text
stringlengths 247
9.78k
|
|---|
Equipment 520 300
Accumulated Depreciation–Office 147 300
Equipment
To record depreciation of office
equipment for a month
(d) 31 Wages Expense 511 720
Wages Payable 214 720
To accrue unrecorded wages
(e) 31 Unearned Design Revenue 213 800
Design Revenue 411 800
To recognize payment
for services not yet
performed
(f) 31 Accounts Receivable 113 400
Design Revenue 411 400
To accrue design fees
earned but unrecorded
158 CHAPTER 4 Completing the Accounting Cycle
2. Recording the closing entries in the general journal. The Income State-
ment columns of the work sheet show all the accounts that need to be closed,
except for the Withdrawals account. Exhibits 4-1 through 4-5 show how the
closing entries are entered in the journal and posted to the ledger.
3. Preparing the financial statements. Once the work sheet has been completed,
preparing the financial statements is simple because the account balances have
been sorted into the Income Statement and Balance Sheet columns.
STOP
& APPLY
Place the following columns of a work sheet in the proper order:
a. Balance Sheet columns d. Adjusted Trial Balance columns
b. Trial Balance columns e. Adjustments columns
c. Income Statement columns
SOLUTION
b., e., d., c., a.
(cid:2) WESTWOOD MOVERS: REVIEW PROBLEM
In the Decision Point at the beginning of the chapter, we pointed out that at the end
of an accounting period, Westwood Movers, like all other companies, must prepare its
accounts for the next accounting period. We posed these questions:
• What steps must a company follow to prepare its accounts for the next
accounting period?
• After following these steps, how is the ending balance of the owner’s Capital
account determined?
1. Prepare the necessary closing entries from the partial adjusted trial balance
for Westwood Movers that appears in the Decision Point. (As we noted earlier,
this adjusted trial balance omits all balance sheet accounts except the owner’s
equity accounts.)
Preparation of 2. Compute the ending balance of the owner’s Capital account.
Closing Entries
3. User insight: In the closing process, why is it unnecessary to consider balance
LO2 sheet accounts other than owner’s equity accounts?
Westwood Movers: Review Problem 159
Answers to
1. Closing entries prepared:
Review Problem
2. Ending balance of the J. Thomas, Capital account computed:
3. The reason other balance sheet accounts are not considered in the closing
process is that the balances of all asset and liability accounts carry over to the
next accounting period. Thus, they do not need to be set to zero, as do the
income statements accounts and the Withdrawals account. Also, they do not
need to be updated, as does the owner’s Capital account.
160 CHAPTER 4 Completing the Accounting Cycle
STOP
& REVIEW
LO1 Describe the accounting The steps in the accounting cycle are as follows: (1) analyze business transac-
cycle and the role of tions from source documents; (2) record the transactions by entering them in
closing entries in the the general journal; (3) post the entries to the ledger, and prepare a trial bal-
preparation of fi nancial ance; (4) adjust the accounts, and prepare an adjusted trial balance; (5) prepare
statements. financial statements; and (6) close the accounts, and prepare a post-closing trial
balance. (Step 6 may occur before or after Step 5.)
Closing entries have two purposes: (1) They clear the balances of all tem-
porary accounts (revenue, expense, and Withdrawals accounts) so that they
have zero balances at the beginning of the next accounting period, and (2)
they summarize a period’s revenues and expenses in the Income Summary
account so that the net income or loss for the period can be transferred as a
total to owner’s Capital.
LO2 Prepare closing entries. The first two steps in preparing closing entries are to transfer the balances of the
revenue and expense accounts to the Income Summary account. The balance of
the Income Summary account is then transferred to the owner’s Capital account.
Finally, the balance of the Withdrawals account is transferred to owner’s Capital.
After the closing entries have been posted to the ledger accounts, a post-closing |
trial balance is prepared as a final check on the balance of the ledger and to ensure
that all temporary (nominal) accounts have been closed.
LO3 Prepare reversing Reversing entries are optional journal entries made on the first day of an
entries. accounting period. Reversing entries have the opposite effect of adjusting
entries made at the end of the previous period—that is, a reversing entry
debits the credits and credits the debits of an earlier adjusting entry. The sole
purpose of reversing entries is to simplify routine bookkeeping procedures,
and they apply only to certain adjusting entries. As used in this text, reversing
entries apply only to accruals.
LO4 Prepare and use a The five steps in preparing a work sheet are (1) enter and total the account
work sheet. balances in the Trial Balance columns; (2) enter and total the adjustments in
the Adjustments columns; (3) enter and total the adjusted account balances in
the Adjusted Trial Balance columns; (4) extend the account balances from the
Adjusted Trial Balance columns to the Income Statement or Balance Sheet col-
umns; and (5) total the Income Statement and Balance Sheet columns, enter
the net income or net loss in both pairs of columns as a balancing figure, and
recompute the column totals.
A work sheet is useful in recording both adjusting and closing entries and in
preparing the financial statements. The income statement and balance sheet can
be prepared directly from the Income Statement and Balance Sheet columns of
the completed work sheet. The statement of owner’s equity is prepared using
owner’s Withdrawals, net income, additional investments, and the beginning bal-
ance of the owner’s Capital account.
Stop & Review 161
REVIEW of Concepts and Terminology
The following concepts and terms Crossfooting 154 (LO4) Reversing entry 152 (LO3)
were introduced in this chapter: Income Summary account 146 (LO1) Temporary accounts 144 (LO1)
Accounting cycle 144 (LO1) Permanent accounts 144 (LO1) Working papers 154 (LO4)
Closing entries 144 (LO1) Post-closing trial balance 150 (LO2) Work sheet 154 (LO4)
162 CHAPTER 4 Completing the Accounting Cycle
CHAPTER ASSIGNMENTS
BUILDING Your Basic Knowledge and Skills
Short Exercises
LO1 Accounting Cycle
SE 1. Resequence the following activities to indicate the usual order of the
accounting cycle:
a. Close the accounts.
b. Analyze the transactions.
c. Post the entries to the ledger.
d. Prepare the financial statements.
e. Adjust the accounts.
f. Record the transactions in the journal.
g. Prepare the post-closing trial balance.
h. Prepare the initial trial balance.
i. Prepare the adjusted trial balance.
LO2 Closing Revenue Accounts
SE 2. Assume that at the end of the accounting period there are credit balances
of $6,800 in Patient Services Revenues and $3,600 in Laboratory Fees Revenues.
Prepare the required closing entry in journal form. The accounting period ends
December 31.
LO2 Closing Expense Accounts
SE 3. Assume that debit balances at the end of the accounting period are $2,800
in Rent Expense, $2,200 in Wages Expense, and $1,000 in Other Expenses.
Prepare the required closing entry in journal form. The accounting period ends
December 31.
LO2 Closing the Income Summary Account
SE 4. Assuming that total revenues were $10,400 and total expenses were $6,000,
prepare the entry in journal form to close the Income Summary account to the R.
Shah, Capital account. The accounting period ends December 31.
LO2 Closing the Withdrawals Account
SE 5. Assuming that withdrawals during the accounting period were $1,600,
prepare the entry in journal form to close the R. Shah, Withdrawals account to
the R. Shah, Capital account. The accounting period ends December 31.
LO2 Posting Closing Entries
SE 6. Show the effects of the transactions in SE 2, SE 3, SE 4, and SE 5 by enter-
ing beginning balances in appropriate T accounts and recording the transactions.
Assume that the R. Shah, Capital account had a beginning balance of $1,300.
Chapter Assignments 163
LO3 Preparation of Reversing Entries
SE 7. B elow, indicated by letters, are the adjusting entries at the end of March. |
Account Name Debit Credit
Prepaid Insurance (a) 180
Accumulated Depreciation–Office Equipment (b) 1,050
Salaries Expense (c) 360
Insurance Expense (a) 180
Depreciation Expense–Office Equipment (b) 1,050
Salaries Payable (c) 360
1,590 1,590
Prepare the required reversing entry in journal form.
LO3 Effects of Reversing Entries
SE 8. Assume that prior to the adjustments in SE 7, Salaries Expense had a
debit balance of $1,800 and Salaries Payable had a zero balance. Prepare a
T account for each of these accounts. Enter the beginning balance; post the
adjustment for accrued salaries, the appropriate closing entry, and the reversing
entry; and enter the transaction in the T accounts for a payment of $480 for
salaries on April 3.
LO2 Preparation of Closing Entries
SE 9. The adjusted trial balance for Mendoza Company on December 31, 2011,
contains the following accounts and balances: C. Mendoza, Capital, $4,300; C.
Mendoza, Withdrawals, $175; Service Revenue, $1,300; Rent Expense, $200;
Wages Expense, $450; Utilities Expense, $100; and Telephone Expense, $25.
Prepare the closing entries.
LO2 LO4 Preparation of Closing Entries from a Work Sheet
SE 10. Prepare the required closing entries in journal form for the year
ended December 31, using the following items from the Income State-
ment columns of a work sheet and assuming that withdrawals by the owner,
T. Jameson, were $7,000:
Account Name Debit Credit
Repair Revenue 35,860
Wages Expense 13,260
Rent Expense 2,800
Supplies Expense 6,390
Insurance Expense 1,370
Depreciation Expense–Repair Equipment 3,020
26,840 35,860
Net Income 9,020
35,860 35,860
164 CHAPTER 4 Completing the Accounting Cycle
Exercises
LO1 LO2 Discussion Questions
E 1. Develop brief answers to each of the following questions:
1. Why is the accounting cycle called a “cycle”?
2. Could closing entries be made without using the Income Summary account?
3. Why does the post-closing trial balance contain only balance sheet accounts?
LO3 LO4 Discussion Questions
E 2. Develop brief answers to each of the following questions:
1. Why are reversing entries helpful?
2. Under what circumstances would the Income Statement and Balance Sheet
columns on a work sheet balance when they are initially totaled?
LO2 Preparation of Closing Entries
E 3. The income statement accounts for the Monroe Realty Company at the end
of its fiscal year are shown below. Prepare the required closing entries in journal
form. Chris Ross is the owner.
Account Name Debit Credit
Commission Revenue $26,620
Wages Expense $9,110
Rent Expense 1,300
Supplies Expense 4,160
Insurance Expense 915
Depreciation Expense–Office Equipment 1,345
Total Expenses 16,830
Net Income $ 9,790
LO3 Reversing Entries
E 4. S elected September T accounts for Hubbord Company are presented below.
SUPPLIES SUPPLIES EXPENSE
Dr. Cr. Dr. Cr.
9/1 Bal. 860 9/30 Adj. 1,280 9/30 Adj. 1,280 9/30 Closing 1,280
Sept. purchases 940 Bal. —
Bal. 520
WAGES PAYABLE WAGES EXPENSE
Dr. Cr. Dr. Cr.
9/30 Adj. 640 Sept. wages 3,940 9/30 Closing 4,580
Bal. 640 9/30 Adj. 640
Bal. —
1. In which of the accounts would a reversing entry be helpful? Why?
2. Prepare the appropriate reversing entry.
3. Prepare the entry to record a payment on October 25 for wages totaling
$3,140. How much of this amount represents wages expense for October?
Chapter Assignments 165
LO2 Preparation of a Trial Balance
E 5. The following alphabetical list presents the accounts and balances for Sally’s
Cleaners on June 30, 2011. All the accounts have normal balances.
Accounts Payable $15,420
Accounts Receivable 7,650
Accumulated Depreciation–Office Equipment 1,350
Advertising Expense 1,800
Cash 7,635
Office Equipment 15,510
Prepaid Insurance 1,680
Rent Expense 7,200
Revenue from Commissions 57,900
S. Nash, Capital 30,630
S. Nash, Withdrawals 27,000
Supplies 825
Wages Expense 36,000
Prepare the trial balance by listing the accounts in the correct order, with the bal-
ances in the appropriate debit or credit column.
LO4 Completion of a Work Sheet
E 6. The following is a highly simplified alphabetical list of trial balance accounts
and their normal balances for the month ended March 31, 2011: |
Accounts Payable $ 4
Accounts Receivable 7
Accumulated Depreciation–Office Equipment 1
Cash 4
J. Wells, Capital 12
J. Wells, Withdrawals 6
Office Equipment 8
Prepaid Insurance 2
Service Revenue 23
Supplies 4
Unearned Revenues 3
Utilities Expense 2
Wages Expense 10
1. Prepare a work sheet, entering the trial balance accounts in the order in which
they would normally appear and entering the balances in the correct debit or
credit column.
2. Complete the work sheet using the following information: expired insurance,
$1; estimated depreciation on office equipment, $1; accrued wages, $1; and
unused supplies on hand, $1. In addition, $2 of the unearned revenues bal-
ance had been earned by the end of the month.
LO4 Preparation of Statement of Owner’s Equity
E 7. The Capital, Withdrawals, and Income Summary accounts for Eva’s Hair
Salon are shown in T account form at the top of the next page. The closing
entries have been recorded for the year ended December 31, 2010.
166 CHAPTER 4 Completing the Accounting Cycle
E. KRISTEN, CAPITAL
Dr. Cr.
12/31/10 4,500 12/31/09 13,000
12/31/10 9,500
Bal. 18,000
INCOME SUMMARY
Dr. Cr.
12/31/10 21,500 12/31/10 31,000
12/31/10 9,500
Bal. —
E. KRISTEN, WITHDRAWALS
Dr. Cr.
4/1/10 1,500 12/31/10 4,500
7/1/10 1,500
10/1/10 1,500
Bal. —
Prepare a statement of owner’s equity for Eva’s Hair Salon.
LO3 LO4 Preparation of Adjusting and Reversing Entries from Work Sheet Columns
E 8. The items that appear below are from the Adjustments columns of a work
sheet dated June 30, 2011.
Adjustments
Account Name Debit Credit
Prepaid Insurance (a) 240
Office Supplies (b) 630
Accumulated Depreciation–Office Equipment (c) 1,400
Accumulated Depreciation–Store Equipment (d) 2,200
Office Salaries Expense (e) 240
Store Salaries Expense (e) 480
Insurance Expense (a) 240
Office Supplies Expense (b) 630
Depreciation Expense–Office Equipment (c) 1,400
Depreciation Expense–Store Equipment (d) 2,200
Salaries Payable (e) 720
5,190 5,190
1. Prepare the adjusting entries in journal form.
2. Where required, prepare appropriate reversing entries in journal form.
LO2 LO4 Preparation of Closing Entries from the Work Sheet
E 9. The items that follow are from the Income Statement columns of the
work sheet for Ben’s Repair Shop for the year ended December 31, 2011.
Prepare entries in journal form to close the revenue, expense, Income Summary,
and Withdrawals accounts. The owner, Ben Junkus, withdrew $6,000 during
the year.
Chapter Assignments 167
Income Statement
Account Name Debit Credit
Repair Revenue 25,620
Wages Expense 8,110
Rent Expense 1,200
Supplies Expense 4,260
Insurance Expense 915
Depreciation Expense–Repair Equipment 1,345
15,830 25,620
Net Income 9,790
25,620 25,620
LO4 Adjusting Entries and Preparation of a Balance Sheet
E 10. In the partial work sheet for L. Wung Company that follows, the Trial
Balance and Income Statement columns have been completed. All amounts are
in dollars.
Trial Balance Income Statement
Account Name Debit Credit Debit Credit
Cash 14
Accounts Receivable 24
Supplies 22
Prepaid Insurance 16
Building 50
Accumulated
Depreciation–Building 16
Accounts Payable 8
Unearned Revenues 4
L. Wung, Capital 64
Revenues 88 92
Wages Expense 54 60
180 180
Insurance Expense 8
Supplies Expense 16
Depreciation Expense–
Building 4
Wages Payable
88 92
Net Income 4
92 92
1. Show the adjustments that have been made in journal form without giving an
explanation.
2. Prepare a balance sheet for December 31, 2010.
168 CHAPTER 4 Completing the Accounting Cycle
Problems
LO1 LO2 Preparation of Closing Entries
P 1. Affordable Trailer Rental rents small trailers by the day for local moving jobs.
This is its adjusted trial balance at the end of the current fiscal year:
Aff ordable Trailer Rental
Adjusted Trial Balance
June 30, 2011
Cash $ 692
Accounts Receivable 972
Supplies 119
Prepaid Insurance 360
Trailers 12,000
Accumulated Depreciation–Trailers $ 7,200
Accounts Payable 271
Wages Payable 200
A. Tropp, Capital 5,694
A. Tropp, Withdrawals 7,200
Trailer Rentals Revenue 45,546
Wages Expense 23,400
Insurance Expense 720
Supplies Expense 266
Depreciation Expense–Trailers 2,400 |
Other Expenses 10,782
$58,911 $58,911
Required
1. From the information given, record closing entries in journal form.
User insight (cid:2) 2. If closing entries were not prepared at the end of the accounting period, what
problems would result in the next accounting period?
LO1 LO2 Closing Entries Using T Accounts and Preparation of Financial Statements
P 2. The adjusted trial balance for Settles Tennis Club at the end of the c ompany’s
fiscal year appears at the top of the next page.
Required
1. Prepare T accounts and enter the balances for B. Settles, Capital; B. Settles,
Withdrawals; Income Summary, and all revenue and expense accounts.
2. Enter the four required closing entries in the T accounts, labeling the com-
ponents a, b, c, and d, as appropriate.
3. Prepare an income statement, a statement of retained earnings, and a balance
sheet for Settles Tennis Club.
4. Explain why it is necessary to make closing entries at the end of an account-
ing period.
Chapter Assignments 169
Settles Tennis Club
Adjusted Trial Balance
June 30, 2011
Cash $ 26,200
Prepaid Advertising 9,600
Supplies 1,200
Land 100,000
Building 645,200
Accumulated Depreciation–Building $ 260,000
Equipment 156,000
Accumulated Depreciation–Equipment 50,400
Accounts Payable 73,000
Wages Payable 9,000
Property Taxes Payable 22,500
Unearned Revenue–Locker Fees 3,000
B. Settles, Capital 471,150
B. Settles, Withdrawals 54,000
Revenue from Court Fees 678,100
Revenue from Locker Fees 9,600
Wages Expense 351,000
Maintenance Expense 51,600
Advertising Expense 39,750
Utilities Expense 64,800
Supplies Expense 6,000
Depreciation Expense–Building 30,000
Depreciation Expense–Equipment 12,000
Property Taxes Expense 22,500
Miscellaneous Expense 6,900 6,900
$1,576,750 $1,576,750
LO2 Preparation of Closing Entries
P 3. Robert Half International, Inc. is a global specialized staffing firm. Infor-
mation adapted from the statement of earnings (in thousands, without earnings
per share information) in its annual report for the year ended December 31,
2005, follows.1 The firm reported distributing cash (dividends) in the amount of
$47,781,000 to the owners in 2005.
Revenues
Service revenues $3,338,439
Interest income 10,948
Total revenues $3,349,387
Expenses
Employee compensation and benefits $1,965,390
Selling, general, and administrative expenses 991,823
Income taxes 154,304
Total expenses $3,111,517
Net income $ 237,870
170 CHAPTER 4 Completing the Accounting Cycle
Required
1. Prepare in journal form the closing entries Robert Half would have made on
December 31, 2005. Treat income taxes as an expense and cash distributions
to owners as withdrawals.
2. Based on your handling of requirement 1 and the effect of expenses and cash
distributions on owner’s capital, what theoretical reason can you give for not
including expenses and cash distributions in the same closing entry?
LO2 LO3 LO4 Preparation of a Work Sheet, Financial Statements, and Adjusting, Closing,
and Reversing Entries
P 4. At the end of the fiscal year, the trial balance of Reed Delivery Service
appeared as shown below.
Reed Delivery Service
Trial Balance
August 31, 2010
Cash $ 10,072
Accounts Receivable 29,314
Prepaid Insurance 5,340
Delivery Supplies 14,700
Offi ce Supplies 2,460
Land 15,000
Building 196,000
Accumulated Depreciation–Building $ 53,400
Trucks 103,800
Accumulated Depreciation–Trucks 30,900
Offi ce Equipment 15,900
Accumulated Depreciation–Offi ce Equipment 10,800
Accounts Payable 9,396
Unearned Lockbox Fees 8,340
Mortgage Payable 72,000
N. Reed, Capital 128,730
N. Reed, Withdrawals 30,000
Delivery Service Revenue 283,470
Lockbox Fees Earned 28,800
Truck Drivers’ Wages Expense 120,600
Offi ce Salaries Expense 44,400
Gas, Oil, and Truck Repairs Expense 31,050
Interest Expense 7,200
$625,836 $625,836
Required
1. Enter the trial balance amounts in the Trial Balance columns of a work sheet
and complete the work sheet using the information that follows:
a. Expired insurance, $3,060.
b. Inventory of unused delivery supplies, $1,430.
c. Inventory of unused office supplies, $186.
d. Estimated depreciation on the building, $14,400. |
e. Estimated depreciation on the trucks, $15,450.
f. Estimated depreciation on the office equipment, $2,700.
g. The company credits the lockbox fees of customers who pay in advance
to the Unearned Lockbox Fees account. Of the amount credited to this
account during the year, $5,630 had been earned by August 31.
Chapter Assignments 171
h. Lockbox fees earned but unrecorded and uncollected at the end of the
accounting period, $816.
i. Accrued but unpaid truck drivers’ wages at the end of the year, $1,920.
2. Prepare an income statement, a statement of owner’s equity, and a balance
sheet for the company. Assume the owner, Natalie Reed, made no additional
investments.
3. Prepare adjusting, closing, and, when necessary, reversing entries from the
work sheet.
User insight (cid:2) 4. Can the work sheet be used as a substitute for the financial statements?
Explain your answer.
LO1 LO2 The Complete Accounting Cycle Without a Work Sheet: Two Months (second
month optional)
P 5. On May 1, 2011, Conrad Sayer opened Conrad’s Repair Service. During the
month, he completed the following transactions for the company:
May 1 Began business by depositing $5,000 in a bank account in the
name of the company.
1 Paid the rent for the store for current month, $425.
1 Paid the premium on a one-year insurance policy, $480.
2 Purchased repair equipment from Chmura Company, $4,200.
Terms were $600 down and $300 per month for one year. First
payment is due June 1.
5 Purchased repair supplies from Brown Company on credit,
$468.
8 Paid cash for an advertisement in a local newspaper, $60.
15 Received cash repair revenue for the first half of the month,
$400.
21 Paid Brown Company on account, $225.
31 Received cash repair revenue for the last half of May, $975.
31 Made a withdrawal, $300.
Required for May
1. Prepare journal entries to record the May transactions.
2. Open the following accounts: Cash (111); Prepaid Insurance (117);
Repair Supplies (119); Repair Equipment (144); Accumulated Depreciation–
Repair Equipment (145); Accounts Payable (212); C. Sayer, Capital (311);
C. Sayer, Withdrawals (313); Income Summary (314); Repair Revenue
(411); Store Rent Expense (511); Advertising Expense (512); Insurance
Expense (513); Repair Supplies Expense (514); and Depreciation Expense–
Repair Equipment (515). Post the May journal entries to the ledger
accounts.
3. Using the following information, record adjusting entries in the general
journal and post to the ledger accounts:
a. One month’s insurance has expired.
b. The remaining inventory of unused repair supplies is $169.
c. The estimated depreciation on repair equipment is $70.
4. From the accounts in the ledger, prepare an adjusted trial balance.
(Note: Normally, a trial balance is prepared before adjustments but is omitted
here to save time.)
5. From the adjusted trial balance, prepare an income statement, a statement of
owner’s equity, and a balance sheet for May.
6. Prepare and post closing entries.
7. Prepare a post-closing trial balance.
172 CHAPTER 4 Completing the Accounting Cycle
(Optional)
During June, Conrad Sayer completed these transactions for Conrad’s Repair
Service:
June 1 Paid the monthly rent, $425.
1 Made the monthly payment to Chmura Company, $300.
6 Purchased additional repair supplies on credit from Brown Com-
pany, $863.
15 Received cash repair revenue for the first half of the month,
$914.
20 Paid cash for an advertisement in the local newspaper, $60.
23 Paid Brown Company on account, $600.
30 Received cash repair revenue for the last half of the month,
$817.
30 Recorded a withdrawal by owner, $300.
8. Prepare and post journal entries to record the June transactions.
9. Using the following information, record adjusting entries in the general jour-
nal and post to the ledger accounts:
a. One month’s insurance has expired.
b. The inventory of unused repair supplies is $413.
c. The estimated depreciation on repair equipment is $70.
10. From the accounts in the ledger, prepare an adjusted trial balance.
11. From the adjusted trial balance, prepare the June income statement, state- |
ment of owner’s equity, and balance sheet.
12. Prepare and post closing entries.
13. Prepare a post-closing trial balance.
Alternate Problems
LO1 LO2 Preparation of Closing Entries
P 6. The adjusted trial balance for Patch Consultant Company at the end of its
fiscal year is shown below.
Patch Consultant Company
Adjusted Trial Balance
December 31, 2011
Cash $ 7,275
Accounts Receivable 2,325
Prepaid Insurance 585
Offi ce Supplies 440
Offi ce Equipment 6,300
Accumulated Depreciation–Offi ce Equipment $ 765
Automobile 6,750
Accumulated Depreciation–Automobile 750
Accounts Payable 1,700
Unearned Consulting Fees 1,500
S. Patch, Capital 14,535
S. Patch, Withdrawals 7,000
Consulting Fees Earned 31,700
Offi ce Salaries Expense 13,500
Advertising Expense 2,525
Rent Expense 2,650
Telephone Expense 1,600
$50,950 $50,950
Chapter Assignments 173
Required
1. Prepare the required closing entries.
User insight (cid:2) 2. Explain why closing entries are necessary at the end of the accounting
period.
LO2 Preparation of Closing Entries
P 7. The adjusted trial balance for Greg Painting Company at December 31,
2011, is provided below. The owner made no investments during the period.
Greg Painting Company
Adjusted Trial Balance
December 31, 2011
Cash $ 4,750
Accounts Receivable 2,592
Prepaid Insurance 380
Prepaid Rent 200
Painting Supplies 152
Painting Equipment 3,875
Accumulated Depreciation–Painting Equipment $ 320
Truck 7,200
Accumulated Depreciation–Truck 720
Accounts Payable 420
Wages Payable 295
Unearned Painting Revenue 1,690
G. Rak, Capital 15,034
G. Rak, Withdrawals 2,000
Painting Revenue 14,620
Wages Expense 5,680
Rent Expense 1,350
Gas, Oil, and Other Truck Expenses 580
Insurance Expense 380
Supplies Expense 2,920
Depreciation Expense–Painting Equipment 320
Depreciation Expense–Truck 720
$33,099 $33,099
Required
Prepare in journal form the required closing entries.
LO2 LO4 Preparation of a Work Sheet, Financial Statements,
and Adjusting and Closing Entries
P 8. Pierot Theater Company’s trial balance at the end of its current fiscal year is
shown at the top of the next page.
174 CHAPTER 4 Completing the Accounting Cycle
Pierot Theater Company
Trial Balance
June 30, 2010
Cash $ 31,800
Accounts Receivable 18,544
Prepaid Insurance 19,600
Offi ce Supplies 780
Cleaning Supplies 3,590
Land 20,000
Building 400,000
Accumulated Depreciation–Building $ 39,400
Theater Furnishings 370,000
Accumulated Depreciation–Theater Furnishings 65,000
Offi ce Equipment 31,600
Accumulated Depreciation–Offi ce Equipment 15,560
Accounts Payable 45,506
Gift Books Liability 41,900
Mortgage Payable 300,000
P. Rieu, Capital 312,648
P. Rieu, Withdrawals 60,000
Ticket Sales Revenue 411,400
Theater Rental Revenue 45,200
Usher Wages Expense 157,000
Offi ce Wages Expense 24,000
Utilities Expense 112,700
Interest Expense 27,000
$1,276,614 $1,276,614
Required
1. Enter Pierot Theater Company’s trial balance amounts in the Trial Balance
columns of a work sheet and complete the work sheet using the following
information:
a. Expired insurance, $17,400.
b. Inventory of unused office supplies, $244.
c. Inventory of unused cleaning supplies, $468.
d. Estimated depreciation on the building, $14,000.
e. Estimated depreciation on the theater furnishings, $36,000.
f. Estimated depreciation on the office equipment, $3,160.
g. The company credits all gift books sold during the year to the Gift
Books Liability account. A gift book is a booklet of ticket coupons
that is purchased in advance as a gift. The recipient redeems the coupons
at some point in the future. On June 30 it was estimated that $37,800
worth of the gift books had been redeemed.
h. Accrued but unpaid usher wages at the end of the accounting period,
$860.
2. Prepare an income statement, a statement of owner’s equity, and a balance
sheet. Assume no additional investments by the owner, Pierot Rieu.
3. Prepare adjusting and closing entries from the work sheet.
User insight (cid:2) 4. Can the work sheet be used as a substitute for the financial statements?
Explain your answer.
Chapter Assignments 175
LO2 Preparation of Closing Entries
P 9. The adjusted trial balance for Burke Consultants Company at the end of its |
fiscal year is shown below.
Burke Consultants Company
Adjusted Trial Balance
December 31, 2010
Cash $ 7,575
Accounts Receivable 2,625
Prepaid Insurance 585
Offi ce Supplies 440
Offi ce Equipment 6,300
Accumulated Depreciation–Offi ce Equipment $ 765
Automobile 6,750
Accumulated Depreciation–Automobile 750
Accounts Payable 1,700
Unearned Consulting Fees 1,500
D. Burke, Capital 14,535
D. Burke, Withdrawals 7,000
Consulting Fees Earned 32,550
Offi ce Salaries Expense 13,500
Advertising Expense 2,525
Rent Expense 2,650
Telephone Expense 1,850
$51,800 $51,800
Required
Prepare in journal form the required closing entries for Burke Consultants
Company.
LO2 Preparation of Closing Entries
P 10. The adjusted trial balance for Van Rental Service at the end of its fiscal year
is shown on the next page.
Required
Prepare in journal form the required closing entries for Van Rental Service.
176 CHAPTER 4 Completing the Accounting Cycle
Van Rental Service
Adjusted Trial Balance
December 31, 2010
Cash $ 10,215
Accounts Receivable 12,100
Prepaid Rent 13,000
Prepaid Insurance 4,700
Prepaid Maintenance 10,350
Spare Parts 11,520
Vans 310,000
Accumulated Depreciation–Vans $ 55,000
Notes Payable 48,730
Unearned Rental Revenue 35,500
R. Krazel, Capital 115,305
R. Krazel, Withdrawals 18,000
Rental Revenue 523,498
Gas and Oil Expense 87,100
Salaries Expense 202,710
Advertising Expense 36,800
Rent Expense 12,000
Insurance Expense 1,800
Spare Parts Expense 9,294
Depreciation Expense–Vans 27,500
Maintenance Expense 10,944
$778,033 $778,033
ENHANCING Your Knowledge, Skills, and Critical Thinking
LO1 Interim Financial Statements
C 1. Offshore Drilling Company provides services for drilling operations off the coast
of Louisiana. The company has a significant amount of debt to Southern National
Bank in Baton Rouge. The bank requires the company to provide it with quarterly
financial statements. Explain what is involved in preparing financial statements every
quarter.
LO1 Purpose of Closing Entries
C 2. Maury Jacobs, owner of Jacobs Furniture Company, notices the amount
of time it takes the company’s accountant to prepare closing entries. He sug-
gests that the company could save time and money by not doing closing
entries. He argues that only adjusting entries are needed to determine the
company’s earnings. Explain the purposes of closing entries and why they are
worth doing.
LO1 Accounting Efficiency
C 3. Way Heaters Company manufactures industrial heaters used in making candy.
It sells its heaters to some customers on credit with generous terms specifying pay-
ment six months after purchase and an interest rate based on current bank rates.
Because the interest on the loans accrues a little every day but is not paid until the
Chapter Assignments 177
note’s due date, an adjusting entry must be made at the end of each accounting
period to debit Interest Receivable and credit Interest Income for the amount
of the interest accrued but not received to date. The company prepares financial
statements every month. Keeping track of what has been accrued in the past is
time-consuming because the notes carry different dates and interest rates.
Form in-class groups to determine what the accountant can do to simplify the
process of making the adjusting entry for accrued interest each month. Compare
the groups’ solutions in a class discussion.
LO1 Ethics and Time Pressure
C 4. James Bear, an accountant for Rosa Company, has made adjusting entries
and is preparing the adjusted trial balance for the first six months of the year.
Financial statements must be delivered to the bank by 5 P.M. to support a criti-
cal loan agreement. By noon, Bear has been unable to balance the adjusted
trial balance. The figures are off by $1,320, so he increases the balance of the
owner’s Capital account by $1,320. He closes the accounts, prepares the state-
ments, and sends them to the bank on time. Bear hopes that no one will notice
the problem and believes that he can find the error and correct it by the end
of next month. Are Bear’s actions ethical? Why or why not? Did he have other
alternatives? |
LO1 Fiscal Year, Closing Process, and Interim Reports
C 5. Refer to the notes to the financial statements in the CVS annual report in the
Supplement to Chapter 5. When does CVS end its fiscal year? For what reasons
might it have chosen this date? From the standpoint of completing the account-
ing cycle, what advantage does this date have? Does CVS prepare interim finan-
cial statements? What are the implications of interim financial statements for the
accounting cycle?
LO1 Interim Financial Reporting and Seasonality
C 6. Both CVS and Southwest Airlines provide quarterly financial informa-
tion in their financial statements. Quarterly financial reports provide impor-
tant information about the “seasonality” of a company’s operations. Seasonality
refers to how dependent a company is on sales during different seasons of the
year, and how that affects a company’s need to plan for cash flows and inven-
tory. From the quarterly financial information for CVS in the Supplement to
Chapter 5, determine the effects of seasons on CVS’s net revenues and net
earnings by calculating for the most recent year the percentage of quarterly net
sales and net earnings to annual net sales and net earnings. Discuss the results.
How do you think the effect of seasons might differ for Southwest’s operating
revenues and income?
COMPREHENSIVE Problem: Miller Design Studio
This comprehensive problem involving Miller Design Studio covers all the learn-
ing objectives in this chapter and in the chapters on measuring business transac-
tions and measuring business income. To complete the problem, you may some-
times have to refer to this material.
The July 31, 2011, post-closing trial balance for the Miller Design Studio is
on the next page.
178 CHAPTER 4 Completing the Accounting Cycle
Miller Design Studio
Post-Closing Trial Balance
July 31, 2011
Cash $22,480
Accounts Receivable 5,000
Offi ce Supplies 3,660
Prepaid Rent 1,600
Offi ce Equipment 16,320
Accumulated Depreciation–Offi ce Equipment $ 300
Accounts Payable 6,280
Unearned Design Revenue 600
Wages Payable 720
41,160
J. Miller, Capital
$49,060 $49,060
During August, the studio engaged in these transactions:
Aug. 1 Received an additional investment of cash from J. Miller,
$20,000.
2 Purchased additional office equipment with cash, $4,700.
7 Purchased additional office supplies for cash, $540.
8 Completed the series of designs that began on July 31 and billed
for the total design services performed, including the accrued rev-
enues of $800 that had been recognized in an adjusting entry in
July, $1,400.
12 Paid the amount due for the office equipment purchased last
month, $3,000.
13 A ccepted an advance in cash for design work to be done,
$2,400.
15 Performed design services and received a cash fee, $2,900.
16 R eceived payment on account for design services performed last
month, $2,800.
19 M ade a partial payment on the utilities bill that was received and
recorded at the end of July, $140.
20 P erformed design services for Rave Department Stores and
agreed to accept payment next month, $3,200.
21 Performed design services for cash, $1,160.
22 Received and paid the utilities bill for August, $900.
23 Paid the assistant for four weeks’ wages, $4,800.
26 Paid the rent for September in advance, $1,600.
30 P aid cash to J. Miller as a withdrawal for personal expenses,
$2,800.
Required
1. Record entries in journal form and post to the ledger accounts the optional
reversing entries on August 1 for Wages Payable and Accounts Receivable
(see adjustment for unrecorded wages on page 116 and adjustment for design
revenue on page 119). (Begin the general journal on page 5.)
2. Record the transactions for August in journal form.
3. Post the August transactions to the ledger accounts.
4. Prepare the Trial Balance columns of a work sheet.
Chapter Assignments 179
5. Prepare adjusting entries and complete the work sheet using the information
below.
a. One month’s prepaid rent has expired, $1,600.
b. An inventory of supplies reveals $2,020 still on hand on August 31.
c. Depreciation on equipment for August is calculated to be $300. |
d. Services performed for which payment had been received in advance
totaled $1,300.
e. Services performed that will not be billed until September totaled $580.
f. Wages accrued by the end of August, $720.
6. From the work sheet, prepare an income statement, a statement of owner’s
equity, and a balance sheet for August 31, 2011.
7. Record the adjusting entries on August 31, 2011, in journal form, and post
them to the ledger accounts.
8. Record the closing entries on August 31, 2011, in journal form, and post
them to the ledger accounts.
9. Prepare a post-closing trial balance at August 31, 2011.
C H A P T E R
5 Financial Reporting
and Analysis
O wners, creditors, and other interested parties rely on the
Making a
Statement integrity of a company’s financial reports. A company’s man-
agers and accountants therefore have a responsibility to act ethically
INCOME STATEMENT
in the reporting process. However, what is often overlooked is that
Revenues
the users of financial reports also have a responsibility to recognize
– Expenses
and understand the types of judgments and estimates that underlie
these reports.
= Net Income
STATEMENT OF LEARNING OBJECTIVES
RETAINED EARNINGS
Beginning Balance LO1 Describe the objective of financial reporting and identify
the qualitative characteristics, conventions, and ethical
+ Net Income
considerations of accounting information. (pp. 182–185)
– Withdrawals
= Ending Balance LO2 Define and describe the conventions of consistency, full
disclosure, materiality, conservatism, and cost-benefit. (pp. 185–189)
BALANCE SHEET LO3 Identify and describe the basic components of a classified
Assets Liabilities
balance sheet. (pp. 190–195)
LO4 Describe the features of multistep and single-step classified
Owner’s
Equity income statements. (pp. 196–200)
A = L + OE LO5 Use classified financial statements to evaluate liquidity and
profitability. (pp. 201–208)
STATEMENT OF CASH FLOWS
Operating activities
+ Investing activities
+ Financing activities
= Change in Cash
+ Beginning Balance
= Ending Cash Balance
Grouping like accounts on the
balance sheet and income
statement aids analysis.
180
DECISION POINT (cid:2) A USER’S FOCUS
(cid:2) How should the income
statement be organized to
FUN-FOR-FEET COMPANY
provide the best information?
(cid:2) What key measures best
capture a company’s financial
Fun-For-Feet Company is a retailer of casual footwear for college stu-
performance?
dents. It has two stores, and the owner, Jay Bonali, now wants to open a
third. To obtain a loan so that he can open a third store, he will have to
present the company’s financial statements to his bank. Shown below
is the kind of income statement Jay has always prepared in the past.
He is concerned that this simple, single-step income statement may not
provide the bank with adequate information about how the company
generates its income, and he is also wondering how he can best show
the bank that the company is profitable. In other words, he is looking for
answers to the two questions that appear in the margin to the right.
Fun-For-Feet Company
Income Statement
For the Year Ended December 31, 2011
Revenues
Net sales $1,207,132
Interest income 5,720
Total revenues $1,212,852
Costs and expenses
Cost of goods sold $787,080
Selling expenses 203,740
General and administrative expenses 100,688
Interest expense 13,560
Total costs and expenses 1,105,068
Net income $ 107,784
181
182 CHAPTER 5 Financial Reporting and Analysis
Foundations
By issuing stocks and bonds that are traded in financial markets, companies can
of Financial raise the cash they need to carry out current and future business activities. Investors
are interested mainly in returns from dividends and increases in the market value of
Reporting
their investment. Creditors want to know if the firm can repay a loan plus interest in
accordance with specified terms. Very importantly, both investors and creditors need
LO1 Describe the objective of
to know if the firm can generate adequate cash flows to maintain its liquidity. Finan-
financial reporting and identify
cial statements are important to both groups in making that judgment. They offer |
the qualitative characteristics,
valuable information that helps investors and creditors judge a company’s ability to
conventions, and ethical
pay dividends or other distributions to owners and repay debts with interest.
considerations of accounting
In the following sections, we describe the objectives of financial reporting
information.
and the qualitative characteristics, accounting conventions, and ethical consider-
ations that are involved. Figure 5-1 illustrates these factors.
Objective of Financial Reporting
The Financial Accounting Standards Board (FASB) emphasizes the needs of cur-
rent and potential investors (owners) and creditors while recognizing the needs
of other users when it defines the objective of financial reporting as follows:1
To provide financial information about the reporting entity that is useful
to present and potential equity investors, lenders, and other creditors in
making decisions in their capacity as capital providers. Information that is
decision-useful to capital providers may also be useful to other users of
financial reporting who are not capital providers.
To be useful for decision making, financial reporting must enable the user to do
the following:
(cid:2) Assess cash flow prospects. Since the ultimate value of an entity and its
ability to pay dividends, interest, and otherwise provide returns to capital
providers depends on its ability to generate future cash flows, capital pro-
viders and other users need information to help make judgments about the
entity’s ability to generate cash flows.
(cid:2) Assess stewardship. Since management is accountable for the custody and
safekeeping of the entity’s economic resources and for their efficient and prof-
itable use, capital providers and others need information about the entity’s
resources (assets), claims against them (liabilities and owner’s [stockholders’]
equity), and changes in these resources and claims as impacted by transac-
tions (earnings and cash flows) and other economic events.
Financial reporting includes the financial statements periodically presented
to parties outside the business. The statements—the balance sheet, the income
statement, the statement of owner’s equity, and the statement of cash flows—are
important outputs of the accounting system but not the only output. Manage-
ment’s explanations and other information, including underlying assumptions and
significant uncertainties about methods and estimates used in the financial reports,
constitute important components of financial reporting by an entity. Because of a
potential conflict of interest between managers, who must prepare the statements,
and investors or creditors, who invest in or lend money to the business, financial
statements usually are audited by outside accountants to ensure their reliability.
Qualitative Characteristics of Accounting Information
Students in their first accounting course often get the idea that accounting is
100 percent accurate. Contributing to this perception is that introductory text-
books like this one present the basics of accounting in a simple form to help
students understand them. All the problems can be solved, and all the numbers
Foundations of Financial Reporting 183
FIGURE 5-1
Factors Affecting Financial Reporting
OBJECTIVE OF FINANCIAL REPORTING
To provide financial information that is useful in making decisions in assessing:
• Cash flow prospects
• Stewardship
QUALITATIVE CHARACTERISTICS ACCOUNTING CONVENTIONS ETHICAL FINANCIAL REPORTING
DECISION USEFULNESS • Consistency CERTIFICATION
Accountants must provide information • Full disclosure Chief Executive Officer, Chief Financial
that is useful in making decisions. • Materiality Officer, and auditors must certify that
financial statements are accurate,
• Conservatism
complete, and not misleading.
RELEVANCE FAITHFUL • Cost-benefit
REPRESENTATION
• Predictive value
• Complete
• Confirmative
value • Neutral
• Free from
material error
COMPLEMENTARY QUALITIES
• Comparability
• Verifiability
• Timeliness
• Understandability
add up; what is supposed to equal something else does. Accounting seems very |
much like mathematics in its precision. In practice, however, accounting infor-
mation is neither simple nor precise, and it rarely satisfies all criteria. The FASB
emphasizes this fact in the following statement:
The information provided by financial reporting often results from approxi-
mate, rather than exact, measures. The measures commonly involve numer-
ous estimates, classifications, summarizations, judgments, and allocations. The
outcome of economic activity in a dynamic economy is uncertain and results
from combinations of many factors. Thus, despite the aura of precision that
may seem to surround financial reporting in general and financial statements
in particular, with few exceptions the measures are approximations, which
may be based on rules and conventions, rather than exact amounts.2
The goal of generating accounting information is to provide data that different
users need to make informed decisions for their unique situations. How this goal
is achieved provides much of the interest and controversy in accounting. To facili-
tate interpretation of accounting information, the FASB has established standards, or
qualitative characteristics, by which to judge the information.3 The most important
or fundamental qualitative characteristics are relevance and faithful representation.
Relevance means that the information has a direct bearing on a decision. In
other words, if the information were not available, a different decision would be
made. To be relevant, information must have predictive value, confirmative value,
or both. Information has predictive value if it helps current and potential investors
(owners) and creditors make decisions about the future. For example, the statement
of cash flows can provide information as to whether the company has sufficient
184 CHAPTER 5 Financial Reporting and Analysis
funds to expand or if it will need to raise funds from capital providers. Information
has confirmative value if it provides the information needed to determine if expec-
tations have been met. For example, the income statement provides information
as to whether a company has met earnings expectations for the past accounting
period. Predictive and confirmative sources of information are obviously interre-
lated. The statement of cash flows also confirms expectations about various prior
actions, and the income statement helps to determine future earnings.
Faithful representation means that the financial reporting for an entity must
be a reliable depiction of what it purports to represent. To be faithful, financial
information must be complete, neutral, and free from material error. Complete
information includes all information necessary for a reliable decision. Neutral infor-
mation implies the absence of bias intended to attain a predetermined result or to
induce a particular behavior. Freedom from material error means that information
must meet a minimum level of accuracy so that the information does not distort
what it depicts. It does not mean that information is absolutely accurate, because
most financial information is based on estimates and judgments. If major uncertain-
ties as to the faithful representation exist, they should be disclosed.
The following are qualitative characteristics that complement the quality of
information:
(cid:2) Comparability is the quality that enables users to identify similarities and dif-
ferences between two sets of economic phenomena.
(cid:2) Verifiability is the quality that helps assure users that information faithfully
represents what it purports to depict.
(cid:2) Timeliness is the quality that enables users to receive information in time to
influence a decision.
(cid:2) Understandability is the quality that enables users to comprehend the mean-
ing of the information they receive.
Accounting Conventions
For accounting information to be understandable, accountants must prepare
financial statements in accordance with accepted practices. But the decision
maker also must know how to interpret the information; in making decisions,
he or she must judge what information to use, how to use it, and what it means. |
Familiarity with the accounting conventions, or constraints on accounting, used
in preparing financial statements enable the user to better understand accounting
information. These conventions, which we discuss later in the chapter, affect how
and what information is presented in financial statements.
Ethical Financial Reporting
As we noted earlier in the text, in 2002, in the wake of accounting scandals at
Enron and WorldCom, Congress passed the Sarbanes-Oxley Act. One of the
important outcomes of this legislation was that the Securities and Exchange
Commission instituted rules requiring the chief executive officers and chief finan-
cial officers of all publicly traded companies to certify that, to their knowledge,
the quarterly and annual statements that their companies file with the SEC are
accurate and complete. Subsequently, an investigation by the audit committee
of Dell Computer’s board of directors and management disclosed weaknesses in
the company’s controls and led to restatements of the financial statements for the
prior four years. After extensive improvements in control and the restatements,
the company’s chief executive officer, Michael S. Dell, made the following certi-
fying statement in the company’s annual report to the SEC:
Accounting Conventions for Preparing Financial Statements 185
Based on my knowledge, the financial statements, and other financial infor-
mation included in this report, fairly present in all material respects the
financial condition, results of operations and cash flows . . . for the periods
represented in this report.4
The chief financial officer may sign a similar certification.
As the Enron and WorldCom scandals demonstrated, fraudulent financial
reporting can have high costs for investors, lenders, employees, and customers.
It can also have high costs for the people who condone, authorize, or prepare
misleading reports—even those at the highest corporate levels. In March 2005,
Bernard J. Ebbers, former CEO of WorldCom, was convicted of seven counts
of filing false reports with the SEC and one count each of securities fraud and
conspiracy.5 In 2006, both Kenneth Lay, former chairman of Enron Corporation,
and Jeffrey Skilling, Enron’s former CEO, were convicted on charges similar to
the ones of which Ebbers was convicted.
STOP
& APPLY
The lettered items below represent a classification scheme for the concepts of financial accounting. Match
each numbered term in the list that follows with the letter of the category in which it belongs.
a. Decision makers (users of accounting 4. Assess stewardship
information) 5. Faithful representation
b. Objectives of accounting information 6. Recognition
c. Accounting measurement considerations 7. Investors
d. Accounting processing considerations 8. Predictive value
e. Qualitative characteristics 9. Management
10. Valuation
1. Furnishing information that is useful in
11. Internal accounting control
assessing cash flow prospects
2. Verifiability 12. Furnishing information that is useful to
investors and creditors
3. Relevance
SOLUTION
1. b; 2. e; 3. e; 4. b; 5. e; 6. c; 7. a; 8. e; 9. a; 10. c; 11. d; 12. b
Accounting
Financial statements are based largely on estimates and the application of account-
Conventions for ing rules for recognition and allocation. To facilitate interpretation, accountants
depend on five conventions, or rules of thumb, in recording transactions and pre-
Preparing Financial
paring financial statements: consistency, full disclosure, materiality, conservatism,
Statements and cost-benefit.
LO2 Define and describe the
Consistency
conventions of consistency,
full disclosure, materiality, Consistent use of accounting measures and procedures is important in achiev-
conservatism, and cost-benefit. ing comparability. The consistency convention requires that once a company
186 CHAPTER 5 Financial Reporting and Analysis
Like any other manufacturer, Good-
year must ensure that the quality
of its products is consistent and
that its accounting methods are as
well. When a company changes an
accounting method, it must inform |
users of its financial statements of the
change. Such information is essential
in making effective comparisons of a
company’s performance over several
periods or in comparing its perfor-
mance with that of other companies.
Courtesy of Zanskar/Dreamstime.
has adopted an accounting procedure, it must use it from one period to the
next unless a note to the financial statements informs users of a change in pro-
cedure. Generally accepted accounting principles specify what the note must
contain:
The nature of and justification for a change in accounting principle and
its effect on income should be disclosed in the financial statements of
the period in which the change is made. The justification for the change
should explain clearly why the newly adopted accounting principle is
preferable.6
For example, in the notes to its financial statements, Goodyear Tire & Rubber
Company disclosed that it had changed its method of accounting for invento-
ries with the approval of its auditors because management felt the new method
improved the matching of revenues and costs. Without such an acknowledgment,
users of financial statements can assume that the treatment of a particular transac-
tion, account, or item has not changed since the last period. For consistency, all
years presented use this new method.
Full Disclosure (Transparency)
The convention of full disclosure (or transparency) requires that financial state-
ments present all the information relevant to users’ understanding of the state-
ments. That is, the statements must be transparent so that they include any
explanation needed to keep them from being misleading. Explanatory notes are
therefore an integral part of the financial statements. For instance, as we have
already mentioned, the notes should disclose any change that a company has
made in its accounting procedures.
A company must also disclose significant events arising after the balance sheet
date in the financial statements. Suppose a firm has purchased a piece of land for a
future subdivision. Shortly after the end of its fiscal year, the firm is served papers
to halt construction because the Environmental Protection Agency asserts that
the land was once a toxic waste dump. This information, which obviously affects
the users of the financial statements, must be disclosed in the statements for the
fiscal year just ended.
Accounting Conventions for Preparing Financial Statements 187
Additional note disclosures required by the FASB and other official bodies
include the accounting procedures used in preparing the financial statements and
important terms of a company’s debt, commitments, and contingencies. How-
ever, the statements can become so cluttered with notes that they impede rather
than help understanding. Beyond the required disclosures, the application of the
full-disclosure convention is based on the judgment of management and of the
accountants who prepare the financial statements.
In recent years, investors and creditors also have had an influence on full
disclosure. To protect them, independent auditors, the stock exchanges, and the
SEC have made more demands for disclosure by publicly owned companies. The
SEC has pushed especially hard for the enforcement of full disclosure. As a result,
more and better information about corporations is available to the public today
than ever before.
Study Note
Materiality
Theoretically, a $10 stapler is
a long-term asset and should Materiality refers to the relative importance of an item or event. In general, an
therefore be capitalized and item or event is material if there is a reasonable expectation that knowing about
depreciated over its useful life. it would influence the decisions of users of financial statements. Some items or
However, the convention of events are so small or insignificant that they would make little difference to deci-
materiality allows the stapler sion makers no matter how they are handled. Thus, a large company like Dell
to be expensed entirely in the Computer Corporation may decide that expenditures for durable items of less |
year of purchase because its than $500 should be charged as expenses rather than recorded as long-term assets
cost is small and writing it off in and depreciated.
one year will have no effect on The materiality of an item normally is determined by relating its dollar value
anyone’s decision making.
to an element of the financial statements, such as net income or total assets. As a
rule, when an item is worth 5 percent or more of net income, accountants treat
it as material. However, materiality depends not only on the value of an item but
also on its nature. For example, in a multimillion-dollar company, a mistake of
Study Note
$5,000 in recording an item may not be important, but the discovery of even a
small bribe or theft can be very important. Moreover, many small errors can add
The purpose of conservatism is
up to a material amount.
not to produce the lowest net
income and lowest asset value.
It is a guideline for choosing Conservatism
among GAAP alternatives, and it
should be used with care. WWhen accountants are uncertain about the judgments or estimates they must
make, which is often the case, they look to the convention of conservatism. This
FOCUS ON BUSINESS PRACTICE
How Much Is Material? It’s Not Only a Matter of Numbers
The materiality issue was long a pet peeve of the SEC, of materiality—the rule of thumb of 5 percent or more of
which contended that companies were increasingly net income that accountants and companies have tradi-
abusing the convention to protect their stocks from tionally used—is acceptable as an initial screening. How-
taking a pounding when earnings did not reach their ever, the rule states that companies cannot decline to
targets. In consequence, the SEC issued a rule that put book items in the interest of meeting earnings estimates,
stricter requirements on the use of materiality. In addi- preserving a growing earnings trend, converting a loss to
tion to providing quantitative guides, the rule includes a profit, increasing management compensation, or hid-
qualitative considerations. The percentage assessment ing an illegal transaction, such as a bribe.7
188 CHAPTER 5 Financial Reporting and Analysis
FOCUS ON BUSINESS PRACTICE
How Will Convergence of U.S. GAAP with IFRS Affect Accounting Conventions?
The FASB and the IASB are working toward converging adoption of IFRS. For instance, conservatism, which has
U.S. generally accepted accounting principles (GAAP) with been the bedrock of accounting practice for many decades,
international financial reporting standards (IFRS). Their goal would no longer be part of the conceptual framework. The
is “to increase the international comparability and the qual- practice of writing up the value of a nonfinancial asset, such
ity of standards used in the United States [which] is consis- as inventory or equipment, that has increased in fair value
tent with the FASB’s obligation to its domestic constituents, and recording it as income under IFRS would be consid-
who benefit from comparability across national borders.”8 ered a violation of the conservatism convention under U.S.
In addition to the comparability convention being affected, GAAP. Such changes will influence the way accountants in
other accounting conventions will also be affected by the the United States analyze financial statements.
convention holds that when faced with choosing between two equally acceptable
procedures, or estimates, accountants should choose the one that is least likely to
overstate assets and income.
One of the most common applications of the conservatism convention is
the use of the lower-of-cost-or-market method in accounting for inventories.
Under this method, if an item’s market value is greater than its original cost,
the more conservative cost figure is used. If the market value is below the origi-
nal cost, the more conservative market value is used. The latter situation often
occurs in the computer industry.
Conservatism can be a useful tool in doubtful cases, but when it is abused, it
can lead to incorrect and misleading financial statements. For example, there is no |
uncertainty about how a long-term asset of material cost should be treated. When
conservatism is used to justify expensing such an asset in the period of p urchase,
income and assets for the current period will be understated, and income in future
periods will be overstated. Its cost should be recorded as an asset and spread
over the useful life of the asset, as explained in Chapter 3. Accountants there-
fore depend on the conservatism convention only when uncertain about which
accounting procedure or estimate to use.
Cost-Benefit
The cost-benefit convention holds that the benefits to be gained from provid-
ing accounting information should be greater than the costs of providing it. Of
course, minimum levels of relevance and reliability must be reached if accounting
information is to be useful. Beyond the minimum levels, however, it is up to the
FASB and the SEC, which stipulate the information that must be reported, and
the accountant, who provides the information, to judge the costs and benefits in
each case.
Firms use the cost-benefit convention for both accounting and nonac-
counting decisions. Department stores could almost completely eliminate
shoplifting if they hired five times as many clerks as they now have and assigned
them to watching customers. The benefit would be reduced shoplifting. The
cost would be reduced sales (customers do not like being closely watched) and
increased wages expense. Although shoplifting is a serious problem for depart-
ment stores, the benefit of reducing shoplifting in this way does not outweigh
the cost.
Accounting Conventions for Preparing Financial Statements 189
FOCUS ON BUSINESS PRACTICE
When Is “Full Disclosure” Too Much? It’s a Matter of Cost and Benefits.
The large accounting firm of Ernst & Young reported that Although more accessible and less costly, summary reports
over a 20-year period, the total number of pages in the are controversial because many analysts feel that it is in the
annual reports of 25 large, well-known companies increased notes that one gets the detailed information necessary to under-
an average of 84 percent, and the number of pages of notes stand complex business operations. One analyst remarked, “To
increased 325 percent—from 4 to 17 pages. Management’s banish the notes for fear they will turn off readers would be like
discussion and analysis increased 300 percent, from 3 pages eliminating fractions from math books on the theory that the
to 12.9 Because some people feel that “these documents are average student prefers to work with whole numbers.”10 Where
so daunting that people don’t read them at all,” the SEC this controversy will end, nobody knows. Detailed reports still
allows companies to issue to the public “summary reports” must be filed with the SEC, but more and more companies are
in which the bulk of the notes can be reduced. providing summary reports to the public.
The costs and benefits of a requirement for accounting disclosure are both
immediate and deferred. Judging the final costs and benefits of a far-reaching
and costly requirement for accounting disclosure is difficult. For instance, the
FASB allows certain large companies to make a supplemental disclosure in their
financial statements of the effects of changes in consumer price levels. Most com-
panies choose not to present this information because they believe the costs of
producing and providing it exceed its benefits to the readers of their financial
statements. Cost-benefit is a question that the FASB, the Securities and Exchange
Commission, and all other regulators face. Even though there are no definitive
ways of measuring costs and benefits, much of an accountant’s work deals with
these concepts.
STOP
& APPLY
Each of the five accounting conventions below is described in one of the statements in the numbered
list that follows. Match each statement to the letter of the appropriate convention.
_____ a. Consistency 3. A company uses the same method of rev-
_____ b. Full disclosure enue recognition year after year.
_____ c. Materiality 4. Several accounts are grouped into one |
category because the total amount of
_____ d. Conservatism
each account is small.
_____ e. Cost-benefit
5. A company does not keep detailed
records of certain operations because the
1. A note to the financial statements explains the
information gained from the detail is not
company’s method of revenue recognition.
deemed useful.
2. Inventory is accounted for at its market
value, which is less than its original cost.
SOLUTION
1. b; 2. d; 3. a; 4. c; 5. e
190 CHAPTER 5 Financial Reporting and Analysis
Classified
As you know, a balance sheet presents a company’s financial position at a particular
Balance Sheet time. The balance sheets we have presented thus far categorize accounts as assets,
liabilities, and owner’s equity. Because even a fairly small company can have hun-
dreds of accounts, simply listing accounts in these broad categories is not particularly
LO3 Identify and describe
helpful to a statement user. Setting up subcategories within the major categories can
the basic components of a
make financial statements much more useful. This format enables owners and credi-
classified balance sheet.
tors to study and evaluate relationships among the subcategories.
General-purpose external financial statements that are divided into subcat-
egories are called classified financial statements. Figure 5-2 depicts the subcat-
egories into which assets, liabilities, and owner’s equity are usually broken down.
The subcategories of Cruz Company’s classified balance sheet, shown in
Exhibit 5-1, typify those used by most corporations in the United States. The
subcategories under owner’s equity would, of course, be different if Cruz Com-
pany was a corporation or partnership rather than a sole proprietorship.
Assets
As you can see in Exhibit 5-1, the classified balance sheet of a U.S. company typi-
cally divides assets into four categories:
1. Current assets
2. Investments
3. Property, plant, and equipment
4. Intangible assets
These categories are listed in the order of their presumed ease of conversion into
cash. For example, current assets are usually more easily converted to cash than are
property, plant, and equipment. For simplicity, some companies group investments,
intangible assets, and other miscellaneous assets into a category called other assets.
Current Assets Current assets are cash and other assets that a company can
reasonably expect to convert to cash, sell, or consume within one year or its nor-
mal operating cycle, whichever is longer. A company’s normal operating cycle
is the average time it needs to go from spending cash to receiving cash. For
example, suppose a company uses cash to buy inventory and sells the inventory
to a customer on credit. The resulting receivable must be collected in cash before
the normal operating cycle ends.
The normal operating cycle for most companies is less than one year, but
there are exceptions. For example, because of the length of time it takes The
Boeing Company to build aircraft, its normal operating cycle exceeds one year.
The inventory used in building the planes is nonetheless considered a current asset
because the planes will be sold within the normal operating cycle. Another exam-
ple is a company that sells on an installment basis. The payments for a t elevision
FIGURE 5-2
Classified Balance Sheet
ASSETS LIABILITIES
• Current assets • Current liabilities
• Investments • Long-term liabilities
=
• Property, plant, and
equipment
OWNER’S EQUITY
• Intangible assets
• Capital
Classified Balance Sheet 191
EXHIBIT 5-1
Classified Balance Sheet Cruz Company
for Cruz Company Balance Sheet
December 31, 2010
Assets
Current assets
Cash $ 41,440
Short-term investments 28,000
Notes receivable 32,000
Accounts receivable 141,200
Merchandise inventory 191,600
Prepaid insurance 26,400
Supplies 6,784
Total current assets $467,424
Investments
Land held for future use 50,000
Property, plant, and equipment
Land $ 18,000
Building $ 82,600
Less accumulated depreciation 34,560 48,040
Equipment $108,000
Less accumulated depreciation 57,800 50,200
Total property, plant, and equipment 116,240
Intangible assets |
Trademark 2,000
Total assets $635,664
Liabilities
Current liabilities
Notes payable $ 60,000
Accounts payable 102,732
Salaries payable 8,000
Total current liabilities $ 170,732
Long-term liabilities
Mortgage payable 71,200
Total liabilities $241,932
Owner’s Equity
M. Cruz, Capital $393,732
Total owner’s equity 393,732
Total liabilities and owner’s equity $635,664
set or a refrigerator can extend over 24 or 36 months, but these receivables are
still considered current assets.
Cash is obviously a current asset. Short-term investments, notes and accounts
receivable, and inventory that a company expects to convert to cash within the
next year or the normal operating cycle are also current assets. On the balance
sheet, they are listed in order of their ease of conversion to cash.
192 CHAPTER 5 Financial Reporting and Analysis
Prepaid expenses, such as rent and insurance paid in advance, and invento-
ries of supplies bought for use rather than for sale should be classified as current
assets. These assets are current in the sense that if they had not been bought ear-
lier, a current outlay of cash would be needed to obtain them.
In deciding whether an asset is current or noncurrent, the idea of “reason-
able expectation” is important. For example, Short-Term Investments, also called
Marketable Securities, is an account used for temporary investments, such as U.S.
Treasury bills, of “idle” cash—that is, cash that is not immediately required for
operating purposes. Management can reasonably expect to sell these securities
as cash needs arise over the next year or within the company’s current operating
cycle. Investments in securities that management does not expect to sell within
the next year and that do not involve the temporary use of idle cash should be
shown in the investments category of a classified balance sheet.
Investments The investments category includes assets, usually long-term,
Study Note that are not used in normal business operations and that management does not
plan to convert to cash within the next year. Items in this category are securities
For an investment to
held for long-term investment, long-term notes receivable, land held for future
be classified as current,
use, plant or equipment not used in the business, and special funds established to
management must expect to
pay off a debt or buy a building. Also included are large permanent investments
sell it within the next year or the
in another company for the purpose of controlling that company.
current operating cycle, so it
must be readily marketable.
Property, Plant, and Equipment Property, plant, and equipment are
tangible long-term assets used in a business’s day-to-day operations. They repre-
sent a place to operate (land and buildings) and the equipment used to produce,
sell, and deliver goods or services. They are therefore also called operating assets
or, sometimes, fixed assets, tangible assets, long-lived assets, or plant assets. Through
depreciation, the costs of these assets (except land) are spread over the periods they
benefit. Past depreciation is recorded in the Accumulated Depreciation accounts.
To reduce clutter on the balance sheet, property, plant, and equipment are
often combined—for example:
Property, plant, and equipment (net) $116,240
The company provides the details in a note to the financial statements.
The property, plant, and equipment category also includes natural resources
owned by the company, such as forest lands, oil and gas properties, and coal
mines, if they are used in the regular course of business. If they are not, they are
listed in the investments category.
Intangible Assets Intangible assets are long-term assets with no physical sub-
stance whose value stems from the rights or privileges they extend to their owners.
Some of these assets, such as patents and copyrights, are recorded at cost, which is
spread over the expected life of the right or privilege. Others with indefinite lives,
such as trademarks and brands, are recorded at cost and remain at that amount unless
it becomes apparent that they have lost their value. Also, goodwill, which arises in an |
acquisition of another company, is an intangible asset that is recorded at cost but is
not amortized. It is reviewed each year for possible loss of value, or impairment.
Liabilities
Liabilities are divided into two categories that are based on when the liabilities fall
due: current liabilities and long-term liabilities.
Current Liabilities Current liabilities are obligations that must be satisfied
within one year or within the company’s normal operating cycle, whichever is longer.
These liabilities are typically paid out of current assets or by incurring new short-term
Classified Balance Sheet 193
liabilities. They include notes payable, accounts payable, the current portion of long-
term debt, salaries and wages payable, and customer advances (unearned revenues).
Long-Term Liabilities Debts that fall due more than one year in the future or
Study Note beyond the normal operating cycle, which will be paid out of noncurrent assets, are
long-term liabilities. Mortgages payable, long-term notes, bonds payable, employee
The portion of a mortgage that
pension obligations, and long-term lease liabilities generally fall into this category.
is due during the next year or
the current operating cycle
would be classified as a current Owner’s Equity
liability; the portion due after
the next year or the current The terms owner’s equity, capital, and net worth are used interchangeably. They
operating cycle would be all refer to the owner’s interest in a company. The first two terms are preferred
classified as a long-term liability. to net worth because most assets are recorded at original cost rather than at cur-
rent value. For this reason, the ownership section will not represent “worth.” It is
really a claim against the assets of the company.
Although the form of business organization does not usually affect the
accounting treatment of assets and liabilities, the equity section of the balance
Study Note sheet differs depending on whether the business is a sole proprietorship, a part-
nership, or a corporation.
The only difference in equity
between a sole proprietorship
Sole Proprietorship You are already familiar with the owner’s equity sec-
and a partnership is the number
tion of a sole proprietorship, like the one shown in the balance sheet for Cruz
of Capital accounts.
Company in Exhibit 5-1:
Owner’s Equity
M. Cruz, Capital $393,732
Partnership The equity section of a partnership’s balance sheet is called part-
ners’ equity. It might appear as follows:
Partners’ Equity
R. Hay, Capital $ 168,750
M. Cruz, Capital 224,982
Total partners’ equity $393,732
Corporation Corporations are by law separate, legal entities that are owned
by their stockholders. The equity section of a balance sheet for a corporation is
called stockholders’ equity and has two parts: contributed, or paid-in, capital and
retained earnings. It might appear like this:
Stockholders’ Equity
Contributed capital
Common stock, $10 par value, $200,000
20,000 shares authorized,
issued, and outstanding
Additional paid-in capital 40,000
Total contributed capital $240,000
Retained earnings 153,732
Total stockholders’ equity 393,732
Total liabilities and stockholders’ equity $635,664
Remember that owner’s equity accounts show the sources of and claims on
assets. Of course, the claims are not on any particular asset but on the assets as
a whole. It follows, then, that a corporation’s contributed and earned capital
194 CHAPTER 5 Financial Reporting and Analysis
accounts measure its stockholders’ claims on assets and also indicate the sources of
the assets. The contributed capital (also called paid-in capital) accounts reflect
the amounts of assets invested by stockholders. Generally, contributed capital is
shown on corporate balance sheets by two amounts: (1) the face, or par, value
of issued stock and (2) the amounts paid in, or contributed, in excess of the par
value per share. In the illustration above, stockholders invested amounts equal to
the par value of the outstanding stock of $200,000 plus $40,000 in additional
paid-in capital for a total of $240,000. |
The Retained Earnings account is sometimes called Earned Capital because it
represents the stockholders’ claim to the assets that are earned from operations and
reinvested in corporate operations. Distributions of assets to shareholders, which are
called dividends, reduce the Retained Earnings account balance just as withdrawals
of assets by the owner of a business reduce the Capital account balance. Thus the
Retained Earnings account balance, in its simplest form, represents the earnings of
the corporation less dividends paid to stockholders over the life of the business.
Dell’s Balance Sheets
Although balance sheets generally resemble the one shown in Exhibit 5-1 for
Cruz Company, no two companies have financial statements that are exactly alike.
EXHIBIT 5-2 Classified Balance Sheet for Dell Computer Corporation
Dell Computer Corporation
Consolidated Statement of Financial Position
(in millions)
January 30, February 1,
2009 2008
Assets
Current assets:
Cash and cash equivalents $ 8,352 $ 7,764
Short-term investments 740 208
Accounts receivable, net 4,731 5,961
Financing receivables, net 1,712 1,732
Inventories 867 1,180
Other 3,749 3,035
Total current assets 20,151 19,880
Property, plant, and equipment, net 2,277 2,668
Investments 454 1,560
Other non-current assets 3,618 3,453
Total assets $26,500 $27,561
Liabilities and Stockholders’ Equity
Current liabilities:
Short-term debt $ 113 $ 225
Accounts payable 8,309 11,492
Accrued and other liabilities 6,437 6,809
Total current liabilities 14,859 18,526
Long-term debt 1,898 362
Other non-current liabilities 5,472 4,844
Total liabilities 22,229 23,732
Classified Balance Sheet 195
EXHIBIT 5-2 Classified Balance Sheet for Dell Computer Corporation (continued)
January 30, February 1,
2009 2008
Stockholders’ equity:
Preferred stock and capital in excess of $.01 par value; — —
shares issued and outstanding: none
Common stock and capital in excess of $.01 par value; 11,189 10,589
shares authorized: 7,000; shares issued: 3,338*
and 3,320,* respectively; shares outstanding:
1,944 and 2,060, respectively
Treasury stock, at cost; 919 and 785 shares, respectively (27,904) (25,037)
Retained earnings 20,677 18,199
Other comprehensive loss 309 (16)
Total stockholders’ equity 4,271 3,735
Total liabilities and stockholders’ equity $ 26,500 $ 27,561
*Includes an immaterial amount of redeemable common stock.
Source: Adapted from Dell Computer Corporation, Form 10-K, 2009.
The balance sheet of Dell Computer Corporation is a good example of some of
the variations. As shown in Exhibit 5-2, it provides data for two years so that
users can evaluate the change from one year to the next. Note that its major clas-
sifications are similar, but not identical, to those of Cruz Company. For instance,
Cruz has asset categories for investments and intangibles, and Dell has an asset
category called “other non-current assets,” which is a small amount of its total
assets. Also note that Dell has a category called “other non-current liabilities.”
Because this category is listed after long-term debt, it represents longer-term lia-
bilities, due more than one year after the balance sheet date.
STOP
& APPLY
The lettered items below represent a classification scheme for a balance sheet. The numbered items are
account titles. Match each account with the letter of the category in which it belongs, or indicate that it
does not appear on the balance sheet.
a. Current assets 3. Land Held for Future Use
b. Investments 4. Property Taxes Payable
c. Property, plant, and equipment 5. Note Payable in Five Years
d. Intangible assets 6. Investment by Owner
e. Current liabilities 7. Land Used in Operations
f. Long-term liabilities 8. Accumulated Depreciation
g. Owner’s Capital 9. Accounts Receivable
h. Not on balance sheet 10. Interest Expense
11. Unearned Revenue
1. Trademark
12. Prepaid Rent
2. Marketable Securities
SOLUTION
1. d; 2. a; 3. b; 4. e; 5. f; 6. g; 7. c; 8. c; 9. a; 10. h; 11. e; 12. a
196 CHAPTER 5 Financial Reporting and Analysis
Forms of the
In the income statements we have presented thus far, expenses have been deducted |
I ncome Statement from revenue in a single step to arrive at net income. Here, we look at a multistep
income statement and a single-step format more complex than the one we pre-
sented in earlier chapters.
LO4 Describe the features of
multistep and single-step
Multistep Income Statement
classified income statements.
A multistep income statement goes through a series of steps, or subtotals, to
arrive at net income. Figure 5-3 compares the multistep income statement of a
service company with that of a merchandising company, which buys and sells
products, and a manufacturing company, which makes and sells products.
As you can see in Figure 5-3, in a service company’s multistep income state-
ment, the operating expenses are deducted from revenues in a single step to arrive
at income from operations. In contrast, because manufacturing and merchandis-
ing companies make or buy goods for sale, they must include an additional step
for the cost of goods sold. Exhibit 5-3 shows a multistep income statement for
Cruz Company, a merchandising company.
Net Sales The first major part of a merchandising or manufacturing company’s
multistep income statement is net sales, often simply called sales. Net sales consist
FIGURE 5-3 SERVICE COMPANY MERCHANDISING OR
The Components of Multistep MULTISTEP MANUFACTURING COMPANY
Income Statements for Service INCOME STATEMENT MULTISTEP INCOME STATEMENT
and Merchandising or Manufacturing
REVENUES NET SALES
Companies
minus
Study Note COST OF GOODS SOLD
The multistep income statement
minus equals
is a valuable analytical tool that
is often overlooked. Analysts
frequently convert a single-step STEP 1: GROSS MARGIN
statement into a multistep one
because the latter separates minus
operating sources of income
from nonoperating ones.
Owners want income to result OPERATING EXPENSES OPERATING EXPENSES
primarily from operations, not
from one-time gains or losses. equals equals
STEP 1: INCOME FROM OPERATIONS STEP 2: INCOME FROM OPERATIONS
plus or minus plus or minus
STEP 2: OTHER REVENUES AND EXPENSES STEP 3: OTHER REVENUES AND EXPENSES
equals equals
STEP 3: NET INCOME STEP 4: NET INCOME
Forms of the Income Statement 197
EXHIBIT 5-3 Multistep Income
Statement for Cruz Company Cruz Company
Income Statement
For the Year Ended December 31, 2010
Step 1 Net sales $1,248,624
Cost of goods sold 815,040
Gross margin $ 433,584
Step 2 Operating expenses
Selling expenses $219,120
General and administrative expenses 138,016
Total operating expenses 357,136
Income from operations $ 76,448
Step 3 Other revenues and expenses
Interest income $ 5,600
Less interest expense 10,524
Excess of other expenses over other revenues 4,924
Step 4 Net income $ 71,524
of the gross proceeds from sales (gross sales) less sales returns and allowances and
any discounts allowed.
(cid:2) Gross sales consist of total cash sales and total credit sales during an accounting
period. Even though the cash may not be collected until the following account-
ing period, under the revenue recognition rule, revenue is recorded as earned
when title for merchandise passes from seller to buyer at the time of sale.
(cid:2) Sales returns and allowances are cash refunds, credits on account, and dis-
counts from selling prices made to customers who have received defective
products or products that are otherwise unsatisfactory. If other discounts are
given to customers, they also should be deducted from gross sales.
Managers, owners, and others often use the amount of sales and trends in sales as
indicators of a firm’s progress. To detect trends, they compare the net sales of dif-
ferent accounting periods. Increasing sales suggest growth; decreasing sales indi-
cate the possibility of decreased future earnings and other financial problems.
Cost of Goods Sold The second part of a multistep income statement for a
merchandiser or manufacturer is cost of goods sold, also called cost of sales. Cost
of goods sold (an expense) is the amount a merchandiser paid for the merchan-
dise it sold during an accounting period. For a manufacturer, it is the cost of mak- |
ing the products it sold during an accounting period.
Gross Margin The third major part of a multistep income statement for a
Study Note merchandiser or manufacturer is gross margin, or gross profit, which is the differ-
ence between net sales and the cost of goods sold (Step 1 in Exhibit 5-3). To be
Gross margin is an important
successful, companies must achieve a gross margin sufficient to cover operating
measure of profitability. When it
expenses and provide an adequate net income.
is less than operating expenses,
Managers are interested in both the amount and percentage of gross mar-
the company has suffered a loss
from operations. gin. The percentage is computed by dividing the amount of gross margin by net
sales. In the case of Cruz Company, the amount of gross margin is $433,584,
and the percentage of gross margin is 34.7 percent ($433,584 (cid:5) $1,248,624).
198 CHAPTER 5 Financial Reporting and Analysis
This information is useful in planning business operations. For instance, man-
agement may try to increase total sales by reducing the selling price. Although
this strategy reduces the percentage of gross margin, it will work if the total of
items sold increases enough to raise the absolute amount of gross margin. This is
the strategy followed by discount warehouse stores like Sam’s Club and Costco
Wholesale Corporation.
On the other hand, management may decide to keep a high gross margin
from sales and try to increase sales and the amount of gross margin by increasing
operating expenses, such as advertising. This is the strategy used by upscale spe-
cialty stores like Neiman Marcus and Tiffany & Co. Other strategies to increase
gross margin from sales include using better purchasing methods to reduce cost
of goods sold.
Operating Expenses Operating expenses—expenses incurred in running a
business other than the cost of goods sold—are the next major part of a multistep
income statement. Operating expenses are often grouped into the categories of
selling expenses and general and administrative expenses.
(cid:2) Selling expenses include the costs of storing goods and preparing them for
sale; preparing displays, advertising, and otherwise promoting sales; and deliv-
ering goods to a buyer if the seller has agreed to pay the cost of delivery.
(cid:2) General and administrative expenses include expenses for accounting, person-
nel, credit checking, collections, and any other expenses that apply to overall
operations. Although occupancy expenses, such as rent expense, insurance
expense, and utilities expense, are often classified as general and administra-
tive expenses, they can also be allocated between selling expenses and general
and administrative expenses.
Careful planning and control of operating expenses can improve a company’s
profitability.
Income from Operations Income from operations, or operating income, is
Study Note the difference between gross margin and operating expenses (Step 2 in Exhibit 5-3).
It represents the income from a company’s main business. Income from operations
Many financial analysts use
is often used to compare the profitability of two or more companies or divisions
income from operations as a key
within a company.
measure of profitability.
Other Revenues and Expenses Other revenues and expenses, also called
nonoperating revenues and expenses, are not related to a company’s operating
activities (Step 3 in Exhibit 5-3). This section of a multistep income statement
includes revenues from investments (such as dividends and interest on stocks,
bonds, and savings accounts) and interest earned on credit or notes extended to
customers. It also includes interest expense and other expenses that result from
borrowing money or from credit extended to the company. If a company has
other kinds of revenues and expenses not related to its normal business opera-
tions, they, too, are included in this part of the income statement.
An analyst who wants to compare two companies independent of their financ-
ing methods—that is, before considering other revenues and expenses—would |
focus on income from operations.
Income Taxes Income taxes, also called provision for income taxes, represent
the expense for federal, state, and local taxes on corporate income. Income taxes
do not appear on the income statements of sole proprietorships and partnerships
because the persons who own these businesses are the tax-paying units; they pay
income taxes on their share of the business income. Corporations, however, must
Forms of the Income Statement 199
report and pay income taxes on their earnings. Income taxes are shown as a sepa-
rate item on a corporation’s income statement. Usually, the word expense is not
used on the statement.
Because federal, state, and local income taxes for corporations are substan-
tial, they have a significant effect on business decisions. Current federal income
tax rates for corporations vary from 15 percent to 35 percent depending on the
amount of income before income taxes and other factors. Most other taxes, such
as property and employment taxes, are included in operating expenses.
Net Income Net income is the final figure, or “bottom line,” of an income
statement. It is what remains of gross margin after operating expenses have been
deducted and other revenues and expenses have been added or deducted (Step 4
in Exhibit 5-3).
Net income is an important performance measure because it represents the
amount of earnings that accrue to owners. It is the amount transferred to owner’s
capital from all the income that business operations have generated during an
accounting period. Both managers and owners often use net income to measure a
business’s financial performance over the past accounting period.
Dell’s Income Statements
Like balance sheets, income statements vary among companies. You will
rarely, if ever, find an income statement exactly like the one we have pre-
sented for Cruz Company. Companies use both different terms and differ-
ent structures. For example, as you can see in Exhibit 5-4, in its multistep
income statement, Dell Computer Corporation provided three years of data
for purposes of comparison.
EXHIBIT 5-4 Multistep Income Statement for Dell Computer Corporation
Dell Computer Corporation
Consolidated Statement of Income
(in millions, except per share amounts)
Fiscal Year Ended
January 30, 2009 February 1, 2008 February 2, 2007
Net revenue $61,101 $61,133 $57,420
Cost of revenue 50,144 49,462 47,904
Gross margin 10,957 11,671 9,516
Operating expenses:
Selling, general, and administrative 7,102 7,538 5,948
In-process research and development 2 83 —
Research, development, and engineering 663 610 498
Total operating expenses 7,767 8,231 6,446
Operating income 3,190 3,440 3,070
Investment and other income, net 134 387 275
Income before income taxes 3,324 3,827 3,345
Income tax provision 846 880 762
Net income $ 2,478 $ 2,947 $ 2,583
Source: Dell Computer Corporation, Form 10-K, 2009.
200 CHAPTER 5 Financial Reporting and Analysis
EXHIBIT 5-5 Single-Step Income
Cruz Company
Statement for Cruz Company
Income Statement
For the Year Ended December 31, 2010
Revenues
Net sales $1,248,624
Interest income 5,600
Total revenues $1,254,224
Costs and expenses
Cost of goods sold $815,040
Selling expenses 219,120
General and administrative expenses 138,016
Interest expense 10,524
Total costs and expenses 1,182,700
Net income $ 71,524
Single-Step Income Statement
Study Note
Exhibit 5-5 shows a single-step income statement for Cruz Company. In this
If you encounter income type of statement, net income is derived in a single step by putting the major
statement components not
categories of revenues in the first part of the statement and the major catego-
covered in this chapter, refer
ries of costs and expenses in the second part. Both the multistep form and the
to the index at the end of the
single-step form have advantages: The multistep form shows the components
book to find the topic and read
used in deriving net income, and the single-step form has the advantage of
about it.
simplicity.
STOP
& APPLY
A classification scheme for a multistep income statement and a list of accounts appear below. Match |
each account with the category in which it belongs, or indicate that it is not on the income statement.
a. Net sales 3. Dividend Income
b. Cost of goods sold 4. Delivery Expense
c. Selling expenses 5. Office Salaries Expense
d. General and administrative expenses 6. Wages Payable
e. Other revenues and expenses 7. Sales Salaries Expense
f. Not on income statement 8. Advertising Expense
9. Interest Expense
1. Sales Returns and Allowances
10. Commissions Expense
2. Cost of Sales
SOLUTION
1. a; 2. b; 3. e; 4. c; 5. d; 6. f; 7. c; 8. c; 9. e; 10. c
Using Classified Financial Statements 201
Using Classified
Owners and creditors base their decisions largely on their assessments of a firm’s
F inancial potential liquidity and profitability, and in making those assessments, they often
rely on ratios. As you will see in the following pages, ratios use the components of
Statements
classified financial statements to reflect how well a firm has performed in terms of
maintaining liquidity and achieving profitability.
LO5 Use classified financial
statements to evaluate liquidity
Evaluation of Liquidity
and profitability.
Liquidity means having enough money on hand to pay bills when they are due
and to take care of unexpected needs for cash. Two measures of liquidity are
Study Note
wworking capital and the current ratio.
Accounts must be classified
WWorking Capital Working capital is the amount by which current assets
correctly before the ratios
exceed current liabilities. It is an important measure of liquidity because current
are computed. If they are not
lliabilities must be satisfied within one year or one operating cycle, whichever is
classified correctly, the ratios
llonger, and current assets are used to pay the current liabilities. Thus, the excess
will be incorrect.
of current assets over current liabilities—the working capital—is what is on hand
tto continue business operations.
For Cruz Company, working capital is computed as follows:
Current assets $467,424
Less current liabilities 170,732
Working capital $296,692
Working capital can be used to buy inventory, obtain credit, and finance
expanded sales. Lack of working capital can lead to a company’s failure.
Current Ratio The current ratio is closely related to working capital. Many
bankers and other creditors believe it is a good indicator of a company’s ability to
pay its debts on time. The current ratio is the ratio of current assets to current
liabilities. For Cruz Company, it is computed like this:
Current Assets $467,424
Current Ratio (cid:2) (cid:2) (cid:2) 2.7
Current Liabilities $170,732
FIGURE 5-4
Average Current Ratio for Selected Advertising 1.3
Industries Interstate
1.0
Trucking
Auto and
1.9
Home Supply
Grocery
1.8
Stores
Machinery 1.7
Computers 1.2
0 0.5 1 1.5 2 2.5 3
Service Industries Merchandising Industries Manufacturing Industries
Source: Data from Dun & Bradstreet, Industry Norms and Key Business Ratios, 2005–2006.
Thus, Cruz Company has $2.70 of current assets for each $1.00 of current liabili-
ties. Is that good or bad? The answer requires a comparison of this year’s current
ratio with ratios for earlier years and with similar measures for companies in the
same industry, which for Cruz Company is auto and home supply.
202 CHAPTER 5 Financial Reporting and Analysis
As Figure 5-4 illustrates, the average current ratio varies from industry to
industry. For the advertising industry, which has no merchandise inventory, the
current ratio is 1.3. The auto and home supply industry, in which companies
carry large merchandise inventories, has an average current ratio of 1.9. The cur-
rent ratio for Cruz Company, 2.7, exceeds the average for its industry.
A very low current ratio, of course, can be unfavorable, indicating that a com-
pany will not be able to pay its debts on time. But that is not always the case. For
example, McDonald’s and various other successful companies have very low current
ratios because they carefully plan their cash flows. A very high current ratio may
indicate that a company is not using its assets to the best advantage. In other words, |
it could probably use its excess funds more effectively to increase its overall profit.
Evaluation of Profitability
Just as important as paying bills on time is profitability—the ability to earn a
satisfactory income. As a goal, profitability competes with liquidity for manage-
rial attention because liquid assets, although important, are not the best profit-
producing resources. Cash, of course, means purchasing power, but a satisfactory
profit can be made only if purchasing power is used to buy profit-producing (and
less liquid) assets, such as inventory and long-term assets.
To evaluate a company’s profitability, you must relate its current performance
to its past performance and prospects for the future, as well as to the averages of
other companies in the same industry. The following are the ratios commonly
used to evaluate a company’s ability to earn income:
1. Profit margin 4. Debt to equity ratio
2. Asset turnover 5. Return on equity
3. Return on assets
Profit Margin The profit margin shows the percentage of each sales dollar that
results in net income. It should not be confused with gross margin, which is not
a ratio but rather the amount by which revenues exceed the cost of goods sold.
Cruz Company has a profit margin of 5.7 percent. It is computed as follows:
FOCUS ON BUSINESS PRACTICE
How Has the Goal of Convergence of U.S. GAAP and IFRS Made Financial Analysis More Difficult?
Although the SEC believes that the ideal outcome of a both standards in a recent year (earnings in millions of
cooperative international accounting standard-setting euros):
process would be worldwide use of a single set of high-
IFRS GAAP %
quality accounting standards for both domestic and
Earnings Earnings Diff.
cross-border financial reporting, the reality is that such
Bayer AG 1,695 269 530.1%
consistency does not now exist and will be a challenge
Reed Elsevier 625 399 56.6
to implement.11 For a period of time, users of financial
Benetton Group 125 100 25.0
statements will have difficulty comparing companies’
performance. Profitability measures of foreign firms Given that assets and equity for these companies are
that file in the United States using IFRS will not be com- also likely to differ as well as the use of fair value in valuing
parable to profitability measures of companies that file assets and liabilities, all profitability ratios—profit margin,
using U.S. GAAP. For instance, consider the reporting asset turnover, return on assets, debt to equity ratio, and
earnings of the following European companies under return on equity—will be affected.
Using Classified Financial Statements 203
Net Income $71,524
Profit Margin (cid:2) (cid:2) (cid:2) 0.057, or 5.7%
Net Sales $1,248,624
FIGURE 5-5
Average Profit Margin for Selected Advertising 3.8%
Industries
Interstate
4.1%
Trucking
Auto and
2.5%
Home Supply
Grocery
2.3%
Stores
Machinery 4.3%
Computers 0.5%
0 1 2 3 4 5 6
Service Industries Merchandising Industries Manufacturing Industries
Source: Data from Dun & Bradstreet, Industry Norms and Key Business Ratios, 2005–2006.
Thus, on each dollar of net sales, Cruz Company makes 5.7 cents. A difference of
1 or 2 percent in a company’s profit margin can be the difference between a fair
year and a very profitable one.
Asset Turnover The asset turnover ratio measures how efficiently assets are
used to produce sales. In other words, it shows how many dollars of sales are
generated by each dollar of assets. A company with a higher asset turnover uses its
assets more productively than one with a lower asset turnover.
The asset turnover ratio is computed by dividing net sales by average total
assets. Average total assets are the sum of assets at the beginning of an accounting
period and at the end of the period divided by 2. For example, if Cruz Company
had assets of $594,480 at the beginning of the year, its asset turnover would be
computed as follows:
Net Sales
Asset Turnover (cid:2)
Average Total Assets
$1,248,624 $1,248,624
(cid:2) (cid:2) (cid:2) 2.0 Times
($635,664 (cid:3) $594,480) (cid:5) 2 $615,072
FIGURE 5-6 Times
Average Asset Turnover for Advertising 3.9 |
Selected Industries
Interstate
3.3
Trucking
Auto and
3.0
Home Supply
Grocery
5.0
Stores
Machinery 1.9
Computers 1.6
0 1 2 3 4 5 6
Service Industries Merchandising Industries Manufacturing Industries
Source: Data from Dun & Bradstreet, Industry Norms and Key Business Ratios, 2005–2006.
204 CHAPTER 5 Financial Reporting and Analysis
Thus, Cruz Company would produce $2.00 in sales for each dollar invested in
aassets. This ratio shows a relationship between an income statement figure (net
Study Note
ssales) and a balance sheet figure (total assets).
Return on assets is one of the
most widely used measures of RReturn on Assets Both the profit margin and asset turnover ratios have limita-
profitability because it reflects ttions. The profit margin ratio does not consider the assets necessary to produce
both the profit margin and asset iincome, and the asset turnover ratio does not take into account the amount of
turnover. iincome produced. The return on assets ratio overcomes these deficiencies by relat-
iing net income to average total assets. For Cruz Company, it is computed like this:
Net Income
Return on Assets (cid:2)
Average Total Assets
$71,524
(cid:2)
($635,664 (cid:3) $594,480) (cid:5) 2
(cid:2) $71,524
(cid:2) 0.116, or 11.6%
$615,072
FIGURE 5-7
Average Return on Assets for Advertising 14.8%
Selected Industries Interstate
13.5%
Trucking
Auto and
7.5%
Home Supply
Grocery
11.5%
Stores
Machinery 8.2%
Computers 0.8%
0 3 6 9 12 15 18 21
Service Industries Merchandising Industries Manufacturing Industries
Source: Data from Dun & Bradstreet, Industry Norms and Key Business Ratios, 2005–2006.
For each dollar invested, Cruz Company’s assets generate 11.6 cents of net
income. This ratio indicates the income-generating strength (profit margin) of
the company’s resources and how efficiently the company is using all its assets
(asset turnover).
Return on assets, then, combines profit margin and asset turnover:
Net Income Net Sales Net Income
(cid:6) (cid:2)
Net Sales Average Total Assets Average Total Assets
Profit Margin (cid:6) Asset Turnover (cid:2) Return on Assets
5.7% (cid:6) 2.00 Times (cid:2) 11.4%*
Thus, a company’s management can improve overall profitability by increasing
the profit margin, the asset turnover, or both. Similarly, in evaluating a company’s
overall profitability, a financial statement user must consider how these two ratios
interact to produce return on assets.
*The slight difference between 11.4 and 11.6 percent is due to rounding.
Using Classified Financial Statements 205
By studying Figures 5-5, 5-6, and 5-7, you can see the different ways in
which various industries combine profit margin and asset turnover to produce
return on assets. For instance, by comparing the return on assets for grocery
stores and computer companies, you can see how they achieve that return in very
different ways. The grocery store industry has a profit margin of 2.3 percent,
which when multiplied by an asset turnover of 5.0 times gives a return on assets
of 11.5 percent. The auto and home supply industry has a higher profit margin,
2.5 percent, and a lower asset turnover, 3.0 times, and produces a return on
assets of 7.5 percent.
Cruz Company’s profit margin of 5.7 percent is well above the auto and
home supply industry’s average, but its asset turnover of 2.0 times lags behind the
industry average. Cruz Company is sacrificing asset turnover to achieve a higher
profit margin. This strategy is evidently working, because Cruz Company’s return
on assets of 11.4 percent exceeds the industry average of 7.5 percent.
Debt to Equity Ratio Another useful measure of profitability is the debt to
equity ratio, which shows the proportion of a company’s assets that is financed
by creditors and the proportion that is financed by the owner. This ratio is com-
puted by dividing total liabilities by owner’s equity. The balance sheets of most
companies do not show total liabilities; a short way of determining them is to
deduct the total owner’s equity from total assets.
A debt to equity ratio of 1.0 means that total liabilities equal owner’s |
equity—that half of a company’s assets are financed by creditors. A ratio of
0.5 means that one-third of a company’s total assets are financed by creditors.
A company with a high debt to equity ratio is at risk in poor economic times
because it must continue to repay creditors. Owner’s investments, on the other
hand, do not have to be repaid, and withdrawals can be deferred when a company
suffers because of a poor economy.
Cruz Company’s debt to equity ratio is computed as follows:
Total Liabilities $241,932
Debt to Equity Ratio (cid:2) (cid:2) (cid:2) 0.614, or 61.4%
Owner’s Equity $393,732
FIGURE 5-8
Average Debt to Equity Ratio Advertising 192.7%
for Selected Industries Interstate
136.1%
Trucking
Auto and
95.8%
Home Supply
Grocery
77.7%
Stores
Machinery 82.7%
Computers 109.2%
0 30 60 90 120 150 180 210
Service Industries Merchandising Industries Manufacturing Industries
Source: Data from Dun & Bradstreet, Industry Norms and Key Business Ratios, 2005–2006.
The debt to equity ratio of 61.4 percent means that Cruz Company receives less
than half of its financing from creditors and that it receives more than half from
the owner.
The debt to equity ratio does not fit neatly into either the liquidity or
profitability category. It is clearly very important to liquidity analysis because
206 CHAPTER 5 Financial Reporting and Analysis
FOCUS ON BUSINESS PRACTICE
What Performance Measures Do Top Companies Use to Compensate Executives?
The boards of directors of public companies often use finan- goals combined with sales growth 61 percent of the time
cial ratios to judge the performance of their top executives compared to 43 percent for not-so-successful companies.
and to determine annual bonuses. Public companies must Among the most common earnings goals are return on
disclose the ratios or performance measures they use in assets (19 percent for the best companies versus 5 percent
creating these compensation plans. Studies show that the for other companies) and return on equity (19 percent ver-
most successful companies over a sustained period of time, sus 7 percent). Clearly, successful companies set objectives
like Dell Computer, tend to focus the most on profitability that will provide incentives to management to increase
measures. For instance, successful companies use earnings profitability.12
it relates to debt and its repayment. It is also relevant to profitability for two
reasons:
1. Creditors are interested in the proportion of the business that is debt-financed
because the more debt a company has, the more profit it must earn to ensure
the payment of interest to creditors.
2. Owners are interested in the proportion of the business that is debt-financed
because the amount of interest paid on debt affects the amount of profit left
to provide a return on the owner’s investment.
The debt to equity ratio also shows how much expansion is possible through bor-
rowing additional long-term funds.
Figure 5-8 shows that the debt to equity ratio in selected industries varies from
a low of 77.7 percent in the grocery stores industry to a high of 192.7 percent in
the advertising industry.
Return on Equity Of course, owners are interested in how much they have
earned on their investment in the business. Their return on equity is measured
by the ratio of net income to average owner’s equity. Taking the ending owner’s
equity from the balance sheet and assuming that beginning owner’s equity is
$402,212, Cruz Company’s return on equity is computed as follows:
Net Income
Return on Equity (cid:2)
Average Owner’s Equity
$71,524 $71,524
(cid:2) (cid:2) (cid:2) 0.180, or 18.0%
($393,732 (cid:3) $402,212) (cid:5) 2 $397,972
FIGURE 5-9
Average Return on Equity for Advertising 43.2%
Selected Industries Interstate
31.9%
Trucking
Auto and
14.6%
Home Supply
Grocery
20.4%
Stores
Machinery 15.0%
Computers 1.7%
0 10 20 30 40 50 60
Service Industries Merchandising Industries Manufacturing Industries
Source: Data from Dun & Bradstreet, Industry Norms and Key Business Ratios, 2005–2006.
Using Classified Financial Statements 207
Thus, Cruz Company earned 18.0 cents for every dollar invested by the owner. |
Whether this is an acceptable return depends on several factors, such as how
much the company earned in previous years and how much other companies
in the same industry earned. As measured by return on equity, the advertising
industry is the most profitable of our sample industries, with a return on equity of
43.2 percent (see Figure 5-9). Cruz Company’s average return on equity of 18.0
percent is better than the average of 14.6 percent for the auto and home supply
industry.
STOP
& APPLY
Roth Company is considering applying for a bank loan. Various data from the classified financial
statements of Roth Company are presented below.
2011 2010 2011 2010
Current assets $200,000 $170,000 Owner’s equity $ 640,000 $ 610,000
Total assets 880,000 710,000 Sales 1,200,000 1,050,000
Current liabilities 90,000 50,000 Net income 60,000 80,000
Long-term liabilities 150,000 50,000
Its total assets and owner’s equity at the beginning of 2010 were $690,000 and $590,000,
respectively.
a. Use (1) liquidity analysis and (2) profitabil- b. Discuss Roth’s profitability and liquidity.
ity analysis to document the Roth’s financial Do you think it will qualify for a bank loan?
position.
SOLUTION
a. (1) Current Assets Current Liabilities Working Capital Current Ratio
2010 $170,000 $50,000 $120,000 3.40
2011 200,000 90,000 110,000 2.22
Decrease in working capital $ 10,000
Decrease in current ratio 1.18
(2) Profitability analysis
Average Return Average Return
Net Profit Total Asset on Owner’s on
Income Sales Margin Assets Turnover Assets Equity Equity
2010 $80,000 $1,050,000 7.6% $700,0001 1.50 11.4% $600,0003 13.3%
2011 60,000 1,200,000 5.0% 795,0002 1.51 7.6% 625,0004 9.6%
Increase (decrease) ($20,000) $ 150,000 (2.6)% $ 95,000 0.01 (3.8)% $ 25,000 (3.7)%
b. Liquidity and profitability discussed
Both working capital and the current ratio declined between 2010 and 2011 because the $40,000 increase in
current liabilities ($90,000 (cid:4) $50,000) was greater than the $30,000 increase in current assets.
Net income decreased by $20,000 despite an increase in sales of $150,000 and an increase in average total
assets of $95,000. Thus, the profit margin fell from 7.6 percent to 5.0 percent, and return on assets fell from
11.4 percent to 7.6 percent. Asset turnover showed almost no change and so did not contribute to the decline
1($710,000 (cid:3) $690,000) (cid:5) 2
2($880,000 (cid:3) $710,000) (cid:5) 2
3($610,000 (cid:3) $590,000) (cid:5) 2
4($640,000 (cid:3) $610,000) (cid:5) 2
(continued)
208 CHAPTER 5 Financial Reporting and Analysis
in profitability. The decrease in return on equity, from 13.3 percent to 9.6 percent, was not as great as the
decrease in return on assets because the growth in total assets was financed mainly by debt rather than by
owner’s equity, as shown in the capital structure analysis below.
Total Liabilities Owner’s Equity Debt to Equity Ratio
2010 $100,000 $610,000 16.4%
2011 240,000 640,000 37.5%
Increase $140,000 $ 30,000 21.1%
Total liabilities increased by $140,000, while owner’s equity increased by $30,000. Thus, the amount of the business
financed by debt in relation to the amount financed by owner’s equity increased between 2010 and 2011.
Both liquidity and profitability have declined. Roth will probably have to focus on improving current operations
before expanding or getting a bank loan.
(cid:2) FUN-FOR-FEET COMPANY: REVIEW PROBLEM
In the Decision Point at the beginning of the chapter, we noted that Jay Bonali, owner
of Fun-For-Feet Company, was seeking answers to the following questions:
• How should the income statement be organized to provide the best information?
• What key measures best capture a company’s financial performance?
The multi-step form of the income statement provides more useful information than
the single-step form because it enables the user to understand how the company gen-
erates its income. Further, the key ratios of asset turnover, profit margin, and return on
assets are important measures of profitability.
1. Using the information in Fun-For-Feet’s single-step income statement shown in |
the Decision Point, prepare a multi-step income statement.
Multi-Step Income 2. Assuming average total assets are $1,000,000 and average total owner’s equity
Statement and is $400,000, compute the following profitability ratios: asset turnover, profit
margin, and return on assets.
Profi tability Ratios
LO4 LO5 3. User insight: Explain why the multi-step income statement helps users
understand the business better.
Answers to
1. Multi-step income statement prepared
Review Problem
Fun-For-Feet Company
Income Statement
For the Year Ended December 31, 2011
Revenues
Net sales $1,207,132
Less cost of goods sold 787,080
Gross margin $ 420,052
Operating expenses
Selling expenses $203,740
General and administrative expenses 100,688
Total operating expenses 304,428
Income from operations $ 115,624
Fun-For-Feet Company: Review Problem 209
Other income and expense
Interest income $ 5,720
Less interest expense 13,560
Excess of other expenses over other 7,780
revenues
Net Income $ 107,784
2. Profitability ratios computed
Asset turnover: Net sales/Average total assets
$1,207,132/$1,000,000 (cid:2) 1.2 times
Profit margin: Net income/Net sales
$107,784/$1,207,132 (cid:2) 0.089, or 8.9%
Return on assets: Net income/Average total assets
$107,784/$1,000,000 (cid:2) 0.1077, or 10.8%
3. Multi-step income statement discussed
The multi-step income statement helps users understand the business better
because it separates the operating (income from operations) part of the busi-
ness from the investing (interest income) and financing (interest expense) parts
of the business. It also shows the amount (gross margin) available to pay operat-
ing expenses on products sold.
210 CHAPTER 5 Financial Reporting and Analysis
STOP
& REVIEW
LO1 Describe the objective of The objective of financial reporting is to provide financial information about the
fi nancial reporting and reporting entity that is useful to present and potential equity investors, lenders,
identify the qualitative and other creditors in making decisions in their capacity as capital providers. To
characteristics, conven- be decision-useful, financial information must be useful in assessing cash flow
tions, and ethical consid- prospects and stewardship. Because of the estimates and judgment that go into
erations of accounting preparing financial information, such information must exhibit the qualitative
information. characteristics of relevance and faithful representation. To be relevant, infor-
mation must have predictive value, confirmative value, or both. To be faithful,
financial information must be complete, neutral, and free from material error.
Complementing the quality of information are the qualities of comparability,
verifiability, timeliness, and understandability. It is also important for users to
understand the constraints on financial information or accounting conventions
used to prepare financial statements. Since the passage of the Sarbanes-Oxley
Act in 2002, CEOs and CFOs have been required to certify to the accuracy and
completeness of their companies’ financial statements.
LO2 Defi ne and describe Because accountants’ measurements are not exact, certain conventions are applied
the conventions of to help users interpret financial statements. Consistency requires the use of the
consistency, full dis- same accounting procedures from period to period and enhances the compara-
closure, materiality, bility of financial statements. Full disclosure means including all relevant infor-
conservatism, and mation in the financial statements. The materiality convention has to do with
determining the relative importance of an item. Conservatism entails using the
cost-benefi t.
procedure that is least likely to overstate assets and income. The cost-benefit con-
vention holds that the benefits to be gained from providing accounting informa-
tion should be greater than the costs of providing it.
LO3 Identify and describe the The basic components of a classified balance sheet are as follows:
basic components of a Assets Liabilities Owner’s Equity
classifi ed balance sheet. |
Current assets Current liabilities Owner’s capital
Investments Long-term liabilities
Property, plant, and equipment
Intangible assets
Current assets are cash and other assets that a firm can reasonably expect to con-
vert to cash or use up during the next year or the normal operating cycle, which-
ever is longer. Investments are assets, usually long-term, that are not used in the
normal operation of a business. Property, plant, and equipment are tangible long-
term assets used in day-to-day operations. Intangible assets are long-term assets
with no physical substance whose value stems from the rights or privileges they
extend to owners.
A current liability is an obligation due to be paid or performed during the
next year or the normal operating cycle, whichever is longer. Long-term liabilities
are debts that fall due more than one year in the future or beyond the normal
operating cycle.
Stop & Review 211
The equity section of a sole proprietorship’s balance sheet differs from the
equity section of a partnership’s or corporation’s balance sheet in that it does not
have subcategories for contributed capital (the assets invested by stockholders)
and retained earnings (stockholders’ claim to assets earned from operations and
reinvested in operations).
LO4 Describe the features Classified income statements for external reporting can be in multistep or single-
of multistep and single- step form. The multistep form arrives at net income through a series of steps; the
step classifi ed income single-step form arrives at it in a single step. A multistep income statement usually
statements. has a separate section for other revenues and expenses.
LO5 Use classifi ed In evaluating a company’s liquidity and profitability, investors (owners) and cred-
fi nancial statements to itors rely on the data provided in classified financial statements. Two measures of
evaluate liquidity and liquidity are working capital and the current ratio. Five measures of profitability
profi tability. are profit margin, asset turnover, return on assets, debt to equity ratio, and return
on equity. Industry averages are useful in interpreting these ratios.
REVIEW of Concepts and Terminology
The following concepts and terms Intangible assets 192 (LO3) Retained Earnings 194 (LO3)
were introduced in this chapter: Investments 192 (LO3) Sales returns and allowances
Accounting conventions 184 (LO1) Long-term liabilities 193 (LO3) 197 (LO4)
Classified financial statements Manufacturing company 196 (LO4) Single-step income statement
190 (LO3) Materiality 187 (LO2) 200 (LO4)
Comparability 184 (LO2) Merchandising company 196 (LO4) Timeliness 184 (LO1)
Conservatism 187 (LO2) Multistep income statement Understandability 184 (LO1)
Consistency 185 (LO2) 196 (LO4) Verifiability 184 (LO1)
Contributed capital 194 (LO3) Net income 199 (LO4) Working capital 201 (LO5)
Cost-benefit 188 (LO2) Net sales 196 (LO4) Key Ratios
Cost of goods sold 197 (LO4) Normal operating cycle 190 (LO3)
Asset turnover 203 (LO5)
Current assets 190 (LO3) Operating expenses 198 (LO4)
Current ratio 201 (LO5)
Current liabilities 192 (LO3) Other assets 190 (LO3)
Debt to equity ratio 205 (LO5)
Faithful representation 184 (LO1) Other revenues and expenses
Full disclosure 186 (LO2) 198 (LO4) Profit margin 202 (LO5)
Gross margin 197 (LO4) Property, plant, and equipment Return on assets 204 (LO5)
192 (LO3) Return on equity 206 (LO5)
Gross sales 197 (LO4)
Qualitative characteristics 183 (LO1)
Income from operations 198 (LO4)
Relevance 183 (LO1)
Income taxes 198 (LO4)
212 CHAPTER 5 Financial Reporting and Analysis
CHAPTER ASSIGNMENTS
BUILDING Your Basic Knowledge and Skills
Short Exercises
LO1 Objectives and Qualitative Characteristics
SE 1. Identify each of the following statements as related to either an objective (O)
of financial information or as a qualitative (Q) characteristic of accounting
information:
1. Information about business resources, claims to those resources, and changes
in them should be provided.
2. Decision makers must be able to interpret accounting information.
3. Information that is useful in making investment and credit decisions should be |
furnished.
4. Accounting information must exhibit relevance and faithful representation.
5. Information useful in assessing cash flow prospects should be provided.
LO2 Accounting Conventions
SE 2. State which of the accounting conventions—consistency, full disclo-
sure, materiality, conservatism, or cost-benefit—is being followed in each case
described below.
1. Management provides detailed information about the company’s long-term
debt in the notes to the financial statements.
2. A company does not account separately for discounts received for prompt pay-
ment of accounts payable because few of these transactions occur and the total
amount of the discounts is small.
3. Management eliminates a weekly report on property, plant, and equipment
acquisitions and disposals because no one finds it useful.
4. A company follows the policy of recognizing a loss on inventory when the
market value of an item falls below its cost but does nothing if the market
value rises.
5. When several accounting methods are acceptable, management chooses a
single method and follows that method from year to year.
LO3 Classification of Accounts: Balance Sheet
SE 3. Tell whether each of the following accounts is a current asset; an invest-
ment; property, plant, and equipment; an intangible asset; a current liability; a
long-term liability; owner’s equity; or not on the balance sheet:
1. Delivery Trucks 6. Prepaid Insurance
2. Accounts Payable 7. Trademark
3. Note Payable (due in 90 days) 8. Investment to Be Held Six Months
4. Delivery Expense 9. Factory Not Used in Business
5. Owner’s Capital
LO3 Classified Balance Sheet
SE 4. Using the following accounts, prepare a classified balance sheet at year
end, May 31, 20xx: Accounts Payable, $800; Accounts Receivable, $1,100;
Accumulated Depreciation–Equipment, $700; Cash, $200; Owner’s Invest-
ment, $1,000; Equipment, $3,000; Franchise, $200; Investments (long-term),
$500; Merchandise Inventory, $600; Notes Payable (long-term), $400; Owner’s
Chapter Assignments 213
Capital, $?; Wages Payable, $100. Assume that this is the company’s first year of
operations.
LO4 Classification of Accounts: Income Statement
SE 5. Tell whether each of the following accounts is part of net sales, cost of
goods sold, operating expenses, or other revenues and expenses, or is not on the
income statement:
1. Delivery Expense
2. Interest Expense
3. Unearned Revenue
4. Sales Returns and Allowances
5. Cost of Sales
6. Depreciation Expense
7. Investment Income
8. Owner’s Capital
LO4 Single-Step Income Statement
SE 6. Using the following accounts, prepare a single-step income statement at
year end, May 31, 20xx: Cost of Goods Sold, $840; General Expenses, $450;
Interest Expense, $210; Interest Income, $90; Net Sales, $2,400; Selling
Expenses, $555.
LO4 Multistep Income Statement
SE 7. Using the accounts presented in SE 6, prepare a multistep income statement.
LO5 Liquidity Ratios
SE 8. Using the following accounts and balances taken from a year-end balance
sheet, compute working capital and the current ratio:
Accounts Payable $ 7,000
Accounts Receivable 10,000
Cash 4,000
Marketable Securities 2,000
Merchandise Inventory 12,000
Notes Payable in Three Years 13,000
Property, Plant, and Equipment 40,000
Owner’s Capital 48,000
LO5 Profitability Ratios
SE 9. Using the following information from a balance sheet and an income state-
ment, compute the (1) profit margin, (2) asset turnover, (3) return on assets,
(4) debt to equity ratio, and (5) return on equity. (The previous year’s total assets
were $200,000, and owner’s equity was $140,000.)
Total assets $240,000
Total liabilities 60,000
Total owner’s equity 180,000
Net sales 260,000
Cost of goods sold 140,000
Operating expenses 80,000
LO5 Profitability Ratios
SE 10. Assume that a company has a profit margin of 6.0 percent, an asset turnover
of 3.2 times, and a debt to equity ratio of 50 percent. What are the company’s
return on assets and return on equity?
214 CHAPTER 5 Financial Reporting and Analysis
Exercises
LO1 LO2 Discussion Questions
E 1. Develop a brief answer to each of the following questions: |
1. How do the four basic financial statements meet the stewardship objective of
financial reporting?
2. What are some areas that require estimates to record transactions under the
matching rule?
3. How can financial information be consistent but not comparable?
4. When might an amount be material to management but not to the CPA audit-
ing the financial statements?
LO3 LO4 Discussion Questions
LO5 E 2. Develop a brief answer to each of the following questions:
1. Why is it that land held for future use and equipment not currently used in
the business are classified as investments rather than as property, plant, and
equipment?
2. Which is the better measure of a company’s performance—income from oper-
ations or net income?
3. Why is it important to compare a company’s financial performance with indus-
try standards?
4. Is the statement “Return on assets is a better measure of profitability than
profit margin” true or false and why?
LO1 LO2 Financial Accounting Concepts
E 3. The lettered items below represent a classification scheme for the concepts of
financial accounting. Match each numbered term in the list that follows with the
letter of the category in which it belongs.
a. Decision makers (users of accounting information)
b. Business activities or entities relevant to accounting measurement
c. Objective of accounting information
d. Accounting measurement considerations
e. Accounting processing considerations
f. Qualitative characteristics
g. Accounting conventions
h. Financial statements
1. Conservatism 11. Full disclosure 17. Internal accounting
2. Verifiability 12. Furnishing informa- control
3. Statement of tion that is useful 18. Valuation
cash flows to investors and 19. Investors
4. Materiality creditors 20. Completeness
5. Faithful representation 13. Specific business 21. Relevance
6. Recognition entities 22. Furnishing informa-
7. Cost-benefit 14. Classification tion that is useful in
8. Predictive value 15. Management assessing cash flow
9. Business transactions 16. Neutrality prospects
10. Consistency
LO2 Accounting Concepts and Conventions
E 4. Each of the statements below violates a convention in accounting. State
which of the following accounting conventions is violated: consistency, material-
ity, conservatism, full disclosure, or cost-benefit.
Chapter Assignments 215
1. A series of reports that are time-consuming and expensive to prepare are pre-
sented to the owner each month, even though they are never used.
2. A company changes its method of accounting for depreciation.
3. The company in 2 does not indicate in the financial statements that the method
of depreciation was changed; nor does it specify the effect of the change on
net income.
4. A company’s new office building, which is built next to the company’s exist-
ing factory, is debited to the factory account because it represents a fairly small
dollar amount in relation to the factory.
5. The asset account for a pickup truck still used in the business is written down
to what the truck could be sold for, even though the carrying value under
conventional depreciation methods is higher.
LO3 Classification of Accounts: Balance Sheet
E 5. The lettered items below represent a classification scheme for a balance sheet,
and the numbered items in the list below are account titles. Match each account
with the letter of the category in which it belongs.
a. Current assets d. Intangible assets g. Owner’s equity
b. Investments e. Current liabilities h. Not on balance sheet
c. Property, plant, f. Long-term liabilities
and equipment
1. Patent
2. Building Held for Sale
3. Prepaid Rent
4. Wages Payable
5. Note Payable in Five Years
6. Building Used in Operations
7. Fund Held to Pay Off Long-Term Debt
8. Inventory
9. Prepaid Insurance
10. Depreciation Expense
11. Accounts Receivable
12. Interest Expense
13. Unearned Revenue
14. Short-Term Investments
15. Accumulated Depreciation
16. Owner’s Capital
LO3 Classified Balance Sheet Preparation
E 6. The following data pertain to Branner Company: Accounts Payable, $10,200;
Accounts Receivable, $7,600; Accumulated Depreciation–Building, $2,800; Accumu- |
lated Depreciation–Equipment, $3,400; Bonds Payable, $12,000; Building, $14,000;
Cash, $6,240; Copyright, $1,240; Equipment, $30,400; Inventory, $8,000; Invest-
ment in Corporate Securities (long-term), $4,000; Investment in Six-Month Govern-
ment Securities, $3,280; F. Branner, Capital, $47,640; Land, $1,600; Prepaid Rent,
$240; and Revenue Received in Advance, $560.
Prepare a classified balance sheet at December 31, 2011. Assume that this is
Branner Company’s first year of operations.
216 CHAPTER 5 Financial Reporting and Analysis
LO4 Classification of Accounts: Income Statement
E 7. Using the classification scheme below for a multistep income statement,
match each account with the letter of the category in which it belongs.
a. Net sales d. General and administrative expenses
b. Cost of sales e. Other revenues and expenses
c. Selling expenses f. Not on income statement
1. Sales Discounts
2. Cost of Goods Sold
3. Dividend Income
4. Advertising Expense
5. Office Salaries Expense
6. Freight Out Expense
7. Prepaid Insurance
8. Utilities Expense
9. Sales Salaries Expense
10. Rent Expense
11. Depreciation Expense–Delivery Equipment
12. Interest Expense
LO4 Preparation of Income Statements
E 8. A company has the following data: net sales, $202,500; cost of goods sold,
$110,000; selling expenses, $45,000; general and administrative expenses,
$30,000; interest expense, $2,000; and interest income, $1,500.
1. Prepare a single-step income statement.
2. Prepare a multistep income statement.
LO4 Multistep Income Statement
E 9. A single-step income statement appears below. Present the information in a
multistep income statement, and indicate what insights can be obtained from the
multistep form as opposed to the single-step form.
Vision Company
Income Statement
For the Year Ended December 31, 2011
Revenues
Net sales $1,207,132
Interest income 5,720
Total revenues $1,212,852
Costs and expenses
Cost of goods sold $787,080
Selling expenses 203,740
General and administrative expenses 100,688
Interest expense 13,560
Total costs and expenses 1,105,068
Net income $ 107,784
Chapter Assignments 217
LO5 Liquidity Ratios
E 10. The accounts and balances that follow are from the general ledger of Dimaz
Company. Compute the (1) working capital and (2) current ratio.
Accounts Payable $ 6,640
Accounts Receivable 4,080
Cash 600
Current Portion of Long-Term Debt 4,000
Long-Term Investments 8,320
Marketable Securities 5,040
Merchandise Inventory 10,160
Notes Payable (90 days) 6,000
Notes Payable (2 years) 16,000
Notes Receivable (90 days) 10,400
Notes Receivable (2 years) 8,000
Prepaid Insurance 160
Property, Plant, and Equipment 48,000
Property Taxes Payable 500
I. Dimaz, Capital 22,640
Salaries Payable 340
Supplies 140
Unearned Revenue 300
LO5 Profitability Ratios
E 11. The following end-of-year amounts are from the financial statements of
Jang Company: total assets, $213,000; total liabilities, $86,000; owner’s equity,
$127,000; net sales, $391,000; cost of goods sold, $233,000; operating expenses,
$94,000; and withdrawals, $20,000. During the past year, total assets increased by
$37,500. Total owner’s equity was affected only by net income and withdrawals.
Compute the (1) profit margin, (2) asset turnover, (3) return on assets, (4) debt
to equity ratio, and (5) return on equity.
LO5 Liquidity and Profitability Ratios
E 12. T he simplified balance sheet and income statement for a company appear below.
Balance Sheet
December 31, 2011
Assets Liabilities
Current assets $ 55,000 Current liabilities $ 25,000
Investments 10,000 Long-term liabilities 30,000
Property, plant, Total liabilities $ 55,000
and equipment 146,500
Intangible assets 18,500 Owner’s Equity
Owner’s capital 175,000
Total liabilities
Total assets $230,000 and owner’s equity $230,000
(continued)
218 CHAPTER 5 Financial Reporting and Analysis
Income Statement
For the Year Ended December 31, 2011
Net sales $415,000
Cost of goods sold 250,000
Gross margin $165,000
Operating expenses 130,000
Net income $ 35,000
Total assets and owner’s equity at the beginning of 2011 were $180,000 and
$140,000, respectively. The owner made no investments or withdrawals during
the year. |
1. Compute the following liquidity measures: (a) working capital and (b) current
ratio.
2. Compute the following profitability measures: (a) profit margin, (b) asset turn-
over, (c) return on assets, (d) debt to equity ratio, and (e) return on equity.
Problems
LO2 Accounting Conventions
P 1. In each case below, accounting conventions may have been violated.
1. After careful study, Lipski Company, which has offices in 40 states, has deter-
mined that its method of depreciating office furniture should be changed. The
new method is adopted for the current year, and the change is noted in the
financial statements.
2. In the past, Gomez Company has recorded operating expenses in general
accounts (e.g., Salaries Expense and Utilities Expense). Management has
determined that despite the additional recordkeeping costs, the c ompany’s
income statement should break down each operating expense into its compo-
nents of selling expense and administrative expense.
3. Param Company’s auditor discovered that a company official had autho-
rized the payment of a $1,200 bribe to a local official. Management argued
that because the item was so small in relation to the size of the company
($1,700,000 in sales), the illegal payment should not be disclosed.
4. K&T Bookstore built a small addition to its main building to house a new
computer games section. Because no one could be sure that the computer
games section would succeed, the accountant took a conservative approach
and recorded the addition as an expense.
5. Since it began operations ten years ago, Chang Company has used the same
generally accepted inventory method. The company does not disclose in its
financial statements what inventory method it uses.
Required
In each of these cases, identify the accounting convention that applies, state
whether or not the treatment is in accord with the convention and generally
accepted accounting principles, and briefly explain why.
Chapter Assignments 219
LO4 Forms of the Income Statement
P 2. The income statements that follow are for Doug’s Tools Corporation.
Doug’s Tools Corporation
Income Statements
For the Years Ended July 31, 2012 and 2011
2012 2011
Revenues
Net sales $464,200 $388,466
Interest income 1,420 750
Total revenues $465,620 $389,216
Costs and expenses
Cost of goods sold $243,880 $198,788
Selling expenses 95,160 55,644
General and administrative expenses 90,840 49,286
Interest expense 5,600 1,100
Total costs and expenses $435,480 $304,818
Net income $ 30,140 $ 84,398
Required
1. From the information provided, prepare a multistep income statement for
2011 and 2012 showing percentages of net sales for each component.
User insight (cid:2) 2. Did income from operations increase or decrease between 2011 and 2012?
Write a short explanation of why this change occurred.
LO3 LO5 Classified Balance Sheet
P 3. The following information is from the June 30, 2011, post-closing trial
balance of Mike’s Hardware Company.
Account Name Debit Credit
Cash $ 32,000
Short-Term Investments 33,000
Notes Receivable 10,000
Accounts Receivable 276,000
Merchandise Inventory 145,000
Prepaid Rent 1,600
Prepaid Insurance 4,800
Sales Supplies 1,280
Office Supplies 440
Deposit for Future Advertising 3,680
Building, Not in Use 49,600
Land 23,400
Delivery Equipment 41,200
Accumulated Depreciation–Delivery Equipment $ 28,400
Trademark 4,000
Accounts Payable 114,600
Salaries Payable 5,200
Interest Payable 840
Long-Term Notes Payable 80,000
M. Logan, Capital 396,960
220 CHAPTER 5 Financial Reporting and Analysis
Required
1. From the information provided, prepare a classified balance sheet for Mike’s
Hardware Company.
2. Compute Mike’s Hardware’s current ratio and debt to equity ratio.
User insight (cid:2) 3. As a user of the classified balance sheet, why would you want to know the
current ratio or the debt to equity ratio?
LO5 Liquidity and Profitability Ratios
P 4. Arun Company has had poor operating results for the past two years. As
the accountant for Arun Company, you have the following information avail-
able to you:
2010 2009
Current assets $ 22,500 $ 17,500
Total assets 72,500 55,000 |
Current liabilities 10,000 5,000
Long-term liabilities 10,000 —
Owner’s equity 52,500 50,000
Net sales 131,000 100,000
Net income 8,000 5,500
Total assets and owner’s equity at the beginning of 2009 were $45,000 and
$40,000, respectively. The owner made no investments in 2009 or 2010.
Required
User insight (cid:2) 1. Compute the following measures of liquidity for 2009 and 2010: (a) working
capital and (b) current ratio. Comment on the differences between the years.
2. Compute the following measures of profitability for 2009 and 2010:
(a) profit margin, (b) asset turnover, (c) return on assets, (d) debt to equity
ratio, and (e) return on equity. Comment on the change in performance
from 2009 to 2010.
LO3 LO4 Classified Financial Statement Preparation and Analysis
LO5 P 5. Jimenez Company sells outdoor sports equipment. At the December 31,
2009, year end, the following financial information was available from the income
statement: administrative expenses, $80,800; cost of goods sold, $350,420; inter-
est expense, $22,640; interest income, $2,800; net sales, $714,390; and selling
expenses, $220,200.
The following information was available from the balance sheet (after
closing entries were made): accounts payable, $32,600; accounts receivable,
$104,800; accumulated depreciation–delivery equipment, $17,100; a ccumulated
depreciation–store fixtures, $42,220; cash, $28,400; delivery equipment, $88,500;
inventory, $136,540; investment in securities (long-term), $56,000; invest-
ment in U.S. government securities (short-term), $39,600; long-term notes pay-
able, $100,000; C. Jimenez, Capital, $359,300 (ending balance); notes payable
(short-term), $50,000; prepaid expenses (short-term), $5,760; and store fixtures,
$141,620.
Total assets and total owner’s equity at December 31, 2008, were $524,400
and $376,170, respectively, and owner’s withdrawals for the year were $60,000. The
owner did not make any additional investments in the company during the year.
Required
1. From the information above, prepare (a) an income statement in single-step
form, (b) a statement of owner’s equity, and (c) a classified balance sheet.
Chapter Assignments 221
2. From the statements you have prepared, compute the following measures:
(a) working capital and current ratio (for liquidity); and (b) profit margin,
asset turnover, return on assets, debt to equity ratio, and return on equity
(for profitability).
User insight (cid:2) 3. Using the industry averages for the auto and home supply business in
Figures 5-4 through 5-9 in this chapter, determine whether Jimenez
Company needs to improve its liquidity or its profitability. Explain your
answer, making recommendations as to specific areas on which Jimenez
Company should concentrate.
Alternate Problems
LO2 Accounting Conventions
P 6. In each case below, accounting conventions may have been violated.
1. Rhonda’s Manufacturing Company uses the cost method for computing the
balance sheet amount of inventory unless the market value of the inventory is
less than the cost, in which case the market value is used. At the end of the
current year, the market value is $151,000 and the cost is $162,000. Rhon-
da’s Manufacturing Company uses the $151,000 figure to compute the value
of inventory because management believes it is the more cautious approach.
2. Goldman Company has annual sales of $10,000,000. It follows the practice of
recording any items costing less than $250 as expenses in the year purchased.
During the current year, it purchased several chairs for the executive confer-
ence room at $245 each, including freight. Although the chairs were expected
to last for at least ten years, they were recorded as an expense in accordance
with company policy.
3. Helman Company closed its books on October 31, 2010, before preparing its
annual report. On November 3, 2010, a fire destroyed one of the company’s
two factories. Although the company had fire insurance and would not suffer a
loss on the building, it seemed likely that it would suffer a significant decrease
in sales in 2011 because of the fire. It did not report the fire damage in its |
2010 financial statements because the fire had not affected its operations dur-
ing that year.
4. Cure Drug Company spends a substantial portion of its profits on research
and development. The company had been reporting its $6,000,000 expendi-
ture for research and development as a lump sum, but management recently
decided to begin classifying the expenditures by project, even though its
recordkeeping costs will increase.
5. During the current year, Curt Nives Company (CNC) changed from one
generally accepted method of accounting for inventories to another method.
Required
For each of these cases, identify the accounting convention that applies, state
whether or not the treatment is in accord with the convention and GAAP, and
briefly explain why.
222 CHAPTER 5 Financial Reporting and Analysis
LO4 Forms of the Income Statement
P 7. Oak Nursery Company’s single-step income statements for 2011 and 2010
follow.
Oak Nursery Company
Income Statements
For the Years Ended April 30, 2011 and 2010
2011 2010
Revenues
Net sales $525,932 $475,264
Interest income 1,800 850
Total revenues $527,732 $476,114
Costs and expenses
Cost of goods sold $234,948 $171,850
Selling expenses 161,692 150,700
General and administrative expenses 62,866 42,086
Interest expense 3,600 1,700
Total costs and expenses $463,106 $366,336
Net income $ 64,626 $109,778
Required
1. From the information provided, prepare multistep income statements for
2010 and 2011 showing percentages of net sales for each component.
User insight (cid:2) 2. Did income from operations increase or decrease from 2010 to 2011? Write
a short explanation of why this change occurred.
LO5 Liquidity and Profitability Ratios
P 8. A summary of data from the income statements and balance sheets for Roman
Construction Supply Company for 2011 and 2010 appears below.
2011 2010
Current assets $ 183,000 $ 155,000
Total assets 1,160,000 870,000
Current liabilities 90,000 60,000
Long-term liabilities 400,000 290,000
Owner’s equity 670,000 520,000
Net sales 2,300,000 1,740,000
Net income 150,000 102,000
Total assets and owner’s equity at the beginning of 2010 were $680,000 and
$420,000, respectively.
Required
User insight (cid:2) 1. Compute the following liquidity measures for 2010 and 2011: (a) working
capital and (b) current ratio. Comment on the differences between the years.
User insight (cid:2) 2. Compute the following measures of profitability for 2010 and 2011:
(a) profit margin, (b) asset turnover, (c) return on assets, (d) debt to equity
ratio, and (e) return on equity. Comment on the change in performance
from 2010 to 2011.
Chapter Assignments 223
LO3 LO4 Classified Financial Statement Preparation and Analysis
LO5 P 9. Wu Company sells outdoor sports equipment. At the December 31, 2010,
year end, the following financial information was available from the income state-
ment: administrative expenses, $161,600; cost of goods sold, $700,840; interest
expense, $45,280; interest income, $5,600; net sales, $1,428,780; and selling
expenses, $440,400.
The following information was available from the balance sheet (after
closing entries were made): accounts payable, $65,200; accounts receivable,
$209,600; accumulated depreciation–delivery equipment, $34,200; accumulated
depreciation–store fixtures, $84,440; cash, $56,800; delivery equipment,
$177,000; inventory, $273,080; investment in securities (long-term), $112,000;
investment in U.S. government securities (short-term), $79,200; long-term
notes payable, $200,000; Y. Wu, Capital, $718,600 (ending balance); notes pay-
able (short-term), $100,000; prepaid expenses (short-term), $11,520; and store
fixtures, $283,240.
Total assets and total owner’s equity at December 31, 2009, were $1,048,800
and $752,340, respectively, and owner’s withdrawals for the year were $120,000. The
owner did not make any additional investments in the company during the year.
Required
1. From the information above, prepare (a) an income statement in single-step
form, (b) a statement of owner’s equity, and (c) a classified balance sheet.
2. From the statements you have prepared, compute the following measures: (a) |
working capital and current ratio (for liquidity); and (b) profit margin, asset turn-
over, return on assets, debt to equity ratio, and return on equity (for profitability).
User insight (cid:2) 3. Using the industry averages for the auto and home supply business in
Figures 5-4 through 5-9 in this chapter, determine whether Wu Company
needs to improve its liquidity or its profitability. Explain your answer,
making recommendations as to specific areas on which Wu Company
should concentrate.
LO5 Liquidity and Profitability Ratios
P 10. Rollins Products Company has had poor operating results for the past two
years. As the accountant for Rollins Products Company, you have the following
information available to you:
2011 2010
Current assets $ 45,000 $ 35,000
Total assets 145,000 110,000
Current liabilities 20,000 10,000
Long-term liabilities 20,000 —
Owner’s equity 105,000 100,000
Net sales 262,000 200,000
Net income 16,000 11,000
Total assets and owner’s equity at the beginning of 2010 were $90,000 and
$80,000, respectively. The owner made no investments in 2010 or 2011.
Required
1. Compute the following measures of liquidity for 2010 and 2011: (a) working
capital and (b) current ratio. Comment on the differences between the years.
2. Compute the following measures of profitability for 2009 and 2010:
(a) profit margin, (b) asset turnover, (c) return on assets, (d) debt to equity
ratio, and (e) return on equity. Comment on the change in performance
from 2010 to 2011.
224 CHAPTER 5 Financial Reporting and Analysis
ENHANCING Your Knowledge, Skills, and Critical Thinking
LO2 Consistency and Full Disclosure
C 1. City Parking, which operates a seven-story parking building in downtown
Pittsburgh, has a calendar year end. It serves daily and hourly parkers, as well as
monthly parkers who pay a fixed monthly rate in advance. The company tradi-
tionally has recorded all cash receipts as revenues when received. Most monthly
parkers pay in full during the month prior to that in which they have the right
to park. The company’s auditors have said that beginning in 2009, the com-
pany should consider recording the cash receipts from monthly parking on an
accrual basis, crediting Unearned Revenues. Total cash receipts for 2009 were
$1,250,000, and the cash receipts received in 2009 and applicable to January
2010 were $62,500. Discuss the relevance of the accounting conventions of con-
sistency, full disclosure, and materiality to the decision to record the monthly
parking revenues on an accrual basis.
LO2 Materiality
C 2. Kubicki Company operates a chain of designer bags and shoes stores in the
Houston area. This year the company achieved annual sales of $75 million, on
which it earned a net income of $3 million. At the beginning of the year, manage-
ment implemented a new inventory system that enabled it to track all purchases
and sales. At the end of the year, a physical inventory reveals that the actual inven-
tory was $120,000 below what the new system indicated it should be. The inven-
tory loss, which probably resulted from shoplifting, is reflected in a higher cost of
goods sold. The problem concerns management but seems to be less important
to the company’s auditors. What is materiality? Why might the inventory loss
concern management more than it does the auditors? Do you think the amount
of inventory loss is material?
LO5 Comparison of Profitability
C 3. Two of the largest chains of grocery stores in the United States are Albert-
son’s, Inc., and the Great Atlantic & Pacific Tea Company (A&P). In a recent
fiscal year, Albertson’s had a net income of $765 million, and A&P had a net
income of $14 million. It is difficult to judge which company is more profitable
from those figures alone because they do not take into account the relative sales,
sizes, and investments of the companies. Data (in millions) needed to complete a
financial analysis of the two companies follow:13
Albertson’s A&P
Net sales $36,762 $10,151
Beginning total assets 15,719 3,335
Ending total assets 16,078 3,309
Beginning total liabilities 10,017 2,489 |
Ending total liabilities 10,394 2,512
Beginning stockholders’ equity 5,702 846
Ending stockholders’ equity 5,684 797
Chapter Assignments 225
1. Determine which company was more profitable by computing profit margin,
asset turnover, return on assets, debt to equity ratio, and return on equity for the
two companies. Comment on the relative profitability of the two companies.
2. What do the ratios tell you about the factors that go into achieving an ade-
quate return on assets in the grocery industry? For industry data, refer to
Figures 5-4 through 5-9 in this chapter.
3. How would you characterize the use of debt financing in the grocery indus-
try and the use of debt by these two companies?
LO1 Qualitative Characteristics of Accounting Information
C 4. Review the multistep income statement presented in Exhibits 5-3 and 5-4.
In your group, discuss how this form of the income statement meets each of
these qualitative characteristics of accounting information: understandability,
usefulness, relevance, and reliability. Be prepared to present your conclusions
in class.
LO3 LO4 Classified Balance Sheet and Multistep Income Statement
C 5. Refer to CVS Corporation’s annual report in the Supplement to Chapter 5 to
answer the following questions.
1. Consolidated balance sheets:
a. Did the amount of working capital increase or decrease from 2007 to
2008? By how much?
b. Did the current ratio improve from 2007 to 2008?
c. Does the company have long-term investments or intangible assets?
d. Did the debt to equity ratio of CVS change from 2007 to 2008?
e. What proportion of owners’ (shareholders’) equity is retained earnings?
2. Consolidated statements of operations:
a. Does CVS use a multistep or single-step income statement?
b. Is it a comparative statement?
c. What is the trend of net earnings?
d. How significant are income taxes for CVS?
LO5 Financial Analysis
C 6. Compare the financial performance of CVS and Southwest Airlines Co. on
the basis of liquidity and profitability for 2008 and 2007. Use the following ratios:
working capital, current ratio, debt to equity ratio, profit margin, asset turnover,
return on assets, and return on equity. In 2006, total assets and total stockhold-
ers’ equity for CVS were $20,574.1 million and $9,917.6 million, respectively.
Southwest’s total assets were $13,460 million, and total stockholders’ equity was
$6,449 million in 2006. Comment on the relative performance of the two com-
panies. In general, how does Southwest’s performance compare to CVS’s with
respect to liquidity and profitability? What distinguishes Southwest’s profitability
performance from that of CVS?
S U P P L E M E N T
T O C H A P T E R
How to Read
5
an Annual Report
M ore than 4 million corporations are chartered in the United
States. Most of them are small, family-owned businesses. They
are called private or closely held corporations because their common stock
is held by only a few people and is not for sale to the public. Larger
companies usually find it desirable to raise investment funds from many
investors by issuing common stock to the public. These companies are
called public companies. Although they are fewer in number than private
companies, their total economic impact is much greater.
Public companies must register their common stock with the Securi-
ties and Exchange Commission (SEC), which regulates the issuance and
subsequent trading of the stock of public companies. The SEC requires
the management of public companies to report each year to stockholders
on their companies’ financial performance. This report, called an annual
report, contains the company’s annual financial statements and other per-
tinent data. Annual reports are a primary source of financial information
about public companies and are distributed to all of a company’s stock-
holders. They must also be filed with the SEC on a Form 10-K.
The general public may obtain an annual report by calling or writ-
ing the company or accessing the report online at the company’s web-
site. If a company has filed its 10-K electronically with the SEC, it can |
be accessed at www.sec.gov/edgar.shtml. Many libraries also maintain
files of annual reports or have them available on electronic media, such
as Compact Disclosure.
This supplement describes the major components of the typical
annual report. We have included many of these components in the
annual report of CVS Caremark Corporation, one of the country’s
most successful retailers. Case assignments in each chapter refer to
this annual report. For purposes of comparison, the supplement also
includes the financial statements and summary of significant account-
ing policies of Southwest Airlines Co., one of the largest and most
successful airlines in the United States.
The Components of an Annual Report
In addition to listing the corporation’s directors and officers, an annual
report usually contains a letter to the stockholders (also called share-
holders), a multiyear summary of financial highlights, a description of
the company, management’s discussion and analysis of the company’s
operating results and financial condition, the financial statements,
notes to the financial statements, a statement about management’s
responsibilities, and the auditors’ report.
226
How to Read an Annual Report 227
Letter to the Stockholders
Traditionally, an annual report begins with a letter in which the top officers of the
corporation tell stockholders about the company’s performance and prospects. In
CVS’s 2008 annual report, the chairman and chief executive officer wrote to the
stockholders about the highlights of the past year, the key priorities for the new
year, and other aspects of the business. He reported as follows:
Today, we are the nation’s largest pharmacy health care company.
With U.S. health care costs expected to reach more than $4 trillion
annually over the next decade, we are beginning to deliver healthy
outcomes for patients and driving down costs in ways that no other
company in our industry can.
Financial Highlights
The financial highlights section of an annual report presents key statistics for at least
a five-year period but often for a ten-year period. It is often accompanied by graphs.
CVS’s annual report, for example, gives key figures for sales, operating profits, and
other key measures. Note that the financial highlights section often includes nonfi-
nancial data and graphs, such as the number of stores in CVS’s case.
Description of the Company
An annual report contains a detailed description of the company’s products and
divisions. Some analysts tend to scoff at this section of the annual report because
it often contains glossy photographs and other image-building material, but it
should not be overlooked because it may provide useful information about past
results and future plans.
Management’s Discussion and Analysis
In this section, management describes the company’s financial condition and
results of operations and explains the difference in results from one year to the
next. For example, CVS’s management explains the effects of its strategy to relo-
cate some of its stores:
Total net revenues continued to benefit from our active relocation pro-
gram, which moves existing in-line shopping center stores to larger,
more convenient, freestanding locations. Historically, we have achieved
significant improvements in customer count and net revenue when we
do this. As of December 31, 2008, approximately 62% of our existing
stores were freestanding, compared to approximately 64% and 61% at
December 29, 2007 and December 30, 2006, respectively. During
2008, the decrease in the percentage of freestanding stores resulted from
the addition of the Longs Drug Stores.
CVS’s management also describes the increase in cash flows from investing
activities:
Net cash used in investing activities increased to $4.6 billion in 2008.
This compares to $3.1 billion in 2007 and $4.6 billion in 2006. The
increase in net cash used in investing activities during 2008 was pri-
marily due to the Longs Acquisition. The $3.1 billion of net cash
used in investing activities during 2007 was primarily due to the
Caremark Merger. The increase in net cash used in investing activi- |
ties during 2006 was primarily due to the Albertson’s Acquisition.
228 SUPPLEMENT TO CHAPTER 5
Financial Statements
All companies present the same four basic financial statements in their annual
reports, but the names they use may vary. As you can see in Exhibits S-1 to S-4,
CVS presents statements of operations (income statements), balance sheets, state-
ments of cash flows, and statements of shareholders’ equity (includes retained
earnings). (Note that the numbers given in the statements are in millions, but the
last six digits are omitted. For example, $4,793,300,000 is shown as $4,793.3.)
The headings of CVS’s financial statements are preceded by the word con-
solidated. A corporation issues consolidated financial statements when it consists
of more than one company and has combined the companies’ data for reporting
purposes.
CVS provides several years of data for each financial statement: two years for
the balance sheet and three years for the others. Financial statements presented
in this fashion are called comparative financial statements. Such statements are in
accordance with generally accepted accounting principles and help readers assess
the company’s performance over several years.
CVS’s fiscal year ends on the Saturday nearest the end of December (Decem-
ber 31, 2008 in the latest year). Retailers commonly end their fiscal years during
a slow period, usually the end of January, which is in contrast to CVS’s choosing
the end of December.
Income Statements CVS uses a multistep form of the income statement in
that results are shown in several steps (in contrast to the single-step form illus-
trated in the chapter). The steps are gross profit, operating profit, earnings before
income tax provision, and net earnings (see Exhibit S-1). The company also
shows net earnings available to common shareholders, and it discloses the basic
earnings per share and diluted earnings per share. Basic earnings per share is used
for most analysis. Diluted earnings per share assumes that all rights that could be
exchanged for common shares, such as stock options, are in fact exchanged. The
weighted average number of shares of common stock, used in calculating the per
share figures, are shown at the bottom of the income statement.
Balance Sheets CVS has a typical balance sheet for a retail company (see
Exhibit S-2). In the assets and liabilities sections, the company separates out the
current assets and the current liabilities. Current assets will become available as cash
or will be used up in the next year; current liabilities will have to be paid or satisfied
in the next year. These groupings are useful in assessing a company’s liquidity.
Several items in the shareholders’ equity section of the balance sheet may
need explanation. Common stock represents the number of shares outstanding at
par value. Capital surplus (additional paid-in capital) represents amounts invested
by stockholders in excess of the par value of the common stock. Preferred stock
is capital stock that has certain features that distinguish it from common stock.
Treasury stock represents shares of common stock the company repurchased.
Statements of Cash Flows Whereas the income statement reflects CVS’s
profitability, the statement of cash flows reflects its liquidity (see Exhibit S-3).
This statement provides information about a company’s cash receipts, cash pay-
ments, and investing and financing activities during an accounting period.
The first major section of CVS’s consolidated statements of cash flows shows
cash flows from operating activities. It shows the cash received and paid for vari-
ous items related to the company’s operations. The second major section is cash
flows from investing activities. Except for acquisitions in 2006, 2007, and 2008,
the largest outflow in this category is additions for property and equipment. This
figure demonstrates that CVS is a growing company. The third major section
How to Read an Annual Report 229
EXHIBIT S-1
CVS’s Income Statements
CVS Caremark Corporation
Consolidated means that data from all CVS’s fiscal year ends on the Saturday |
Consolidated Statements of Operations
companies owned by CVS are combined. closest to December 31.
Fiscal Year Ended
Dec. 31, 2008 Dec. 29, 2007 Dec. 30, 2006
(In millions, except per share amounts) (52 weeks) (52 weeks) (53 weeks)
Net revenues $87,471.9 $76,329.5 $43,821.4
Cost of revenues 69,181.5 60,221.8 32,079.2
Gross profit 18,290.4 16,107.7 11,742.2
Total operating expenses 12,244.2 11,314.4 9,300.6
Operating profit1 6,046.2 4,793.3 2,441.6
Interest expense, net2 509.5 434.6 215.8
Earnings before income tax provision 5,536.7 4,358.7 2,225.8
Loss from discontinued operations, (132) — —
net of income tax benefit of $82.4
Income tax provision 2,192.6 1,721.7 856.9
Net earnings3 3,212.1 2,637.0 1,368.9
Preference dividends, net of income tax benefit4 14.1 14.2 13.9
Net earnings available to common shareholders $ 3,198.0 $ 2,622.8 $ 1,355.0
BASIC EARNINGS PER COMMON SHARE:5
Net earnings $ 2.23 $ 1.97 $ 1.65
Weighted average common shares outstanding 1,433.5 1,328.2 820.6
DILUTED EARNINGS PER COMMON SHARE:
Net earnings $ 2.18 $ 1.92 $ 1.60
Weighted average common shares outstanding 1,469.1 1,371.8 853.2
DIVIDENDS DECLARED PER COMMON SHARE: $ 0.25800 $ 0.22875 $ 0.15500
1. This section shows earnings from ongoing operations.
2. CVS shows interest expense and income taxes separately.
3. The net earnings figure moves to the statements of shareholders’ equity.
4. CVS shows the dividends distributed to preferred shareholders. This distribution is not an expense.
5. CVS discloses various breakdowns of earnings per share.
is cash flows from financing activities. You can see here that CVS’s largest cash
inflows are for borrowing of long-term and short-term debt.
At the bottom of the statements of cash flows, you can see a reconciliation of net
earnings to net cash provided by operating activities. This disclosure is important to
the user because it relates the goal of profitability (net earnings) to liquidity (net cash
provided). Most companies substitute this disclosure for the operating activities at the
beginning of their statement of cash flows, as illustrated in Chapter 1.
Statements of Shareholders’ Equity Instead of a simple statement of
retained earnings, CVS presents consolidated statements of shareholders’ equity
(see Exhibit S-4). These statements explain the changes in components of stock-
holders’ equity, including retained earnings.
230 SUPPLEMENT TO CHAPTER 5
EXHIBIT S-2 CVS’S Balance Sheets
CVS Caremark Corporation
Consolidated Balance Sheets
(In millions, except shares and per share amounts) Dec. 31, 2008 Dec. 29, 2007
ASSETS:
Cash and cash equivalents $ 1,352.4 $ 1,056.6
Short-term investments — 27.5
Accounts receivable, net 5,384.3 4,579.6
CVS categorizes certain
Inventories 9,152.6 8,008.2
assets as current assets.
Deferred income taxes 435.2 329.4
Other current assets 201.7 148.1
Total current assets $ 16,526.2 14,149.4
Property and equipment, net $ 8,125.2 $ 5,852.8
Goodwill 25,493.9 23,922.3
Intangible assets, net 10,466.2 10,429.6
These are noncurrent
Deferred income taxes — —
or long-term assets.
Other assets 368.4 367.8
Total assets $ 60,959.9 $ 54,721.9
LIABILITIES:
Accounts payable $ 3,800.7 $ 3,593.0
Claims and discounts payable 2,814.2 2,484.3
Accrued expenses 3,177.6 2,556.8
CVS categorizes certain liabilities
Short-term debt as current liabilities. 3,044.1 2,085.0
Current portion of long-term debt 653.3 47.2
Total current liabilities 13,489.9 10,766.3
Long-term debt 8,057.2 8,349.7
Deferred income taxes These are noncurrent 3,701.7 3,426.1
Other long-term liabilities or long-term liabilities. 1,136.7 857.9
Commitments and contingencies (Note 11)
Balances in the shareholders’
equity section are from the state-
SHAREHOLDERS’ EQUITY:
ments of shareholders’ equity.
Preferred stock, $0.01 par value: authorized 120,619 shares; — —
no shares issued or outstanding
Preference stock, series one ESOP convertible, par value $1.00: 191.5 203.0
authorized 50,000,000 shares; issued and outstanding 3,798,000 shares
at December 29, 2007 and 3,990,000 shares at December 30, 2006
Common stock, par value $0.01: authorized 3,200,000,000 shares; 16.0 15.9 |
issued 1,590,139,000 shares at December 29, 2007 and 847,266,000 shares
at December 30, 2006
Treasury stock, at cost: 153,682,000 shares at December 30, 2007 and (5,812.3) (5,620.4)
21,529,000 shares at December 30, 2006
Shares held in trust, 9,224,000 shares at December 29, 2007 (55.5) (301.3)
Guaranteed ESOP obligation — (44.5)
Capital surplus 27,279.6 26,831.9
Retained earnings 13,097.8 10,287.0
Accumulated other comprehensive loss (142.7) (49.7)
Total shareholders’ equity 34,574.4 31,321.9
Total liabilities and shareholders’ equity $ 60,959.9 $ 54,721.9
How to Read an Annual Report 231
EXHIBIT S-3 CVS’s Statements of Cash Flows
CVS Corporation
Consolidated Statements of Cash Flows
Cash flows are shown for operating activities, Fiscal Year Ended
investing activities, and financing activities.
Dec. 31, 2008 Dec. 29, 2007 Dec. 30, 2006
(In millions) (52 weeks) (52 weeks) (53 weeks)
CASH FLOWS FROM OPERATING ACTIVITIES:
Cash receipts from revenues $69,493.7 $61,986.3 $43,273.7
Cash paid for inventory (51,374.7) (45,772.6) (31,422.1)
Cash paid to other suppliers and employees (11,832.0) (10,768.6) (9,065.3)
Interest and dividends received 20.3 33.6 15.9
Interest paid (573.7) (468.2) (228.1)
Income taxes paid (1,786.5) (1,780.8) (831.7)
NET CASH PROVIDED BY OPERATING ACTIVITIES 3,947.1 3,229.7 1,742.4
CASH FLOWS FROM INVESTING ACTIVITIES:
Additions to property and equipment (2,179.9) (1,805.3) (1,768.9)
Proceeds from sale-leaseback transactions 203.8 601.3 1,375.6
Acquisitions (net of cash acquired) and other investments (2,650.7) (1,983.3) (4,224.2)
Cash outflow from hedging activities — — (5.3)
Sale of short-term investments 27.5 — —
Proceeds from sale or disposal of assets 18.7 105.6 29.6
NET CASH USED IN INVESTING ACTIVITIES (4,580.6) (3,081.7) (4,593.2)
CASH FLOWS FROM FINANCING ACTIVITIES:
Additions to/(reductions in) short-term debt 959.0 242.3 1,589.3
Repayment of debt assumed in acquisition (352.8) — —
Additions to long-term debt 350.0 6,000.0 1,500.0
Reductions in long-term debt (1.8) (821.8) (310.5)
Dividends paid (383.0) (322.4) (140.9)
Proceeds from exercise of stock options 327.8 552.4 187.6
Excess tax benefits from stock based compensation 53.1 97.8 42.6
Repurchase of common stock (23.0) (5,370.4) —
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES 929.3 377.9 2,868.1
Net increase in cash and cash equivalents 295.8 525.9 17.3
Cash and cash equivalents at beginning of year 1,056.6 530.7 513.4
CASH AND CASH EQUIVALENTS AT END OF YEAR Cash and cash equivalents $ 1,352.4 $ 1,056.6 $ 530.7
RECONCILIATION OF NET EARNINGS TO NET CASH PROVIDED move to balance sheets.
BY OPERATING ACTIVITIES
Net earnings $ 3,212.1 $ 2,637.0 $ 1,368.9
Adjustments required to reconcile net earnings to 1,274.2 1,094.6 733.3
net cash provided by operating activities:
Depreciation and amortization Stock based compensation 92.5 78.0 69.9
Deferred income taxes and other non-cash items (3.4) 40.1 98.2
Change in operating assets and liabilities providing/(requiring)
cash, net of effects from acquisitions:
Accounts receivable, net (291.0) 279.7 (540.1)
This section explains the
Inventories (448.1) (448.0) (624.1)
difference between net
Other current assets 12.5 (59.2) (21.4)
earnings and net cash
Other assets 19.1 (26.4) (17.2)
provided by operating
Accounts payable activities. (63.9) (181.4) 396.7
Accrued expenses 182.5 (168.2) 328.9
Other long-term liabilities 0.6 (16.5) (50.7)
NET CASH PROVIDED BY OPERATING ACTIVITIES $ 3,947.1 $ 3,229.7 $ 1,742.4
232 SUPPLEMENT TO CHAPTER 5
EXHIBIT S-4 CVS’s Statements of Stockholders’ Equity
CVS Caremark Corporation
Consolidated Statements of Shareholders’ Equity
Each component of shareholders’
Shares Dollars
equity is explained.
Dec. 31, Dec. 29, Dec. 30, Dec. 31, Dec. 29, Dec. 30,
( In millions) 2008 2007 2006 2008 2007 2006
PREFERENCE STOCK:
Beginning of year 3.8 4.0 4.2 $ 203.0 $ 213.3 $ 222.6
Conversion to common stock (0.2) (0.2) (0.2) (11.5) (10.3) (9.3)
End of year 3.6 3.8 4.0 191.5 203.0 213.3
COMMON STOCK:
Beginning of year 1,590.1 847.3 838.8 15.9 8.5 8.4
Common stock issued for Caremark Merger — 712.7 — — 7.1 — |
Stock options exercised and awards 13.2 30.1 8.5 0.1 0.3 0.1
End of year 1,603.3 1,590.1 847.3 16.0 15.9 8.5
TREASURY STOCK:
Beginning of year (153.7) (21.5) (24.5) (5,620.4) (314.5) (356.5)
Purchase of treasury shares (6.5) (135.0) 0.1 (33.0) (5,378.7) (0.1)
Transfer from Trust (7.5) — — (272.3) — —
Conversion of preference stock 1.0 0.9 0.8 35.2 24.7 11.7
Employee stock purchase plan issuance 2.2 1.9 2.1 78.2 48.1 30.4
End of year (164.5) (153.7) (21.5) (5,812.3) (5,620.4) (314.5)
GUARANTEED ESOP OBLIGATION:
Beginning of year (44.5) (82.1) (114.0)
Reduction of guaranteed ESOP Obligation 44.5 37.6 31.9
End of year — (44.5) (82.1)
SHARES HELD IN TRUST:
Beginning of year (9.2) — — (301.3) — —
Transfer to treasury stock 7.5 — — 245.8 — —
Shares acquired through Caremark Merger — (9.2) — — (301.3) —
End of year (1.7) (9.2) (55.5) (301.3) —
CAPITAL SURPLUS:
Beginning of year 26,831.9 2,198.4 1,922.4
Common stock issued for Caremark Merger, — 23,942.4 —
net of issuance costs
Conversion of shares held in Trust to treasury stock 26.5
Stock option activity and awards 391.8 607.7 235.8
Tax benefit on stock options and awards 53.1 97.8 42.6
Conversion of preference stock (23.7) (14.4) (2.4)
End of year 27,279.6 26,831.9 2,198.4
ACCUMULATED OTHER COMPREHENSIVE LOSS:
Beginning of year (49.7) (72.6) (90.3)
Recognition of unrealized gain/(loss) on 3.4 3.4 (0.3)
derivatives, net of income tax
Pension liability adjustment (96.4) 19.5 23.6
Pension liability adjustment to initially apply — — (5.6)
SFAS No. 158, net of tax benefit
End of year (142.7) (49.7) (72.6)
How to Read an Annual Report 233
EXHIBIT S-4 continued
RETAINED EARNINGS:
Beginning of year 10,287.0 7,966.6 6,738.6
Net earnings are from
Net earnings 3,212.1 2,637.0 1,368.9
the income statement.
Common stock dividends (369.7) (308.8) (127.0)
Preference stock dividends (14.0) (14.8) (15.6)
Tax benefit on preference stock dividends 0.6 1.2 1.7
Adoption of EITF 06-04 and EITF 06-10 (18.2) — —
Adoption of FIN 48 — 5.8 —
End of year 13,097.8 10,287.0 7,966.6
TOTAL SHAREHOLDERS’ EQUITY $34,574.4 $31,321.9 $9,917.6
COMPREHENSIVE INCOME:
Net earnings $ 3,212.1 $ 2,637.0 $1,368.9
Recognition of unrealized gain/(loss) on derivatives, 3.4 3.4 (0.3)
net of income tax
Pension liability, net of income tax (96.4) 19.5 23.6
COMPREHENSIVE HOME $ 3,119.1 $ 2,659.9 $1,392.2
Notes to the Financial Statements
To meet the requirements of full disclosure, a company must add notes to
the financial statements to help users interpret some of the more complex items. The
notes are considered an integral part of the financial statements. In recent years, the
need for explanation and further details has become so great that the notes often
take more space than the statements themselves. The notes to the financial state-
ments include a summary of significant accounting policies and explanatory notes.
Summary of Significant Accounting Policies Generally accepted account-
ing principles require that the financial statements include a Summary of Signifi-
cant Accounting Policies. In most cases, this summary is presented in the first note
to the financial statements or as a separate section just before the notes. In this
summary, the company tells which generally accepted accounting principles it has
followed in preparing the statements. For example, in CVS’s report, the company
states the principles followed for revenue recognition:
The RPS [Retail Pharmacy Segment] recognizes revenue from the
sale of merchandise (other than prescription drugs) at the time
the merchandise is purchased by the retail customer. Revenue from
the sale of prescription drugs is recognized at the time the prescrip-
tion is filled, which is or approximates when the retail customer picks
up the prescription. Customer returns are not material. Revenue gen-
erated from the performance of services in the RPS’ healthcare clin-
ics is recognized at the time the services are performed. . . .The PSS
[Pharmacy Services Segment] recognizes revenues from prescription
drugs sold by its mail service pharmacies and under national retail |
pharmacy network contracts where the PSS is the principal using the
gross method at the contract prices negotiated with its customers.
Explanatory Notes Other notes explain some of the items in the financial
statements. For example, CVS describes its commitments for future lease pay-
ments as follows:
234 SUPPLEMENT TO CHAPTER 5
Following is a summary of the future minimum lease payments under
capital and operating leases as of December 31, 2008:
(In millions) Capital Leases Operating Leases
2009 17.0 1,744.2
2010 17.2 1,854.4
2011 17.2 1,609.0
2012 17.6 1,609.0
2013 17.9 1,682.6
Thereafter 83.0 14,821.0
$169.9 $23,294.6
Information like this is very useful in determining the full scope of a company’s
liabilities and other commitments.
Supplementary Information Notes In recent years, the FASB and the SEC
have ruled that certain supplemental information must be presented with finan-
cial statements. Examples are the quarterly reports that most companies present to
their stockholders and to the SEC. These quarterly reports, called interim financial
statements, are in most cases reviewed but not audited by a company’s independent
CPA firm. In its annual report, CVS presents unaudited quarterly financial data
from its 2008 quarterly statements. The quarterly data also includes the high and
low price for the company’s common stock during each quarter.
Reports of Management’s Responsibilities
Separate statements of management’s responsibility for the financial state-
ments and for internal control structure accompany the financial statements as
required by the Sarbanes-Oxley Act of 2002. In its reports, CVS’s management
acknowledges its responsibility for the consistency, integrity, and presentation of
the financial information and for the system of internal controls.
Reports of Certified Public Accountants
The registered independent auditors’ report deals with the credibility of the finan-
cial statements. This report, prepared by independent certified public accoun-
tants, gives the accountants’ opinion about how fairly the statements have been
presented. Because management is responsible for preparing the financial state-
ments, issuing statements that have not been independently audited would be
like having a judge hear a case in which he or she was personally involved. The
certified public accountants add the necessary credibility to management’s figures
for interested third parties. They report to the board of directors and the stock-
holders rather than to the company’s management.
In form and language, most auditors’ reports are like the one shown in
Figure S-1. Usually, such a report is short, but its language is very important.
It normally has four parts, but it can have a fifth part if an explanation is needed.
1. The first paragraph identifies the financial statements that have been audited.
It also identifies responsibilities. The company’s management is responsible
for the financial statements, and the auditor is responsible for expressing an
opinion on the financial statements based on the audit.
2. The second paragraph, or scope section, states that the examination was made
in accordance with standards of the Public Company Accounting Oversight
Board (PCAOB). This paragraph also contains a brief description of the
objectives and nature of the audit.
How to Read an Annual Report 235
3. The third paragraph, or opinion section, states the results of the auditors’ exami-
nation. The use of the word opinion is very important because the auditor does
not certify or guarantee that the statements are absolutely correct. To do so
would go beyond the truth, because many items, such as depreciation, are based
on estimates. Instead, the auditors simply give an opinion about whether, over-
all, the financial statements “present fairly,” in all material respects, the com-
pany’s financial position, results of operations, and cash flows. This means that
the statements are prepared in accordance with generally accepted accounting
principles. If, in the auditors’ opinion, the statements do not meet accepted |
standards, the auditors must explain why and to what extent.
4. The fourth paragraph identifies a new accounting standard adopted by the
company.
5. The fifth paragraph says the company’s internal controls are effective.
FIGURE S-1 Auditor’s Report for CVS Caremark Corporation
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders
CVS Caremark Corporation
1. We have audited the accompanying consolidated ended December 31, 2008 and December 29,
balance sheets of CVS Caremark Corporation as of 2007, i n conformity with U.S. generally accepted
December 31, 2008 and December 29, 2007, and accounting principles.
the related consolidated statements of operations,
4. As discussed in Note 1 to the consolidated finan-
shareholders’ equity and cash flows for the fiscal
cial statements, effective December 31, 2006, CVS
years ended December 31, 2008 and December 29,
Caremark Corporation adopted Financial Account-
2007. These financial statements are the responsi-
ing Standards Board (FASB) Interpretation No. 48,
bility of the Company’s management. Our respon-
Accounting for Uncertainty in Income Taxes—an
sibility is to express an opinion on these financial
interpretation of FASB Statement No. 109 and effec-
statements based on our audits.
tive December 30, 2007, CVS Caremark Corpora-
2. We conducted our audits in accordance with the tion adopted Emerging Issues Task Force (EITF)
standards of the Public Company Accounting No. 06-4, Accounting for Deferred Compensation
Oversight Board (United States). Those standards and Postretirement Benefit Aspects of Endorsement
require that we plan and perform the audit to Split-Dollar Life Insurance Arrangements and EITF
obtain reasonable assurance about whether the No. 06-10, Accounting for Collateral Assignment
financial statements are free of material misstate- Split-Dollar Life Insurance Arrangements.
ment. An audit includes examining, on a test basis,
5. We also have audited, in accordance with the stan-
evidence supporting the amounts and disclosures
dards of the Public Company Accounting O versight
in the financial statements. An audit also includes
Board (United States), CVS Caremark Corpora-
assessing the accounting principles used and sig-
tion’s internal control over financial reporting as of
nificant estimates made by management, as well
December 31, 2008, based on criteria established
as evaluating the overall financial statement pre-
in Internal Control—Integrated Framework issued
sentation. We believe that our audits provide a
by the Committee of Sponsoring Organizations of
reasonable basis for our opinion.
the Treadway Commission and our report dated
3. In our opinion, the financial statements referred February 26, 2009 expressed an unqualified opin-
to above present fairly, in all material respects, the ion thereon.
consolidated financial position of CVS C aremark
Corporation at December 31, 2008 and Decem- Ernst and Young LLP
ber 29, 2007, and the consolidated results of its Boston, Massachusetts
operations and its cash flows for the fiscal years February 26, 2009
236 SUPPLEMENT TO CHAPTER 5
How to Read an Annual Report 237
238 SUPPLEMENT TO CHAPTER 5
How to Read an Annual Report 239
240 SUPPLEMENT TO CHAPTER 5
How to Read an Annual Report 241
242 SUPPLEMENT TO CHAPTER 5
How to Read an Annual Report 243
244 SUPPLEMENT TO CHAPTER 5
How to Read an Annual Report 245
246 SUPPLEMENT TO CHAPTER 5
How to Read an Annual Report 247
248 SUPPLEMENT TO CHAPTER 5
How to Read an Annual Report 249
250 SUPPLEMENT TO CHAPTER 5
How to Read an Annual Report 251
252 SUPPLEMENT TO CHAPTER 5
How to Read an Annual Report 253
254 SUPPLEMENT TO CHAPTER 5
How to Read an Annual Report 255
256 SUPPLEMENT TO CHAPTER 5
How to Read an Annual Report 257
Item8. FinancialStatementsandSupplementaryData
SOUTHWESTAIRLINESCO.
CONSOLIDATEDBALANCESHEET
December31,
2008 2007
(Inmillions,except
sharedata)
ASSETS
Currentassets:
Cashandcashequivalents ................................................... $ 1,368 $ 2,213
Short-terminvestments ..................................................... 435 566 |
Accountsandotherreceivables ............................................... 209 279
Inventoriesofpartsandsupplies,atcost ....................................... 203 259
Fuelderivativecontracts .................................................... — 1,069
Deferredincometaxes...................................................... 365 —
Prepaidexpensesandothercurrentassets ...................................... 313 57
Totalcurrentassets ...................................................... 2,893 4,443
Propertyandequipment,atcost:
Flightequipment .......................................................... 13,722 13,019
Groundpropertyandequipment .............................................. 1,769 1,515
Depositsonflightequipmentpurchasecontracts ................................. 380 626
15,871 15,160
Lessallowancefordepreciationandamortization ................................ 4,831 4,286
11,040 10,874
Otherassets ................................................................ 375 1,455
$14,308 $16,772
LIABILITIESANDSTOCKHOLDERS’EQUITY
Currentliabilities:
Accountspayable ......................................................... $ 668 $ 759
Accruedliabilities ......................................................... 1,012 3,107
Airtrafficliability ......................................................... 963 931
Currentmaturitiesoflong-termdebt........................................... 163 41
Totalcurrentliabilities ................................................... 2,806 4,838
Long-termdebtlesscurrentmaturities ........................................... 3,498 2,050
Deferredincometaxes........................................................ 1,904 2,535
Deferredgainsfromsaleandleasebackofaircraft .................................. 105 106
Otherdeferredliabilities ...................................................... 1,042 302
Commitmentsandcontingencies
Stockholders’equity:
Commonstock,$1.00parvalue:2,000,000,000sharesauthorized;807,611,634shares
issuedin2008and2007 .................................................... 808 808
Capitalinexcessofparvalue ................................................ 1,215 1,207
Retainedearnings ......................................................... 4,919 4,788
Accumulatedothercomprehensiveincome(loss) ................................ (984) 1,241
Treasurystock,atcost:67,619,062and72,814,104sharesin2008and2007,
respectively ............................................................ (1,005) (1,103)
Totalstockholders’equity ................................................. 4,953 6,941
$14,308 $16,772
Seeaccompanyingnotes.
44
258 SUPPLEMENT TO CHAPTER 5
SOUTHWESTAIRLINESCO.
CONSOLIDATEDSTATEMENTOFINCOME
YearsEndedDecember31,
2008 2007 2006
(Inmillions,except
pershareamounts)
OPERATINGREVENUES:
Passenger ................................................. $10,549 $9,457 $8,750
Freight .................................................... 145 130 134
Other ..................................................... 329 274 202
Totaloperatingrevenues.................................... 11,023 9,861 9,086
OPERATINGEXPENSES:
Salaries,wages,andbenefits .................................. 3,340 3,213 3,052
Fuelandoil ................................................ 3,713 2,690 2,284
Maintenancematerialsandrepairs .............................. 721 616 468
Aircraftrentals ............................................. 154 156 158
Landingfeesandotherrentals ................................. 662 560 495
Depreciationandamortization ................................. 599 555 515
Otheroperatingexpenses ..................................... 1,385 1,280 1,180
Totaloperatingexpenses ................................... 10,574 9,070 8,152
OPERATINGINCOME ...................................... 449 791 934
OTHEREXPENSES(INCOME):
Interestexpense............................................. 130 119 128
Capitalizedinterest .......................................... (25) (50) (51)
Interestincome ............................................. (26) (44) (84)
Other(gains)losses,net ...................................... 92 (292) 151 |
Totalotherexpenses(income) ............................... 171 (267) 144
INCOMEBEFOREINCOMETAXES .......................... 278 1,058 790
PROVISIONFORINCOMETAXES ........................... 100 413 291
NETINCOME .............................................. $ 178 $ 645 $ 499
NETINCOMEPERSHARE,BASIC ........................... $ .24 $ .85 $ .63
NETINCOMEPERSHARE,DILUTED......................... $ .24 $ .84 $ .61
Seeaccompanyingnotes.
45
How to Read an Annual Report 259
SOUTHWESTAIRLINESCO.
CONSOLIDATEDSTATEMENTOFSTOCKHOLDERS’EQUITY
YearsEndedDecember31,2008,2007,and2006
Accumulated
Capitalin other
Common excessof Retained comprehensive Treasury
Stock parvalue earnings income(loss) stock Total
(Inmillions,exceptpershareamounts)
BalanceatDecember31,2005 ................ $802 $ 963 $4,018 $ 892 $ — $ 6,675
Purchaseofsharesoftreasurystock .......... — — — — (800) (800)
Issuanceofcommonandtreasurystockpursuant
toEmployeestockplans ................. 6 39 (196) — 410 259
Taxbenefitofoptionsexercised ............. — 60 — — — 60
Share-basedcompensation ................. — 80 — — — 80
Cashdividends,$.018pershare ............. — — (14) — — (14)
Comprehensiveincome(loss)
Netincome ........................... — — 499 — — 499
Unrealized(loss)onderivativeinstruments .. — — — (306) — (306)
Other ................................ — — — (4) — (4)
Totalcomprehensiveincome............ 189
BalanceatDecember31,2006 ................ $808 $1,142 $4,307 $ 582 $ (390) $ 6,449
Purchaseofsharesoftreasurystock .......... — — — — (1,001) (1,001)
Issuanceofcommonandtreasurystockpursuant
toEmployeestockplans ................. — — (150) — 288 138
Taxbenefitofoptionsexercised ............. — 28 — — — 28
Share-basedcompensation ................. — 37 — — — 37
Cashdividends,$.018pershare ............. — — (14) — — (14)
Comprehensiveincome(loss)
Netincome ........................... — — 645 — — 645
Unrealizedgainonderivativeinstruments ... — — — 636 — 636
Other ................................ — — — 23 — 23
Totalcomprehensiveincome............ 1,304
BalanceatDecember31,2007 ................ $808 $1,207 $4,788 $ 1,241 $(1,103) $ 6,941
Purchaseofsharesoftreasurystock ........ — — — — (54) (54)
Issuanceofcommonandtreasurystock
pursuanttoEmployeestockplans ........ — — (34) — 152 118
Taxbenefitofoptionsexercised ............ — (10) — — — (10)
Share-basedcompensation ................ — 18 — — — 18
Cashdividends,$.018pershare ............ — — (13) — — (13)
Comprehensiveincome(loss)
Netincome ........................... — — 178 — — 178
Unrealized(loss)onderivative
instruments......................... — — — (2,166) — (2,166)
Other ................................ — — — (59) — (59)
Totalcomprehensiveincome(loss) ..... (2,047)
BalanceatDecember31,2008 ............... $808 $1,215 $4,919 $ (984) $(1,005) $ 4,953
Seeaccompanyingnotes.
46
260 SUPPLEMENT TO CHAPTER 5
SOUTHWESTAIRLINESCO.
CONSOLIDATEDSTATEMENTOFCASHFLOWS
YearsEndedDecember31,
2008 2007 2006
(Inmillions)
CASHFLOWSFROMOPERATINGACTIVITIES:
Netincome ....................................................... $ 178 $ 645 $ 499
Adjustmentstoreconcilenetincometonetcashprovidedbyoperating
activities:
Depreciationandamortization ...................................... 599 555 515
Deferredincometaxes ............................................ 56 328 277
Amortizationofdeferredgainsonsaleandleasebackofaircraft ........... (12) (14) (16)
Share-basedcompensationexpense .................................. 18 37 80
Excesstaxbenefitsfromshare-basedcompensationarrangements.......... — (28) (60)
Changesincertainassetsandliabilities:
Accountsandotherreceivables ................................... 71 (38) (5)
Othercurrentassets ............................................ (384) (229) 87
Accountspayableandaccruedliabilities ............................ (1,853) 1,609 (223)
Airtrafficliability ............................................. 32 131 150
Other,net ...................................................... (226) (151) 102
Netcashprovidedby(usedin)operatingactivities .................... (1,521) 2,845 1,406
CASHFLOWSFROMINVESTINGACTIVITIES: |
Purchasesofpropertyandequipment,net ............................... (923) (1,331) (1,399)
Purchasesofshort-terminvestments ................................... (5,886) (5,086) (4,509)
Proceedsfromsalesofshort-terminvestments ........................... 5,831 4,888 4,392
DebtorinpossessionloantoATAAirlines,Inc. .......................... — — 20
Other,net ........................................................ — — 1
Netcashusedininvestingactivities ............................... (978) (1,529) (1,495)
CASHFLOWSFROMFINANCINGACTIVITIES:
Issuanceoflong-termdebt ........................................... 1,000 500 300
Proceedsfromcreditlineborrowing ................................... 91 — —
Proceedsfromrevolvingcreditagreement .............................. 400 — —
Proceedsfromsaleandleasebacktransactions ........................... 173 — —
ProceedsfromEmployeestockplans .................................. 117 139 260
Paymentsoflong-termdebtandcapitalleaseobligations ................... (55) (122) (607)
Paymentsofcashdividends .......................................... (13) (14) (14)
Repurchaseofcommonstock ........................................ (54) (1,001) (800)
Excesstaxbenefitsfromshare-basedcompensationarrangements............ — 28 60
Other,net ........................................................ (5) (23) —
Netcashprovidedby(usedin)financingactivities .................... 1,654 (493) (801)
NETINCREASE(DECREASE)INCASHANDCASHEQUIVALENTS .... (845) 823 (890)
CASHANDCASHEQUIVALENTSATBEGINNINGOFPERIOD ........ 2,213 1,390 2,280
CASHANDCASHEQUIVALENTSATENDOFPERIOD ............... $ 1,368 $ 2,213 $ 1,390
SUPPLEMENTALDISCLOSURES
Cashpaymentsfor:
Interest,netofamountcapitalized ..................................... $ 100 $ 63 $ 78
Incometaxes...................................................... $ 71 $ 94 $ 15
Seeaccompanyingnotes.
47
How to Read an Annual Report 261
NOTESTOCONSOLIDATEDFINANCIALSTATEMENTS
December31,2008
1. SummaryofSignificantAccountingPolicies issuedbymajorcorporationsandfinancialinstitutions,
short-term securities issued by the U.S. Government,
BasisofPresentation
and certain auction rate securities with auction reset
Southwest Airlines Co. (the Company) is a major periodsoflessthan12monthsforwhichauctionshave
domestic airline that provides point-to-point, low-fare beensuccessfulorareexpectedtobesuccessfulwithin
service. The Consolidated Financial Statements the following 12 months. All of these investments are
include the accounts of the Company and its wholly classified asavailable-for-sale securities andarestated
owned subsidiaries. All significant intercompany at fair value, except for $17 million in auction rate
balances and transactions have been eliminated. The securities that are classified as trading securities as
preparation of financial statements in conformity with discussedinNote11.Forallshort-terminvestments,at
generally accepted accounting principles in the United each reset period, the Company accounts for the
States (GAAP) requires management to make transaction as “Proceeds from sales of short-term
estimates and assumptions that affect the amounts investments” for the security relinquished, and a
reported in the financial statements and accompanying “Purchase of short-investments” for the security
notes.Actualresultscoulddifferfromtheseestimates. purchased, in the accompanying Consolidated
Statement ofCashFlows.Unrealized gainsandlosses,
Certain prior period amounts have been net of tax, are recognized in “Accumulated other
reclassified to conform to the current presentation. In comprehensive income (loss)” in the accompanying
the Consolidated Statement of Income for the years Consolidated Balance Sheet. Realized net gains on
ended December 31, 2007 and 2006, jet fuel sales specific investments, which totaled $13 million in
taxes and jet fuel excise taxes are both presented as a 2008, $17 million in 2007, and $17 million in 2006,
component of “Fuel and oil” instead ofbeingincluded arereflectedin“Interestincome”intheaccompanying
in“Otheroperatingexpenses”aspreviouslypresented. ConsolidatedStatementofIncome. |
For the years ended December 31, 2007 and 2006, the
Companyreclassified atotalof$154millionand$146 The Company’s cash and cash equivalents and
million,respectively, injetfuelsalestaxesandjetfuel short-term investments as of December 31, 2007
excise taxes as a result of this change in presentation. included $2.0 billion in collateral deposits received
For the year ended December 31,2008,“Fuelandoil” from a counterparty of the Company’s fuel derivative
includes$187millioninjetfuelsalestaxesandjetfuel instruments. As of December 31, 2008, the Company
excisetaxes. did not hold any cash collateral deposits from
counterparties, but had $240 million of its cash on
Cashandcashequivalents deposit with a counterparty. Although amounts
provided or held are not restricted in any way,
Cash in excess of that necessary for operating investment earnings from these deposits generally
requirements is invested in short-term, highly liquid, must be remitted back to the entity that provided the
income-producing investments. Investments with deposit.DependingonthefairvalueoftheCompany’s
maturitiesofthreemonthsorlessareclassifiedascash fuel derivative instruments, the amounts of collateral
and cash equivalents, which primarily consist of deposits held or provided at any point in time can
certificates of deposit, money market funds, and fluctuate significantly. Therefore, the Company
investment grade commercial paper issued by major generally excludes cash collateral deposits held, but
corporations and financial institutions. Cash and cash includes deposits provided, in its decisions related to
equivalents are stated at cost, which approximates long-term cash planning and forecasting. See Note 10
marketvalue. forfurther information onthesecollateral depositsand
fuelderivativeinstruments.
Short-terminvestments
Accountsandotherreceivables
Short-term investments consist of investments
with maturities of greater than three months but less Accountsandotherreceivablesarecarriedatcost.
than twelve months. These are primarily money They primarily consist of amounts due from credit
market funds and investment grade commercial paper card companies associated with sales of tickets
48
262 SUPPLEMENT TO CHAPTER 5
NOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)
forfuturetravelandamountsduefromcounterparties losses associated withtheuseofthelong-lived asset.
associated with fuel derivative instruments that have Excluding the impact of cash collateral deposits with
settled. The amount of allowance for doubtful counterparties based on the fair value of the
accounts as of December 31, 2008, 2007, and 2006 Company’sfuelderivativeinstruments,theCompany
was immaterial. In addition, the provision for continuestoexperiencepositivecashflowassociated
doubtful accounts and write-offs for 2008, 2007, and with its aircraft fleet, and there have been no
2006wereimmaterial. impairments of long-lived assets recorded during
2008,2007,or2006.
Inventories
Aircraftandenginemaintenance
Inventoriesprimarilyconsistofflightequipment
expendable parts, materials, aircraft fuel, and The cost of scheduled inspections and repairs
supplies. All of these items are carried at average and routine maintenance costs for all aircraft and
cost,lessanallowanceforobsolescence.Theseitems engines are charged to maintenance expense as
aregenerallychargedtoexpensewhenissuedforuse. incurred.Modificationsthatsignificantlyenhancethe
The reserve for obsolescence was immaterial at operating performance or extend the useful lives of
December 31, 2008, 2007, and 2006. In addition, the aircraft orenginesarecapitalizedandamortizedover
Company’sprovisionforobsolescenceandwrite-offs theremaininglifeoftheasset.
for2008,2007,and2006wasimmaterial.
Intangibleassets
Propertyandequipment
Intangible assets primarily consist of leasehold
Property and equipment is stated at cost. rights to airport owned gates. These assets are
Depreciation is provided by the straight-line method amortized on a straight-line basis over the expected
to estimated residual values over periods generally useful life of the lease, approximately 20 years. The |
ranging from 23to 25yearsforflight equipment and accumulated amortization related to the Company’s
5 to 30 years for ground property and equipment intangible assets at December 31, 2008, and 2007,
once the asset is placed in service. Residual values was $12 million and $9 million, respectively. The
estimated for aircraft are generally 10 to 15 percent Company periodically assesses its intangible assets
and for ground property and equipment range from for impairment in accordance with SFAS 142,
zero to 10 percent. Property under capital leases and Goodwill and Other Intangible Assets; however, no
related obligations is recorded at an amount equal to impairmentshavebeennoted.
the present value of future minimum lease payments
computedonthebasisoftheCompany’sincremental
Revenuerecognition
borrowing rate or, when known, the interest rate
implicit in the lease. Amortization of property under Tickets sold are initially deferred as “Air traffic
capitalleasesisonastraight-line basisoverthelease liability”. Passenger revenue is recognized when
termandisincludedindepreciationexpense. transportation is provided. “Air traffic liability”
primarily represents tickets sold for future travel
When appropriate, the Company evaluates its dates and estimated refunds and exchanges of tickets
long-lived assets used in operations for impairment. sold for past travel dates. The majority of the
Impairment losses would be recorded when events Company’s tickets sold are nonrefundable. Tickets
and circumstances indicate that an asset might be thataresoldbutnotflownonthetraveldate(whether
impaired and the undiscounted cash flows to be refundable or nonrefundable) can be reused for
generated by that asset are less than the carrying another flight, up to a year from the date of sale, or
amounts of the asset. Factors that would indicate refunded (if the ticket is refundable). A small
potential impairment include, but are not limited to, percentage of tickets (or partial tickets) expire
significant decreases in the market value ofthelong- unused.TheCompanyestimatestheamountoffuture
lived asset(s), a significant change in the long-lived refunds and exchanges, net of forfeitures, for all
asset’sphysicalcondition,andoperatingorcashflow unusedticketsoncetheflightdatehaspassed.
49
How to Read an Annual Report 263
NOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)
The Company is also required to collect certain December 31, 2008, 2007, and 2006 was $199
taxes and fees from Customers on behalf of million,$191million,and$182million,respectively.
government agencies and remit these back to the
applicable governmental entity on a periodic basis.
Share-basedEmployeecompensation
These taxes and fees include U.S. federal
transportation taxes, federal security charges, and The Company has share-based compensation
airport passenger facility charges. These items are plans covering the majority of its Employee groups,
collected from Customers at the time they purchase including a plan covering the Company’s Board of
their tickets, but are not included in Passenger Directors and plans related to employment contracts
revenue. The Company records a liability upon with the Chairman Emeritus of the Company. The
collection from the Customer and relieves the Company accounts for share-based compensation
liabilitywhenpaymentsareremittedtotheapplicable utilizing the fair value recognition provisions of
governmentalagency. SFAS No. 123R, “Share-Based Payment.” See Note
14.
Frequentflyerprogram
The Company records a liability for the Financialderivativeinstruments
estimated incremental cost of providing free travel
The Company accounts for financial derivative
under its Rapid Rewards frequent flyer program at
instruments utilizing Statement of Financial
the time an award is earned. The estimated
Accounting Standards No. 133 (SFAS 133),
incremental cost includes direct passenger costs such
“AccountingforDerivativeInstruments andHedging
as fuel, food, and other operational costs, but does
Activities,” as amended. The Company utilizes
notincludeanycontributiontooverheadorprofit. |
various derivative instruments, including crude oil,
unleaded gasoline, and heating oil-based derivatives,
The Company also sells frequent flyer credits
toattempttoreducetheriskofitsexposuretojetfuel
and related services to companies participating in its
price increases. These instruments primarily consist
Rapid Rewards frequent flyer program. Funds
ofpurchasedcalloptions,collarstructures,andfixed-
received from the sale of flight segment credits are
priceswapagreements,anduponproperqualification
accountedforundertheresidualvaluemethod.Under
are accounted for as cash-flow hedges, as defined by
thismethod,theCompanyhasdeterminedtheportion
SFAS 133. The Company has also entered into
of funds received for sale of flight segment credits
interest rate swap agreements to convert a portion of
that relate to free travel, currently estimated at 81
its fixed-rate debt to floating rates and one floating-
percent of the amount received per flight segment
rate debt issuance to a fixed-rate. These interest rate
credit sold. These amounts are deferred and
hedges are accounted for as fair value hedges or as
recognizedas“Passengerrevenue”whentheultimate
cashflowhedges,asdefinedbySFAS133.
free travel awards are flown or the credits expire
unused. The remaining 19 percent of the amount
Since the majority of the Company’s financial
received per flight segment credit sold, which is
derivative instruments are not traded on a market
assumed not to be associated with future travel,
exchange, the Company estimates their fair values.
includes items such as access to the Company’s
Depending on the type of instrument, the values are
frequent flyer program population for marketing/
determined by the use of present value methods or
solicitation purposes, use of the Company’s logo on
standardoptionvaluemodelswithassumptionsabout
co-branded credit cards, and other trademarks,
commodity prices based on those observed in
designs, images, etc. of the Company for use in
underlyingmarkets.Also,sincethereisnotareliable
marketing materials. This remaining portion is
forward market for jet fuel, the Company must
recognizedin“Otherrevenue”intheperiodearned.
estimate the future prices of jet fuel in order to
measure the effectiveness of the hedging instruments
Advertising
in offsetting changes to those prices, as required by
The Company expenses the costs of advertising SFAS 133. Forward jet fuel prices are estimated
as incurred. Advertising expense for the years ended through utilization of a statistical-based regression
50
264 SUPPLEMENT TO CHAPTER 5
NOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)
equationwithdatafrommarketforwardpricesoflike liabilities, as measured by current enacted tax rates.
commodities. This equation is then adjusted for Whenappropriate,inaccordancewithSFAS109,the
certain items, such as transportation costs, that are Company evaluates the need for a valuation
stated in the Company’s fuel purchasing contracts allowancetoreducedeferredtaxassets.
withitsvendors.
TheCompany’spolicyforrecordinginterestand
For the effective portion of settled hedges, as penalties associated with audits is to record such
defined in SFAS 133, the Company records the items as a component of income before taxes.
associated gains or losses as a component of “Fuel Penalties are recorded in “Other (gains) losses, net,”
and oil” expense in the Consolidated Statement of and interest paid or received is recorded in interest
Income. For amounts representing ineffectiveness, as expense or interest income, respectively, in the
defined, or changes in fair value of derivative statement of income. For the year ended
instruments for which hedge accounting is not December 31, 2008, the Company recorded no
applied,theCompanyrecordsanygainsorlossesasa interest related to the settlement of audits for certain
component of “Other (gains) losses, net”, in the priorperiods.
Consolidated Statement of Income. Amounts that are
paid or received associated with the purchase or sale ConcentrationRisk
of financial derivative instruments (i.e., premium
Approximately 77 percent of the Company’s |
costs of option contracts) are classified as a
Employees are unionized and are covered by
component of “Other (gains) losses, net”, in the
collective bargaining agreements. Historically, the
Consolidated Statement of Income in the period in
Company has managed this risk by maintaining
which the instrument settles or expires. All cash
positive relationships with its Employees and its
flows associated with purchasing and selling
Employee’s Representatives. The following
derivatives are classified as operating cash flows in
Employee groups are under agreements that have
the Consolidated Statement of Cash Flows, within
become amendable and are currently in negotiations:
“Changes in certain assets and liabilities.” See Note
Pilots, Flight Attendants, Ramp, Operations,
10forfurtherinformationonSFAS133andfinancial
Provisioning, and Freight Agents, Stock Clerks, and
derivativeinstruments.
Customer Service and Reservations Agents. The
Company reached a Tentative Agreement with its
Softwarecapitalization Mechanics during fourth quarter 2008, and the
agreement was ratified by this group during
TheCompanycapitalizescertaincostsrelatedto
January 2009. The Company’s Aircraft Appearance
the acquisition and development of software in
Technicians and its Flight Dispatchers are subject to
accordance with Statement of Position 98-1,
agreementsthatbecomeamendableduring2009.
“Accounting for the Costs of Computer Software
Developed or Obtained for Internal Use.” The The Company attempts to minimize its
Companyamortizesthesecostsusingthestraight-line concentration risk with regards to its cash, cash
method over the estimated useful life of the software equivalents, and its investment portfolio. This is
whichisgenerallyfiveyears. accomplished by diversifying and limiting amounts
among different counterparties, the type of
investment, and the amount invested in any
Incometaxes
individualsecurityormoneymarketfund.
The Company accounts for deferred income
taxes utilizing Statement of Financial Accounting To manage risk associated with financial
Standards No. 109 (SFAS 109), “Accounting for derivativeinstrumentsheld,theCompanyselectsand
Income Taxes”, as amended. SFAS 109 requires an will periodically review counterparties based on
asset and liability method, whereby deferred tax credit ratings, limits its exposure to a single
assets and liabilities are recognized based on the tax counterparty,andmonitorsthemarketpositionofthe
effects of temporary differences between the program and its relative market position with each
financial statements and the tax bases of assets and counterparty.TheCompanyalsohasagreementswith
51
How to Read an Annual Report 265
NOTESTOCONSOLIDATEDFINANCIALSTATEMENTS—(Continued)
counterparties containing early termination rights The Company operates an all-Boeing 737 fleet
and/or bilateral collateral provisions whereby of aircraft. If the Company was unable to acquire
securityisrequiredifmarketriskexposureexceedsa additional aircraft from Boeing, or Boeing was
specified threshold amount or credit ratings fall unable or unwilling to provide adequate support for
below certain levels. At December 31, 2008, the its products, the Company’s operations could be
Company had provided $240 million in cash adversely impacted. However, the Company
collateral deposits to one of its counterparties under considers its relationship with Boeing to be excellent
these bilateral collateral provisions. The cash and believes the advantages of operating a single
collateral provided to the counterparty has been fleettypeoutweightherisksofsuchastrategy.
recorded as a reduction to “Cash and cash
equivalents” and an increase to “Prepaid expenses
and other current assets.” Cash collateral deposits
serve to decrease, but not totally eliminate, thecredit
risk associated with the Company’s hedging
program.SeeNote10forfurtherinformation.
52
C H A P T E R
The Operating Cycle
6
and Merchandising
Operations
B uying and selling goods and services is fundamental to the
Making a
Statement operation of retail and wholesale merchandising businesses. |
Managers who do not understand the dynamics of the cash flows
INCOME STATEMENT
of buying and selling merchandise and collecting from customers
Revenues
run the risk of putting their company in bankruptcy. Today’s global
– Expenses
environment, in which many goods are purchased and sold over-
seas, presents managers with additional challenges. In this chap-
= Net Income
ter, we address the management of the operating cycle, the choice
STATEMENT OF of inventory systems, merchandising income statements, and the
OWNER’S EQUITY
recording of merchandising transactions.
Beginning Balance
+ Net Income
– Withdrawals LEARNING OBJECTIVES
= Ending Balance
LO1 Identify the management issues related to merchandising
businesses. (pp. 268–272)
BALANCE SHEET
Assets Liabilities LO2 Describe the terms of sale related to merchandising
transactions. (pp. 272–275)
Owner’s
LO3 Prepare an income statement and record merchandising
Equity
trans act ions under the perpetual inventory system.
A = L + OE (pp. 275–280)
LO4 Prepare an income statement and record merchandising
STATEMENT OF CASH FLOWS transactions under the periodic inventory system.
Operating activities
(pp. 281–286)
+ Investing activities
+ Financing activities
= Change in Cash
Merch+a Bnedgiisninningg t Braanlasnacections
can affect all the financial
= Ending Cash Balance
statements.
Merchandising transactions
can affect all the financial
statements.
266
DECISION POINT (cid:2) A USER’S FOCUS (cid:2) How can merchandising
transactions be recorded
FONG COMPANY
to reflect the company’s
performance?
Fong Company is a small but successful and fast-growing merchan- (cid:2) How can the company
dising company that specializes in selling stylish, low-priced fashions efficiently manage its cycle
of merchandising operations?
to young people. Like all merchandisers, Fong has two key decisions
to make: the price at which it will sell goods and the level of service
it will provide. A department store may set the price of its merchan-
dise at a relatively high level and provide a great deal of service. A
discount store, on the other hand, may price its merchandise at a
relatively low level and provide limited service. Fong Company is a
discount merchandiser.
A list of Fong’s transactions during a typical month appears on
the next page. Such transactions make up the company’s merchan-
dising, or operating, cycle. Fong has to know how to record these
transactions so that its financial statements give an accurate picture
of the company’s performance. Fong also has to know how to man-
age its merchandising cycle efficiently so that it has adequate cash
on hand to maintain liquidity.
226677
268 CHAPTER 6 The Operating Cycle and Merchandising Operations
July 1 Sold merchandise to Pablo Lopez on credit, terms n/30, FOB shipping
point, $2,100 (cost, $1,260).
2 Purchased merchandise on credit from Dorothy Company, terms n/30,
FOB shipping point, $3,800.
2 Paid Custom Freight $290 for freight charges on merchandise received.
9 Purchased merchandise on credit from MNR Company, terms n/30,
FOB shipping point, $3,600, including $200 freight costs paid by MNR
Company.
11 Accepted from Pablo Lopez a return of merchandise, which was returned
to inventory, $300 (cost, $180).
14 Returned for credit $600 of merchandise purchased on July 2.
16 Sold merchandise for cash, $1,000 (cost, $600).
22 Paid Dorothy Company for purchase of July 2 less return on July 14.
23 Received full payment from Pablo Lopez for his July 1 purchase, less
return on July 11.
Managing
A merchandising business earns income by buying and selling goods, which
Merchandising are called merchandise inventory. Whether a merchandiser is a wholesaler or a
retailer, it uses the same basic accounting methods as a service company. How-
Businesses
ever, the buying and selling of goods adds to the complexity of the business and
of the accounting process. To understand the issues involved in accounting for a
LO1 Identify the management merchandising business, one must be familiar with the issues involved in manag-
issues related to merchandising ing such a business. |
businesses.
Operating Cycle
Merchandising businesses engage in a series of transactions called the operating cycle.
Study Note Figure 6-1 shows the transactions that make up this cycle. Some companies buy mer-
chandise for cash and sell it for cash, but these companies are usually small companies,
A company must provide
such as a produce market or a hot dog stand. Most companies buy merchandise on
financing for the average
credit and sell it on credit, thereby engaging in the following four transactions:
days’ inventory on hand plus
the average number of days 1. Purchase of merchandise inventory for cash or on credit
to collect credit sales less the
2. Payment for purchases made on credit
average number of days it is
allowed to pay its suppliers.
3. Sales of merchandise inventory for cash or on credit
4. Collection of cash from credit sales
The first three transactions represent the time it takes to purchase inventory, sell
it, and collect for it. Merchandisers must be able to do without the cash for this
period of time either by relying on cash flows from other sources within the com-
pany or by borrowing. If they lack the cash to pay bills when they come due, they
can be forced out of business. Thus managing cash flow is a critical concern.
The suppliers that sold the company the merchandise usually also sell on
credit and thus help alleviate the cash flow problem by providing financing for a
period of time before they require payment (transaction 4). However, this period
is rarely as long as the operating cycle. The period between the time the supplier
must be paid and the end of the operating cycle is sometimes referred to as the
cash gap, and more formally as the financing period.
The financing period, illustrated in Figure 6-2, is the amount of time from
the purchase of inventory until it is sold and payment is collected, less the amount
Managing Merchandising Businesses 269
FIGURE 6-1 Purchases
Cash Flows in the for cash
Operating Cycle
Payment ACCOUNTS Purchase MERCHANDISE
CASH
of cash PAYABLE on credit INVENTORY
Sales for cash
Collection Sales on
of cash credit
ACCOUNTS
RECEIVABLE
of time creditors give the company to pay for the inventory. Thus, if it takes
60 days to sell the inventory, 60 days to collect for the sale, and creditors’ pay-
ment terms are 30 days, the financing period is 90 days. During the financing
period, the company will be without cash from this series of transactions and will
need either to have funds available internally or to borrow from a bank.
The type of merchandising operation in which a company engages can affect
the financing period. For example, compare Costco’s financing period with that
of a traditional discount store chain, Target Corporation:
Target Costco Difference
Days’ inventory on hand 56 days 31 days (25) days
Days’ receivable 34 4 (30)
Less days’ payable (59) (31) (28)
Financing period 31 days 4 days (27) days
Costco has an advantage over Target because it holds its inventory for a shorter
period before it sells it and collects receivables much faster. Its very short financ-
ing period is one of the reasons Costco can charge such low prices. Helpful ratios
for calculating the three components of the financing period will be covered in
subsequent chapters on inventories, receivables, and current liabilities.
By reducing its financing period, a company can improve its cash flow. Many
merchandisers, including Costco, do this by selling as much as possible for cash.
FIGURE 6-2 1. Inventory 2. Inventory
The Financing Period Purchased Sold
OPERATING CYCLE
INVENTORY
PAYABLES RECEIVABLES
FINANCING PERIOD
0 20 40 60 80 100 120
Days
4. Cash Paid 3. Cash Received
270 CHAPTER 6 The Operating Cycle and Merchandising Operations
Cash sales include sales made on bank credit cards, such as Visa or MasterCard,
Study Note and on debit cards, which draw directly on the purchaser’s bank account. They
are considered cash sales because funds from them are available to the merchan-
A sale takes place when title to
diser immediately. Small retail stores may have mostly cash sales and very few |
the goods transfers to the buyer.
credit sales, whereas large wholesale concerns may have almost all credit sales.
Choice of Inventory System
Another issue in managing a merchandising business is the choice of inventory
system. Management must choose the system or combination of systems that
best achieves the company’s goals. The two basic systems of accounting for the
many items in merchandise inventory are the perpetual inventory system and the
periodic inventory system.
Under the perpetual inventory system, continuous records are kept of the
Study Note quantity and, usually, the cost of individual items as they are bought and sold. Under
this system, the cost of each item is recorded in the Merchandise Inventory account
Under the perpetual inventory
when it is purchased. As merchandise is sold, its cost is transferred from the Merchan-
system, the Merchandise
dise Inventory account to the Cost of Goods Sold account. Thus, at all times the
Inventory account and the
balance of the Merchandise Inventory account equals the cost of goods on hand, and
Cost of Goods Sold account are
the balance in Cost of Goods Sold equals the cost of merchandise sold to customers.
updated with every sale.
Managers use the detailed data that the perpetual inventory system provides
to respond to customers’ inquiries about product availability, to order inventory
more effectively and thus avoid running out of stock, and to control the costs
associated with investments in inventory.
Under the periodic inventory system, the inventory not yet sold, or on
Study Note hand, is counted periodically. This physical count is usually taken at the end of the
accounting period. No detailed records of the inventory on hand are maintained
The value of ending inventory
during the accounting period. The figure for inventory on hand is accurate only
on the balance sheet is
on the balance sheet date. As soon as any purchases or sales are made, the inven-
determined by multiplying the
tory figure becomes a historical amount, and it remains so until the new ending
quantity of each inventory item
inventory amount is entered at the end of the next accounting period.
by its unit cost.
Some retail and wholesale businesses use the periodic inventory system
because it reduces the amount of clerical work. If a business is fairly small, man-
agement can maintain control over its inventory simply through observation or
by using an offline system of cards or computer records. But for larger businesses,
the lack of detailed records may lead to lost sales or high operating costs.
Because of the difficulty and expense of accounting for the purchase and sale
of each item, companies that sell items of low value in high volume have tradi-
tionally used the periodic inventory system. Examples of such companies include
drugstores, automobile parts stores, department stores, and discount stores. In
contrast, companies that sell items that have a high unit value, such as appliances
or automobiles, have tended to use the perpetual inventory system.
The distinction between high and low unit value for inventory systems has
blurred considerably in recent years. Although the periodic inventory system is
still widely used, computerization has led to a large increase in the use of the per-
petual inventory system. It is important to note that the perpetual inventory sys-
tem does not eliminate the need for a physical count of the inventory. A physical
count of inventory should be taken periodically to ensure that the actual number
of goods on hand matches the quantity indicated by the computer records.
Foreign Business Transactions
Most large merchandising and manufacturing firms and even many small ones
transact some of their business overseas. For example, a U.S. manufacturer may
expand by selling its product to foreign customers, or it may lower its product
cost by buying a less expensive part from a source in another country. Such sales
Managing Merchandising Businesses 271
FOCUS ON BUSINESS PRACTICE
How Have Bar Codes Influenced the Choice of Inventory Systems? |
Most grocery stores, which traditionally used the periodic retail companies, and in manufacturing firms and hospitals
inventory system, now employ bar coding to update the as well. It has also become a major factor in the increased
physical inventory as items are sold. At the checkout coun- use of the perpetual inventory system. Interestingly, some
ter, the cashier scans the electronic marking on each prod- retail businesses now use the perpetual inventory system
uct, called a bar code or universal product code (UPC), into for keeping track of the physical flow of inventory and
the cash register, which is linked to a computer that records the periodic inventory system for preparing their financial
the sale. Bar coding has become common in all types of statements.
and purchase transactions may take place in Japanese yen, British pounds, or some
other foreign currency.
When an international transaction involves two different currencies, as most
such transactions do, one currency has to be translated into another by using an
exchange rate. As we noted earlier in the text, an exchange rate is the value of one
currency stated in terms of another. We also noted that the values of other cur-
rencies in relation to the dollar rise and fall daily according to supply and demand.
Thus, if there is a delay between the date of sale or purchase and the date of
receipt of payment, the amount of cash involved in an international transaction
may differ from the amount originally agreed on.
If the billing of an international sale and the payment for it are both in the
domestic currency, no accounting problem arises. For example, if a U.S. maker of
precision tools sells $160,000 worth of its products to a British company and bills
the British company in dollars, the U.S. company will receive $160,000 when it
collects payment. However, if the U.S. company bills the British company in Brit-
ish pounds and accepts payment in pounds, it will incur an exchange gain or loss
if the exchange rate between dollars and pounds changes between the date of sale
and the date of payment.
For example, assume that the U.S. company billed the sale of $200,000 at
£100,000, reflecting an exchange rate of 2.00 (that is, $2.00 per pound) on the
sale date. Now assume that by the date of payment, the exchange rate has fallen
to 1.90. When the U.S. company receives its £100,000, it will be worth only
$190,000 (£100,000 (cid:6) $1.90 (cid:2) $190,000). It will have incurred an exchange
loss of $10,000 because it agreed to accept a fixed number of British pounds in
payment for its products, and the value of each pound dropped before the pay-
ment was made. Had the value of the pound in relation to the dollar increased,
the company would have made an exchange gain.
The same logic applies to purchases as to sales, except that the relationship of
exchange gains and losses to changes in exchange rates is reversed. For example,
assume that the U.S company purchases products from the British company for
$200,000. If the payment is to be made in U.S. dollars, no accounting problem
arises. However, if the British company expects to be paid in pounds, the U.S.
company will have an exchange gain of $10,000 because it agreed to pay a fixed
£100,000, and between the dates of purchase and payment, the exchange value
of the pound decreased from $2.00 to $1.90. To make the £100,000 payment,
the U.S. company has to expend only $190,000.
Exchange gains and losses are reported on the income statement. Because
of their bearing on a company’s financial performance, they are of considerable
interest to managers and investors. Lack of uniformity in international accounting
standards is another matter of which investors must be wary.
272 CHAPTER 6 The Operating Cycle and Merchandising Operations
STOP
& APPLY
The management of SavRite Company made the decisions below. Indicate whether each decision
pertains primarily to (a) cash flow management, (b) choice of inventory system, or (c) foreign
transactions.
1. Decided to increase the credit terms offered 3. Decided that sales would benefit if sales |
to customers from 20 days to 30 days to people knew the amount of each item of
speed up collection of accounts. inventory that was on hand at any one time.
2. Decided to purchase goods made by a 4. Decided to try to negotiate a longer time to
supplier in India. pay suppliers than had been previously granted.
SOLUTION
1. a; 2. c; 3. b; 4. a
Terms of Sale
When goods are sold on credit, both parties should understand the amount and
timing of payment as well as other terms of the purchase, such as who pays deliv-
LO2 Describe the terms of ery charges and what warranties or rights of return apply. Sellers quote prices
sale related to merchandising in different ways. Many merchants quote the price at which they expect to sell
transactions. their goods. Others, particularly manufacturers and wholesalers, quote prices as
a percentage (usually 30 percent or more) off their list or catalogue prices. Such a
reduction is called a trade discount.
Study Note For example, if an article is listed at $1,000 with a trade discount of 40 percent,
or $400, the seller records the sale at $600, and the buyer records the purchase at
A trade discount applies to the
$600. The seller may raise or lower the trade discount depending on the quantity
list or catalogue price. A sales
purchased. The list or catalogue price and related trade discount are used only to
discount applies to the sales
arrive at an agreed-on price; they do not appear in the accounting records.
price.
Sales and Purchases Discounts
The terms of sale are usually printed on the sales invoice and thus constitute part
of the sales agreement. Terms differ from industry to industry. In some indus-
tries, payment is expected in a short period of time, such as 10 or 30 days. In
these cases, the invoice is marked “n/10” (“net 10”) or “n/30” (“net 30”),
meaning that the amount of the invoice is due either 10 days or 30 days after the
invoice date. If the invoice is due 10 days after the end of the month, it is marked
“n/10 eom.”
In some industries, it is customary to give a discount for early payment. This
Study Note discount, called a sales discount, is intended to increase the seller’s liquidity by
reducing the amount of money tied up in accounts receivable. An invoice that
Early collection also has the
offers a sales discount might be labeled “2/10, n/30,” which means that the
advantage of reducing the
buyer either can pay the invoice within 10 days of the invoice date and take a
probability of a customer’s
2 percent discount or can wait 30 days and pay the full amount of the invoice. It
defaulting.
is often advantageous for a buyer to take the discount because the saving of 2 per-
cent over a period of 20 days (from the 11th day to the 30th day) represents an
effective annual rate of 36.5 percent (365 days (cid:5) 20 days (cid:6) 2% (cid:2) 36.5%). Most
companies would be better off borrowing money to take the discount. The prac-
tice of giving sales discounts has been declining because it is costly to the seller
and because, from the buyer’s viewpoint, the amount of the discount is usually
very small in relation to the price of the purchase.
Terms of Sale 273
Because it is not possible to know at the time of a sale whether the customer
will pay in time to take advantage of a sales discount, the discounts are recorded
only at the time the customer pays. For example, suppose Kloss Motor Company
sells merchandise to a customer on September 20 for $600 on terms of 2/10,
n/30. Kloss records the sale on September 20 for the full amount of $600. If the
customer takes advantage of the discount by paying on or before September 30,
Kloss will receive $588 in cash and will reduce its accounts receivable by $600.
The difference of $12 ($600 (cid:6) 0.02) will be debited to an account called Sales
Discounts. Sales Discounts is a contra-revenue account with a normal debit bal-
ance that is deducted from sales on the income statement.
The same logic applies to purchases discounts, which are discounts that a
buyer takes for the early payment of merchandise. For example, the buyer in the |
transaction described above will record the purchase on September 20 at $600. If
the buyer pays on or before September 30, it will record cash paid of $588 and
reduce its accounts payable by $600. The difference of $12 is recorded as a credit
to an account called Purchases Discounts. The Purchases Discounts account reduces
cost of goods sold or purchases depending on the inventory method used.
Transportation Costs
In some industries, the seller usually pays transportation costs and charges a price
that includes those costs. In other industries, it is customary for the purchaser to
pay transportation charges. Special terms designate whether the seller or the pur-
chaser pays the freight charges.
FOB shipping point means that the seller places the merchandise “free on
board” at the point of origin and the buyer bears the shipping costs. The title to
the merchandise passes to the buyer at that point. For example, when the sales
agreement for the purchase of a car says “FOB factory,” the buyer must pay the
freight from the factory where the car was made to wherever he or she is located,
and the buyer owns the car from the time it leaves the factory. FOB destina-
tion means that the seller bears the transportation costs to the place where the
Shipping terms affect the financial
statements. FOB shipping point means
the buyer pays the freight charges;
when relatively small, these charges
are usually included in cost of goods
sold on the buyer’s income statement.
FOB destination means the seller pays
the freight charges; they are included
in selling expenses on the seller’s
income statement.
Courtesy of Borilov/Dreamstime LLC.
274 CHAPTER 6 The Operating Cycle and Merchandising Operations
merchandise is delivered. The seller retains title until the merchandise reaches its
destination and usually prepays the shipping costs, in which case the buyer makes
no accounting entry for freight. The effects of these special shipping terms are
summarized as follows:
Who Pays the Cost
Shipping Term Where Title Passes of Transportation
FOB shipping point At origin Buyer
FOB destination At destination Seller
When the buyer pays the transportation charge, it is called freight-in, and
it is added to the cost of merchandise purchased. Thus, freight-in increases the
buyer’s cost of merchandise inventory, as well as the cost of goods sold after the
product is sold. When freight-in is a relatively small amount, most companies
include the cost in the cost of goods sold on the income statement rather than
going to the trouble of allocating part of it to merchandise inventory.
Shipping terms affect the financial statements. FOB shipping point means the
buyer pays the freight charges; when relatively small, these charges are usually
included in cost of goods sold on the buyer’s income statement. FOB destination
means the seller pays the freight charges; they are included in selling expenses on the
seller’s income statement. When the seller pays the transportation charge, it is called
delivery expense, or freight-out. Because the seller incurs this cost to facilitate the
sale of its product, the cost is included in selling expenses on the income statement.
Terms of Debit and Credit Card Sales
Many retailers allow customers to use debit or credit cards to charge their pur-
chases. Debit cards deduct directly from a person’s bank account, whereas a
credit card allows for payment later. Five of the most widely used credit cards
are American Express, Discover Card, Diners Club, MasterCard, and Visa. The
customer establishes credit with the lender (the credit card issuer) and receives a
plastic card to use in making charges. If a seller accepts the card, the customer
signs an invoice at the time of the sale. The sale is communicated to the seller’s
bank, resulting in a cash deposit in the seller’s bank account. Thus, the seller
does not have to establish the customer’s credit, collect from the customer, or
tie up money in accounts receivable. As payment, the lender, rather than paying
the total amount of the credit card sales, takes a discount of 2 to 6 percent. The |
discount is a selling expense for the merchandiser. For example, if a restaurant
makes sales of $1,000 on Visa credit cards and Visa takes a 4 percent discount on
the sales, the restaurant would record Cash in the amount of $960 and Credit
Card Expense in the amount of $40.
FOCUS ON BUSINESS PRACTICE
Are We Becoming a Cashless Society?
Are checks and cash obsolete? Do you “swipe it”? Most $1 trillion outnumber the roughly 40 billion checks written
Americans do. About 75 percent of Americans use credit each year. Consumers like the convenience. Retailers, like
or debit cards rather than checks. Debit cards gener- McDonald’s and Starbucks, like the cards, even though
ate more than 16 billion transactions per year. It is esti- there are fees, because use of cards usually increases the
mated that electronic payments totaling more than amount of sales.1
Perpetual Inventory System 275
STOP
& APPLY
A local company sells refrigerators that it buys from the manufacturer.
a. The manufacturer sets a list or catalogue price c. The manufacturer offers a sales discount of
of $1,200 for a refrigerator. The manufacturer 2/10, n/30. Sales discounts do not apply to
offers its dealers a 40 percent trade discount. shipping costs.
b. The manufacturer sells the machine under
terms of FOB shipping point. The cost of
shipping is $120.
What is the net cost of the refrigerator to the dealer, assuming it is paid for within 10 days of purchase?
SOLUTION
a. $1,200 (cid:4) ($1,200 (cid:6) 0.40) (cid:2) $720 c. $840 (cid:4) ($720 (cid:6) 0.02) (cid:2) $825.60
b. $720 (cid:3) $120 (cid:2) $840
Perpetual
Exhibit 6-1 shows how an income statement appears when a company uses the
Inventory System perpetual inventory system. The focal point of the statement is cost of goods sold,
which is deducted from net sales to arrive at gross margin. Under the perpetual
inventory system, the Merchandise Inventory and Cost of Goods Sold accounts
LO3 Prepare an income state-
are continually updated during the accounting period as purchases, sales, and
ment and record merchandising
other inventory transactions that affect these accounts occur.
transactions under the perpetual
inventory system.
Purchases of Merchandise
Figure 6-3 shows how transactions involving purchases of merchandise are recorded
under the perpetual inventory system. As you can see, the focus of these journal entries
is Accounts Payable. In this section, we present a summary of the entries made for
merchandise purchases. (For a comparison of complete journal entries made under the
perpetual and periodic inventory systems, see the Review Problem in this chapter.)
EXHIBIT 6-1
Kloss Motor Company
Income Statement Under the Perpetual
Income Statement
Inventory System
For the Year Ended December 31, 2010
Net sales $957,300
Study Note
Cost of goods sold* 525,440
On the income statement,
Gross margin $431,860
freight-in is included as part of
Operating expenses 313,936
cost of goods sold, and delivery
expense (freight-out) is included Net income $117,924
as an operating (selling)
expense. *Freight-in has been included in cost of goods sold.
276 CHAPTER 6 The Operating Cycle and Merchandising Operations
FIGURE 6-3 Recording Purchase Transactions Under the Perpetual Inventory System
Assets = Liabilities + Owner’s Equity
Cash Accounts Payable
Aug. 10 4,410 Aug. 6 480 Aug. 3 4,890
Payment
10 4,410
on Account
Purchases
Returns and
Merchandise Inventory Allowances
Aug. 3 4,890 Aug. 6 480
Purchases on Credit
Purchases on Credit
Study Note
Aug. 3: Received merchandise purchased on credit, invoice dated Aug. 1, terms
The Merchandise Inventory n/10, $4,890.
account increases when a
purchase is made. Assets (cid:2) Liabilities (cid:3) Owner’s Equity
MERCHANDISE INVENTORY ACCOUNTS PAYABLE
Dr. Cr. Dr. Cr.
Aug. 3 4,890 Aug. 3 4,890
Entry in Journal Form:
Dr. Cr.
Aug. 3 Merchandise Inventory 4,890
Accounts Payable 4,890
Purchases on credit
Comment: Under the perpetual inventory system, the cost of merchandise is
recorded in the Merchandise Inventory account at the time of purchase. In the
transaction described here, payment is due ten days from the invoice date. If an |
invoice includes a charge for shipping or if shipping is billed separately, it should
be debited to Freight-In.
Purchases Returns and Allowances
Aug. 6: Returned part of merchandise received on Aug. 3 for credit, $480.
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
MERCHANDISE INVENTORY ACCOUNTS PAYABLE
Dr. Cr. Dr. Cr.
Aug. 6 480 Aug. 6 480
Entry in Journal Form:
Dr. Cr.
Aug. 6 Accounts Payable 480
Merchandise Inventory 480
Returned merchandise from purchase
Perpetual Inventory System 277
Comment: Under the perpetual inventory system, when a buyer is allowed
to return all or part of a purchase or is given an allowance—a reduction in
the amount to be paid—Merchandise Inventory is reduced, as is Accounts
Payable.
Payments on Account
Aug. 10: Paid amount in full due for the purchase of Aug. 3, part of which was
returned on Aug. 6, $4,410.
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
CASH ACCOUNTS PAYABLE
Dr. Cr. Dr. Cr.
Aug. 10 4,410 Aug. 10 4,410
Entry in Journal Form:
Dr. Cr.
Aug. 10 Accounts Payable 4,410
Cash 4,410
Made payment on account
Comment: Payment is made for the net amount due of $4,410 ($4,890 (cid:4) $480).
Study Note
The Cost of Goods Sold Sales of Merchandise
account is increased and the
Merchandise Inventory account Figure 6-4 shows how transactions involving sales of merchandise are recorded under
is decreased when a sale is the perpetual inventory system. These transactions involve several accounts, including
made. Cash, Accounts Receivable, Merchandise Inventory, Sales Returns and Allowances,
and Cost of Goods Sold.
FIGURE 6-4 Recording Sales Transactions Under the Perpetual Inventory System
Assets = Liabilities + Owner’s Equity
Cash Sales
Sept. 5 900 Aug. 7 1,200
Receipts on Account
Accounts Receivable Sales Returns and Allowances
Aug. 7 1,200 Aug. 9 300 Sales Returns and Allowances Aug. 9 300
Sept. 5 900
Sales on Credit
Merchandise Inventory Cost of Goods Sold
Aug. 9 180 Aug. 7 720 Sales on Credit Aug. 7 720 Aug. 9 180
Sales Returns and Allowances
278 CHAPTER 6 The Operating Cycle and Merchandising Operations
Sales on Credit
Aug. 7: Sold merchandise on credit, terms n/30, FOB destination, $1,200; the
cost of the merchandise was $720.
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
ACCOUNTS RECEIVABLE SALES
Dr. Cr. Dr. Cr.
Aug. 7 1,200 Aug. 7 1,200
Entry in Journal Form:
Dr. Cr.
Aug. 7 Account Receivable 1,200
Sales 1,200
Sold merchandise to
Gonzales Distributors
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
MERCHANDISE INVENTORY COST OF GOODS SOLD
Dr. Cr. Dr. Cr.
Aug. 7 720 Aug. 7 720
Entry in Journal Form:
Dr. Cr.
Aug. 7 Cost of Goods Sold 720
Merchandise Inventory 720
Transferred cost of merchandise
inventory sold to Cost of Goods Sold
Comment: Under the perpetual inventory system, sales always require two
entries, as shown in Figure 6-4. First, the sale is recorded by increasing Accounts
Receivable and Sales. Second, Cost of Goods Sold is updated by a transfer from
Merchandise Inventory. In the case of cash sales, Cash rather than Accounts
Receivable is debited for the amount of the sale. If the seller pays for the ship-
ping, it should be debited to Delivery Expense.
Sales Returns and Allowances
Aug. 9: Accepted return of part of merchandise sold on Aug. 7 for full credit
and returned it to merchandise inventory, $300; the cost of the merchandise
was $180.
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
ACCOUNTS RECEIVABLE SALES RETURNS AND ALLOWANCES
Dr. Cr. Dr. Cr.
Aug. 9 300 Aug. 9 300
Entry in Journal Form:
Dr. Cr.
Aug. 9 Sales Returns and Allowances 300
Accounts Receivable 300
Accepted returns of merchandise
Perpetual Inventory System 279
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
MERCHANDISE INVENTORY COST OF GOODS SOLD
Dr. Cr. Dr. Cr.
Aug. 9 180 Aug. 9 180
Entry in Journal Form:
Dr. Cr.
Aug. 9 Merchandise Inventory 180
Cost of Goods Sold 180
Transferred cost of merchandise
returned to Merchandise Inventory
Comment: Under the perpetual inventory system, when a seller allows the
Study Note buyer to return all or part of a sale or gives an allowance—a reduction in
amount—two entries are again necessary. First, the original sale is reversed |
Because the Sales account is
by reducing Accounts Receivable and debiting Sales Returns and Allow-
established with a credit, its
ances. The Sales Returns and Allowances account gives management a read-
contra account, Sales Returns
ily available measure of unsatisfactory products and dissatisfied customers.
and Allowances, is established
It is a contra-revenue account with a normal debit balance and is deducted
with a debit.
from sales on the income statement. Second, the cost of the merchandise
must also be transferred from the Cost of Goods Sold account back into the
Merchandise Inventory account. If the company makes an allowance instead
of accepting a return, or if the merchandise cannot be returned to inventory
and resold, this transfer is not made.
Receipts on Account
Sept. 5: Collected in full for sale of merchandise on Aug. 7, less the return on
Aug. 9, $900.
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
CASH
Dr. Cr.
Sept. 5 900
ACCOUNTS RECEIVABLE
Dr. Cr.
Sept. 5 900
Entry in Journal Form:
Dr. Cr.
Sept. 5 Cash 900
Accounts Receivable 900
Received on account
Comment: Collection is made for the net amount due of $900 ($1,200 (cid:4) $300).
280 CHAPTER 6 The Operating Cycle and Merchandising Operations
FOCUS ON BUSINESS PRACTICE
How Are Web Sales Doing?
In spite of the demise of many Internet retailers, merchan- their use of the Internet. Office Depot, which focuses primar-
dise sales over the Internet continue to thrive. Internet sales ily on business-to-business Internet sales, has set up custom-
are expected to exceed $150 million in 2008.2 To date, the ized web pages for tens of thousands of corporate clients.
companies that have been most successful in using the These websites allow customers to make online purchases
Internet to enhance their operations have been established and check store inventories. Although Internet transactions
mail-order retailers like Lands’ End and L.L. Bean. Other are recorded in the same way as on-site transactions, the
retailers, such as Office Depot, have also benefited from technology adds a level of complexity to the transactions.
STOP
& APPLY
The numbered items that follow are account titles, and the lettered items are types of merchandis-
ing transactions. For each transaction, indicate which accounts are debited or credited by placing the
account numbers in the appropriate columns.
1. Cash 5. Sales
2. Accounts Receivable 6. Sales Returns and Allowances
3. Merchandise Inventory 7. Cost of Goods Sold
4. Accounts Payable
Account Account Account Account
Debited Credited Debited Credited
a. Purchase on credit ___ ___ e. Sale for cash ___ ___
b. Purchase return for credit ___ ___ f. Sales return for credit ___ ___
c. Purchase for cash ___ ___ g. Payment on account ___ ___
d. Sale on credit ___ ___ h. Receipt on account ___ ___
SOLUTION
Account Account Account Account
Debited Credited Debited Credited
a. Purchase on credit 3 4 e. Sale for cash 1,7 3,5
b. Purchase return for credit 4 3 f. Sales return for credit 3,6 2,7
c. Purchase for cash 3 1 g. Payment on account 4 1
d. Sale on credit 2,7 3,5 h. Receipt on account 1 2
Periodic Inventory System 281
Periodic
Exhibit 6-2 shows how an income statement appears when a company uses the
Inventory System periodic inventory system. A major feature of this statement is the computation
of cost of goods sold. Cost of goods sold must be computed on the income state-
ment because it is not updated for purchases, sales, and other transactions during
LO4 Prepare an income state-
the accounting period, as it is under the perpetual inventory system. Figure 6-5
ment and record merchandising
illustrates the components of cost of goods sold.
transactions under the periodic
It is important to distinguish between goods available for sale and cost of
inventory system.
goods sold. Cost of goods available for sale is the total cost of merchandise that
could be sold in the accounting period. Cost of goods sold is the cost of merchan-
dise actually sold. The difference between the two numbers is the amount not
sold, or the ending merchandise inventory. Cost of goods available for sale is the |
sum of the following two factors:
(cid:2) The amount of merchandise on hand at the beginning of accounting period
or beginning inventory.
(cid:2) The net purchases during the period. (Net purchases consist of total purchases
less any deductions such as purchases returns and allowances and freight-in.)
As you can see in Exhibit 6-2, Kloss Motor Company has cost of goods avail-
able for sale during the period of $718,640 ($211,200 (cid:3) $507,440). The end-
ing inventory of $193,200 is deducted from this figure to determine the cost of
goods sold. Thus, the company’s cost of goods sold is $525,440 ($718,640 (cid:4)
$193,200). Figure 6-5 illustrates these relationships in visual form.
An important component of the cost of goods sold section is net cost of pur-
chases. As you can see in the income statement in Exhibit 6-2, net cost of purchases
is the sum of net purchases and freight-in. Net purchases equal total purchases
less any deductions, such as purchases returns and allowances and any discounts
allowed by suppliers for early payment. Freight-in is added to net purchases because
transportation charges are a necessary cost of receiving merchandise for sale.
EXHIBIT 6-2
Kloss Motor Company
Income Statement Under the Periodic
Income Statement
Inventory System
For the Year Ended December 31, 2010
Net sales $957,300
Cost of goods sold
Study Note
Merchandise inventory,
December 31, 2009 $211,200
Most published financial
statements are condensed, Purchases $505,600
eliminating the detail shown Less purchases returns and
here under cost of goods sold. allowances 31,104
Net purchases $474,496
Freight-in 32,944
Net cost of purchases 507,440
Cost of goods available for sale $718,640
Less merchandise inventory,
December 31, 2010 193,200
Cost of goods sold 525,440
Gross margin $431,860
Operating expenses 313,936
Net income $117,924
282 CHAPTER 6 The Operating Cycle and Merchandising Operations
FIGURE 6-5
Beginning Cost of
The Components of Cost of Goods Sold
inventory goods sold
12/31/2009: in 2010:
Merchandise sold
$211,200 $525,440 to customers
Cost of goods
available
Net cost of
for sale:
purchases
$718,640
for 2010:
Ending
$507,440 inventory Merchandise
12/31/2010: carried over
to next year
$193,200
Purchases of Merchandise
Figure 6-6 shows how transactions involving purchases of merchandise are
recorded under the periodic inventory system. A primary difference between the
perpetual and periodic inventory systems is that in the perpetual inventory sys-
Study Note tem, the Merchandise Inventory account is adjusted each time a purchase, sale,
or other inventory transaction occurs, whereas in the periodic inventory system,
Purchases accounts and
the Merchandise Inventory account stays at its beginning balance until the physi-
Purchases Returns and
cal inventory is recorded at the end of the period. The periodic system uses a
Allowances accounts are used
only in conjunction with a Purchases account to accumulate purchases during an accounting period and a
periodic inventory system. Purchases Returns and Allowances account to accumulate returns of and allow-
ances on purchases.
We will now illustrate how Kloss Motor Company would record purchase
transactions under the periodic inventory system.
Purchases on Credit
Study Note
Aug. 3: Received merchandise purchased on credit, invoice dated Aug. 1, terms
Under the periodic inventory n/10, $4,890.
system, the Purchases account
increases when a company Assets (cid:2) Liabilities (cid:3) Owner’s Equity
makes a purchase.
PURCHASES ACCOUNTS PAYABLE
Dr. Cr. Dr. Cr.
Aug. 3 4,890 Aug. 3 4,890
Entry in Journal Form:
Dr. Cr.
Aug. 3 Purchases 4,890
Accounts Payable 4,890
Purchases on credit
Comment: Under the periodic inventory system, the cost of merchandise is
recorded in the Purchases account at the time of purchase. This account is
a temporary one used only with the periodic inventory system. Its sole pur-
pose is to accumulate the total cost of merchandise purchased for resale dur-
ing an accounting period. (Purchases of other assets, such as equipment, are
recorded in the appropriate asset account, not in the Purchases account.) The |
Purchases account does not indicate whether merchandise has been sold or is
still on hand.
Periodic Inventory System 283
FIGURE 6-6 Recording Purchase Transactions Under the Periodic Inventory System
Assets = Liabilities + Owner’s Equity
Cash Accounts Payable Purchases Purchases
on Credit
Aug. 10 4,410 Aug. 6 480 Aug. 3 4,890 Aug. 3 4,890
10 4,410
Payment on
Account Purchases Returns
and Allowances
Purchases Returns
Aug. 6 480
and Allowances
Purchases Returns and Allowances
Aug. 6: Returned part of merchandise received on Aug. 3 for credit, $480.
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
PURCHASES RETURNS AND ALLOWANCES ACCOUNTS PAYABLE
Dr. Cr. Dr. Cr.
Aug. 6 480 Aug. 6 480
Entry in Journal Form:
Dr. Cr.
Aug. 6 Accounts Payable 480
Study Note
Purchases Returns and Allowances 480
Because the Purchases account Returned merchandise from purchase
is established with a debit,
Comment: Under the periodic inventory system, the amount of a return or allow-
its contra account, Purchases
ance is recorded in the Purchases Returns and Allowances account. This account
Returns and Allowances, is
established with a credit. is a contra-purchases account with a normal credit balance, and it is deducted from
purchases on the income statement. Accounts Payable is also reduced.
Payments on Account
Aug. 10: Paid amount in full due for the purchase of Aug. 3, part of which was
returned on Aug. 6, $4,410.
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
CASH ACCOUNTS PAYABLE
Dr. Cr. Dr. Cr.
Aug. 10 4,410 Aug. 10 4,410
Entry in Journal Form:
Dr. Cr.
Aug. 10 Accounts Payable 4,410
Cash 4,410
Made payment on account
Comment: Payment is made for the net amount due of $4,410 ($4,890 (cid:4) $480).
284 CHAPTER 6 The Operating Cycle and Merchandising Operations
FIGURE 6-7 Recording Sales Transactions Under the Periodic Inventory System
Assets = Liabilities + Owner’s Equity
Cash Sales
Sept. 5 900 Aug. 7 1,200
Receipts on Account
Accounts Receivable Sales Returns and Allowances
Sales Returns
Aug. 7 1,200 Aug. 9 300 Aug. 9 300
and Allowances
Sept. 5 900
Sales on Credit
Sales of Merchandise
Figure 6-7 shows how transactions involving sales of merchandise are recorded
under the periodic inventory system.
Sales on Credit
Aug. 7: Sold merchandise on credit, terms n/30, FOB destination, $1,200; the
cost of the merchandise was $720.
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
ACCOUNTS RECEIVABLE SALES
Dr. Cr. Dr. Cr.
Aug. 7 1,200 Aug. 7 1,200
Entry in Journal Form:
Dr. Cr.
Aug. 7 Accounts Receivable 1,200
Sales 1,200
Sold merchandise on credit
Comment: As shown in Figure 6-7, under the periodic inventory system, sales
require only one entry to increase Sales and Accounts Receivable. In the case of cash
sales, Cash rather than Accounts Receivable is debited for the amount of the sale. If
the seller pays for the shipping, the amount should be debited to Delivery Expense.
Sales Returns and Allowances
Aug. 9: Accepted return of part of merchandise sold on Aug. 7 for full credit and
returned it to merchandise inventory, $300; the cost of the merchandise was $180.
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
ACCOUNTS RECEIVABLE SALES RETURNS AND ALLOWANCES
Dr. Cr. Dr. Cr.
Aug. 9 300 Aug. 9 300
Entry in Journal Form:
Dr. Cr.
Aug. 9 Sales Returns and Allowances 300
Accounts Receivable 300
Accepted return of merchandise
Periodic Inventory System 285
Comment: Under the periodic inventory system, when a seller allows the buyer
to return all or part of a sale or gives an allowance, only one entry is needed to
reduce Accounts Receivable and debit Sales Returns and Allowances. The Sales
Returns and Allowances account is a contra-revenue account with a normal debit
balance and is deducted from sales on the income statement.
Receipts on Account
Sept. 5: Collected in full for sale of merchandise on Aug. 7, less the return on
Aug. 9, $900.
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
CASH
Dr. Cr.
Sept. 5 900
ACCOUNTS RECEIVABLE
Dr. Cr.
Sept. 5 900
Entry in Journal Form:
Dr. Cr.
Sept. 5 Cash 900
Accounts Receivable 900
Received on account
Comment: Collection is made for the net amount due of $900 ($1,200 (cid:4) $300). |
FOCUS ON BUSINESS PRACTICE
Are Sales Returns Worth Accounting For?
Some industries routinely have a high percentage of sales of potential buyers, they must distribute large numbers
returns. More than 6 percent of all nonfood items sold in of copies to many outlets. Magazine publishers like AOL
stores are eventually returned to vendors. This amounts to Time Warner expect to sell no more than 35 to 38 per-
over $100 billion a year, or more than the gross national cent of the magazines they send to newsstands and other
product of two-thirds of the world’s nations.3 Book pub- outlets.4 In all these businesses, it pays management to
lishers like Simon & Schuster often have returns as scrutinize the Sales Returns and Allowances account for
high as 30 to 50 percent because to gain the attention ways to reduce returns and increase profitability.
286 CHAPTER 6 The Operating Cycle and Merchandising Operations
STOP
& APPLY
The numbered items below are account titles, and the lettered items are types of merchandising
transactions. For each transaction, indicate which accounts are debited or credited by placing the
account numbers in the appropriate columns.
1. Cash 5. Sales
2. Accounts Receivable 6. Sales Returns and Allowances
3. Merchandise Inventory 7. Purchases
4. Accounts Payable 8. Purchases Returns and Allowances
Account Account Account Account
Debited Credited Debited Credited
a. Purchase on credit ___ ___ e. Sale for cash ___ ___
b. Purchase return for credit ___ ___ f. Sales return for credit ___ ___
c. Purchase for cash ___ ___ g. Payment on account ___ ___
d. Sale on credit ___ ___ h. Receipt on account ___ ___
SOLUTION
Account Account Account Account
Debited Credited Debited Credited
a. Purchase on credit 7 4 e. Sale for cash 1 5
b. Purchase return for credit 4 8 f. Sales return for credit 6 2
c. Purchase for cash 7 1 g. Payment on account 4 1
d. Sale on credit 2 5 h. Receipt on account 1 2
(cid:2) FONG COMPANY: REVIEW PROBLEM
In the chapter’s opening Decision Point Fong Company, a merchandiser, engaged in
several transactions shown in the Financial Highlights and faced these questions:
• How can merchandising transactions be recorded to reflect the company's
performance?
• How can the company efficiently manage its cycle of merchandising operations?
Required
1. Record the transactions listed in the Decision Point in journal form, assuming
that Fong Company uses (a) the perpetual inventory system and (b) the periodic
inventory system.
2. User insight: Discuss how Fong Company can manage its operating cycle so that
Merchandising
it has adequate cash to maintain liquidity.
Transactions
LO2 LO3
Fong Company: Review Problem 287
Answers to
1(a) and (b). Transactions recorded in journal form (accounts that differ under the two
Review Problem
systems are in bold type)
A B C D E F G H I J K L M N
1 1. Perpetual Inventory System 2. Periodic Inventory System
2 July 1 Accounts Receivable 2,100 Accounts Receivable 2,100
3 Sales 2,100 Sales 2,100
4 Sold merchandise on Sold merchandise on
5 account to Pablo Lopez, account to Pablo Lopez,
6 terms n/30, FOB shipping terms n/30, FOB shipping
7 point point
8 1 Cost of Goods Sold 1,260
9 Merchandise Inventory 1,260
10 Transferred cost of
11 merchandise sold to Cost
12 of Goods Sold account
13 2 Merchandise Inventory 3,800 Purchases 3,800
14 Accounts Payable 3,800 Accounts Payable 3,800
15 Purchased merchandise Purchased merchandise
16 on account from Dorothy on account from Dorothy
17 Company, terms n/30, FOB Company, terms n/30, FOB
18 shipping point shipping point
19 2 Freight-In 290 Freight-In 290
20 Cash 290 Cash 290
21 Paid freight on previous Paid freight on previous
22 purchase purchase
23 9 Merchandise Inventory 3,400 Purchases 3,400
24 Freight-In 200 Freight-In 200
25 Accounts Payable 3,600 Accounts Payable 3,600
26 Purchased merchandise on Purchased merchandise on
27 account from MNR Company, account from MNR Company,
28 terms n/30, FOB shipping terms n/30, FOB shipping
29 point, freight paid by supplier point, freight paid by supplier
30 11 Sales Returns and Allowances 300 Sales Returns and Allowances 300 |
31 Accounts Receivable 300 Accounts Receivable 300
32 Accepted return of Accepted return of
33 merchandise from Pablo merchandise from Pablo
34 Lopez Lopez
(continued)
288 CHAPTER 6 The Operating Cycle and Merchandising Operations
A B C D E F G H I J K L M N
1 1. Perpetual Inventory System 2. Periodic Inventory System
2 July 11 Merchandise Inventory 180
3 Cost of Goods Sold 180
4 Transferred cost of
5 merchandise returned to
6 Merchandise Inventory
7 account
8 14 Accounts Payable 600 Accounts Payable 600
9 Merchandise Inventory 600 Purchases Returns and Allowances 600
10 Returned portion of Returned portion of
11 merchandise purchased merchandise purchased
12 from Dorothy Company from Dorothy Company
13 16 Cash 1,000 Cash 1,000
14 Sales 1,000 Sales 1,000
15 Sold merchandise for cash Sold merchandise for cash
16 16 Cost of Goods Sold 600
17 Merchandise Inventory 600
18 Transferred cost of
19 merchandise sold to Cost of
20 Goods Sold account
21 22 Accounts Payable 3,200 Accounts Payable 3,200
22 Cash 3,200 Cash 3,200
23 Made payment on account to Made payment on account to
24 Dorothy Company Dorothy Company
25 $3,800 (cid:4) $600 = $3,200 $3,800 (cid:4) $600 = $3,200
26 23 Cash 1,800 Cash 1,800
27 Accounts Receivable 1,800 Accounts Receivable 1,800
28 Received payment on Received payment on
29 account from Pablo Lopez account from Pablo Lopez
30 $2,100 (cid:4) $300 = $1,800 $2,100 (cid:4) $300 = $1,800
2. Cycle of merchandising transactions discussed
Fong engages in all parts of the merchandising cycle. It buys goods on credit,
which gives it time to carry the goods in inventory until customers buy them. It
sells the goods both for cash and on credit. When it sells on credit, it must wait
to collect payment. Thus, the company must arrange for short-term financing to
ensure that it has enough cash on hand to maintain liquidity.
Stop & Review 289
STOP
& REVIEW
LO1 Identify the Merchandising companies differ from service companies in that they earn income
management by buying and selling goods. The buying and selling of goods adds to the com-
issues related to plexity of the business and raises three issues that management must address. First,
merchandising the series of transactions in which merchandising companies engage (the operating
businesses. cycle) requires careful cash flow management. Second, management must choose
whether to use the perpetual or the periodic inventory system. Third, if a company
has international transactions, it must deal with changing exchange rates.
LO2 Describe the terms of A trade discount is a reduction from the list or catalogue price of a product. A sales
sale related to merchan- discount is a discount given for early payment of a sale on credit. Terms of 2/10,
dising transactions. n/30 mean that the buyer can take a 2 percent discount if the invoice is paid within
10 days of the invoice date. Otherwise, the buyer is obligated to pay the full amount in
30 days. Discounts on sales are recorded in the Sales Discounts account, and discounts
on purchases are recorded in the Purchases Discounts account. FOB shipping point
means that the buyer bears the cost of transportation and that title to the goods passes
to the buyer at the shipping origin. FOB destination means that the seller bears the
cost of transportation and that title does not pass to the buyer until the goods reach
their destination. To the seller, debit and credit card sales are similar to cash sales.
LO3 Prepare an income Under the perpetual inventory system, the Merchandise Inventory account is
statement and record continuously adjusted by entering purchases, sales, and other inventory transac-
merchandising transac- tions as they occur. Purchases increase the Merchandise Inventory account, and
tions under the perpet- purchases returns decrease it. As goods are sold, their cost is transferred from the
ual inventory system. Merchandise Inventory account to the Cost of Goods Sold account.
LO4 Prepare an income When the periodic inventory system is used, the cost of goods sold section of the
statement and record income statement must include the following elements: |
merchandising transac- Purchases (cid:4) Purchases Returns and Allowances (cid:3) Freight-in (cid:2) Net cost of Purchases
tions under the periodic Beginning Merchandise Inventory (cid:3) Net Cost of Purchases (cid:2) Cost of Goods
inventory system. Available for Sale
Cost of Goods Available for Sale (cid:4) Ending Merchandise Inventory (cid:2) Cost of
Goods Sold
Under the periodic inventory system, the Merchandise Inventory account stays
at the beginning level until the physical inventory is recorded at the end of the
accounting period. A Purchases account is used to accumulate purchases of mer-
chandise during the accounting period, and a Purchases Returns and Allowances
account is used to accumulate returns of purchases and allowances on purchases.
REVIEW of Concepts and Terminology
The following concepts and terms Freight-in 274 (L02) Purchases account 282 (L04)
were introduced in this chapter: Merchandise inventory 268 (LO1) Purchases discounts 273 (L02)
Cost of goods available for sale Merchandising business 268 (LO1) Purchases Returns and Allowances
281 (L04) Net cost of purchases 281 (L04) account 283 (L04)
Delivery expense 274 (L02) Net purchases 281 (L04) Sales discount 272 (L02)
Exchange gain or loss 271 (LO1) Operating cycle 268 (LO1) Sales Returns and Allowances
Financing period 268 (LO1) account 279 (L03)
Periodic inventory system 270 (LO1)
FOB destination 273 (L02) Trade discount 272 (L02)
Perpetual inventory system 270 (LO1)
FOB shipping point 273 (L02)
290 CHAPTER 6 The Operating Cycle and Merchandising Operations
CHAPTER ASSIGNMENTS
BUILDING Your Basic Knowledge and Skills
Short Exercises
LO1 Identification of Management Issues
SE 1. Identify each of the following decisions as most directly related to (a) cash
flow management, (b) choice of inventory system, or (c) foreign merchandising
transactions:
1. Determination of the amount of time from the purchase of inventory until it
is sold and the amount due is collected
2. Determination of the effects of changes in exchange rates
3. Determination of policies governing sales of merchandise on credit
4. Determination of whether to use the periodic or the perpetual inventory system
LO1 Operating Cycle
SE 2. On average, Mason Company holds its inventory 40 days before it is sold,
waits 25 days for customers’ payments, and takes 33 days to pay suppliers. For
how many days must it provide financing in its operating cycle?
LO2 Terms of Sale
SE 3. A dealer buys tooling machines from a manufacturer and resells them to its
customers.
a. The manufacturer sets a list or catalogue price of $12,000 for a machine. The
manufacturer offers its dealers a 40 percent trade discount.
b. The manufacturer sells the machine under terms of FOB shipping point. The
cost of shipping is $700.
c. The manufacturer offers a sales discount of 2/10, n/30. The sales discount
does not apply to shipping costs.
What is the net cost of the machine to the dealer, assuming it is paid for within
10 days of purchase?
LO2 Sales and Purchases Discounts
SE 4. On April 15, Meier Company sold merchandise to Curran Company for
$5,000 on terms of 2/10, n/30. Assume a return of merchandise on April 20
of $850 and collection in full on April 25. What is the amount collected by
Meier on April 25?
LO3 Purchases of Merchandise: Perpetual Inventory System
SE 5. Record in T account form each of the following transactions, assuming the
perpetual inventory system is used:
Aug. 2 Purchased merchandise on credit from Indio Company, invoice
dated August 1, terms n/10, FOB shipping point, $1,150.
3 Received bill from Lee Shipping Company for transportation costs
on August 2 shipment, invoice dated August 1, terms n/30, $105.
7 Returned damaged merchandise received from Indio Company
on August 2 for credit, $180.
10 Paid in full the amount due to Indio Company for the purchase
of August 2, part of which was returned on August 7.
Chapter Assignments 291
LO4 Purchases of Merchandise: Periodic Inventory System
SE 6. Record in T account form the transactions in SE 5, assuming the periodic
inventory system is used. |
LO4 Cost of Goods Sold: Periodic Inventory System
SE 7. Using the following data and assuming cost of goods sold is $273,700, pre-
pare the cost of goods sold section of a merchandising income statement (periodic
inventory system). Include the amount of purchases for the month of October.
Freight-in $13,800
Merchandise inventory, Sept. 30, 20xx 37,950
Merchandise inventory, Oct. 31, 20xx 50,600
Purchases ?
Purchases returns and allowances 10,350
LO4 Sales of Merchandise: Periodic Inventory System
SE 8. Record in T account form the following transactions, assuming the periodic
inventory system is used:
Aug. 4 Sold merchandise on credit to Rivera Company, terms n/30,
FOB destination, $5,040.
5 Paid transportation costs for sale of August 4, $462.
9 Part of the merchandise sold on August 4 was accepted back
from Rivera Company for full credit and returned to
merchandise inventory, $1,470.
Sept. 3 Collected in full the amount due from Rivera Company for
merchandise sold on August 4, less the return on August 9.
Exercises
LO1 LO2 Discussion Questions
E 1. Develop a brief answer to each of the following questions:
1. Can a company have a “negative” financing period?
2. Suppose you sold goods to a company in Europe at a time when the exchange
rate for the dollar was declining in relation to the euro. Would you want the
European company to pay you in dollars or euros?
3. Which inventory system—the perpetual or periodic—is more useful to man-
agement? Why?
LO2 LO3 Discussion Questions
LO4
E 2. Develop a brief answer to each of the following questions:
1. Assume a large shipment of uninsured merchandise to your company is
destroyed when the delivery truck has an accident and burns. Would you
want the terms to be FOB shipping point or FOB destination?
2. Under the perpetual inventory system, the Merchandise Inventory account is
constantly updated. What would cause it to have the wrong balance?
3. Why is a physical inventory needed under both the periodic and perpetual
inventory systems?
LO1 Management Issues and Decisions
E 3. The management of Posad Cotton Company made the decisions that follow.
Indicate whether each decision pertains primarily to (a) cash flow management,
(b) choice of inventory system, or (c) foreign transactions.
292 CHAPTER 6 The Operating Cycle and Merchandising Operations
1. Decided to reduce the credit terms offered to customers from 30 days to
20 days to speed up collection of accounts.
2. Decided that the benefits of keeping track of each item of inventory as it is
bought and sold would exceed the costs of such a system.
3. Decided to purchase goods made by a Chinese supplier.
4. Decided to switch to a new cleaning service that will provide the same service
at a lower cost with payment due in 30 days instead of 20 days.
LO1 Foreign Merchandising Transactions
E 4. Elm Company purchased a special-purpose machine from Ritholz Company on
credit for €75,000. At the date of purchase, the exchange rate was $1.00 per euro.
On the date of the payment, which was made in euros, the value of the euro was
$1.25. Did Elm incur an exchange gain or loss? How much was it?
LO2 Terms of Sale
E 5. A household appliance dealer buys refrigerators from a manufacturer and
resells them to its customers.
a. The manufacturer sets a list or catalogue price of $2,500 for a refrigerator.
The manufacturer offers its dealers a 30 percent trade discount.
b. The manufacturer sells the machine under terms of FOB destination. The
cost of shipping is $240.
c. The manufacturer offers a sales discount of 2/10, n/30. Sales discounts do
not apply to shipping costs.
What is the net cost of the refrigerator to the dealer, assuming it is paid for within
10 days of purchase?
LO2 LO4 Sales Involving Discounts: Periodic Inventory System
E 6. Given the following transactions engaged in by Stanford Company, prepare
journal entries and, assuming the periodic inventory system, determine the total
amount received from Penkas Company.
Mar. 1 Sold merchandise on credit to Penkas Company, terms 2/10,
n/30, FOB shipping point, $1,000.
3 Accepted a return from Penkas Company for full credit, $400. |
10 Collected amount due from Penkas Company for the sale, less
the return and discount.
11 Sold merchandise on credit to Penkas Company, terms 2/10,
n/30, FOB shipping point, $1,600.
31 Collected amount due from Penkas Company for the sale of
March 11.
LO2 LO3 Purchases Involving Discounts: Perpetual Inventory System
E 7. Lien Company engaged in the following transactions:
July 2 Purchased merchandise on credit from Jonak Company, terms
2/10, n/30, FOB destination, invoice dated July 1, $4,000.
6 Returned some merchandise to Jonak Company for full credit,
$500.
11 Paid Jonak Company for purchase of July 2 less return and discount.
14 Purchased merchandise on credit from Jonak Company, terms
2/10, n/30, FOB destination, invoice dated July 12, $4,500.
31 Paid amount owed Jonak Company for purchase of July 14.
Chapter Assignments 293
Prepare journal entries and, assuming the perpetual inventory system, determine
the total amount paid to Jonak Company.
LO3 Preparation of the Income Statement: Perpetual Inventory System
E 8. Selected account balances at December 31, 2011, for Receptions, Etc., are
listed below. Prepare an income statement for the year ended December 31,
2011. Show detail of net sales. The company uses the perpetual inventory system,
and Freight-In has not been included in Cost of Goods Sold.
Account Name Debit Credit
Sales $498,000
Sales Returns and Allowances $ 23,500
Cost of Goods Sold 284,000
Freight-In 14,700
Selling Expenses 43,000
General and Administrative Expenses 87,000
LO3 Recording Purchases: Perpetual Inventory System
E 9. The following transactions took place under the perpetual inventory system.
Record each transaction in T account form.
a. Purchased merchandise on credit, terms n/30, FOB shipping point, $2,500.
b. Paid freight on the shipment in transaction a, $135.
c. Purchased merchandise on credit, terms n/30, FOB destination, $1,400.
d. Purchased merchandise on credit, terms n/30, FOB shipping point, $2,600,
which includes freight paid by the supplier of $200.
e. Returned part of the merchandise purchased in transaction c, $500.
f. Paid the amount owed on the purchase in transaction a.
g. Paid the amount owed on the purchase in transaction d.
h. Paid the amount owed on the purchase in transaction c less the return in e.
LO3 Recording Sales: Perpetual Inventory System
E 10. On June 15, Palmyra Company sold merchandise for $5,200 on terms of
n/30 to Lim Company. On June 20, Lim Company returned some of the mer-
chandise for a credit of $1,200, and on June 25, Lim paid the balance owed. Give
Palmyra’s entries in T account form to record the sale, return, and receipt of cash
under the perpetual inventory system. The cost of the merchandise sold on June
15 was $3,000, and the cost of the merchandise returned to inventory on June
20 was $700.
LO4 Preparation of the Income Statement: Periodic Inventory System
E 11. Using the selected year-end account balances at December 31, 2010, for
the Morris General Store shown below, prepare a 2010 income statement. Show
detail of net sales. The company uses the periodic inventory system. Beginning
merchandise inventory was $28,000; ending merchandise inventory is $21,000.
Account Name Debit Credit
Sales $309,000
Sales Returns and Allowances $ 15,200
Purchases 114,800
Purchases Returns and Allowances 7,000
Freight-In 5,600
Selling Expenses 56,400
General and Administrative Expenses 37,200
294 CHAPTER 6 The Operating Cycle and Merchandising Operations
LO4 Merchandising Income Statement: Missing Data, Multiple Years
E 12. Determine the missing data for each letter in the following three income
statements for Sampson Paper Company (in thousands):
2011 2010 2009
Sales $ p $ h $572
Sales returns and allowances 48 38 a
Net sales q 634 b
Merchandise inventory, beginning r i 76
Purchases 384 338 c
Purchases returns and allowances 62 j 34
Freight-in s 58 44
Net cost of purchases 378 k d
Cost of goods available for sale 444 424 364
Merchandise inventory, ending 78 l 84
Cost of goods sold t 358 e
Gross margin 284 m 252
Selling expenses u 156 f
General and administrative expenses 78 n 66 |
Total operating expenses 260 256 g
Net income v o 54
LO4 Recording Purchases: Periodic Inventory System
E 13. Using the data in E 9, give the entries in T account form to record each of
the transactions under the periodic inventory system.
LO4 Recording Sales: Periodic Inventory System
E 14. Using the relevant data in E 10, give the entries in T account form to
record each of the transactions under the periodic inventory system.
Problems
LO1 LO3 Merchandising Income Statement: Perpetual Inventory System
P 1. At the end of the fiscal year, June 30, 2010, selected accounts from the
adjusted trial balance for Barbara’s Video Store were as follows:
Barbara’s Video Store
Partial Adjusted Trial Balance
June 30, 2010
Sales $870,824
Sales Returns and Allowances $ 25,500
Cost of Goods Sold 442,370
Freight-In 20,156
Store Salaries Expense 216,700
Office Salaries Expense 53,000
Advertising Expense 36,400
Rent Expense 28,000
Insurance Expense 5,600
Utilities Expense 18,320
Store Supplies Expense 3,328
Office Supplies Expense 3,628
Depreciation Expense–Store Equipment 3,600
Depreciation Expense–Office Equipment 3,700
Chapter Assignments 295
Required
1. Prepare a multistep income statement for Barbara’s Video Store. Freight-In
should be combined with Cost of Goods Sold. Store Salaries Expense, Adver-
tising Expense, Store Supplies Expense, and Depreciation Expense–Store
Equipment are selling expenses. The other expenses are general and admin-
istrative expenses. The company uses the perpetual inventory system. Show
details of net sales and operating expenses.
User insight (cid:2) 2. Based on your knowledge at this point in the course, how would you use the
income statement for Barbara’s Video Store to evaluate the company’s profit-
ability? What other financial statement should you consider and why?
LO3 Merchandising Transactions: Perpetual Inventory System
P 2. V argo Company engaged in the following transactions in August 2011:
Aug. 7 Sold merchandise on credit to Ken Smith, terms n/30, FOB
shipping point, $3,000 (cost, $1,800).
8 Purchased merchandise on credit from Novak Company, terms
n/30, FOB shipping point, $6,000.
9 Paid Smart Company for shipping charges on merchandise pur-
chased on August 8, $254.
10 Purchased merchandise on credit from Mara’s Company, terms
n/30, FOB shipping point, $9,600, including $600 freight costs
paid by Sewall.
14 Sold merchandise on credit to Rose Milito, terms n/30, FOB
shipping point, $2,400 (cost, $1,440).
14 Returned damaged merchandise received from Novak Company
on August 8 for credit, $600.
17 Received check from Ken Smith for his purchase of August 7.
19 Sold merchandise for cash, $1,800 (cost, $1,080).
20 Paid Mara’s Company for purchase of August 10.
21 Paid Novak Company the balance from the transactions of
August 8 and August 14.
24 Accepted from Rose Milito a return of merchandise, which was
put back in inventory, $200 (cost, $120).
Required
1. Prepare entries in journal form (refer to the Review Problem) to record the
transactions, assuming use of the perpetual inventory system.
User insight (cid:2) 2. Receiving cash rebates from suppliers based on the past year’s purchases is a
common practice in some industries. If at the end of the year Vargo Com-
pany receives rebates in cash from a supplier, should these cash rebates be
reported as revenue? Why or why not?
LO1 LO4 Merchandising Income Statement: Periodic Inventory System
P 3. Selected accounts from the adjusted trial balance for Louise’s Gourmet Shop
as of March 31, 2011, the end of the current fiscal year, appear on the next page.
The merchandise inventory for Louise’s Gourmet Shop was $38,200 at the begin-
ning of the year and $29,400 at the end of the year.
Required
1. Using the information given, prepare a multistep income statement for Louise’s
Gourmet Shop. Store Salaries Expense, Advertising Expense, Store Supplies
Expense, and Depreciation Expense–Store Equipment are selling expenses. The
other expenses are general and administrative expenses. The company uses the
periodic inventory system. Show details of net sales and operating expenses. |
296 CHAPTER 6 The Operating Cycle and Merchandising Operations
Louise’s Gourmet Shop
Partial Adjusted Trial Balance
March 31, 2011
Sales $168,700
Sales Returns and Allowances $ 5,700
Purchases 70,200
Purchases Returns and Allowances 2,600
Freight-In 2,300
Store Salaries Expense 33,125
Office Salaries Expense 12,875
Advertising Expense 23,800
Rent Expense 2,400
Insurance Expense 1,300
Utilities Expense 1,560
Store Supplies Expense 2,880
Office Supplies Expense 1,075
Depreciation Expense–Store Equipment 1,050
Depreciation Expense–Office Equipment 800
User insight (cid:2) 2. Based on your knowledge at this point in the course, how would you use the
income statement for Louise’s Gourmet Shop to evaluate the company’s
profitability? What other financial statements should you consider, and why?
LO4 Merchandising Transactions: Periodic Inventory System
P 4. Use the data in P 2 for this problem.
Required
1. Prepare entries in journal form to record the transactions, assuming use of
the periodic inventory system. (Use the Review Problem in this chapter as a
model.)
User insight (cid:2) 2. Most companies call the first line of the income statement net sales. Other
companies call it sales. Do you think these terms are equivalent and compa-
rable? What would be the content of net sales? Why might a company use
sales instead of net sales?
LO3 Merchandising Transactions: Perpetual Inventory System
P 5. T attle Company engaged in the following transactions in October 2010:
Oct. 7 Sold merchandise on credit to Lina Ortiz, terms n/30, FOB
shipping point, $6,000 (cost, $3,600).
8 Purchased merchandise on credit from Ruff Company, terms
n/30, FOB shipping point, $12,000.
9 Paid Ruff Company for shipping charges on merchandise pur-
chased on October 8, $508.
10 Purchased merchandise on credit from Sewall Company, terms
n/30, FOB shipping point, $19,200, including $1,200 freight
costs paid by Sewall.
14 Sold merchandise on credit to Peter Watts, terms n/30, FOB
shipping point, $4,800 (cost, $2,880).
Chapter Assignments 297
Oct. 14 Returned damaged merchandise received from Ruff Company on
October 8 for credit, $1,200.
17 Received check from Lina Ortiz for her purchase of October 7.
19 Sold merchandise for cash, $3,600 (cost, $2,160).
20 Paid Sewall Company for purchase of October 10.
21 Paid Ruff Company the balance from the transactions of
October 8 and October 14.
24 Accepted from Peter Watts a return of merchandise, which was
put back in inventory, $400 (cost, $240).
Required
1. Prepare entries in journal form (refer to the Review Problem) to record the
transactions, assuming use of the perpetual inventory system.
User insight (cid:2) 2. Receiving cash rebates from suppliers based on the past year’s purchases is a
common practice in some industries. If at the end of the year Tattle Com-
pany receives rebates in cash from a supplier, should these cash rebates be
reported as revenue? Why or why not?
Alternate Problems
LO1 LO3 Merchandising Income Statement: Perpetual Inventory System
P 6. At the end of the fiscal year, August 31, 2010, selected accounts from the
adjusted trial balance for Pasha’s Patio Furniture were as follows:
Pasha’s Patio Furniture
Partial Adjusted Trial Balance
August 31, 2010
Sales $169,000
Sales Returns and Allowances $ 9,000
Cost of Goods Sold 61,400
Freight-In 2,300
Store Salaries Expense 32,825
Office Salaries Expense 12,875
Advertising Expense 24,100
Rent Expense 2,400
Insurance Expense 1,200
Utilities Expense 1,560
Store Supplies Expense 2,680
Office Supplies Expense 1,175
Depreciation Expense–Store Equipment 1,250
Depreciation Expense–Office Equipment 800
Required
1. Using the information given, prepare a multistep income statement for
Pasha’s Patio Furniture. Store Salaries Expense, Advertising Expense, Store
Supplies Expense, and Depreciation Expense–Store Equipment are selling
expenses. The other expenses are general and administrative expenses. The
company uses the perpetual inventory system. Show details of net sales and
operating expenses.
298 CHAPTER 6 The Operating Cycle and Merchandising Operations |
User insight (cid:2) 2. Based on your knowledge at this point in the course, how would you use the
income statement for Pasha’s Patio Furniture to evaluate the company’s prof-
itability? What other financial statement should be considered, and why?
LO3 Merchandising Transactions: Perpetual Inventory System
P 7. Sarah Company engaged in the following transactions in July 2010:
July 1 Sold merchandise to Chi Dong on credit, terms n/30, FOB ship-
ping point, $2,100 (cost, $1,260).
3 Purchased merchandise on credit from Angel Company, terms
n/30, FOB shipping point, $3,800.
5 Paid Speed Freight for freight charges on merchandise received,
$290.
8 Purchased merchandise on credit from Expo Supply Company,
terms n/30, FOB shipping point, $3,600, which includes $200
freight costs paid by Expo Supply Company.
12 Returned some of the merchandise purchased on July 3 for
credit, $600.
15 Sold merchandise on credit to Tom Kowalski, terms n/30, FOB
shipping point, $1,200 (cost, $720).
17 Sold merchandise for cash, $1,000 (cost, $600).
18 Accepted for full credit a return from Chi Dong and returned
merchandise to inventory, $200 (cost, $120).
24 Paid Angel Company for purchase of July 3 less return of July 12.
25 Received check from Chi Dong for July 1 purchase less the
return on July 18.
Required
1. Prepare entries in journal form to record the transactions, assuming use of
the perpetual inventory system. (Use the Review Problem in this chapter as a
model.)
User insight (cid:2) 2. Most companies call the first line of the income statement net sales. Other
companies call it sales. Do you think these terms are equivalent and compa-
rable? What would be the content of net sales? Why might a company use
sales instead of net sales?
LO1 LO4 Merchandising Income Statement: Periodic Inventory System
P 8. Selected accounts from the adjusted trial balance of Daniel’s Sports Equip-
ment on September 30, 2010, the fiscal year end, appear at the top of the next
page. The company’s beginning merchandise inventory was $81,222 and ending
merchandise inventory is $76,664 for the period.
Required
1. Prepare a multistep income statement for Daniels’s Sports Equipment. Store
Salaries Expense, Advertising Expense, Store Supplies Expense, and Depreci-
ation Expense–Store Equipment are selling expenses. The other expenses are
general and administrative expenses. The company uses the periodic inven-
tory system. Show details of net sales and operating expenses.
User insight (cid:2) 2. Based on your knowledge at this point in the course, how would you
use the income statement for Daniel’s Sports Equipment to evaluate the
company’s profitability? What other financial statements should you con-
sider and why?
Chapter Assignments 299
Daniel’s Sports Equipment
Partial Adjusted Trial Balance
September 30, 2010
Sales $440,912
Sales Returns and Allowances $ 18,250
Purchases 221,185
Purchases Returns and Allowances 30,238
Freight-In 10,078
Store Salaries Expense 105,550
Office Salaries Expense 26,500
Advertising Expense 20,200
Rent Expense 15,000
Insurance Expense 2,200
Utilities Expense 18,760
Store Supplies Expense 464
Office Supplies Expense 814
Depreciation Expense–Store Equipment 1,800
Depreciation Expense–Office Equipment 1,850
LO4 Merchandising Transactions: Periodic Inventory System
P 9. Use the data in P 7 for this problem.
Required
1. Prepare entries in journal form to record the transactions, assuming use of
the periodic inventory system. (Use the Review Problem in this chapter as a
model.)
User insight (cid:2) 2. Receiving cash rebates from suppliers based on the past year’s purchases is
common in some industries. If at the end of the year, Sarah Company receives
rebates in cash from a supplier, should these cash rebates be reported as rev-
enue? Why or why not?
LO4 Merchandising Transactions: Periodic Inventory System
P 10. Use the data in P 5 for this problem.
Required
1. Prepare entries in journal form to record the transactions, assuming use of the peri-
odic inventory system. (Use the Review Problem in this chapter as a model.)
ENHANCING Your Knowledge, Skills, and Critical Thinking |
LO1 Cash Flow Management
C 1. Jewell Home Source has operated in Kansas for 30 years. The company has
always prided itself on giving customers individual attention. It carries a large
inventory so it can offer a good selection and deliver purchases quickly. It accepts
credit cards and checks but also provides 90 days of credit to reliable customers
who have purchased from the company in the past. It maintains good relations
with suppliers by paying invoices quickly.
300 CHAPTER 6 The Operating Cycle and Merchandising Operations
During the past year, the company has been strapped for cash and has had
to borrow from the bank to pay its bills. An analysis of its financial statements
reveals that, on average, inventory is on hand for 70 days before being sold, and
receivables are held for 90 days before being collected. Accounts payable are paid,
on average, in 20 days.
What are the operating cycle and the financing period? How long are Jewell’s
operating cycle and financing period? Describe three ways in which Jewell can
improve its management of cash flow.
LO1 Periodic Versus Perpetual Inventory Systems
C 2. Books-For-All is a well-established chain of 20 bookstores in western Ohio.
In recent years, the company has grown rapidly, adding five new stores in regional
malls. The manager of each store selects stock based on the market in his or her
region. Managers select items from a master list of available titles that the cen-
tral office provides. Every six months, a physical inventory is taken, and financial
statements are prepared using the periodic inventory system. At that time, books
that have not sold well are placed on sale or, whenever possible, returned to the
publisher.
Management has found that when selecting books, the new managers are not
judging the market as well as the managers of the older, established stores. Thus,
management is thinking about implementing a perpetual inventory system and
carefully monitoring sales from the central office. Do you think Books Unlimited
should switch to the perpetual inventory system or stay with the periodic inven-
tory system? Discuss the advantages and disadvantages of each system.
LO1 LO3 Comparison of Traditional Merchandising with E-commerce
C 3. E-commerce is a word coined to describe business conducted over the Internet.
E-commerce is similar in some ways to traditional retailing, but it presents new
challenges. Go to the website of Amazon.com. Investigate and list the steps a
customer takes to purchase an item on the site. How do these steps differ from
those in a traditional retail store such as Borders or Barnes & Noble? What are
some of the accounting challenges in recording Internet transactions? Be pre-
pared to discuss your results in class.
LO1 LO2 Merchandise Accounting and Inventory Systems
C 4. Go to a retail business, such as a bookstore, clothing shop, gift shop, grocery
store, hardware store, or car dealership, in your local shopping area or a shopping
mall. Ask to speak to someone who is knowledgeable about the store’s inventory
methods. Your instructor will assign groups to find the answers to the following
questions. Be prepared to discuss your findings in class.
1. Merchandising Accounting Is the company a part of a chain or is it a small
business? Does the company sell only merchandise or a combination of mer-
chandise and services? How are sales recorded? Does the company sell on
credit? If so, who decides who gets credit and what are the typical terms? Does
the company buy any merchandise or, in the case of a chain, does it order
merchandise? If it purchases merchandise, how are purchases recorded?
2. Inventory Systems How is each item of inventory identified? Does the busi-
ness have a computerized or a manual inventory system? Which inventory
system, periodic or perpetual, is used? How often do employees take a physi-
cal inventory? What procedures are followed in taking a physical inventory?
What kinds of inventory reports are prepared or received?
Chapter Assignments 301
LO1 Operating Cycle and Financing Period |
C 5. Refer to CVS’s annual report in the Supplement to Chapter 5 and to
Figures 6-1 and 6-2 in this chapter. Assume that at any one time CVS has about
76 days of merchandise inventory available for sale, takes about 18 days to collect
its receivables, and takes about 40 days to pay its creditors. Write a memorandum
to your instructor briefly describing CVS’s operating cycle and financing period.
The memorandum should identify the most common transactions in CVS’s oper-
ating cycle. It should also refer to the importance of accounts receivable, accounts
payable, and merchandise inventory in CVS’s financial statements. Complete the
memorandum by explaining why the operating cycle and financing period are
favorable to the company.
LO1 Income Statement Analysis
C 6. Refer to the CVS annual report in the Supplement to Chapter 5 and to
the following data (in millions) for Walgreens in 2008: net sales, $59,034; cost
of sales, $42,391; total operating expenses, $13,202; and inventories, $7,249.
Determine which company—CVS or Walgreens—had more profitable merchan-
dising operations in 2008 by preparing a schedule that compares the companies
in terms of net sales, cost of sales, gross margin, total operating expenses, and
income from operations as a percentage of sales. (Hint: Put the income state-
ments in comparable formats.) In addition, for each company, compute inventory
as a percentage of the cost of goods sold. Which company has the highest prices
in relation to costs of sales? Which company is more efficient in its operating
expenses? Which company manages its inventory better? Overall, on the basis of
the income statement, which company is more profitable? Explain your answers.
S U P P L E M E N T
T O C H A P T E R
Special-Purpose
6
Journals
S pecial-purpose journals promote efficiency, economy, and
control. Although manual special-purpose journals are used
by companies that have not yet computerized their systems, the
concepts that underlie these journals also underlie the programs
that drive computerized general ledger accounting systems.
Most business transactions—90 to 95 percent—fall into one of
four categories. Each kind of transaction can be recorded in a special-
purpose journal.
SPECIAL-PURPOSE POSTING
TRANSACTION JOURNAL ABBREVIATION
Sale of merchandise Sales journal S
on credit
Purchase on credit Purchases journal P
Receipt of cash Cash receipts journal CR
Disbursement Cash payments journal CP
of cash
The general journal is used to record transactions that do not fall into
any of these special categories. For example, purchase returns, sales
returns, and adjusting and closing entries are recorded in the general
journal. (When transactions are posted from the general journal to the
ledger accounts, the posting abbreviation used is J.)
Using special-purpose journals greatly reduces the work involved
in entering and posting transactions in the general ledger. For exam-
ple, in most cases, instead of posting every debit and credit for each
transaction, only the total amounts of the transactions are posted. In
addition, labor can be divided by assigning each journal to a differ-
ent employee. This division of labor is important in establishing good
internal control.
Sales Journal
The sales journal is designed to handle all credit sales. Cash sales
are recorded in the cash receipts journal. Exhibit S6-1 illustrates a
page from a typical sales journal and related ledger accounts. The
302
Special-Purpose Journals 303
EXHIBIT S6-1
Sales Journal Page 1
Sales Journal and Related
Ledger Accounts Amount (Debit/
Invoice Post. Credit Accounts
Date Account Debited Number Terms Ref. Receivable/Sales)
Study Note
July 1 Peter Clark 721 2/10, n/30 √ 750
The checkmarks indicate daily
5 Georgetta Jones 722 2/10, n/30 √ 500
postings to the subsidiary
accounts, which normally 8 Eugene Cumberland 723 2/10, n/30 √ 335
are listed in alphabetical or 12 Maxwell Gertz 724 2/10, n/30 √ 1,165
numerical order. Also, the 18 Peter Clark 725 1/10, n/30 √ 1,225
column totals are posted to
25 Michael Powers 726 2/10, n/30 √ 975
the appropriate general ledger
4,950 |
accounts at the end of the
(114/411)
month.
Post total at end of month.
Accounts Receivable 114 Sales 411
Balance Balance
Post. Post.
Date Ref. Debit Credit Debit Credit Date Ref. Debit Credit Debit Credit
July 31 S1 4,950 4,950 July 31 S1 4,950 4,950
page records six sales transactions involving five customers. Notice how the
sales journal saves time:
1. Only one line is needed to record each transaction. Each entry consists of
a debit to a customer in Accounts Receivable. The corresponding credit to
Sales is understood.
2. The account names do not have to be written out because each entry auto-
matically is debited to Accounts Receivable and credited to Sales.
3. No explanations are necessary because the function of the sales journal is to
record credit sales only.
4. Only one amount—the total credit sales for the month—has to be posted.
It is posted twice: once as a debit to Accounts Receivable and once as
a credit to Sales. You can see the time this saves for the six transactions
listed in Exhibit S6-1. Imagine the time saved when there are hundreds
of sales transactions.
Controlling Accounts and Subsidiary Journals Controlling accounts
and subsidiary ledgers contain important details about the figures in special-
purpose journals and other books of original entry. A controlling account, also
called a control account, is an account in the general ledger that maintains the
total of the individual account balances in a subsidiary ledger. A subsidiary led-
ger is a ledger separate from the general ledger that contains a group of related
304 SUPPLEMENT TO CHAPTER 6
EXHIBIT S6-2
Sales Journal Page 1
Relationship of Sales Journal, General
Ledger, and Accounts Receivable Amount (Debit/
Subsidiary Ledger and the Posting
Credit Accounts
Procedure
Invoice Post. Receivable/
Date Account Debited Number Terms Ref. Sales)
July 1 Peter Clark 721 2/10, n/30 √ 750
Study Note
5 Georgetta Jones 722 2/10, n/30 √ 500
Accounts in the subsidiary 8 Eugene Cumberland 723 2/10, n/30 √ 335
ledger are maintained in 12 Maxwell Gertz 724 2/10, n/30 √ 1,165
alphabetical order. If account 18 Peter Clark 725 1/10, n/30 √ 1,225
numbers are used to identify
25 Michael Powers 726 2/10, n/30 √ 975
customers, the accounts would
be listed in account number 4,950
order.
(114/411)
Post individual amounts daily Post total at end of month
to subsidiary ledger accounts. to general ledger accounts.
Accounts Receivable Subs. Ledger General Ledger
Peter Clark Accounts Receivable 114
Study Note
Post. Balance
Post.
Subsidiary accounts are posted Date Ref. Debit Credit Balance
daily to prevent customers from Date Ref. Debit Credit Debit Credit
exceeding their credit limits and July 1 S1 750 750
to have up-to-date balances for 18 S1 1,225 1,975 July 31 S1 4,950 4,950
customers wishing to pay their
accounts.
Eugene Cumberland
Post.
Date Ref. Debit Credit Balance Sales 411
July 8 S1 335 335 Balance
Post.
Date Ref. Debit Credit Debit Credit
Continue posting to
Maxwell Gertz, July 31 S1 4,950 4,950
Georgetta Jones, and
Michael Powers.
accounts. The total of the balances in the subsidiary ledger accounts equals or ties
in with the balance in the corresponding controlling account.
For example, up to this point we’ve used a single Accounts Receivable account.
However, a single entry in Accounts Receivable does not tell us how much each
customer has bought and how much each customer has paid or still owes. In
practice, almost all companies that sell to customers on credit keep an individual
accounts receivable record for each customer. If the company has 6,000 credit
customers, there are 6,000 accounts receivable. To include all these accounts
in the general ledger with the other asset, liability, and owner’s equity accounts
would make it very bulky. Consequently, most companies place individual
Special-Purpose Journals 305
customers’ accounts in a separate, subsidiary ledger. In the accounts receivable
subsidiary ledger, customers’ accounts are filed either alphabetically or numeri-
cally (if account numbers are used).
When a company puts individual customers’ accounts in an accounts receivable |
subsidiary ledger, it still must maintain an Accounts Receivable account in the gen-
eral ledger. This account controls in the sense that its balance must equal the total
of the individual account balances in the subsidiary ledger. Transactions that involve
accounts receivable, such as credit sales, must be posted to the individual customers’
accounts daily. Postings to the controlling account in the general ledger are made at
least once a month. When the amounts in the subsidiary ledger and the controlling
account do not match, the accountant must find the error and correct it.
Most companies use an accounts payable subsidiary ledger as well. It is pos-
sible to use a subsidiary ledger for almost any account in the general ledger, such
as Notes Receivable, Short-Term Investments, and Equipment, when manage-
ment wants specific information on individual items.
Summary of the Sales Journal Procedure Exhibit S6-2 illustrates the
procedure for using a sales journal:
1. Enter each sales invoice in the sales journal on a single line. Record the date,
the customer’s name, the invoice number, and the amount. No column is
needed for the terms if the terms on all sales are the same.
2. At the end of each day, post each individual sale to the customer’s account in
the accounts receivable subsidiary ledger. As each sale is posted, place a check
mark (or customer account number, if used) in the Post. Ref. (posting reference)
column of the sales journal to indicate that it has been posted. In the Post. Ref.
column of each customer’s account, place an S and the sales journal page number
(S1 means Sales Journal—Page 1) to indicate the source of the entry.
3. At the end of the month, sum the Amount column in the sales journal to
Study Note
determine the total credit sales, and post the total to the general ledger
In theory, the sum of the accounts (debit Accounts Receivable and credit Sales). Place the numbers
account balances from the of the accounts debited and credited beneath the total in the sales journal to
subsidiary accounts must equal indicate that this step has been completed. In the general ledger, indicate the
the balance in the related source of the entry in the Post. Ref. column of each account.
general ledger controlling
4. Verify the accuracy of the posting by adding the account balances of the
account. In practice, however,
accounts receivable subsidiary ledger and comparing the total with the
the equality is verified only at
balance of the Accounts Receivable controlling account in the general
the end of the month, when the
ledger. You can do this by listing the accounts in a schedule of accounts
general ledger is posted.
receivable, like the one in Exhibit S6-3, in the order in which the accounts
EXHIBIT S6-3
Mitchell’s Used Car Sales
Schedule of Accounts Receivable
Schedule of Accounts Receivable
July 31, 2011
Peter Clark $1,975
Eugene Cumberland 335
Maxwell Gertz 1,165
Georgetta Jones 500
Michael Powers 975
$ 4,950
Total Accounts Receivable
306 SUPPLEMENT TO CHAPTER 6
are maintained. This step is performed after posting collections on account
in the cash receipts journal.
SSales Taxes Many cities and states require retailers to collect a sales tax
Study Note
ffrom their customers and periodically remit the total collected to the city or
Columns can be added to a sstate. In this case, an additional column is needed in the sales journal to record
special-purpose journal for tthe credit to Sales Taxes Payable on credit sales. The form of the entry is
accounts that are commonly sshown in Exhibit S6-4.
used.
PPurchases Journal
TTThe purchases journal is used to record purchases on credit. It can take the form
Study Note oof either a single-column journal or a multicolumn journal. In the single-column
jjournal shown in Exhibit S6-5, only credit purchases of merchandise for resale
It is easy to forget that a cash
tto customers are recorded. This kind of transaction is recorded with a debit to
purchase is entered into the
PPurchases and a credit to Accounts Payable. When the single-column purchases |
cash payments journal, not into
jjournal is used, credit purchases of items other than merchandise are recorded in
the purchases journal.
tthe general journal. Cash purchases are never recorded in the purchases journal;
tthey are recorded in the cash payments journal, which we explain later.
Like the Accounts Receivable account, the Accounts Payable account in the
general ledger is generally used as a controlling account. So that the company
knows how much it owes each supplier, it keeps a separate account for each sup-
plier in an accounts payable subsidiary ledger.
The procedure for using the purchases journal is much like that for using the
sales journal:
1. Enter each purchase invoice in the purchases journal on a single line. Record
the date, the supplier’s name, the invoice date, the terms (if given), and the
amount. It is not necessary to record the shipping terms in the terms column
because they do not affect the payment date.
2. At the end of each day, post each individual purchase to the supplier’s account
in the accounts payable subsidiary ledger. As each purchase is posted, place a
check mark in the Post. Ref. column of the purchases journal to show that it
has been posted. Also place a P and the page number of the purchases journal
(P1 stands for Purchases Journal—Page 1) in the Post. Ref. column of each
supplier’s account to show the source of the entry.
3. At the end of the month, sum the Amount column in the purchases journal,
and post the total to the general ledger accounts (a debit to Purchases and a
credit to Accounts Payable). Place the numbers of the accounts debited and
credited beneath the totals in the purchases journal to show that this step has
EXHIBIT S6-4 Section of a Sales Journal with a Column for Sales Taxes
Sales Journal Page 7
Debit Credits
Sales
Invoice Post. Accounts Tax
Date Account Debited Number Terms Ref. Receivable Payable Sales
Sept. 1 Ralph P. Hake 727 2/10, n/30 √ 206 6 200
Special-Purpose Journals 307
EXHIBIT S6-5
Relationship of Single-Column Purchases Journal Page 1
Purchases Journal to the General
Amount
Ledger and the Accounts Payable
(Debit/Credit
Subsidiary Ledger
Date of Post. Purchases/
Date Account Credited Invoice Terms Ref. Accounts Payable)
July 1 Jones Chevrolet 7/1 2/10, n/30 √ 2,500
2 Marshall Ford 7/2 2/15, n/30 √ 300
3 Dealer Sales 7/3 n/30 √ 700
12 Thomas Auto 7/11 n/30 √ 1,400
17 Dealer Sales 7/17 2/10, n/30 √ 3,200
19 Thomas Auto 7/17 n/30 √ 1,100
9,200
(511/212)
Post individual amounts daily. Post total at end of month.
Accounts Payable Subs. Ledger General Ledger
Dealer Sales Accounts Payable 212
Post. Balance
Post.
Date Ref. Debit Credit Balance
Date Ref. Debit Credit Debit Credit
July 3 P1 700 700
July 31 P1 9,200 9,200
17 P1 3,200 3,900
Jones Chevrolet
Post.
Date Ref. Debit Credit Balance
Purchases 511
July 1 P1 2,500 2,500 Balance
Post.
Date Ref. Debit Credit Debit Credit
Continue posting to Marshall
Ford and Thomas Auto. July 31 P1 9,200 9,200
been carried out. In the general ledger, indicate the source of the entry in the
Post. Ref. column of each account.
4. Check the accuracy of the posting by adding the account balances of the
accounts payable subsidiary ledger and comparing the total with the b alance
Study Note
of the Accounts Payable controlling account in the general ledger. This
The multicolumn purchases step can be done by preparing a schedule of accounts payable from the
journal can accommodate the subsidiary ledger.
purchase of anything on credit.
Each column total (except the The single-column purchases journal can be expanded to record credit pur-
total of Other Accounts) must chases of items other than merchandise by adding separate debit columns for other
be posted at the end of the accounts that are used often. For example, the multicolumn purchases journal in
month. Exhibit S6-6 has columns for Freight In, Store Supplies, Office Supplies, and Other
Accounts. Here, the total credits to Accounts Payable ($9,637) equal the total debits
308 SUPPLEMENT TO CHAPTER 6
EXHIBIT S6-6 A Multicolumn Purchases Journal
Purchases Journal Page 1 |
Credit Debits
Other Accounts
Date of Post. Accounts Freight Store Office Post.
Date Account Credited Invoice Terms Ref. Payable Purchases In Supplies Supplies Account Ref. Amount
July 1 Jones Chevrolet 7/1 2/10, n/30 √ 2,500 2,500
2 Marshall Ford 7/2 2/15, n/30 √ 300 300
2 Shelby Car Delivery 7/2 n/30 √ 50 50
3 Dealer Sales 7/3 n/30 √ 700 700
12 Thomas Auto 7/11 n/30 √ 1,400 1,400
17 Dealer Sales 7/17 2/10, n/30 √ 3,200 3,200
19 Thomas Auto 7/17 n/30 √ 1,100 1,100
25 Osborne Supply 7/21 n/10 √ 187 145 42
28 Auto Supply 7/28 n/10 √ 200 Parts 120 200
9,637 9,200 50 145 42 200
(212) (511) (514) (132) (133) (√)
to Purchases, Freight In, Store Supplies, Office Supplies, and Parts ($9,200 (cid:3) $50 (cid:3)
$145 (cid:3) $42 (cid:3) $200). Again, the individual transactions in the Accounts Payable
column are posted daily to the accounts payable subsidiary ledger, and the totals of
each column in the purchases journal are posted monthly to the corresponding gen-
eral ledger accounts. Entries in the Other Accounts column are posted individually
to the named accounts, and the column total is not posted.
Cash Receipts Journal
AAll transactions involving receipts of cash are recorded in the cash receipts journal.
Study Note
EExamples of these transactions are cash from cash sales and cash from credit custom-
The cash receipts journal can eers in payment of their accounts. Although all cash receipts are alike in that they
accommodate all receipts of rrequire a debit to Cash, they differ in that they require a variety of credit entries.
cash. Daily postings are made, TThus, the cash receipts journal must have several columns. The Other Accounts col-
not only to the subsidiary uumn is used to record credits to accounts not specifically represented by a column.
accounts, but also to the “other TThe account numbers are entered in the Post. Ref. column, and the amounts are
accounts.” The Other Accounts pposted daily to the appropriate account in the general ledger. The Other Accounts
column totals, therefore, are ccolumn totals, therefore, are not posted at the end of the month. Only at the end of
not posted at the end of the tthe month are the control account balances meaningful or correct.
month. Only at the end of the The cash receipts journal shown in Exhibit S6-7 has three debit columns and
month are the control account tthree credit columns. The three debit columns are as follows:
balances meaningful or correct.
1. Cash: Each entry must have an amount in this column because each transac-
tion involves a receipt of cash.
2. Sales discounts: This company allows a 2 percent discount for prompt pay-
ment. Therefore, it is useful to have a column for sales discounts. Notice that
in the transactions of July 8 and 28, the debits to Cash and Sales Discounts
equal the credits to Accounts Receivable.
3. Other accounts: The Other Accounts column (sometimes called Sundry
Accounts) is used for transactions that involve both a debit to Cash and a
debit to some account other than Sales Discounts.
Special-Purpose Journals 309
EXHIBIT S6-7 Relationship of the Cash Receipts Journal to the General Ledger and the Accounts Receivable Subsidiary Ledger
Cash Receipts Journal Page 1
Debits Credits
Account Post. Sales Other Accounts Other
Date Debited/Credited Ref. Cash Discounts Accounts Receivable Sales Accounts
July 1 Henry Mitchell, Capital 311 20,000 20,000
5 Sales 1,200 1,200
8 Georgetta Jones √ 490 10 500
13 Sales 1,400 1,400
16 Peter Clark √ 750 750
19 Sales 1,000 1,000
20 Store Supplies 132 500 500
24 Notes Payable 213 5,000 5,000
26 Sales 1,600 1,600
28 Peter Clark √ 588 12 600
32,528 22 1,850 5,200 25,500
(111) (412) (114) (411) (√)
Post individual amounts Post totals at Total not
in Accounts Receivable end of month. posted.
ledger columns daily.
Post individual amounts in
Other Accounts column daily.
General Ledger
Cash 111
Accounts Receivable Subsidiary Ledger
Balance
Post.
Peter Clark
Date Ref. Debit Credit Debit Credit
Post.
July 31 CR1 32,528 32,528 Date Ref. Debit Credit Balance
July 1 S1 750 750
Accounts Receivable 114
16 CR1 750 —
Balance |
Post. 18 S1 1,225 1,225
Date Ref. Debit Credit Debit Credit 28 CR1 600 625
July 31 S1 4,950 4,950
Georgetta Jones
31 CR1 1,850 3,100
Post.
Date Ref. Debit Credit Balance
Store Supplies 132
Balance July 5 S1 500 500
Post.
8 CR1 500 —
Date Ref. Debit Credit Debit Credit
Bal. 500
July 20 CR1 500 — Continue posting to Notes Payable Continue posting to Sales
and Henry Mitchell, Capital. and Sales Discounts.
310 SUPPLEMENT TO CHAPTER 6
These are the credit columns:
1. Accounts receivable: This column is used to record collections on account
from customers. The name of the customer is written in the Account Debited/
Credited column so that the payment can be entered in the corresponding
account in the accounts receivable subsidiary ledger. Posting to the individual
accounts receivable accounts is usually done daily so that each customer’s
balance is up-to-date.
2. Sales: This column is used to record all cash sales during the month. Retail
firms that use cash registers would make an entry at the end of each day for
the total sales from each cash register for that day. The debit, of course, is in
the Cash debit column.
3. Other accounts: This column is used for the credit portion of any entry that
is neither a cash collection from accounts receivable nor a cash sale. The name
of the account to be credited is indicated in the Account Debited/Credited
column. For example, the transactions of July 1, 20, and 24 involve credits to
accounts other than Accounts Receivable or Sales. These individual postings
should be done daily (or weekly if there are just a few of them). If a company
finds that it consistently is crediting a certain account in the Other Accounts
column, it can add another credit column to the cash receipts journal for that
particular account.
The procedure for posting the cash receipts journal, as shown in Exhibit S6-7,
is as follows:
1. Post the transactions in the Accounts Receivable column daily to the indi-
vidual accounts in the accounts receivable subsidiary ledger. The amount
credited to the customer’s account is the same as that credited to Accounts
Receivable. A check mark in the Post. Ref. column of the cash receipts jour-
nal indicates that the amount has been posted, and a CR1 (Cash Receipts
Journal—Page 1) in the Post. Ref. column of each subsidiary ledger account
indicates the source of the entry.
2. Post the debits/credits in the Other Accounts columns daily, or at conve-
nient short intervals during the month, to the general ledger accounts. Write
the account number in the Post. Ref. column of the cash receipts journal as
the individual items are posted to indicate that the posting has been done,
and write CR1 in the Post. Ref. column of the general ledger account to indi-
cate the source of the entry.
3. At the end of the month, total the columns in the cash receipts journal, as
shown below. The sum of the Debits column totals must equal the sum of
the Credits column totals:
Debits Column Totals Credits Column Totals
Cash $32,528 Accounts Receivable $ 1,850
Sales Discounts 22 Sales 5,200
Other Accounts 0 Other Accounts 25,500
Total Debits $32,550 Total Credits $32,550
This step is called crossfooting.
4. Post the Debits column totals as follows:
a. Cash Posted as a debit to the Cash account.
b. Sales Discounts Posted as a debit to the Sales Discounts account.
Special-Purpose Journals 311
5. Post the Credits column totals as follows:
a. A ccounts Receivable Posted as a credit to the Accounts Receivable con-
trolling account.
b. Sales Posted as a credit to the Sales account.
6. Write the account numbers below each column in the cash receipts journal
as they are posted to indicate that these steps have been completed. CR1
is written in the Post. Ref. column of each account in the general ledger to
indicate the source of the entry.
7. Notice that the total of the Other Accounts column is not posted because each
entry was posted separately when the transaction occurred. The individual accounts
were posted in Step 2. Place a check mark at the bottom of the column to show
that postings in that column have been made and that the total is not posted. |
Cash Payments Journal
All transactions involving payments of cash are recorded in the cash payments
Study Note
journal (also called the cash disbursements journal). Examples of these transac-
tions are cash purchases and payments of obligations resulting from earlier pur-
The cash payments journal
can accommodate all cash chases on credit. The form of the cash payments journal is much like that of the
payments. It functions like the cash receipts journal. The cash payments journal shown in Exhibit S6-8 has three
cash receipts journal, although credit columns and five debit columns.
it uses some different general The credit columns for the cash payments journal are as follows:
ledger accounts.
1. Cash: Each entry must have an amount in this column because each transac-
tion involves a payment of cash.
2. Purchases discounts: When purchases discounts are taken, they are recorded
in this column.
3. Other accounts: This column is used to record credits to accounts other
than Cash or Purchases Discounts. Notice that the July 31 transaction shows
a purchase of Land for $15,000, with a check for $5,000 and a note payable
for $10,000.
The debit columns are as follows:
1. Accounts payable: This column is used to record payments to suppliers that
have extended credit to the company. Each supplier’s name is written in the
Payee column so that the payment can be entered in the supplier’s account in
the accounts payable subsidiary ledger.
2. Salary expense, advertising expense, and rent expense: Continue posting
the column total for any column that has an account title at the top. These
are accounts for which there are usually multiple expenditures in a month.
Placing the account number at the bottom of the column indicates the total
has been posted to its respective account.
3. Other accounts: Cash can be expended for many reasons. Therefore, an
Other Accounts or Sundry Accounts column is needed in the cash payments
journal. The title of the account to be debited is written in the Account
Credited/Debited column, and the amount is entered in the Other Accounts
debit column. If a company finds that a particular account appears often in
the Other Accounts column, it can add another debit column to the cash
payments journal.
312 SUPPLEMENT TO CHAPTER 6
EXHIBIT S6-8 Relationship of the Cash Payments Journal to the General Ledger and the Accounts Payable Subsidiary Ledger
Cash Payments Journal Page 1
Credits Debits
Account
Ck. Credited/ Post. Purchases Other Accounts Salary Advertising Rent Other
Date No. Payee Debited Ref. Cash Discounts Accounts Payable Expense Expense Expense Accounts
July 2 101 Sondra Tidmore Purchases 511 400 400
6 102 Daily Journal 100 100
8 103 Siviglia Agency 250 250
11 104 Jones Chevrolet √ 2,450 50 2,500
16 105 Charles Kuntz 600 600
17 106 Marshall Ford √ 294 6 300
24 107 Grabow & Prepaid
Company Insurance 119 480 480
27 108 Dealer Sales √ 3,136 64 3,200
9 Daily Journal 100 100
30 109 A&B Equipment Office
Company Equipment 144 900 400
Service
Equipment 146 500
31 110 Burns Real Estate Notes
Payable 213 5,000 10,000
Land 141 15,000
13,710 120 10,000 6,000 600 200 250 16,780
(111) (512) (√) (212) (611) (612) (613) (√)
Post individual
Post individual Post totals at Totals
amounts in Other
amounts in Accounts end of month. not posted.
Accounts column daily.
Payable column daily.
Accounts Payable Subsidiary Ledger
General Ledger
Dealer Sales
Cash 111
Post.
Balance
Post. Date Ref. Debit Credit Balance
Date Ref. Debit Credit Debit Credit
July 3 P1 700 700
July 31 CR1 32,528 32,528 17 P1 3,200 3,900
31 CP1 13,710 18,818 27 CP1 3,200 700
Prepaid Insurance 119 Jones Chevrolet
Balance Post.
Post.
Date Ref. Debit Credit Balance
Date Ref. Debit Credit Debit Credit
July 1 P1 2,500 2,500
July 24 CP1 480 480
11 CP1 2,500 —
Marshall Ford
Post.
Continue posting to
Date Ref. Debit Credit Balance
Continue posting to Land, Office Purchases Discounts and
Equipment, Service Equipment, Accounts Payable, Salary
July 2 P1 300 300
Notes Payable, and Purchases. Expense, Advertising
17 CP1 300 —
Expense, and Rent Expense
Special-Purpose Journals 313 |
The procedure for posting the cash payments journal, shown in Exhibit S6-8,
is as follows:
1. Post the transactions in the Accounts Payable columns daily to the individual
accounts in the accounts payable subsidiary ledger. Place a check mark in the
Post. Ref. column of the cash payments journal to indicate that the posting
has been made.
2. Post the debits/credits in the Other Accounts debit/credit columns to the
general ledger daily or at convenient short intervals during the month. Write
the account number in the Post. Ref. column of the cash payments journal
as the individual items are posted to indicate that the posting has been com-
pleted and CP1 (Cash Payments Journal-Page 1) in the Post. Ref. column of
each general ledger account.
3. At the end of the month, the columns are footed and crossfooted. That is,
the sum of the Credits column totals must equal the sum of the Debits col-
umn totals, as follows:
Credit Column Totals Debit Column Totals
Cash $13,710 Accounts Payable $ 6,000
Purchases Discounts 120 Salary Expense 600
Other Accounts 10,000 Advertising Expense 200
Rent Expense 250
Other Accounts 16,780
Total Credits $23,830 Total Debits $23,830
4. At the end of the month, post the column totals for Cash, Purchases Dis-
counts, Accounts Payable, Salary Expense, Advertising Expense, and Rent
Expense to their respective accounts in the general ledger. Write the
account number below each column in the cash payments journal as it is
posted to indicate that this step has been completed and CP1 in the Post.
Ref. column of each general ledger account. Place a check mark under the
total of each Other Accounts column in the cash payments journal to indi-
cate that the postings in the column have been made and that the total is
not posted.
General Journal Adjusting and closing entries are recorded in the general
journal. Transactions that do not involve sales, purchases, cash receipts, or cash
payments should also be recorded in the general journal. Usually, there are only
a few of these transactions. Two examples of entries that do not fit in a special-
purpose journal are a return of merchandise bought on account and an allowance
from a supplier for credit.
These entries are shown in Exhibit S6-9. Notice that the entries include
a debit or a credit to a controlling account (Accounts Payable or Accounts
Receivable). The name of the customer or supplier also is given here. When
this kind of debit or credit is made to a controlling account in the general
ledger, the entry must be posted twice: once to the controlling account and
once to the individual account in the subsidiary ledger. This procedure keeps
the subsidiary ledger equal to the controlling account. Notice that the July
26 transaction is posted by a debit to Sales Returns and Allowances in the
general ledger (shown by the account number 413), a credit to the Accounts
Receivable controlling account in the general ledger (account number 114),
and a credit to the Maxwell Gertz account in the accounts receivable subsidiary
ledger (check mark).
314 SUPPLEMENT TO CHAPTER 6
EXHIBIT S6-9
Transactions Recorded General Journal Page 1
in the General Journal
Post.
Date Description Ref. Debit Credit
Study Note
July 25 Accounts Payable, Thomas Auto 212/√ 700
The general journal is used
Purchases Returns and
only to record transactions that
cannot be accommodated by Allowances 513 700
the special-purpose journals. Returned used car for
Whenever a controlling account credit; invoice date 7/11
is recorded, it must be “double
26 Sales Returns and Allowances 413 35
posted” to the general ledger
Accounts Receivable, Maxwell
and the subsidiary accounts.
Gertz 114/√ 35
All general journal entries are
posted daily; column totals are Allowance for faulty tire
neither obtained nor posted.
Problems
Cash Receipt and Cash Payments Journals
P 1. Kimball Company is a small retail business that uses a manual data processing
system similar to the one described in the chapter. Among its special-p urpose
journals are multicolumn cash receipts and cash payments journals. These were |
the cash transactions for Kimball Company during the month of November:
Nov. 1 Paid November rent to R. Carello, $1,000, with check no. 782.
3 Paid Stavos Wholesale on account, $2,300 less a 2 percent
discount, check no. 783.
4 Received payment on account of $1,000, within the 2 percent
discount period, from J. Walker.
5 Cash sales, $2,632.
8 Paid Moving Freight on account, $598, with check no. 784.
9 The owner, Fred Kimball, invested an additional $10,000 in cash
and a truck valued at $14,000 in the business.
11 Paid Escobedo Supply on account, $284, with check no. 785.
14 Cash sales, $2,834.
15 Paid Moving Freight $310 for the freight on a shipment of
merchandise received today, with check no. 786.
16 Paid Ludman Company on account, $1,568 net a 2 percent
discount, with check no. 787.
17 Received payment on account from P. Sivula, $120.
18 Cash sales, $1,974.
19 Received payment on a note receivable, $1,800 plus $36 interest.
20 Purchased office supplies from Escobedo Supply, $108, with
check no. 788.
21 Paid a note payable in full to Kenington Bank, $4,100 including
$100 interest, with check no. 789.
24 Cash sales, $2,964.
Special-Purpose Journals 315
Nov. 25 Paid $500 less a 2 percent discount to Stavos Wholesale, with
check no. 790.
26 Paid sales clerk Tracy Dye $1,100 for her monthly salary, with
check no. 791.
27 Purchased equipment from Standard Corporation for $16,000,
paying $4,000 with check no. 792 and signing a note payable for
the difference.
30 Fred Kimball withdrew $1,200 from the business, using check
no. 793.
Required
1. Enter these transactions in the cash receipts and cash payments journals.
2. Foot and crossfoot the journals.
3. If a manager wanted to know the total sales for the accounting period, where
else would the manager need to refer to obtain the data needed?
Purchases and General Journals
P 2. Meloon Lawn Supply Company uses a multicolumn purchases journal and a
general journal similar to those illustrated in the text. The company also maintains
an accounts payable subsidiary ledger. The items below represent the company’s
credit transactions for the month of July.
July 2 Purchased merchandise from Diego Fertilizer Company, $2,640.
3 Purchased office supplies of $166 and store supplies of $208
from Laronne Supply, Inc.
5 Purchased cleaning equipment from Whitman Company, $1,856.
7 Purchased display equipment from Laronne Supply, Inc.,
$4,700.
10 Purchased lawn mowers from Brandon Lawn Equipment Com-
pany, for resale, $8,400 (which included transportation charges
of $350).
14 Purchased merchandise from Diego Fertilizer Company, $3,444.
18 Purchased a lawn mower from Brandon Lawn Equipment Com-
pany to be used in the business, $950 (which included transpor-
tation charges of $70).
23 Purchased store supplies from Laronne Supply, Inc., $54.
27 Returned a defective lawn mower purchased on July 10 for full
credit, $750.
Required
1. Enter the preceding transactions in the purchases journal and the general
journal. Assume that all terms are n/30 and that invoice dates are the same as
the transaction dates. Use Page 1 for all references.
2. Foot and crossfoot the purchases journal.
3. Open the following general ledger accounts: Store Supplies (116), Office
Supplies (117), Lawn Equipment (142), Display Equipment (144), Clean-
ing Equipment (146), Accounts Payable (211), Purchases (611), Purchases
Returns and Allowances (612), and Freight In (613). Open accounts payable
subsidiary ledger accounts as needed. Post from the journals to the ledger
accounts.
316 SUPPLEMENT TO CHAPTER 6
Comprehensive Use of Special-Purpose Journals
P 3. Ye Olde Book Store opened its doors for business on May 1. During May,
the following transactions took place:
May 1 Linda Berrill began the business by depositing $42,000 in the
new company’s bank account.
3 Issued check no. C001 to Remax Rentals for one month’s rent,
$1,000.
4 Received a shipment of books from Chassman Books, Inc.,
invoice dated May 3, terms 5/10, n/60, FOB shipping point,
$15,680.
5 Received a bill for freight from Menden Shippers for the previous |
day’s shipment, terms n/30, $790.
6 Received a shipment from Lakeside Books, invoice dated May 6,
terms 2/10, n/30, FOB shipping point, $11,300.
7 Issued check no. C002 to Pappanopoulos Freight for transporta-
tion charges on the previous day’s shipment, $574.
8 Issued check no. C003 to Yun Chao Equipment Company for
store equipment, $10,400.
9 Sold books to Midtown Center, terms 5/10, n/30, invoice
no. 1001, $1,564.
10 Returned books to Chassman Books, Inc., for credit, $760.
11 Issued check no. C004 to WCAM for radio commercials, $235.
12 Issued check no. C005 to Chassman Books, Inc., for balance of
amount owed less discount.
13 Cash sales for the first two weeks, $4,018. (For this problem,
cash sales are recorded every two weeks, not daily as they are in
actual practice.)
14 Issued check no. C006 to Lakeside Books, $6,000 less discount.
15 Signed a 90-day, 10 percent note for a bank loan and received
$20,000 in cash.
15 Sold books to Steve Oahani, terms n/30, invoice no. 1002,
$260.
16 Issued a credit memorandum to Midtown Center for returned
books, $124.
17 Received full payment from Midtown Center of balance owed
less discount.
18 Sold books to Missy Porter, terms n/30, invoice no. 1003, $194.
19 Received a shipment from Perspectives Publishing Company,
invoice dated May 18, terms 5/10, n/60, $4,604.
20 Returned additional books purchased on May 4 to Chassman
Books, Inc., for credit at gross price, $1,436.
21 Sold books to Midtown Center, terms 5/10, n/30, invoice
no. 1004, $1,634.
23 Received a shipment from Chassman Books, Inc., invoice dated
May 19, terms 5/10, n/60, FOB shipping point, $2,374.
24 Issued check no. C007 to Menden Shippers for balance owed on
account plus shipping charges of $194 on previous day’s shipment.
27 Cash sales for the second two weeks, $7,488.
29 Issued check no. C008 to Payroll for salaries for first four weeks
of the month, $1,400.
30 Issued check no. C009 to WXAM for radio commercials, $235.
31 Cash sales for the last four days of the month, $554.
Special-Purpose Journals 317
Required
1. Prepare a sales journal, a multicolumn purchases journal, a cash receipts jour-
nal, a cash payments journal, and a general journal. Use Page 1 for all journal
references.
2. Open the following general ledger accounts: Cash (111); Accounts Receiv-
able (112); Store Equipment (141); Accounts Payable (211); Notes Payable
(212); Linda Berrill, Capital (311); Sales (411); Sales Discounts (412); Sales
Returns and Allowances (413); Purchases (511); Purchases Discounts (512);
Purchases Returns and Allowances (513); Freight In (514); Salaries Expense
(611); Advertising Expense (612); and Rent Expense (613).
3. Open accounts receivable subsidiary ledger accounts for Midtown Center,
Steve Oahani, and Missy Porter.
4. Open accounts payable subsidiary ledger accounts for Chassman Books, Inc.;
Lakeside Books; Menden Shippers; and Perspectives Publishing Company.
5. Enter the transactions in the journals and post as appropriate.
6. Foot and crossfoot the journals, and make the end-of-month postings.
7. Prepare a trial balance of the general ledger and prove the control balances
of Accounts Receivable and Accounts Payable by preparing schedules of
accounts receivable and accounts payable.
C H A P T E R
7
Internal Control
I n earlier chapters, we pointed out management’s responsibility
Making a
Statement for ensuring the accuracy and fairness of financial statements.
To fulfill that responsibility, management must see that transac-
INCOME STATEMENT
tions are properly recorded and that the company’s assets are pro-
Revenues
tected. That, in turn, requires a system of internal controls. In this
– Expenses
chapter, we examine internal controls over the transactions of mer-
= Net Income
chandising companies. These controls and the other issues that we
describe apply not just to merchandisers, but to manufacturing and
STATEMENT OF
OWNER’S EQUITY service companies as well.
Beginning Balance
+ Net Income
– Withdrawals LEARNING OBJECTIVES
= Ending Balance
LO1 Identify the management issues related to internal
BALANCE SHEET control. (pp. 320–322) |
Assets Liabilities
LO2 Describe the components of internal control, control activities,
and limitations on internal control. (pp. 322–325)
Owner’s
Equity
LO3 Apply internal control activities to common merchandising
A = L + OE transactions. (pp. 325–332)
STATEMENT OF CASH FLOWS
Operating activities
SUPPLEMENTAL OBJECTIVE
+ Investing activities
+ Financing activities
= Change in Cash SO4 Demonstrate the use of a simple imprest (petty cash)
+ Beginning Balance system. (pp. 332–334)
= Ending Cash Balance
Internal control applies to
all transactions and ensures
the fair presentation of the
financial statements.
318
DECISION POINT (cid:2) A USER’S FOCUS (cid:2) How can Fisher’s Grill maintain
control over its operations?
FISHER’S GRILL
(cid:2) How can Fisher’s Grill’s bank
and other users of its financial
Fisher’s Grill is a popular neighborhood restaurant. Its business has statements be confident that
increased substantially over the past year, and Jane Fisher, the res- the restaurant has an adequate
system of internal control?
taurant’s owner, has had to hire more cashiers, waiters, and kitchen
help. Since taking on the additional staff, she has become concerned
about possible theft of cash and food inventory, and she is looking for
ways to prevent it. She is also concerned about whether the restau-
rant’s sales and other transactions are being recorded properly, for if
they are not, the restaurant’s financial statements will be inaccurate.
She is particularly concerned about this at the moment because she
is considering applying for a bank loan so that she can open a sec-
ond restaurant, and she knows that to obtain a loan, she will have to
present Fisher’s Grill’s financial statements to the bank.
331199
320 CHAPTER 7 Internal Control
Management
Internal control is a process designed by a company to establish the reliability
Issues Related to of the accounting records and financial statements in accordance with generally
accepted accounting principles (GAAP) and to ensure that the company’s assets
Internal Control
are protected.1 Management must assess its needs for internal controls, establish
its responsibility for them, and engage auditors of them, if required.
LO1 Identify the management
issues related to internal control.
The Need for Internal Controls
Buying and selling, the principal transactions of merchandising businesses, involve
assets—cash, accounts receivable, and merchandise inventory—that are vulner-
able to theft and embezzlement. Cash and inventory can, of course, be fairly
easy to steal. The potential for embezzlement exists because the large number
of transactions that are usually involved in a merchandising business (e.g., cash
receipts, receipts on account, payments for purchases, and receipts and shipments
of inventory) makes monitoring the accounting records difficult.
If a merchandising company does not take steps to protect its assets, it can
suffer high losses of both cash and inventory. Management’s responsibility is to
establish an environment, accounting systems, and internal control procedures
that will protect the company’s assets.
A company’s merchandise inventory includes all goods intended for sale
regardless of where they are located—on shelves, in storerooms, in warehouses,
or in trucks between warehouses and stores. It also includes goods in transit from
suppliers if title to the goods has passed to the merchandiser. Ending inventory
does not include merchandise that a company has sold but not yet delivered to
customers. Nor does it include goods that it cannot sell because they are dam-
aged or obsolete. If damaged or obsolete goods can be sold at a reduced price,
however, they should be included in ending inventory at their reduced value.
Merchandisers usually take a physical inventory after the close of business
Study Note
oon the last day of their fiscal year. This process involves an actual count of all mer-
cchandise on hand. It can be a difficult task because it is easy to accidentally omit
Inventory shortages can result
from honest mistakes, such as
iitems or count them twice. A physical inventory must be taken under both the |
accidentally tagging inventory pperiodic and the perpetual inventory systems.
with the wrong number. To facilitate the process, merchandisers often end the fiscal year in a slow season,
wwhen inventories are at relatively low levels. For example, many department stores
eend their fiscal year in January or February. After hours—at night, on a weekend, or
when the store closes for all or part of a day for taking inventory—employees count
all items and record the results on numbered inventory tickets or sheets, following
procedures to ensure that no items will be missed. Using bar coding to take inven-
tory electronically has greatly facilitated the process in many companies.
Most companies experience losses of merchandise inventory from spoilage,
shoplifting, and theft by employees. When such losses occur, the periodic inventory
system provides no means of identifying them because the costs are automatically
included in the cost of goods sold. For example, suppose a company has lost $1,250
in stolen merchandise during an accounting period. When the physical inventory is
taken, the missing items are not in stock, so they cannot be counted. Because the
eending inventory does not contain these items, the amount subtracted from the
Study Note
ccost of goods available for sale is less than it would be if the goods were in stock.
An adjustment to the Merchandise TThe cost of goods sold, then, is overstated by $1,250. In a sense, the cost of goods
Inventory account will be needed ssold is inflated by the amount of merchandise that has been lost.
if the physical inventory reveals The perpetual inventory system makes it easier to identify such losses. Because
a difference between the actual tthe Merchandise Inventory account is continuously updated for sales, purchases,
inventory and the amount in aand returns, the loss will show up as the difference between the inventory records
the records. aand the physical inventory taken at the end of the accounting period. Once the
aamount of the loss has been identified, the ending inventory is updated by crediting
Management Issues Related to Internal Control 321
Merchandise inventory includes all
goods intended for sale wherever
they are located—on store shelves, in
warehouses, on car lots, or in transit
from suppliers if title to the goods has
passed to the merchandiser. To pre-
vent loss of inventory, a merchandiser
must have an effective system
of internal control.
Courtesy of Tony Tremblay/
istockphoto.com.
the Merchandise Inventory account. The offsetting debit is usually an increase in
Cost of Goods Sold because the loss is considered a cost that reduces the company’s
gross margin.
Management’s Responsibility for Internal Control
Management is responsible for establishing a satisfactory system of internal con-
trols. Such a system includes all the policies and procedures needed to ensure
the reliability of financial reporting, compliance with laws and regulations, and
the effectiveness and efficiency of operations. In other words, management must
safeguard the firm’s assets, ensure the reliability of its accounting records, and see
that its employees comply with all legal requirements and operate the firm to the
best advantage of its owners.
Section 404 of the Sarbanes-Oxley Act of 2002 requires that the chief execu-
tive officer, the chief financial officer, and the auditors of a public company fully
document and certify the company’s system of internal controls. For example, in
its annual report, Costco’s management acknowledges its responsibility for inter-
nal control as follows:
Our management is responsible for establishing and maintaining adequate
internal control over financial reporting.2
FOCUS ON BUSINESS PRACTICE
Will Sarbanes-Oxley Stop Fraud?
The Sarbanes-Oxley Act has heightened awareness of system, such as giving the treasurer authorization to set up
internal control and requires increased diligence, but it will a legal entity, set up a bank account, make purchases, and
never stop fraud from occurring. For instance, NBC Uni- pay for them. This situation violated a basic rule of internal |
versal, the large media company, recently reported that control in that the treasurer was able to accomplish both
its treasurer had been arrested for theft of $800,000. The the purchase and the payment with no checks by another
theft occurred due to deficiencies in the internal control person.3
322 CHAPTER 7 Internal Control
Independent Accountant’s Audit of Internal Control
Although privately owned companies usually are not required to have an inde-
pendent certified public accountant audit their financial statements, many com-
panies choose to do so. These companies are also not required to have their
internal control systems audited. Public companies like Costco, on the other
hand, are required to not only have an independent audit of their financial state-
ments; under the Sarbanes-Oxley Act, they must also have an audit of their inter-
nal control over financial reporting. This audit provides reasonable assurance of
the adequacy of management’s assessment that proper records are maintained,
transactions are recorded in accordance with GAAP, and assets are protected. For
instance, Costco’s auditors state:
In our opinion, management maintained, in all material respects, effective
internal control over financial reporting.4
STOP
& APPLY
Match the following items with their related statements below:
a. Internal control _____ 2. E stablished by management to ensure
b. A need of internal control the reliability of accounting records
and financial statements in accor-
c. Management’s responsibility
dance with GAAP
d. Independent accountant’s audit
_____ 3. H uman error can cause errors in the
_____ 1. Provides reasonable assurance to out-
financial statements
side parties that management main-
_____ 4. T o assure the establishment of a sys-
tains internal control over financial
tem of internal control and assess its
reporting
effectiveness
SOLUTION
1. d; 2. a; 3. b; 4. c
Internal Control:
As mentioned earlier, if a merchandising company does not take steps to protect
Components, its assets, it can suffer high losses of cash and inventory through embezzlement
and theft. To avoid such occurrences, management must set up and maintain a
Activities, and
good system of internal control.
Limitations
Components of Internal Control
LO2 Describe the components
An effective system of internal control has five interrelated components:5
of internal control, control activi-
ties, and limitations on internal 1. Control environment: The control environment is created by management’s
control. overall attitude, awareness, and actions. It encompasses a company’s ethics,
philosophy and operating style, organizational structure, method of assigning
authority and responsibility, and personnel policies and practices. Personnel
should be qualified to handle responsibilities, which means that they must be
trained and informed about what is expected of them. For example, the man-
ager of a retail store should train employees to follow prescribed procedures
for handling cash sales, credit card sales, and returns and refunds.
Internal Control: Components, Activities, and Limitations 323
2. Risk assessment: Risk assessment involves identifying areas in which risks of
loss of assets or inaccuracies in accounting records are high so that adequate
controls can be implemented. Among the greater risks in a retail store are
that employees may steal cash and customers may steal goods.
3. Information and communication: Information and communication per-
tains to the accounting system established by management—to the way the
system gathers and treats information about the company’s transactions
and to how it communicates individual responsibilities within the system.
Employees must understand exactly what their functions are.
4. Control activities: Control activities are the policies and procedures man-
agement puts in place to see that its directives are carried out. (Control activi-
ties are discussed in more detail below.)
Study Note
5. Monitoring: Monitoring involves management’s regular assessment of the
The components of internal quality of internal control, including periodic review of compliance with all |
control are equally important policies and procedures. Large companies often have a staff of internal audi-
to manual and computerized tors who review the company’s system of internal control to determine if it is
accounting systems. working properly and if procedures are being followed. In smaller businesses,
owners and managers conduct these reviews.
Control Activities
Control activities are a very important way of implementing internal control. The
goal of these activities is to safeguard a company’s assets and ensure the reliability
of its accounting records.
Control activities include the following:
1. Authorization: Authorization means the approval of certain transactions
and activities. In a retail store, for example, cashiers customarily authorize
cash sales, but other transactions, such as issuing a refund, may require a
manager’s approval.
2. Recording transactions: To establish accountability for assets, all transactions
should be recorded. For example, if a retail store uses a cash register that
records sales, refunds, and other transactions on a paper tape or computer
disk, the cashier can be held accountable for the cash received and the mer-
chandise removed during his or her shift.
FOCUS ON BUSINESS PRACTICE
Which Frauds Are Most Common?
A survey of 5,000 large U.S. businesses disclosed that were notification by an employee, internal controls,
36 percent suffered losses in excess of $1 million (up internal auditor review, notification by a customer, and
from 21 percent in 1998) due to fraud or inventory theft. accidental discovery.
The frauds most commonly cited were credit card fraud, Companies that are successful in preventing fraud have
check fraud, false invoices and phantom vendors, and a good system of internal control, a formal code of eth-
expense account abuse. The most common reasons for ics, and a program to monitor compliance that includes a
the occurrences of these frauds were poor internal con- system for reporting incidents of fraud. These companies
trols, management override of internal controls, and col- routinely communicate the existence of the program to
lusion. The most common methods of detecting them their employees.6
324 CHAPTER 7 Internal Control
3. Documents and records: Well-designed documents help ensure that transac-
tions are properly recorded. For example, using prenumbered invoices and
other documents is a way of ensuring that all transactions are recorded.
4. Physical controls: Physical controls are controls that limit access to assets.
For example, in a retail store, only the person responsible for the cash register
should have access to it. Other employees should not be able to open the
cash drawer when the cashier is not present. Similarly, only authorized per-
sonnel should have access to warehouses and storerooms. Access to account-
ing records, including those stored in company computers, should also be
controlled.
5. Periodic independent verification: Periodic independent verification
means that someone other than the persons responsible for the accounting
records and assets should periodically check the records against the assets.
For example, at the end of each shift or day in a retail store, the owner or
manager should count the cash in the cash drawer and compare the amount
with the amount recorded on the tape or computer disk in the cash register.
Other examples of independent verification are periodic counts of physical
inventory and reconciliations of monthly bank statements.
6. Separation of duties: Separation of duties means that no one person should
authorize transactions, handle assets, or keep records of assets. For example,
in a well-managed electronics store, each employee oversees only a single
part of a transaction. A sales employee takes the order and creates an invoice.
Another employee receives the customer’s cash or credit card payment and
issues a receipt. Once the customer has a receipt, and only then, a third
employee obtains the item from the warehouse and gives it to the customer.
A person in the accounting department subsequently compares all sales |
recorded on the tape or disk in the cash register with the sales invoices and
updates the inventory in the accounting records. The separation of duties
means that a mistake, careless or not, cannot be made without being seen by
at least one other person.
7. Sound personnel practices: Personnel practices that promote internal control
include adequate supervision, rotation of key people among different jobs,
insistence that employees take vacations, and bonding of personnel who
handle cash or inventory. Bonding is the process of carefully checking an
employee’s background and insuring the company against theft by that per-
son. Bonding does not guarantee against theft, but it does prevent or reduce
loss if theft occurs. Prudent personnel practices help ensure that employees
know their jobs, are honest, and will find it difficult to carry out and conceal
embezzlement over time.
Limitations of Internal Control
No system of internal control is without weaknesses. As long as people perform
Study Note
control procedures, an internal control system will be vulnerable to human error.
No control procedure can Errors can arise from misunderstandings, mistakes in judgment, carelessness, dis-
guarantee the prevention traction, or fatigue. And separation of duties can be defeated through collusion
of theft. However, the more by employees who secretly agree to deceive a company. In addition, established
procedures that are in place, procedures may be ineffective against employees’ errors or dishonesty, and con-
the less likely it is that a theft trols that were initially effective may become ineffective when conditions change.
will occur. In some cases, the costs of establishing and maintaining elaborate control systems
may exceed the benefits. In a small business, for example, active involvement by
the owner can be a practical substitute for the separation of some duties.
Internal Control over Merchandising Transactions 325
FOCUS ON BUSINESS PRACTICE
Shoplifters: Beware!
With theft from shoplifting approaching $30 billion per year, across the country. Advanced surveillance software can com-
retailers are increasing their use of physical controls beyond pare a shopper’s movements between video images and
the usual electronic warning if a customer tries to walk out recognize unusual activity. For instance, removing 10 items
without paying. Companies such as Macy’s and Babies ‘R’ from a shelf or opening a drawer that normally is closed
Us have installed more than 6 million video cameras in stores would trigger the system to alert a security guard.7
STOP
& APPLY
Match the following internal control components with the related statements below:
a. Company environment _____ 3. H as an internal audit department
b. Risk assessment _____ 4. P eriodic independent verification of
employees’ work
c. Information and communication
_____ 5. Assesses the possibility of losses
d. Control activities
_____ 6. Instructs and trains employees
e. Monitoring _____ 7. H as well-designed documents and
_____ 1. Establishes separation of duties records
_____ 2. C ommunicates appropriate informa- _____ 8. L imits physical access to authorized
tion to employees personnel
SOLUTION
1. d; 2. c; 3. e; 4. d; 5. b; 6. a; 7. d; 8. d
Internal
Sound internal control activities are needed in all aspects of a business, but par-
Control over ticularly when assets are involved. Assets are especially vulnerable when they enter
and leave a business. When sales are made, for example, cash or other assets enter
Merchandising
the business, and goods or services leave. Controls must be set up to prevent theft
Transactions during those transactions. Purchases of assets and payments of liabilities must
also be controlled; adequate purchasing and payment systems can safeguard most
LO3 Apply internal control such transactions. In addition, assets on hand—such as cash, investments, inven-
activities to common merchan- tory, plant, and equipment—must be protected.
dising transactions.
Internal Control and Management Goals
When a system of internal control is applied effectively to merchandising trans- |
actions, it can achieve important management goals. As we have noted, it can
prevent losses of cash and inventory due to theft or fraud, and it can ensure that
records of transactions and account balances are accurate. It can also help manag-
ers achieve three broader goals:
1. Keeping enough inventory on hand to sell to customers without overstocking
merchandise
326 CHAPTER 7 Internal Control
2. Keeping sufficient cash on hand to pay for purchases in time to receive discounts
Study Note
3. Keeping credit losses as low as possible by making credit sales only to custom-
Maintaining internal control
ers who are likely to pay on time
is especially difficult for a
merchandiser. Management In this section of the text, you will see how merchandising companies apply
must not only establish internal control activities to such transactions as cash sales, receipts, purchases,
controls for cash sales, receipts, and cash payments. Service and manufacturing businesses use similar procedures.
purchases, and cash payments
but also go to great lengths
Control of Cash
to manage and protect its
inventory.
One control that managers use to meet the broad goals listed above is the cash
budget, which projects future cash receipts and disbursements. By maintaining
adequate cash balances, a company is able to take advantage of discounts on pur-
chases, prepare to borrow money when necessary, and avoid the damaging effects
of being unable to pay bills when they are due. By investing excess cash, the com-
pany can earn interest until the cash is needed.
A more specific control is the separation of duties that involve the handling
of cash. Such separation makes theft without detection extremely unlikely unless
two or more employees conspire. The separation of duties is easier in large busi-
nesses than in small ones, where one person may have to carry out several duties.
The effectiveness of internal control over cash varies, based on the size and nature
of the company. Most firms, however, should use the following procedures:
1. Separate the functions of authorization, recordkeeping, and custodianship of cash.
2. Limit the number of people who have access to cash, and designate who
those people are.
3. Bond all employees who have access to cash.
4. Keep the amount of cash on hand to a minimum by using banking facilities as
much as possible.
5. Physically protect cash on hand by using cash registers, cashiers’ cages, and safes.
6. Record and deposit all cash receipts promptly, and make payments by check
rather than by currency.
7. Have a person who does not handle or record cash make unannounced audits
of the cash on hand.
8. Have a person who does not authorize, handle, or record cash transactions
reconcile the Cash account each month.
Notice that each of these procedures helps safeguard cash by making it more dif-
ficult for any one individual who has access to cash to steal or misuse it without
being detected.
Control of Cash Receipts
Cash from sales of goods and services can be received by mail or over the counter
in the form of checks, credit or debit cards, or currency. Whatever the source
of the cash, it should be recorded immediately upon receipt in a cash receipts
journal. Such a journal establishes a written record of cash receipts that should
prevent errors and make theft more difficult.
Control of Cash Received by Mail Cash received by mail is vulnerable to
theft by the employees who handle it. For that reason, companies that deal in
Internal Control over Merchandising Transactions 327
FOCUS ON BUSINESS PRACTICE
How Do Computers Promote Internal Control?
One of the more difficult challenges facing computer pro- that require documents and transactions to be in proper
grammers is to build good internal controls into account- order. They typically use passwords and questions about
ing programs. Such programs must include controls that randomly selected personal data to prevent unauthor-
prevent unintentional errors, as well as unauthorized ized access to computer records. They may also use fire-
access and tampering. They prevent errors through rea- walls, which are strong electronic barriers to unauthorized |
sonableness checks (such as not allowing any transac- access, as well as data encryption. Data encryption is a
tions over a specified amount), mathematical checks that way of coding data so that if they are stolen, they are use-
verify the arithmetic of transactions, and sequence checks less to the thief.
mail-order sales generally ask customers to pay by credit card, check, or money
order instead of with currency.
When cash is received in the mail, two or more employees should handle it.
The employee who opens the mail should make a list in triplicate of the money
received. The list should contain each customer’s name, the purpose for which
the money was sent, and the amount. One copy goes with the cash to the cashier,
who deposits the money. The second copy goes to the accounting department
for recording. The person who opens the mail keeps the third copy. Errors can
be easily caught because the amount deposited by the cashier must agree with the
amount received and the amount recorded in the cash receipts journal.
Control of Cash Received Over the Counter Cash registers and prenum-
Study Note
bered sales tickets are common tools for controlling cash received over the coun-
ter. The amount of a cash sale is rung up on the cash register at the time of the
The cashier should not be
sale. The register should be placed so that the customer can see the amount
allowed to remove the cash
register tape or to record the recorded. Each cash register should have a locked-in tape on which it prints the
day’s cash receipts. day’s transactions. At the end of the day, the cashier counts the cash in the regis-
ter and turns it in to the cashier’s office. Another employee takes the tape out of
the cash register and records the cash receipts for the day in the cash receipts jour-
nal. The amount of cash turned in and the amount recorded on the tape should
agree; if not, any differences must be explained.
Large retail chains like Costco commonly monitor cash receipts by having
each cash register tied directly into a computer that records each transaction as it
occurs. Whether the elements are performed manually or with a computer, sepa-
rating responsibility for cash receipts, cash deposits, and recordkeeping is neces-
sary to ensure good internal control.
In some stores, internal control is further strengthened by the use of prenum-
bered sales tickets and a central cash register or cashier’s office, where all sales are
rung up and collected by a person who does not participate in the sale. The sales
person completes a prenumbered sales ticket at the time of the sale, giving one
copy to the customer and keeping a copy. At the end of the day, all sales tickets
must be accounted for, and the sales total computed from the sales tickets must
equal the total sales recorded on the cash register.
Control of Purchases and Cash Disbursements
Cash disbursements are particularly vulnerable to fraud and embezzlement.
In one case, the treasurer of one of the nation’s largest jewelry retailers was
328 CHAPTER 7 Internal Control
FIGURE 7-1 Internal Controls in a Large Company: Separation of Duties and Documentation
Check
VENDOR
Deposit Ticket BANKING
SYSTEM
Goods
Invoice
Purchase Order THE COMPANY
PURCHASING Purchase REQUESTING RECEIVING
Goods
DEPARTMENT Requisition DEPARTMENT DEPARTMENT
Purchase Order Copy
Receiving Report
ACCOUNTING DEPARTMENT TREASURER
Check Authorization
(with documentation)
Monthly Bank Statement
charged with having stolen over $500,000 by systematically overpaying the
company’s federal income taxes and keeping the refund checks as they came
back to the company.
To avoid this type of theft, cash payments should be made only after they
have been specifically authorized and supported by documents that establish the
validity and amount of the claims. A company should also separate the duties
involved in purchasing goods and services and the duties involved in paying for
them. The degree of separation that is possible varies, depending on the size of
the business.
Figure 7-1 shows how a large company can maximize the separation of |
duties. Five internal units (the requesting department, the purchasing depart-
ment, the accounting department, the receiving department, and the treasurer)
and two firms outside the company (the vendor and the bank) play a role in
this control plan. Notice that business documents are crucial components of
the plan.
Figure 7-2, on pages 330–331, illustrates the typical sequence in which docu-
ments are used in a company’s internal control plan for purchases and cash dis-
bursements.
Item 1—Purchase Requisition To begin, the credit office (requesting depart-
Study Note
ment) of Laboda Sportswear Company fills out a formal request for a purchase, or
A purchase requisition is not purchase requisition, for office supplies. The head of the requesting department
the same as a purchase order. approves it and forwards it to the purchasing department.
A purchase requisition is sent
Item 2—Purchase Order The people in the purchasing department prepare
to the purchasing department;
a purchase order. The purchase order indicates that Laboda will not pay any bill
a purchase order is sent to the
that does not include a purchase order number. The purchase order is addressed
vendor.
to the vendor (seller) and contains a description of the quantity and type of items
ordered, the expected price, the shipping date and terms, and other instructions.
Internal Control over Merchandising Transactions 329
Item 3—Invoice After receiving the purchase order, the vendor, Hen-
Study Note
dderson Supply Company, ships the goods and sends an invoice to Laboda
SSportswear. The invoice shows the quantity of goods delivered, describes what
Invoice is the business term for
tthey are, and lists the price and terms of payment. If all the goods cannot be
bill. Every business document
must have a number for sshipped immediately, the invoice indicates the estimated date of shipment for
purposes of reference. tthe remainder.
Item 4—Receiving Report When the goods reach Laboda’s receiving depart-
mment, an employee notes the quantity, type of goods, and their condition on a
receiving report. The receiving department does not receive a copy of the pur-
chase order or the invoice, so its employees don’t know what should be received
or its value. Thus, they are not tempted to steal any excess that may be delivered.
Item 5—Check Authorization The receiving report goes to the accounting
department, where it is compared with the purchase order and the invoice. If
everything is correct, the accounting department completes a check authoriza-
tion and attaches it to the three supporting documents. The check authorization
form has a space for each item to be checked off as it is examined. Notice that
the accounting department has all the documentary evidence for the transaction
but does not have access to the assets purchased. Nor does it write the check for
payment. This means that the people doing the accounting cannot conceal fraud
by falsifying documents.
Item 6—Check Finally, the treasurer examines all the documents. If the
Study Note
ttreasurer approves them, he or she signs a check made out to the vendor in
Internal control documents tthe amount of the invoice less any applicable discount. In some systems, the
sometimes do not exist in paper aaccounting department fills out the check so that all the treasurer has to do
form in today’s computerized iis inspect and sign it. The check is then sent to the vendor, with a remittance
accounting systems, but they do aadvice showing what the check is for. A vendor that is not paid the proper
exist internally and are subject aamount will complain, of course, thus providing a form of outside control
to the same separation of duties oover the payment.
as in manual systems.
Item 7—Bank Statement The vendor deposits the check in its bank, and
tthe canceled check appears in Laboda Sportswear’s next bank statement. If the
ttreasurer has made the check out for the wrong amount (or altered an amount
that was already filled in), the problem will show up in the company’s bank rec-
onciliation.
As shown in Figure 7-2, every action is documented and verified by at least |
one other person. Thus, the requesting department cannot work out a kickback
scheme to make illegal payments to the vendor because the receiving department
independently records receipts and the accounting department verifies prices. The
receiving department cannot steal goods because the receiving report must equal
the invoice. For the same reason, the vendor cannot bill for more goods than it
ships. The treasurer verifies the accounting department’s work, and the account-
ing department ultimately checks the treasurer’s work.
The system we have described is a simple one that provides adequate internal
control. There are many variations on it.
330 CHAPTER 7 Internal Control
FIGURE 7-2 Internal Control Plan for Purchases and Cash Disbursements
1 PURCHASE REQUISITION No. 7077
Laboda Sportswear Company
From: Credit Office Date: September 6, 2010
To: Purchasing Department Suggested Vendor: Henderson Supply
Please purchase the following items: Company
Quantity Number Description
20 boxes X 144 Office Supplies
2 PURCHASE ORDER No. J 102
Reason for Request To be filled in by Purchasing Department Laboda Sportswear Company
8428 Rocky Island Avenue
Six months’ supply Chicago, Illinois 60643
for office Date ordered 9/8/2010 P.O. No. J 102 To: Henderson Supply Company Date: September 8, 2010
Approved 2 M5 e2 s5 a ,2 5 It lh l iS nt or ie se t 61611 FOB: Destination
Ship by: September 12, 2010
Ship to: Laboda Sportswear Company
Above Address Terms: 2/10, n/30
Please ship the following:
Quantity Number Description Price Per Amount
3
INVOICE No. 0468 20 boxes X 144 Office Supplies 12.00 box $240.00
Henderson Supply Company Date: September 12, 2010
2 M5 e2 s5 a 2 , 5 Ilt lh in S ot ir se 6e 1t 611 Your Order No.: J 102
Sold to: Ship to: P ou nr ac lh l a ss he i po mrd ee nr t n s u am ndb e inr vm oiu cs et s a .ppear Ordered by
Laboda Sportswear Company Same
8428 Rocky Island Avenue
Chicago, Illinois 60643
Sales Representative: Joe Jacobs
Quantity
Ordered Shipped Description Price Per Amount
20 20 X 144 Office Supplies 12.00 box $240.00 4 RECEIVING REPORT No. JR065
Laboda Sportswear Company
8428 Rocky Island Avenue
Chicago, Illinois 60643
FOB Destination Terms: 2/10, n/30 Date Shipped: 9/12/2010Via: Self Date: September 12, 2010
Quantity Number Description Condition
20 boxes X 144 Office Supplies O.K.
5 CHECK AUTHORIZATION
NO. CHECK Received by
Purchase Order J 102
Receiving Report JR065
INVOICE 0468
Price
Calculations
Terms
6
Approved for Payment Laboda Sportswear Company NO. 2570
8428 Rocky Island Avenue 61-153/313
Chicago, Illinois 60643
9/21 2010
PAY TO
THE ORDER OF Henderson Supply Company $ 235.20
Two hundred thirty-five and 20/100 — — — — — — — — — — Dollars
THE LAKE PARK NATIONAL BANK Laboda Sportswear Company
Chicago, Illinois
by
Remittance Advice
Date P.O. No. DESCRIPTION AMOUNT
9/21/2010 J 102 20 X 144 Office Supplies
Supplier Inv. No. 0468 $240.00
Less 2% discount 4.80
Net $235.20
Laboda Sportswear Company
Internal Control over Merchandising Transactions 331
FIGURE 7-2 continued
Business Verification and
Document Prepared by Sent to Related Procedures
1 Purchase Requesting Purchasing Purchasing verifies authorization.
requisition department department
2 Purchase Purchasing Vendor Vendor sends goods or services in
order department accordance with purchase order.
3 Invoice Vendor Accounting Accounting receives invoice from
department vendor.
4 Receiving Receiving Accounting Accounting compares invoice, purchase
report department department order, and receiving report. Accounting
verifies prices.
5 Check Accounting Treasurer Accounting attaches check authorization
authorization department to invoice, purchase order, and
receiving report.
6 Check Treasurer Vendor Treasurer verifies all documents before
preparing check.
7 Bank Buyer’s Accounting Accounting compares amount and
statement bank department payee’s name on returned check with
check authorization.
Statement of Account with
7 THE LAKE PARK NATIONAL BANK
Chicago, Illinois
Checking Acct No
Laboda Sportswear Company 8030-647-4
8428 Rocky Island Avenue Period covered
Chicago, Illinois 60643 Sept.30-Oct.31,2010 |
Previous Balance Checks/Debits—No. Deposits/Credits—No. S.C. Current Balance
$2,645.78 $4,319.33 ––16 $5,157.12 ––7 $12.50 $3,471.07
CHECKS/DEBITS DEPOSITS/CREDITS DAILY BALANCES
Posting Check Posting
Date No. Amount Date Amount Date Amount
09/30 2,645.78
10/01 2564 100.00 10/01 586.00 10/01 2,881.78
10/01 2565 250.00 10/05 1,500.00 10/04 2,825.60
10/04 2567 56.18 10/06 300.00 10/05 3,900.46
10/05 2566 425.14 10/16 1,845.50 10/06 4,183.34
10/06 2568 17.12 10/21 600.00 10/12 2,242.34
10/12 2569 1,705.80 10/24 300.00CM 10/16 3,687.84
10/12 2570 235.20 10/31 25.62IN 10/17 3,589.09
10/16 2571 400.00 10/21 4,189.09
10/17 2572 29.75 10/24 3,745.59
10/17 2573 69.00 10/25 3,586.09
10/24 2574 738.50 10/28 3,457.95
10/24 5.00DM 10/31 3,471.07
10/25 2575 7.50
10/25 2577 152.00
10/28 118.14NSF
10/28 10.00DM
10/31 12.50SC
Explanation of Symbols:
CM – Credit Memo SC – Service Charge The last amount
DM – Debit Memo EC – Error Correction in this column
NSF– Non-Sufficient Funds OD– Overdraft is your balance.
IN – Interest on Average Balance
Please examine; if no errors are reported within ten (10) days, the account will be
considered to be correct.
332 CHAPTER 7 Internal Control
STOP
& APPLY
Items a–e below are a company’s departments. Items f and g are firms with which the company has
transactions:
a. Requesting department e. Treasurer
b. Purchasing department f. Vendor
c. Receiving department g. Bank
d. Accounting department
Use the letter of the department or firm to indicate which one prepares and sends the business
documents listed below:
Prepared Received Prepared Received
by by by by
1. Receiving report ___ ___ 5. Invoice ___ ___
2. Purchase order ___ ___ 6. Check authorization ___ ___
3. Purchase requisition ___ ___ 7. Bank statement ___ ___
4. Check ___ ___
SOLUTION
Prepared By Received By Prepared By Received By
1. Receiving report c d 5. Invoice f d
2. Purchase order b f 6. Check authorization d e
3. Purchase requisition a b 7. Bank statement g d
4. Check d, e f
Petty Cash
It is not always practical to make every disbursement by check. For example, it is
Funds sometimes necessary to make small payments of cash for such things as postage
stamps, incoming postage, shipping charges due, or minor purchases of pens,
SO4 Demonstrate the use paper, and the like.
For situations in which it is inconvenient to pay by check, most companies
of a simple imprest (petty cash)
set up a petty cash fund. One of the best ways to control a petty cash fund is
system.
through an imprest system. Under this system, a petty cash fund is established
for a fixed amount. A voucher documents each cash payment made from the
fund. The fund is periodically reimbursed, based on the vouchers, by the exact
amount necessary to restore its original cash balance.
Establishing the Petty Cash Fund
Some companies have a regular cashier or other employee who administers the
petty cash fund. To establish the fund, the company issues a check for an amount
intended to cover two to four weeks of small expenditures. The check is cashed
and the money placed in the petty cash box, drawer, or envelope.
The only entry required when the fund is established is to record the check.
Petty Cash Funds 333
Application of Double Entry:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
CASH
Dr. Cr.
Oct. 14 100.00
PETTY CASH
Dr. Cr.
Oct. 14 100.00
Entry in Journal Form:
Dr. Cr.
Oct. 14 Petty Cash 100.00
Cash 100.00
To establish the petty cash fund
Making Disbursements from the Petty Cash Fund
The custodian of the petty cash fund should prepare a petty cash voucher,
Study Note or written authorization, for each expenditure, as shown in Figure 7-3.
On each petty cash voucher, the custodian enters the date, amount, and
Even though withdrawals from
purpose of the expenditure. The person who receives the payment signs the
petty cash are generally small,
voucher.
the cumulative total over time
The custodian should be informed that unannounced audits of the fund will
can represent a substantial
amount. Accordingly, an be made occasionally. The cash in the fund plus the sum of the petty cash vouch- |
effective system of internal ers should at all times equal the amount shown in the Petty Cash account.
control must be established for
the management of the fund. Reimbursing the Petty Cash Fund
At specified intervals, when the fund becomes low, and at the end of an account-
ing period, the petty cash fund is replenished by a check issued to the custodian
for the exact amount of the expenditures. From time to time, there may be minor
discrepancies in the amount of cash left in the fund at the time of reimbursement.
In those cases, the amount of the discrepancy is recorded in a Cash Short or Over
account—as a debit if short or as a credit if over.
Assume that after two weeks the petty cash fund established earlier has a
cash balance of $14.27 and petty cash vouchers as follows: postage, $25.00;
FIGURE 7-3
Petty Cash Voucher PETTY CASH VOUCHER
No. X 744
Oct. 23, 2010
Date
For Postage due
Charge to Postage Expense
Amount $2.86
Approved by Received by
334 CHAPTER 7 Internal Control
supplies, $30.55; and freight-in, $30.00. The entry to replenish, or replace, the
fund would be:
Assets (cid:2) Liabilities (cid:3) Owner’s Equity
CASH POSTAGE EXPENSE
Dr. Cr. Dr. Cr.
Oct. 28 85.73 Oct. 28 25.00
SUPPLIES EXPENSE
Dr. Cr.
Oct. 28 30.55
Entry in Journal Form:
Oct. 28 Dr. Cr. FREIGHT-IN
Postage Expense 25.00 Dr. Cr.
Supplied Expense 30.55 Oct. 28 30.00
Freight-In 30.00
Cash Short or Over 0.18 CASH SHORT OR OVER
Cash 85.73 Dr. Cr.
To replenish the petty cash fund Oct. 28 0.18
Notice that the Petty Cash account was not affected by the entry to replenish
Study Note
the fund. The Petty Cash account is debited when the fund is established or the
fund level is changed. Expense or asset accounts are debited each time the fund
When the petty cash fund is
is replenished, including in this case $0.18 to Cash Short or Over for a small cash
replenished, the Petty Cash
account is neither debited nor shortage. In most cases, no further entries to the Petty Cash account are needed
credited. But if the size of the unless the firm wants to change the fixed amount of the fund.
fund changes, there should be The petty cash fund should be replenished at the end of an accounting period
an entry to Petty Cash. to bring it up to its fixed amount and ensure that changes in the other accounts
involved are reflected in the current period’s financial statements. If, through an
oversight, the petty cash fund is not replenished at the end of the period, expen-
ditures for the period still must appear on the income statement. They are shown
through an adjusting entry debiting the expense accounts and crediting Petty
Cash. The result is a reduction in the petty cash fund and the Petty Cash account
by the amount of the adjusting entry. In the financial statements, the balance of
the Petty Cash account is usually combined with other cash accounts.
STOP
& APPLY
A petty cash fund is established at $100 on May 1. At the end of May, the fund has a cash balance of
$36 and petty cash vouchers for postage, $29, and office supplies, $34. Prepare the entry to establish
the fund on May 1 and the entry on May 31 to replenish the fund.
SOLUTION
May 1 Petty Cash 100
Cash 100
To establish petty cash fund
May 31 Postage Expense 29
Office Supplies Expense 34
Cash Over or Short 1
Cash 64
To replenish petty cash fund
Fisher’s Grill: Review Problem 335
(cid:2) FISHER’S GRILL: REVIEW PROBLEM
In the Decision Point at the start of this chapter, we noted that Jane Fisher, the owner of
Fisher’s Grill, was looking for ways to ensure that the restaurant’s assets were protected
and that all its transactions were recorded properly. We asked these questions:
• How can Fisher’s Grill maintain control over its operations?
• How can Fisher’s Grill’s bank and other users of its financial statements be
confident that the restaurant has an adequate system of internal control?
After reading this chapter, you know that to maintain control over their operations, all
businesses must have an internal control system that ensures that assets are safeguarded
and that records are maintained properly. To implement such a system, managers must |
assess the risks of loss, establish an environment that encourages compliance with con-
trols, implement an accounting system that has a full set of control activities, and con-
tinuously monitor the system to see that it functions as planned. You also know that the
Internal Control best way for any business to assure users of the integrity of its financial statements is to
Procedures have an independent auditor assess the reliability of its internal control system.
Having become aware of all this, Jane Fisher has made several changes to the res-
LO2 LO3
taurant’s internal controls. Among the internal controls she established for cashiers are
the following:
1. Jane Fisher hires experienced cashiers who are bonded and checks the
references of all new employees.
2. New cashiers are trained in all procedures before being allowed to handle cash.
3. All food bills are prenumbered sequentially.
4. When a customer finishes a meal, the waiter writes up a bill that describes the
food items purchased, including the total price.
5. The waiters are not allowed to access the cash register.
6. If the sale is by credit card, the cashier runs the credit card through a scanner
that verifies the customer’s credit. The scanner prints out a receipt and a slip
for the customer to sign. The signed slip is put in the cash register, and the
customer is given the receipt and a copy of the sales invoice.
7. All sales, whether cash or credit, are rung up on the cash register.
8. The cash register is locked with a key. The cashier is the only person other than
Jane Fisher who has a key. The cash register must be locked when the cashier is
not present.
9. Refunds or discounts are made only with Jane Fisher’s approval.
10. At the end of each day, Jane counts the cash and checks in the cash register and
compares the total with the amount recorded on the tape inside the register.
She totals all the signed credit card slips and ensures that the total equals the
amount recorded by the scanner.
336 CHAPTER 7 Internal Control
Required
Match each of the 10 internal controls described above with the following control
activities. (Some may have more than one answer.)
a. Authorization e. Periodic independent verification
b. Recording transactions f. Separation of duties
c. Documents and records g. Sound personnel practices
d. Physical controls
Answers to
1. g 6. b, c
Review Problem
2. g 7. b, d
3. c 8. d
4. a, c 9. a, f
5. d, f 10. e
Stop & Review 337
STOP
& REVIEW
LO1 Identify the manage- Internal control is a process designed by a company to establish the reliability of the
ment issues related to accounting records and financial statements in accordance with generally accepted
internal control. accounting principles (GAAP) and to ensure that the company’s assets are pro-
tected. Management’s responsibility is to establish an environment, accounting
systems, and internal control procedures that will protect the company’s assets and
to assess how well it meets these goals. Public companies must engage an indepen-
dent CPA to verify that management is indeed meeting these goals.
LO2 Describe the compo- Internal control consists of all the policies and procedures a company uses to
nents of internal control, ensure the reliability of financial reporting, compliance with laws and regula-
control activities, and tions, and the effectiveness and efficiency of operations. Internal control has five
limitations on internal components: the control environment, risk assessment, information and com-
control. munication, control activities, and monitoring. Control activities include having
managers authorize certain transactions; recording all transactions to establish
accountability for assets; using well-designed documents to ensure proper record-
ing of transactions; instituting physical controls; periodically checking records
and assets; separating duties; and using sound personnel practices. A system of
internal control relies on the people who implement it. Thus, the effectiveness of
internal control is limited by the people involved. Human error, collusion, and |
failure to recognize changed conditions can contribute to a system’s failure.
LO3 Apply internal control To implement internal control over cash sales, receipts, purchases, and disbursements,
activities to common the functions of authorization, recordkeeping, and custodianship of cash should be
merchandising kept separate. The people who have access to cash should be specifically designated and
transactions. their number limited. Employees who have access to cash should be bonded. The con-
trol system should also provide for the use of banking services, physical protection of
assets, prompt recording and deposit of cash receipts, and payment by check. A person
who does not authorize, handle, or record cash transactions should make unannounced
audits of the cash on hand, and the Cash account should be reconciled each month.
Supplemental Objective
SO4 Demonstrate the use of An imprest system is a method of controlling small cash expenditures by setting
a simple imprest (petty up a fund at a fixed amount and periodically reimbursing the fund by the amount
cash) system. necessary to restore the original balance. A petty cash fund, one example of an
imprest system, is established by a debit to Petty Cash and a credit to Cash. It is
replenished by debits to various expense or asset accounts and a credit to Cash.
Each expenditure should be supported by a petty cash voucher.
REVIEW of Concepts and Terminology
The following concepts and terms Information and communication Petty cash voucher 333 (SO4)
were introduced in this chapter: 323 (LO2) Physical controls 324 (LO2)
Authorization 323 (LO2) Internal control 320 (LO1) Physical inventory 320 (LO1)
Bonding 324 (LO2) Invoice 329 (LO3) Purchase order 328 (LO3)
Check authorization 329 (LO3) Monitoring 323 (LO2) Purchase requisition 328 (LO3)
Control activities 323 (LO2) Periodic independent verification Receiving report 329 (LO3)
Control environment 322 (LO2) 324 (LO2) Risk assessment 323 (LO2)
Imprest system 332 (SO4) Petty cash fund 332 (SO4) Separation of duties 324 (LO2)
338 CHAPTER 7 Internal Control
CHAPTER ASSIGNMENTS
BUILDING Your Basic Knowledge and Skills
Short Exercises
LO1 Internal Control
SE 1. Match the following items with their related statements below:
a. Internal control c. Management’s responsibility
b. A need of internal control d. Independent accountant’s audit
___ 1. Evaluates management’s assessment of internal control over financial
reporting
___ 2. A process that establishes reliability of accounting records and financial
statements in accordance with GAAP
___ 3. Many assets such as cash and inventories are at risk of loss
___ 4. Establishes a system of internal control and assesses its effectiveness
LO2 Components of Internal Control
SE 2. Match each of the following items with the related statement below:
a. Control environment d. Control activities
b. Risk assessment e. Monitoring
c. Information and communication
___ 1. Policies and procedures management puts in place to see that its direc-
tives are carried out
___ 2. Identifying areas where losses may occur
___ 3. Regular assessment of the quality of internal controls
___ 4. Management’s overall attitude, awareness, and actions
___ 5. Pertains to the accounting system
LO2 Limitations of Internal Control
SE 3. Internal control is subject to several inherent limitations. Indicate whether
each of the following situations is an example of (a) human error, (b) collusion
among employees, (c) changed conditions, or (d) cost-benefit considerations:
___ 1. Effective separation of duties in a restaurant is impractical because the
business is too small.
___ 2. The cashier and the manager of a retail shoe store work together to avoid
the internal controls for the purpose of embezzling funds.
___ 3. The cashier in a pizza shop does not understand the procedures for oper-
ating the cash register and thus fails to ring up all the sales and count the
cash at the end of the day.
___ 4. At a law firm, computer supplies are mistakenly delivered to the reception
area instead of the receiving area because the supplier began using a differ- |
ent system of shipment. As a result, the receipt of supplies is not recorded.
LO3 Separation of Duties
SE 4. Match the following functions for collecting cash by Acme Cleaners with
the statements below:
a. Authorization b. Custody c. Recordkeeping
___ 1. The cashier is responsible for funds in the cash register.
___ 2. All sales are recorded on prenumbered invoices and rung up on the cash
register.
___ 3. All refunds must be approved by the manager.
Chapter Assignments 339
LO3 Physical Controls
SE 5. Match the following assets of a small retail store with their related physical
controls below:
a. Cash c. Supplies
b. Merchandise inventory d. Computers
___ 1. An alarm that signals if unsold items leave the store
___ 2. Cash register
___ 3. A locked cabinet in the supplies closet
___ 4. A cable with a lock
___ 5. A locked showcase
LO2 LO3 Internal Control Activities
SE 6. Match the check-writing policies for a small business described below to the
following control activities:
a. Authorization e. Periodic independent verification
b. Recording transactions f. Separation of duties
c. Documents and records g. Sound personnel practices
d. Physical controls
___ 1. T he person who writes the checks to pay bills is different from the people
who authorize the payments and keep records of the payments.
___ 2. T he checks are kept in a locked drawer. The only person who has the key
is the person who writes the checks.
___ 3. T he person who writes the checks is bonded.
___ 4. O nce each month the owner compares and reconciles the amount of
money shown in the accounting records with the amount in the bank
account.
___ 5. The owner of the business approves each check before it is mailed.
___ 6. Information pertaining to each check is recorded on the check stub.
___ 7. E very day, all checks are recorded in the accounting records, using the
information on the check stubs.
LO3 Business Documents
SE 7. Arrange the following business documents in the normal order in which
they would be prepared:
___ 1. Invoice ___ 5. Bank statement
___ 2. Purchase order ___ 6. Purchase requisition
___ 3. Check ___ 7. Check authorization
___ 4. Receiving report
SO4 Petty Cash Fund
SE 8. A petty cash fund is established at $100. At the end of May, the fund has a
cash balance of $36 and petty cash vouchers for postage, $29, and office supplies,
$34. Prepare the entry on May 31, 2011, to replenish the fund.
Exercises
LO1 LO2 Discussion Questions
E 1. Develop a brief answer to each of the following questions:
1. Why is it important for public companies to have an audit of management’s
assessment of internal control?
2. Why is a system of internal control not able to overcome collusion by
employees?
3. Which of the following accounts would be assigned a higher level of risk:
Building or Merchandising Inventory?
340 CHAPTER 7 Internal Control
LO2 LO3 Discussion Questions
E 2. Develop a brief answer to each of the following questions:
1. What role does the internal audit department play in internal control?
2. What role does a bank reconciliation play in internal control over cash?
3. Why is it important to write down the amount of cash received through the
mail or over the counter?
LO2 Components of Internal Control
E 3. Match the following items with the related statements below:
a. Company environment d. Control activities
b. Risk assessment e. Monitoring
c. Information and communication
1. The company has an internal audit department.
2. Management encourages employees to follow the rules.
3. Management regularly considers what losses the company might face.
4. Management puts separation of duties in place.
5. The company gathers appropriate information and communicates it to
employees.
6. Personnel are well trained and instructed in their duties.
7. The company employs good physical controls.
8. Managers are observant and review how procedures by those who report to
them are carried out.
9. The company has a good accounting system.
LO2 LO3 Control Procedures
E 4. Alina Sadofsky, who operates a small grocery store, has established the fol-
lowing policies with regard to the checkout cashiers: |
1. Each cashier has his or her own cash drawer, to which no one else has access.
2. Cashiers may accept checks for purchases under $50 with proper identifica-
tion. For checks over $50, they must receive approval from Sadofsky.
3. Every sale must be rung up on the cash register and a receipt given to the
customer. Each sale is recorded on a tape inside the cash register.
4. At the end of each day, Sadofsky counts the cash in the drawer and compares
it with the amount on the tape inside the cash register.
Match the following conditions for internal control to each of the policies
listed above:
a. Transactions are executed in accordance with management’s general or spe-
cific authorization.
b. Transactions are recorded as necessary to permit preparation of financial
statements and maintain accountability for assets.
c. Access to assets is permitted only as allowed by management.
d. At reasonable intervals, the records of assets are compared with the existing
assets.
LO2 LO3 Internal Control Procedures
E 5. Adelphi Video Store maintains the following policies with regard to pur-
chases of new videotapes at each of its branch stores:
1. Employees are required to take vacations, and the duties of employees are
rotated periodically.
2. Once each month a person from the home office visits each branch store to
examine the receiving records and to compare the inventory of videos with
the accounting records.
Chapter Assignments 341
3. Purchases of new videos must be authorized by purchase order in the home
office and paid for by the treasurer in the home office. Receiving reports are
prepared in each branch and sent to the home office.
4. All new personnel receive one hour of training in how to receive and cata-
logue new videos.
5. The company maintains a perpetual inventory system that keeps track of all
videos purchased, sold, and on hand.
Match the following control procedures to each of the above policies. (Some
may have several answers.)
a. Authorization e. Periodic independent verification
b. Recording transactions f. Separation of duties
c. Documents and records g. Sound personnel practices
d. Physical controls
LO3 Business Documents
E 6. Items a–e below are a company’s departments. Items f and g are firms with
which the company has transactions:
a. Requesting department e. Treasurer
b. Purchasing department f. Vendor
c. Receiving department g. Bank
d. Accounting department
Use the letter of the department or firm to indicate which one prepares and
sends the following business documents:
Prepared by Received by
1. Bank statement ___ ___
2. Purchase requisition ___ ___
3. Purchase order ___ ___
4. Check authorization ___ ___
5. Invoice ___ ___
6. Check ___ ___
7. Receiving report ___ ___
LO3 Use of Accounting Records in Internal Control
E 7. Careful scrutiny of accounting records and financial statements can lead to
the discovery of fraud or embezzlement. Each of the situations that follow may
indicate a breakdown in internal control. Indicate the nature of the possible fraud
or embezzlement in each of these situations.
1. Wages expense for a branch office was 30 percent higher in 2011 than in
2010, even though the office was authorized to employ only the same four
employees and raises were only 5 percent in 2011.
2. Sales returns and allowances increased from 5 percent to 20 percent of sales
in the first two months of 2011, after record sales in 2010 resulted in large
bonuses for the sales staff.
3. Gross margin decreased from 40 percent of net sales in 2010 to 20 percent
in 2011, even though there was no change in pricing. Ending inventory was
50 percent less at the end of 2011 than it was at the beginning of the year.
There is no immediate explanation for the decrease in inventory.
4. A review of daily records of cash register receipts shows that one cashier
consistently accepts more discount coupons for purchases than do the other
cashiers.
342 CHAPTER 7 Internal Control
SO4 Imprest System
E 8. Developing a convenient means of providing sales representatives with cash
for their incidental expenses, such as entertaining a client at lunch, is a prob- |
lem many companies face. Under one company’s plan, the sales representatives
receive advances in cash from the petty cash fund. Each advance is supported
by an authorization from the sales manager. The representative returns the
receipt for the expenditure and any unused cash, which is replaced in the petty
cash fund. The cashier of the petty cash fund is responsible for seeing that the
receipt and the cash returned equal the advance. When the petty cash fund is
reimbursed, the amount of the representative’s expenditure is debited to Direct
Sales Expense.
What is the weak point in this system? What fundamental principle of
internal control is being ignored? What improvement in the procedure can you
suggest?
SO4 Petty Cash Transactions
E 9. A small company maintains a petty cash fund for minor expenditures. In June
and July 2011, the following transactions took place:
a. The fund was established in the amount of $100.00 on June 1 from the pro-
ceeds of check no. 2707.
b. On June 30, the petty cash fund had cash of $15.46 and the following receipts
on hand: postage, $40.00; supplies, $24.94; delivery service, $12.40; and rub-
ber stamp, $7.20. Check no. 2778 was drawn to replenish the fund.
c. On July 31, the petty cash fund had cash of $22.06 and these receipts on
hand: postage, $34.20; supplies, $32.84; and delivery service, $6.40. The
petty cash custodian could not account for the shortage. Check no. 2847
was drawn to replenish the fund.
Prepare entries in journal form necessary to record each transaction.
Problems
LO2 Internal Control Components
P 1. Dodge Company, a small retail bookstore, has experienced losses of inven-
tory over the past year. George Dodge, the owner, on the advice of his accoun-
tant, has adopted a set of internal controls in an effort to stop the losses. Dodge
has taken the following steps:
1. He regularly considers ways in which inventory losses might occur.
2. He had his accountant set up an accounting system over inventory.
3. He requires all new and existing employees to attend a training session in
which they are instructed in their duties.
4. He makes sure that different employees perform the duties of authorization,
custody, and recordkeeping.
5. He spends time “on the floor” encouraging employees to follow the procedures.
6. He periodically gathers appropriate information about inventory situations
and communicates his findings to employees.
7. He had all items in inventory marked with an electronic bar code that signals an
alarm if someone tries to take an item out of the store without paying for it.
8. He observes and reviews how internal control procedures are carried out.
9. He hires his accountant to periodically conduct internal audit work.
Chapter Assignments 343
Required
1. Show that Dodge’s new system engages all the components of internal con-
trol by matching each of the above steps with one of the internal control
components below:
a. Control environment d. Control activities
b. Risk assessment e. Monitoring
c. Information and communication
User insight (cid:2) 2. As the owner of a small company, why is it important that George Dodge
take an active part in the management of the internal control system?
LO2 LO3 Internal Control Procedures
P 2. VuWay Printers makes printers for personal computers and maintains a fac-
tory outlet showroom through which it sells its products to the public. The com-
pany’s management has set up a system of internal controls over the inventory of
printers to prevent theft and to ensure the accuracy of the accounting records.
All printers in inventory at the factory outlet are kept in a secured warehouse
behind the showroom, except for the sample printers on display. Only autho-
rized personnel may enter the warehouse. When a customer buys a printer, a
sales invoice is written in triplicate by the cashier and is marked “paid.” The sales
invoices are sequentially numbered, and all must be accounted for. The cashier
sends the pink copy of the completed invoice to the warehouse, gives the blue
copy to the customer, and keeps the green copy. The customer drives around |
to the warehouse entrance. The warehouse attendant takes the blue copy of the
invoice from the customer and gives the customer the printer and the pink copy
of the invoice.
The company maintains a perpetual inventory system for the printers at the
outlet. The warehouse attendant at the outlet signs an inventory transfer sheet
for each printer received. An accountant at the factory is assigned responsibility
for maintaining the inventory records based on copies of the inventory transfer
sheets and the sales invoices. The records are updated daily and may be accessed
by computer but not modified by the sales personnel and the warehouse atten-
dant. The accountant also sees that all prenumbered inventory transfer sheets are
accounted for and compares copies of them with the ones signed by the ware-
house attendant. Once every three months, the company’s internal auditor takes
a physical count of the printer inventory and compares the results with the per-
petual inventory records.
All new employees are required to read a sales and inventory manual and
attend a two-hour training session about the internal controls. They must dem-
onstrate that they can perform the functions required of them.
Required
1. Give an example of how each of the following control activities is applied to
internal control over inventory at VuWay Printers:
a. Authorization
b. Recording transactions
c. Documents and records
d. Physical controls
e. Periodic independent verification
f. Separation of duties
g. Sound personnel practices
User insight (cid:2) 2. Can the described system protect against an employee who picks up a printer
and carries it off when leaving work?
344 CHAPTER 7 Internal Control
LO2 LO3 Internal Control Activities
P 3. Eyles Sports Shop is a small neighborhood sporting goods store. The shop’s
owner, Samantha Eyles, has set up a system of internal control over sales to pre-
vent theft and to ensure the accuracy of the accounting records.
When a customer buys a product, the cashier writes up a sales invoice that
describes the purchase, including the total price. All sales invoices are prenum-
bered sequentially.
If the sale is by credit card, the cashier runs the credit card through a scanner
that verifies the customer’s credit. The scanner prints out a receipt and a slip for
the customer to sign. The signed slip is put in the cash register, and the customer
is given the receipt and a copy of the sales invoice.
If the sale is by cash or check, the cashier rings it up on the cash register and
gives change, if appropriate. Checks must be written for the exact amount of the
purchase and must be accompanied by identification. The sale is recorded on
a tape inside the cash register that cannot be accessed by the cashier. The cash
register may be locked with a key. The cashier is the only person other than Eyles
who has a key. The cash register must be locked when the cashier is not pres-
ent. Refunds are made only with Eyles’s approval, are recorded on prenumbered
credit memorandum forms, and are rung up on the cash register.
At the end of each day, Eyles counts the cash and checks in the cash
register and compares the total with the amount recorded on the tape inside
the register. Eyles totals all the signed credit card slips and ensures that the
total equals the amount recorded by the scanner. Eyles also makes sure that
all sales invoices and credit memoranda are accounted for. Eyles prepares a
bank deposit ticket for the cash, checks, and signed credit card slips, less $40
in change to be put in the cash register the next day, and removes the record
of the day’s credit card sales from the scanner. All the records are placed in an
envelope that is sealed and sent to the company’s accountant for verification
and recording in the company records. On the way home, Eyles places the
bank deposit in the night deposit box.
The company hires experienced cashiers who are bonded. The owner spends
the first half-day with new cashiers, showing them the procedures and overlook-
ing their work.
Required
1. Give an example of how each of the following control activities is applied to |
internal control over sales and cash at Eyles Sports Shop. (Do not address
controls over inventory.)
a. Authorization
b. Recording transactions
c. Documents and records
d. Physical controls
e. Periodic independent verification
f. Separation of duties
g. Sound personnel practices
User insight (cid:2) 2. Can the system as described protect against a cashier who accepts cash for
a sale but does not ring up the sale and pockets the cash? If so, how does it
prevent this action?
SO4 Imprest (Petty Cash) Transaction
P 4. A small company maintains a petty cash fund for minor expenditures. The
following transactions occurred in June and July 2011:
Chapter Assignments 345
a. The fund was established in the amount of $300.00 on June 1 from the pro-
ceeds of check no. 1515.
b. On June 30, the petty cash fund had cash of $46.38 and the following receipts
on hand: postage, $120.00; supplies, $74.82; delivery service, $37.20; and rub-
ber stamp, $21.60. Check no. 1527 was drawn to replenish the fund.
c. On July 31, the petty cash fund had cash of $66.18 and the following
receipts on hand: postage, $102.60; supplies, $98.52; and delivery service,
$19.20. The petty cash custodian could not account for the shortage. Check
no. 1621 was written to replenish the fund.
Required
1. In journal form, prepare the entries necessary to record each of these
transactions.
User insight (cid:2) 2. A charity reimburses volunteers for small out-of-pocket expenses such as
parking and gasoline when the volunteers are carrying out the business of
the charity. How might an imprest (petty cash) fund be helpful in controlling
these expenditures?
Alternate Problems
LO2 Internal Control Components
P 5. Jason Company, a small electronics distributor, has experienced losses of
inventory over the past year. Sara Jason, the owner, on the advice of her accoun-
tant, has adopted a set of internal controls in an effort to stop the losses. Jason has
taken the following steps:
1. She encourages employees to follow the rules.
2. She regularly considers ways in which inventory losses might occur.
3. She put separation of duties in place.
4. She gathers appropriate information and communicates it to employees.
5. She sees that new and existing employees are well trained and instructed in
their duties.
6. She makes sure inventories are physically protected with locked storage and
electronic monitors.
7. She observes and reviews how procedures by those who report to her are car-
ried out.
8. She had her accountant install a better accounting system over inventory.
9. She trains new employees in how to properly carry out control procedures.
Required
1. Show that Sara Jason’s new system engages all the components of internal
control by matching each of the above steps with one of the internal control
components below:
a. Control environment
b. Risk assessment
c. Information and communication
d. Control activities
e. Monitoring
User insight (cid:2) 2. As the owner of a small company, why is it important that Sarah Jason take an
active part in the management of the internal control system?
LO2 LO3 Control Activities
P 6. Industrial Services Company provides maintenance services to factories in
and around West Bend, Wisconsin. The company, which buys a large amount
346 CHAPTER 7 Internal Control
of cleaning supplies, consistently has been over budget in its expenditures for
these items. In the past, supplies were left out in the open in the warehouse
to be taken each evening as needed by the onsite supervisors. A clerk in the
accounting department periodically ordered additional supplies from a long-
time supplier. No records were maintained other than to record purchases.
Once a year, an inventory of supplies was made for the preparation of the finan-
cial statements.
To solve the budgetary problem, management decides to implement a new
system for purchasing and controlling supplies. The following actions take place:
1. Management places a supplies clerk in charge of a secured storeroom for
cleaning supplies.
2. Supervisors use a purchase requisition to request supplies for the jobs they
oversee. |
Subsets and Splits