 54%

39%

46%

0%

0%

The remainder of the Company's accounts receivable at September 30, 2025 and 2024, were generated from customers located outside of North America, primary retailers, distributors, nurseries and growers in Europe. No concentrations of customers or individual customers within this group account for more than 10% of the Company's accounts receivable at either balance sheet date. The Company's three largest customers are reported within the Global Consumer segment, and are the only customers that individually represent more than 10% of reported consolidated net sales for each of the last three fiscal years. These three customers accounted for the following percentages of consolidated net sales for the fiscal years ended September 30:

2025 2024 2023

Largest Customer 21.0% 20.2% 21.5%

2nd Largest Customer 13.5% 10.9% 11.2%

3rd Largest Customer 13.4% 10.2% 10.5%

Expand Your Critical Thinking 8-49 Instructions

Answer each of the following questions. a. Calculate the accounts receivable turnover and average collection period for 2025 for the company. b. Is accounts receivable a material component of the company's total 2025 current assets? c. Scotts sells seasonal products. How might this affect the accuracy of your answer to part (a)? d. Evaluate the credit risk of Scotts' 2025 concentrated receivables.

e. Comment on the informational value of Scotts' Note 19 on concentrations of credit risk.

Real-World Focus CT8.5 As we discussed in the chapter, companies often have an effective factoring strategy. Instructions

Go to the Commercial Capital LLC website, click on Invoice Factoring, and then answer the following questions. a. What are some of the benefits of factoring? b. What is the range of the percentages of the typical discount rate? c. If a company factors its receivables, what percentage of the value of the receivables can it expect to receive from the factor in the form of cash, and how quickly will it receive the cash? CT8.6 The October 31, 2017, issue of the Wall Street Journal includes an article by Suzanne Kapner entitled "Inside the Decline of Sears, the Amazon of the 20th Century." Instructions

Read the article and then answer the following questions. a. Describe some of the steps that suppliers took in response to the decline of Sears' credit quality. b. As its suppliers took the steps described in part (a), what were the implications for Sears' ability to compete as a retailer? c. How did companies that provide factoring services respond to Sears' troubles?

Decision-Making Across the Organization CT8.7 Emilio and Rene Santos own Club Fandango. From its inception, Club Fandango has sold merchandise on either a cash or credit basis, but no credit cards have been accepted. During the past several months, the Santos have begun to question their credit-sales policies. First, they have lost some sales because of their refusal to allow customers to pay with credit cards. Second, representatives of two metropolitan banks have convinced them to accept their national credit cards. One bank, Business National Bank, has stated that (1) its credit card fee is 4% and (2) it pays the retailer 96 cents on each $1 of sales within 3 days of receiving the credit card billings. The Santos decide that they should determine the cost of carrying their own credit sales. From the accounting records of the past 3 years, they accumulate these data:

Net credit sales Collection agency fees for slow-paying customers Salary of part-time accounts receivable clerk

2025 $500,000 2,900 4,400

2024 $600,000 2,600 4,400

2023 $400,000 1,600 4,400

Credit and collection expenses as a percentage of net credit sales are as follows: uncollectible accounts 1.6%, billing and mailing costs .5%, and credit investigation fee on new customers .2%. Emilio and Rene also determine that the average accounts receivable balance outstanding during the year is 5% of net credit sales. The Santos estimate that they could earn an average of 10% annually on cash invested in other business opportunities. Instructions

With the class divided into groups, answer the following. a. Prepare a tabulation for each year showing total credit and collection expenses in dollars and as a percentage of net credit sales.

8-50

CH A PT ER 8

Reporting and Analyzing Receivables

b. Determine the net credit and collection expenses in dollars and as a percentage of sales after considering the revenue not earned from other investment opportunities. (Note: The income lost on the cash held by the bank for 3 days is considered to be immaterial.) c. Discuss both the financial and nonfinancial factors that are relevant to the decision.

Communication Activity CT8.8 Chien Corporation is a recently formed business selling the "World's Best Doormat." The corporation is selling doormats faster than Chien can make them. It has been selling the product on a credit basis, telling customers to "pay when they can." Oddly, even though sales are tremendous, the company is having trouble paying its bills. Instructions

Write a memo to the president of Chien Corporation discussing these questions: a. What steps should be taken to improve the company's ability to pay its bills? b. What accounting steps should be taken to measure its success in improving collections and in recording its collection success?

c. If the corporation is still unable to pay its bills, what additional steps can be taken with its receivables to ease its liquidity problems?

Ethics Case CT8.9 As its year-end approaches, it appears that Mendez Corporation's net income will increase 10% this year. The president of Mendez Corporation, nervous that the stockholders might expect the company to sustain this 10% growth rate in net income in future years, suggests that the controller increase the allowance for doubtful accounts to 4% of receivables in order to lower this year's net income. The president thinks that the lower net income, which reflects a 6% growth rate, will be a more sustainable rate of growth for Mendez Corporation in future years. The controller of Mendez Corporation believes that the company's yearly allowance for doubtful accounts should be 2% of receivables. Instructions a. Who are the stakeholders in this case? b. Does the president's request pose an ethical dilemma for the controller? c. Should the controller be concerned with Mendez Corporation's growth rate in estimating the allow-

ance? Explain your answer.

All About You CT8.10 Credit card usage in the United States is substantial. Many startup companies use credit cards as a way to help meet short-term financial needs. The most common forms of debt for startups are use of credit cards and loans from relatives. Suppose that you start up Fantastic Sandwich Shop. You invested your savings of $20,000 and borrowed $70,000 from your relatives. Although sales in the first few months are good, you see that you may not have sufficient cash to pay expenses and maintain your inventory at acceptable levels, at least in the short term. You decide you may need to use one or more credit cards to fund the possible cash shortfall. Instructions a. Go to the Internet and find two sources that provide insight into how to compare credit card terms. b. Develop a list, in descending order of importance, as to what features are most important to you in selecting a credit card for your business.

c. Examine the features of your present credit card. (If you do not have a credit card, select a likely one online for this exercise.) Given your analysis above, what are the three major disadvantages of your present credit card?

FASB Codification Activity CT8.ll If your school has a subscription to the FASB Codification, log in and prepare responses to the following. a. How are receivables defined in the Codification? b. What are the conditions under which losses from uncollectible receivables (Bad Debt Expense) should be reported?

Expand Your Critical Thinking

Answers to Insight and Accounting Across the Organization Questions Cookie Jar Allowances Q: How might investors determine that a company is managing its earnings? A: If the balance sheet reflects an increase in Accounts Receivable and a decrease in Allowance for Doubtful Accounts, this could indicate an attempt to manage earnings by reducing the estimated uncollectible percentage. How Does a Credit Card Work? Q: Assume that Foot Locker prepares a bank reconciliation at the end of each month. If some credit card sales have not been processed by the bank, how should Foot Locker treat these transactions on its bank reconciliation? A: Foot Locker would treat the credit card receipts as deposits in transit. It has already recorded the receipts as cash. Its bank will increase Foot Locker's cash account when it receives the receipts. Bad Information Can Lead to Bad Loans Q: What steps should the banks have taken to ensure the accuracy of financial information provided on loan applications? A: At a minimum, the bank should have requested copies of recent income tax forms and contacted the listed employer to verify income. To verify ownership and value of assets, it should have examined bank statements, investment statements, and title documents, and should have employed appraisers. They've Got Your Number Q: Why might a company want to consider a customer's social media network when deciding whether to grant the customer credit? A: A customer's social media network might indicate if the applicant's contacts have had some negative experiences with the applicant, such as the applicant having a history of paying very slowly or not at all.

8-51

Reporting and Analyzing Long-Lived Assets Chapter Preview For airlines and many other companies, making the right decisions regarding long-lived assets is critical because these assets represent huge investments. The discussion in this chapter is in two parts: plant assets and intangible assets. Plant assets are the property, plant, and equipment (physical assets) that commonly come to mind when we think of what a company owns. Intangible assets, such as copyrights and patents, lack physical substance but can be extremely valuable and vital to a company's success.

Feature Story A Tale of Two Airlines So, you're interested in starting a new business. Have you thought about the airline industry? Today, many of the most

profitable airlines are not well-known majors like American Airlines and United. In fact, most giant, older airlines seem to have a history of bankruptcy. In one year, five major airlines representing 24% of total U.S. capacity were operating under bankruptcy protection. 9-1

9-2

CHAPTER 9

ReportingandAnalyzinglong-LivedAssets

Not all airlines are hurting. The growth and profitability in the airline industry today is found at relative newcomers like Southwest Airlines and JetBlue Airways. These and other newer airlines compete primarily on ticket prices. During a recent five-year period, the low-fare airline market share increased by 47%, reaching 22% of U.S. airline capacity. Southwest was the first upstart to make it big. It did so by taking a different approach. It bought small, new, fuel-efficient planes. Also, instead of the "hub-and-spoke" approach used by the majors, it opted for direct, short hop, no frills flights. It was all about controlling costs-getting the most out of its efficient new planes.

Discount airlines such as Sun Country and Allegiant Travel chose an approach quite different from that of Southwest. They buy low-priced used planes that are 20 to 30 years old. When Covid-19 caused a sharp reduction in travel, the price of used planes plummeted. Both of these airlines took advantage of this opportunity by buying even more used planes during this time. Older planes have higher fuel and maintenance costs, but these airlines say the lower initial equipment cost outweighs the additional operating costs.

Chapter Outline REVIEW

LEARNING OBJECTIVES

LO 1 Explain the accounting for

plant asset expenditures.

• Determining the cost of plant assets

PRACTICE

DO IT! 1 Cost of Plant Assets

• Expenditures during useful life • To buy or lease?

LO 2 Apply depreciation methods to plant assets.

• Factors in computing depreciation

DO IT! 2a Straight-Line Depreciation

2b Revised Depreciation

• Depreciation methods • Revising depreciation • Impairments

LO 3 Explain how to account for the disposal of plant assets.

• Retirement of plant assets

LO 4 Identify the basic issues related to reporting intangible assets.

• Accounting for intangible assets

• Sale of plant assets

DO IT! 3 Plant Asset Disposals

DO IT! 4 Classification Concepts

• Types of intangible assets • Research and development costs

LO 5 Discuss how long-lived assets are reported and analyzed.

• Presentation

DO IT! S Asset Turnover

• Analysis

Go to the Review and Practice section at the end of the chapter for a targeted summary and practice applications with solutions. Visit Wiley Course Resources for additional tutorials and practice opportunities.

9.1 Plant Asset Expenditures

9.1

9-3

Plant Asset Expenditures

LEARNING OBJECTIV E 1

Explain the accounting for plant asset expenditures.

Plant assets are resources that have three characteristics. 1. They have physical substance (a definite size and shape). 2. They are used in the operations of the business.

3. They are not intended for sale to customers.

Plant assets are also called property, plant, and equipment; plant and equipment; and fixed assets. These assets are expected to be of use to the company for a number of years. Except for land, plant assets decline in service potential over their useful lives. Because plant assets play a key role in ongoing operations, companies keep plant assets in good operating condition. They also replace worn-out or outdated plant assets, and expand productive resources as needed. Many companies have substantial investments in plant assets. Illustration 9.1 shows the percentages of plant assets in relation to total assets of companies in a number of industries.

Plant Assets as a Percentage of Total Assets I

I

I

I

Wendy's

I

I

JetBlue Airways

I

I

I

Target Tesla

61%

II i

l's% I I

Microsoft

I I I

30% I

I

Caterpillar

730/4

69%

I

ILLUSTRATION 9.1

Percentages of plant assets in relation to total assets

I

1 3% 1

I

I

I

10

20

30

40

50

60

70

80

I

90%

Determining the Cost of Plant Assets The historical cost principle requires that companies record plant assets at cost. Thus, JetBlue Airways and Southwest Airlines record their planes at cost. Cost consists of all expenditures necessary to acquire an asset and make it ready for its intended use. For example, when Boeing buys equipment, the purchase price, freight costs paid by Boeing, and installation costs are all part of the cost of the equipment. Cost is measured by the cash paid in a cash transaction or by the cash equivalent price paid when companies use noncash assets in payment.

• The cash equivalent price is equal to the fair value of the asset given up or the fair value of the asset received, whichever is more clearly determinable. • Once cost is established, it becomes the basis of accounting for the plant asset over its useful life. Current fair value is not used to increase the recorded cost after acquisition. We explain the application of the historical cost principle to each of the major classes of plant assets in the following sections (see International Note).

International Note IFRS is more flexible regarding asset valuation. Companies revalue to fair value when they believe this information is more relevant.

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Reporting and Analyzing Long-Lived Assets

La nd Companies often purchase land as a building site for a manufacturing plant or office building. The cost of land includes the following. 1. The cash purchase price. 2. Closing costs such as title and attorney fees. 3. Real estate broker commissions.

4. Accrued property taxes and other liens assumed by the purchaser.

HELPFUL HINT

Management's intended use is important in applying the historical cost principle.

For example, if the cash price is $50,000 and the purchaser agrees to pay accrued taxes of $5,000, the cost of the land is $55,000. Companies record as debits (increases) to the Land account all necessary costs incurred to make land ready for its intended use (see Helpful Hint). When a company acquires vacant land, these costs include expenditures for clearing, draining, filling, and grading. Sometimes the land has a building on it that must be removed before construction of a new building. In this case, the company debits to the Land account all demolition and removal costs, less any proceeds from salvaged materials. To illustrate, assume that Hayes Company acquires real estate at a cash cost of $100,000. The property contains an old warehouse that is razed at a net cost of $6,000 ($7,500 in demolition costs less $1,500 proceeds from salvaged materials). Additional expenditures are the attorney's fee, $1,000, and the real estate broker's commission, $8,000. The cost of the land is $115,000, computed as shown in Illustration 9.2.

ILLUSTRATION 9.2

Land

Computation of cost of land

Cash price of property Net removal cost of warehouse ($7,500 - $1,500) Attorney's fee Real estate broker's commission

$100,000 6,000 1,000 8,000

Cost of land

$115,000

Hayes makes the following entry to record the acquisition of the land.

-

=-

+115,000 -115,000

Cash Flows '

+Land Cash (To record purchase of land)

115,000 115,000

-115,000

Land Improvements Land improvements are structural additions with limited lives that are made to land. • Examples are driveways, parking lots, fences, and underground sprinklers. • The cost of land improvements includes all expenditures necessary to make the improvements ready for their intended use. For example, the cost of a new parking lot for Home Depot includes the amount paid for paving, fencing, and lighting. Thus, Home Depot debits to Land Improvements the total of all of these costs. Land improvements have limited useful lives. Even when well-maintained, they will eventually need to be replaced. As a result, companies expense (depreciate) the cost of land improvements over their useful lives.

Buildings Buildings are facilities used in operations, such as stores, offices, factories, warehouses, and airplane hangars. Companies debit to the Buildings account all necessary expenditures related to the purchase or construction of a building.

9.1 Plant Asset Expenditures

9-5

• When a building is purchased, such costs include the purchase price, closing costs (attorney's fee, title insurance, etc.), and the real estate broker's commission. Costs to make the building ready for its intended use include expenditures for remodeling and replacing or repairing the roof, floors, electrical wiring, and plumbing. • When a new building is constructed, its cost consists of the contract price plus payments for architects' fees, building permits, and excavation costs. In addition, companies charge certain interest costs to the Buildings account. Interest costs incurred to finance the project are included in the cost of the building when a significant period of time is required to get the building ready for use. In these circumstances, interest costs are considered as necessary as materials and labor. However, the inclusion of interest costs in the cost of a constructed building is limited to interest costs incurred during the construction period. When construction has been completed, the company records subsequent interest payments on funds borrowed to finance the construction as debits (increases) to Interest Expense.

Equipment Equipment includes assets used in operations, such as store check-out counters, office furniture, factory machinery, computers, printers, and delivery trucks. JetBlue Airways' equipment includes aircraft, in-flight entertainment systems, and trucks for ground operations. • The cost of equipment consists of the cash purchase price, sales taxes, freight charges, and insurance during transit paid by the purchaser. • The cost also includes expenditures required in assembling, installing, and testing the equipment. However, companies treat as expenses the costs of motor vehicle licenses and accident insurance on company trucks and cars. Such items are annual recurring expenditures and do not benefit future periods. 1\vo criteria apply in determining the cost of equipment: 1. The frequency of the cost-one time or recurring. 2. The benefit period-the life of the asset or one year.

To illustrate, assume that Lenard Company purchases a delivery truck on January 1 at a cash price of $22,000. Related expenditures are sales taxes $1,320, painting and lettering $500, motor vehicle license $80, and a three-year accident insurance policy $1,600. The cost of the delivery truck is $23,820, computed as shown in Illustration 9.3. ILLUSTRATION 9.3

Delivery Truck Cash price Sales taxes Painting and lettering

$22,000 1,320 500

Cost of delivery truck

$23,820

Computation of cost of delivery truck

Lenard treats the cost of a motor vehicle license as an expense and the cost of an insurance policy as a prepaid asset. Thus, the company records the purchase of the truck and related expenditures as follows.

Equipment License Expense Prepaid Insurance Cash (To record purchase of delivery truck and related expenditures)

=-

+-

+23,820

23,820 80 1,600

-80 Exp +1,600 25,500

For another example, assume Merten Company purchases factory machinery at a cash price of $50,000. Related expenditures are sales taxes $3,000, insurance during shipping $500,

-25,500

Cash Flows ' -25,500

9-6

CH A PT ER 9

Reporting and Analyzing Long-Lived Assets

and installation and testing $1,000. The cost of the factory machinery is $54,500, computed as shown in Illustration 9.4.

ILLUSTRATION 9.4

Computation of cost of factory machinery

Factory Machinery Cash price Sales taxes Insurance during shipping Installation and testing

$50,000

Cost of factory machinery

$54,500

3,000

500 1,000

Thus, Merten records the purchase and related expenditures as follows.

-

=-

+54,500 -54,500

CashFlows ' -54,500

+-

Equipment Cash (To record purchase of factory machinery and related expenditures)

54,500 54,500

Expenditures During Useful Life During the useful life of a plant asset, a company may incur costs for ordinary repairs, additions, or improvements. • Ordinary repairs are expenditures to maintain the operating efficiency and productive life of the asset.

• They usually are small amounts that occur frequently. Examples are motor tune-ups and oil changes, the painting of buildings, and the replacing of worn-out gears on machinery. Companies record such repairs as debits to Maintenance and Repairs Expense as they are incurred. Because they are immediately charged as an expense against revenues, these costs are often referred to as revenue expenditures. In contrast, additions and improvements are costs incurred to increase the operating efficiency, productive capacity, or useful life of a plant asset. • They are usually material in amount and occur infrequently. • Additions and improvements increase the company's investment in productive facilities. Companies generally debit these amounts to the plant asset affected. They are often referred to as capital expenditures. Companies must use good judgment in deciding whether to treat an item as a revenue expenditure or as a capital expenditure. Some companies, in order to boost income, have improperly capitalized expenditures that should have been treated as revenue expenditures. By "capitalizing" these costs, they spread the expense over a number of years rather than expensing all the costs in the current year. Alternatively, assume that Rodriguez Co. purchases a number of wastepaper baskets. The proper accounting would appear to be to capitalize and then depreciate these wastepaper baskets over their useful lives. However, Rodriguez will generally expense these wastepaper baskets immediately. This practice is justified on the basis of materiality. Materiality refers to the impact of an item on a company's financial operations. Recall that the materiality concept states that if an item would not make a difference in decision-making, the company does not have to follow GAAP in reporting that item.

9.1 Plant Asset Expenditures

Anatomy of a Fraud Bernie Ebbers was the founder and CEO of the phone company WorldCom. The company engaged in a series of increasingly large, debt-financed acquisitions of other companies. These acquisitions made the company grow quickly, which made the stock price increase dramatically. However, because the acquired companies all had different accounting systems, WorldCom's financial records were a mess. When WorldCom's performance started to flatten out, Bernie coerced WorldCom's accountants to engage in a number of fraudulent activities to make net income look better than it really was and thus prop up the stock price. One of these frauds involved treating $7 billion of line costs as capital expenditures. The line costs, which were rental fees paid to other phone companies to use their phone lines, had always been properly expensed in previous

years. Capitalization delayed expense recognition to future periods and thus boosted current-period profits.

Total take: $7 billion The Missing Controls

Documentation procedures. The company's accounting system was a disorganized collection of non-integrated systems, which resulted from a series of corporate acquisitions. Top management took advantage of this disorganization to conceal its fraudulent activities. Independent internal verification. A fraud of this size should have been detected by a routine comparison of the actual physical assets with the list of physical assets shown in the accounting records.

To Buy or Lease? In this chapter, we focus on purchased assets, but we want to expose you briefly to an alternative-leasing. A lease is a contractual agreement in which the owner of an asset (the lessor) allows another party (the lessee) to use the asset for a period of time at an agreed price. In many industries, leasing is quite common. For example, one-third of heavy-duty commercial trucks are leased. Some advantages of leasing an asset versus purchasing it are as follows. 1. Reduced risk of obsolescence. Frequently, lease terms allow the party using the asset

(the lessee) to exchange the asset for a more modern one if it becomes outdated. This is much easier than trying to sell an obsolete asset. 2. Little or no down payment. To purchase an asset, most companies must borrow money,

which usually requires a down payment of at least 20%. Leasing an asset requires little or no down payment. 3. Shared tax advantages. Startup companies typically earn little or no profit in their early

years, and so they have little need for the tax deductions available from owning an asset. In a lease, the lessor gets the tax advantage because it owns the asset. It often will pass part of these tax savings on to the lessee in the form of lower lease payments. Airlines often choose to lease many of their airplanes in long-term lease agreements. In recent financial statements, JetBlue Airways stated that it leased 50 of its 243 planes.

Accounting Across the Organization Many U.S. Firms Use Leases

Brian Raisbeck/ iStockphoto

Leasing is big business for U.S. companies. For example, in a recent year leasing accounted for about 33% of all business investment ($264 billion). Who does the most leasing? Interestingly, major banks such as Bank of America Leasing, Wells Fargo Equipment Finance, and U.S. Bank Equipment Finance are the major lessors. Also, many companies have established separate leasing companies, such as Boeing Capital

Corporation, Dell Financial Services, and John Deere Capital Corporation. As an example of the magnitude of leasing, leased planes account for nearly 40% of the U.S. fleet of commercial airlines. Lease Finance Corporation in Los Angeles owns more planes than any airline in the world. Leasing is also becoming increasingly common in the hotel industry. Marriott, Hilton, and Hyatt are increasingly choosing to lease hotels that are owned by someone else. Why might airline managers choose to lease rather than purchase their planes? (Answer is available at the end of the chapter.)

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CHAPTER 9

Reporting and Analyzing Long-Lived Assets

DO IT! 1 I Cost of Plant Assets

ACTION PLAN

Assume that Drummond Corp. purchases a delivery truck for $15,000 cash plus sales taxes of $900 and delivery costs of $500. The buyer also pays $200 for painting and lettering, $600 for an annual insurance policy, and $80 for a motor vehicle license. Explain how the company should account for each of these costs.

• Identify expenditures m ade in order to get delivery equipment ready for its intended use. • Expense operating costs incurred during the useful life of the equipment.

Solution The first four payments ($15,000 purchase price, $900 sales taxes, $500 delivery, and $200 painting and lettering) are expenditures necessary to make the truck ready for its intended use. Thus, the cost of the truck is $16,600. The payments for insurance and the license are operating expenses incurred annually during the useful life of the asset.

Related exercise material: BE9.1, BE9.2, BE9.3, DO IT! 9.1, E9.1, E9.2, and E9.3.

9.2

Depreciation Methods LEARNING OBJECTIVE 2

Apply depreciation methods to plant assets.

As explained in Chapter 4, depreciation is the process of allocating to expense the cost of a plant asset over its useful (service) life in a rational and systematic manner. Such cost allocation is designed to properly record expenses (efforts) with associated revenues (results) (see Illustration 9.5).

ILLUSTRATION 9.5

Depreciation as a cost allocation concept

[£r-"'

~ -----)•

Year!

Year2

Depreciation allocation

Depreciation affects the balance sheet through accumulated depreciation, which companies report as a deduction from plant assets. It affects the income statement through depreciation expense. It is important to understand that depreciation is a cost allocation process, not an asset valuation process. No attempt is made to measure the change in an asset's fair value during ownership. ETHICS N OTE

When a business is acquired, proper allocation of the purchase price to various asset classes is important since different depreciation treatment can materially affect income. For example, buildings are depreciated, but land is not.

• The book value-cost less accumulated depreciation-of a plant asset may differ significantly from its fair value. • If an asset is fully depreciated, it can have zero book value but still have a significant fair value.

Depreciation applies to three classes of plant assets: land improvements, buildings, and equipment (see Ethics Note). Each of these classes is considered to be a depreciable asset because the usefulness to the company and the revenue-producing ability of each class decline over the asset's useful life. Depreciation does not apply to land because its usefulness and revenue-producing ability generally remain intact as long as the land is owned. In fact, in

9.2 Depreciation Methods

many cases, the usefulness of land increases over time because of the scarcity of good sites. Thus, land is not a depreciable asset. • During a depreciable asset's useful life, its revenue-producing ability declines because of wear and tear. A delivery truck that has been driven 100,000 miles will be less useful to a company than one driven only 800 miles. • A decline in revenue-producing ability may also occur because of obsolescence. Obsolescence is the process by which an asset becomes out of date before it physically wears out. The rerouting of major airlines from Chicago's Midway Airport to Chicago-O'Hare International Airport because Midway's runways were too short for giant jets is an example. Similarly, many companies replace their computers long before they originally planned to do so because technological improvements make their old hardware obsolete. Recognizing depreciation for an asset does not result in the accumulation of cash for replacement of the asset. The balance in Accumulated Depreciation represents the total amount of the asset's cost that the company has charged to expense to date; it is not a cash fund.

Factors in Computing Depreciation Three factors affect the computation of depreciation, as shown in Illustration 9.6 (see Helpful Hint). ILLUSTRATION 9.6

Three factors in computing depreciation HELPFUL HINT

Cost: all expenditures necessary to acquire the asset and make it ready for intended use expected life based on need for repa ir, service life, and vulnerability to obsolescence

Salvage value: estimate of the asset's value at the end of its usefu I life

1. Cost. Earlier in the chapter, we explained the considerations that affect the cost of a depreciable asset. Remember that companies record plant assets at cost, in accordance with the historical cost principle. 2. Useful life. Useful life is an estimate of the expected productive life, also called service life, of the asset for its owner. Useful life may be expressed in terms of time, units of activity (such as machine hours), or units of output. Useful life is an estimate. In making the estimate, management considers such factors as the intended use of the asset, repair and maintenance policies, and vulnerability of the asset to obsolescence. The company's past experience with similar assets is often helpful in deciding on expected useful life. 3. Salvage value. Salvage value is an estimate of the asset's value at the end of its useful life for its owner. Companies may base the value on the asset's worth as scrap or on its expected trade-in value. Like useful life, salvage value is an estimate. In making the estimate, management considers how it plans to dispose of the asset and its experience with similar assets.

Depreciation Methods Although a number of methods exist, depreciation is generally computed using one of three methods: 1. Straight-line 2. Declining-balance

Depreciation expense is reported on the income statement. Accumulated depreciation is reported on the balance sheet as a deduction from plant assets.

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CHAPTER 9

Reporting and Analyzing Long-Lived Assets

Like the alternative inventory methods discussed in Chapter 6, each of these depreciation methods is acceptable under generally accepted accounting principles. Management selects the method it believes best measures Straight-line an asset's contribution to revenue over its useful life. Once a company 83% chooses a method, it should apply that method consistently over the useful life of the asset. Consistency enhances the ability to analyze financial statements over multiple years. Other Illustration 9.7 shows the distribution of the primary depreciation 8% methods in a sample of the largest U.S. companies. Clearly, straight-line Units-of-activity depreciation is the most widely used approach. In fact, because some com5% panies use more than one method, straight-line depreciation is used Declining-balance 4% for some or all of the depreciation taken by more than 95% of U.S. companies. For this reason, we illustrate procedures for straight-line depreciation and discuss the alternative depreciation approaches only at a conceptual level. This coverage introduces you to the basic idea of depreciation as an allocation concept without entangling you in too much procedural detail. (Also, note that many calculators are preprogrammed to perform the basic depreciation methods.) Details on the alternative approaches are presented in Appendix 9A.

ILLUSTRATION 9.7 Use of depreciation methods in major U.S. companies

• No matter what method is used, the total amount depreciated over the useful life of the asset is its depreciable cost. • Depreciable cost is equal to the cost of the asset less its salvage value. Our illustration of depreciation methods, both here and in the chapter appendix, is based on the following data relating to a small delivery truck purchased by Bill's Pizzas on January 1, 2025. Cost Estimated salvage value Estimated useful life (in years) Estimated useful life (in miles)

$13,000 $1,000 5 100,000

Straight-Line Method Under the straight-line method, companies expense an equal amount of depreciation each year of the asset's useful life. Management must choose the useful life of an asset based on its own expectations and experience. To compute the annual depreciation expense, we divide depreciable cost by the estimated useful life. As indicated above, depreciable cost represents the total amount subject to depreciation; it is calculated as the cost of the plant asset less its salvage value. Illustration 9.8 shows the computation of depreciation expense in the first year for Bill's Pizzas' delivery truck. ILLUSTRATION 9.8

Formula for straight-line method

Cost

Salvage Value

=

Depreciable Cost

$13,000

$1,000

=

$12,000

t

l

Depreciable Cost $12,000

+

Useful Life (in years)

=

Depreciation Expense

5

=

$2,400 ·---·-------~-----------~-----

Alternatively, we can compute an annual rate at which the company depreciates the delivery truck. In this case, the rate is 20% (100% 7 5 years). When an annual rate is used under the straight-line method, the company applies the percentage rate to the depreciable cost of the asset, as shown in the depreciation schedule in Illustration 9.9.

'

9.2 Depreciation Methods

ILLUSTRATION 9.9

Bill's Pizzas

Year

Computation Annual Depreciation Depreciable Depreciation X = Expense Cost Rate

2025 2026 2027 2028 2029

$12,000 12,000 12,000 12,000 12,000

20% 20 20 20 20

9-11

Straight-line depreciation schedule

EndofYear Accumulated Book Value Depreciation

$ 2,400 2,400 2,400 2,400 2,400 Total $12,000

$ 2,400 4,800 7,200 9,600 12,000

$10,600* 8,200 5,800 3,400 1,000

Depr. Exp. $2,400

*$13,000 - $2,400

'25

'26 '27 Year

'28

'29

Note that the depreciation expense of $2,400 is the same each year. The book value at the end of the useful life is equal to the estimated $1,000 salvage value. What happens when an asset is purchased during the year, rather than on January 1 as in our example? In that case, it is necessary to prorate the annual depreciation for the portion of the year the asset is used. • If Bill's Pizzas had purchased the delivery truck on April 1, 2025, the company would use the truck for 9 months in 2025. • The depreciation for 2025 would be $1,800 ($12,000 x 20% x

f2 of a year).

As indicated earlier, the straight-line method predominates in practice. For example, such large companies as Tesla, Nike, and General Mills use the straight-line method. It is simple to compute, and it records expenses with associated revenues appropriately when the use of the asset is reasonably uniform throughout the service life. Generally, the types of assets that give equal benefits over their useful lives are those for which daily use does not affect productivity. Examples are office furniture and fixtures, buildings, warehouses, and garages for motor vehicles.

ACTION PLAN

DO IT! 2a i Straight-Line Depreciation On January 1, 2025, Iron Mountain Ski Corporation purchased a new snow-grooming machine for $50,000. The machine is estimated to have a 10-year life with a $2,000 salvage value. What journal entry would Iron Mountain Ski Corporation make at December 31, 2025, if it uses the straight-line method of depreciation?

• Calculate depreciable cost (Cost - Salvage value). Divide the depreciable cost by the asset's estimated useful life.

Solution . . Cost - Salvage value Deprec1at10n expense= Useful life

$50,000 - $2,000

= $4,800

Iron Mountain would record the first year's depreciation as follows. Dec. 31

Depreciation Expense Accumulated Depreciation-Equipment (To record annual depreciation on snowgrooming machine)

4,800

L 1lelatedexer~isematerial: BE9.4, DO IT! 9.2~ E9.4, E~S,~~7, andE9.8.

4,800

. ·-·

Declining-Balance Method The declining-balance method computes depreciation expense using a constant rate applied to a declining book value. This method is called an accelerated-depreciation method

M

y

.

CHY

.!

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CHAPTER 9

Reporting and Analyzing Long-Lived Assets

because it results in higher depreciation in the early years of an asset's life than does the straight-line approach. • Because the total amount of depreciation (the depreciable cost) taken over an asset's life is the same no matter what approach is used, the declining-balance method produces a decreasing annual depreciation expense over the asset's useful life. • In early years, declining-balance depreciation expense will exceed straight-line. In later years, it will be less than straight-line. Managers might choose an accelerated approach if they think that an asset's utility will decline quickly. Companies can apply the declining-balance approach at different rates, which result in varying speeds of depreciation. A common declining-balance rate is double the straightline rate. Using that rate, the method is referred to as the double-declining-balance method. If we apply the double-declining-balance method to Bill's Pizzas' delivery truck, assuming a five -year life, we get the pattern of depreciation shown in Illustration 9.10. Illustration 9A.2 presents the computations behind these numbers. Again, note that total depreciation over the life of the truck is $12,000, the depreciable cost.

ILLUSTRATION 9.10

Bill's Pizzas

Declining-balance depreciation schedule Year $5,000 4,000 Depr. 3,000 Exp.

2,000 1,000 0

2025 2026 2027 2028 2029

~

.....

'25

'26

'27

'28

Annual Depreciation Expense $ 5,200

3,120 1,872 1,123 685

Total

EndofYear Accumulated Depreciation $ 5,200 8,320 10,192 11,315 12,000

Book Value $7,800 4,680 2,808 1,685 1,000

$12,000

'29

Year

Units-of-Activity Method As indicated earlier, useful life can be expressed in ways other than a time period. Under the units-of-activity method, useful life is expressed in terms of the total units of production or the use expected from the asset. • The units-of-activity method is ideally suited to factory machinery: Companies can measure production in terms of units of output or in terms of machine hours used in operating the machinery. • It is also possible to use the method for such items as delivery equipment (miles driven) and airplanes (hours in use). The units-of-activity method is generally not suitable for such assets as buildings or furniture because activity levels are difficult to measure for these assets. Applying the units-of-activity method to the delivery truck owned by Bill's Pizzas, we first must know some basic information. Bill's expects to be able to drive the truck a total of 100,000 miles. Illustration 9.11 shows depreciation over the five-year life based on an assumed mileage pattern. Illustration 9A.4 presents the computations used to arrive at these results. As the name implies, under units-of-activity depreciation, the amount of depreciation is proportional to the activity that took place during that period. For example, the delivery truck was driven twice as many miles in 2026 as in 2025, and depreciation was exactly twice as much in 2026 as it was in 2025.

9.2 Depreciation Methods

ILLUSTRATION 9.11

Bill's Pizzas

Year

Units of Activity (miles)

2025 2026 2027 2028 2029

15,000 30,000 20,000 25,000 10,000

$ 1,800

$100,000

$12,000

Total

9-13

EndofYear Accumulated Book Depreciation Value

Annual Depreciation Expense

$ 1,800 5,400 7,800 10,800 12,000

3,600 2,400 3,000 1,200

$11,200 7,600 5,200 2,200 1,000

Units-of-activity depreciation schedule $5,000 4,000 Depr. Exp. 3,000

2,000 1,000

o~---~-~~ '25 '26 '27 '28 '29 Year

Management's Choice: Comparison of Methods Illustration 9.12 compares annual and total depreciation expense for Bill's Pizzas under the three methods.

Year

StraightLine

DecliningBalance

Units-ofActivity

2025 2026 2027 2028 2029

$ 2,400 2,400 2,400 2,400 2,400

$ 5,200 3,120 1,872 1,123 685

$ 1,800 3,600 2,400 3,000 1,200

$12,000

$12,000

$12,000

ILLUSTRATION 9.12

Comparison of depreciation methods

Annual depreciation expense varies considerably among the methods, but total depreciation expense is the same ($12,000} for the five-year period. Each method is acceptable in accounting because each recognizes the decline in service potential of the asset in a rational and systematic manner. Illustration 9.13 graphs the depreciation expense pattern under each method. Depreciation Expense Patterns

ILLUSTRATION 9.13

Patterns of depreciation $5,000 4,000 Depreciation Expense

3 ,000 2,000 1,000

0 -+---~-----~--~~--~-2025

2026

2027

2028

2029

Year

-

Straight-line -

Declining-balance -

Units-of-activity

Depreciation and Income Taxes The Internal Revenue Service (IRS) allows corporate taxpayers to deduct depreciation expense when computing taxable income. However, the tax regulations of the IRS do not require the taxpayer to use the same depreciation method on the tax return that it uses in preparing financial statements (see Helpful Hint). • Many large corporations use straight-line depreciation in their financial statements in order to maximize net income.

HELPFUL HINT

Depreciation per financial statements is usually different from depreciation per tax returns.

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CHAPTER 9

Reporting and Analyzing Long-Lived Assets

• At the same time, they use a special accelerated-depreciation method on their tax returns in order to minimize their income taxes. For tax purposes, taxpayers must use on their tax returns either the straight-line method or a special accelerated-depreciation method called the Modified Accelerated Cost Recovery System (MACRS).

Depreciation Disclosure in the Notes Companies must disclose the choice of depreciation method in their financial statements or in related notes that accompany the statements. Illustration 9.14 shows excerpts from the "Property and equipment" notes from the financial statements of Southwest Airlines. ILLUSTRATION 9.14

Southwest Airlines

Disclosure of depreciation policies

l;tffllM®PI

Notes to the Financial Statements

Property and equipment Depreciation is provided by the straight-line method to estimated residual values over periods generally ranging from 23 to 25 years for flight equipment.

From this note, we learn that Southwest Airlines uses the straight-line method to depreciate its planes over periods of 23 to 25 years.

Revising Periodic Depreciation Management should periodically review annual depreciation expense. If wear and tear or obsolescence indicates that annual depreciation is either inadequate or excessive, the company should change the depreciation expense amount. When a change in an estimate is required, the company makes the change in current and future years but not to prior periods. 1. The company does not change previously recorded depreciation expense. 2. The company revises depreciation expense for current and future years. HELPFUL HINT

Use a step-by-step approach: (1) determine new depreciable cost; (2) divide by remaining useful life.

ILLUSTRATION 9.15

Revised depreciation computation

The rationale for this treatment is that continual restatement of prior periods would adversely affect users' confidence in financial statements. To determine the new annual depreciation expense, the company first computes the asset's depreciable cost at the time of the revision. It then allocates the revised depreciable cost to the remaining useful life (see Helpful Hint). To illustrate, assume that Bill's Pizzas decides on January l , 2028, to extend the estimated useful life of the truck one year (a total life of six years) and increase its salvage value to $2,200. The company has used the straight-line method to depreciate the asset to date. Depreciation per year was $2,400 [($13,000 - $1,000) + 5]. Accumulated depreciation after three years (2025-2027) is $7,200 ($2,400 x 3), and book value is $5,800 ($13,000 - $7,200). The new annual depreciation is $1,200, computed on December 31, 2028, as shown in Illustration 9.15.

Book value, 1/1/28 Less: Revised salvage value

$5,800 2,200

Depreciable cost

$3,600

Revised remaining useful life

3 years

Revised annual depreciation ($3,600 + 3)

$1,200

(2028-2030)

Bill's Pizzas does not make a special entry for the change in estimate. On December 31, 2028, during the preparation of adjusting entries, it records depreciation expense of $1,200 instead of the amount recorded in previous years.

9.2 Depreciation Methods

Companies must disclose in the financial statements significant changes in estimates. • Although a company may have a legitimate reason for changing an estimated life, financial statement users should be aware that some companies might change an estimate simply to achieve financial statement goals. • For example, extending an asset's estimated life reduces depreciation expense and increases current period income. At one time, AirTran Airways (subsequently acquired by Southwest Airlines) increased the estimated useful lives of some of its planes from 25 to 30 years and increased the estimated lives of related aircraft parts from 5 years to 30 years. It disclosed that the change in estimate decreased its net loss for the year by approximately $0.6 million, or about $0.01 per share. Whether these changes were appropriate depends on how reasonable it is to assume that planes will continue to be used for a long time. Our Feature Story suggests that although in the past many planes lasted a long time, it is also clear that because of high fuel costs, airlines have disposed of most of their old, inefficient planes.

Impairments As noted earlier, the book value of plant assets is rarely the same as the fair value. In instances where the value of a plant asset declines substantially, its fair value might fall materially below book value. This may happen because a machine has become obsolete, or the market for the product made by the machine has dried up or has become very competitive. • A permanent decline in the fair value of an asset is referred to as an impairment. • So as not to overstate the asset on the books, the company records a write-down, whereby the asset's book value is reduced to its new fair value during the year in which the decline in value occurs. This is recorded by debiting a loss and crediting accumulated depreciation. For example, Disney recorded a $200 million write-down on its action movie John Carter. Disney spent more than $300 million producing the film. In the past, some companies improperly delayed recording losses on impairments until a year when it was "convenient" to do so-when the impact on the company's reported results was minimized. For example, in a year when a company has record profits, it can afford to write down some of its bad assets without hurting its reported results too much. • As discussed in Chapter 4, the practice of timing the recognition of gains and losses to achieve certain income results is known as earnings management. Earnings management reduces earnings quality. • To minimize earnings management, accounting standards now require immediate loss recognition on impaired assets. Write-downs can create problems for users of financial statements. Critics of write-downs note that after a company writes down assets, its depreciation expense will be lower in all subsequent periods. Some companies improperly inflate asset write-downs in bad years, when they are going to report poor results anyway. (This practice is referred to as "taking a big bath.") Then in subsequent years, when the company recovers, its results will look even better because of lower depreciation expense.

DO IT! 2b

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Revised Depreciation

Chambers Corporation purchased a piece of equipment for $36,000. It estimated a 6-year life and $6,000 salvage value. Thus, straight-line depreciation was $5,000 per year [($36,000- $6,000)-;, 6]. At the end of year three (before the depreciation adjustment), it estimated the new total life to be 10 years and the new salvage value to be $2,000. Compute the revised depreciation.

ACTION PLAN

, Calculate depreciable cost. , Divide depreciable cost by new remaining life.

9-15

9-16

CHAPTER 9

Reporting and Analyzing Long-Lived Assets

Solution Original depreciation expense= [($36,000 - $6,000) + 6] = $5,000 Accumulated depreciation after 2 years = 2 x $5,000 = $10,000 Book value = $36,000 - $10,000 = $26,000 Book value after 2 years of depreciation Less: New salvage value

$26,000 2,000

Depreciable cost

$24,000 8 years

Remaining useful life Revised annual depreciation ($24,000 + 8)

$ 3,000

Related exercise material: BE9.6, DO IT! 9.2b, E9.9, and E9.10.

B

Plant Asset Disposals LEARNING OBJECTIVE 3

Explain how to account for the disposal of plant assets.

Companies dispose of plant assets that are no longer useful to them. Illustration 9.16 shows the three ways in which companies make plant asset disposals. ILLUSTRATION 9. 16

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Methods of plant asset disposal

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