39012773 Supplemental Book

INTRODUCTORY

FINANCIAL

ACCOUNTING

Jacques Maurice, MBA, CA, CMA, FCMA

Rebecca Renfroe, B.Comm, B. Ed, CMA

Introductory Financial Accounting, v.1.1 Page 2

Table of Contents

1. The Accounting Cycle – Income Statement and Statement of Financial Position

3

2. Cash and Investments 48

3. Accounts Receivable 58

4. Inventory 67

5. Long-term Assets 86

6. Liabilities 100

7. Shareholders’ Equity 114

8. The Accounting Cycle Revisited 122

9. The Statement of Cash Flow 131

10. Financial Statement Analysis 146

11. Solutions to Problems 159


1. The Accounting Cycle – Income Statement and Balance

Sheet The Accounting Equation

To begin any discussion about accounting, the Accounting Equation is a critical starting point. The key components of the accounting equation are Assets, Liabilities and Shareholders’ Equity. The definition of an asset is a probable future economic benefit obtained or controlled by a particular entity as a result of a past transaction or event. There are three key components to this definition: a) the asset will provide some probable, future benefit to the company, b) the asset is under the control of the company; and, c) the asset has come into the company’s control through some past transaction or event. Examples of assets are Cash, Accounts Receivable, Inventory and Capital Assets. A liabilitiy, on the other hand, is an obligation of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future. Examples of liabilities are accounts payable and accrued liabilities, bank loans and long-term debt. If you were to liquidate all of the assets of a company and pay off all liabilities with the proceeds, any amount left over would be the Equity in the company. Shareholders’ Equity, as it is sometimes called, is a numerical representation of the shareholders’ interest in a company. The Accounting Equation is as follows:

Assets = Liabilities + Shareholders’ Equity The equation must hold true at all times. How we manage this is through balanced entries. That is, each time we record an event within a company’s accounting life, if we affect one side of the equation, we must also affect the other, OR we can both increase and decrease the same side of the equation to keep it in balance. Hence, we have our second truth of accounting:

Debits = Credits

The normal balances of the above accounts are as follows:

Assets - Debit Liabilities - Credit Shareholders’ Equity - Credit


Let’s look at a few examples of manipulating the Accounting Equation. Recall the accounting equation:

Assets = Liabilities + Shareholders’ Equity Example

(a) When an owner invests their own cash in starting up a company, this will have

two effects. First, the cash account (an asset) will increase, and the Contributed Capital account will also increase. The Contributed Capital account is part of Shareholders’ Equity and comprises of all contributions made by the shareholders to the company. Say an owner invests $50,000 of their own money to start a company. The journal entry would be:

Cash 50,000 Contributed Capital 50,000

The cash account gets debited (dr.) and the Contributed Capital Account gets credited (cr.). Note the convention above: • when writing journal entries, the account label that gets debited is flush

against the left margin and the account label that gets credited is tabbed in; • the debit dollar amount is in the first column whereby the credit dollar

amount is in the second column.

The equation stays in balance as we are increasing both sides of the equation:

Assets = Liabilities + Equity

+ 50,000 +50,000

(b) That same company then uses some of that cash to purchase inventory to resell.

That inventory costs $10,000. The journal entry would be:

Inventory 10,000 Cash 10,000

Note that both of these are asset accounts, but our equation stays balanced because we are increasing one asset (inventory), but decreasing another (cash):


+ 10,000 - 10,000


(c) That same company then purchases an additional $5,000 worth of inventory on account, that is, they do not pay cash but take on an account payable with the supplier. The journal entry would be:

Inventory 5,000 Accounts Payable 5,000

We are increasing an asset, and increasing a liability, therefore, our equation holds true:


+ 10,000 +10,000 (d) The company then uses cash to purchase equipment that costs $75,000. The

journal entry would be:

Equipment 75,000 Cash 75,000

Both the Equipment account and the Cash account are assets, therefore, by increasing one and decreasing another the equation holds true:


+ 75,000 - 75,000

(e) The same company is a little short on cash and has to take out a loan from its

bank. The loan is for $100,000. The journal entry to record the loan would be:

Cash 100,000 Bank Loan 100,000

Upon signing the loan, the company would receive $100,000 cash, therefore, we

increase the asset account Cash. Furthermore, they will take on a liability to pay back the bank the $100,000. By increasing both sides of the equation, an asset and a liability, our equation stays in balance:


+ 100,000 +100,000


Transactions that impact the Statement of Income The above examples used accounts that appear on the Statement of Financial Position. Income Statement accounts will consist of Revenue accounts or Expense accounts. Revenue accounts normally have a credit balance, i.e. when a revenue account is increased we credit the account. Conversely, an expense account’s normal balance is a debit balance. All revenue and expense accounts are temporary accounts in the sense that we start the year with a zero balance in the account. At the end of each year, the income and expense accounts are closed out to zero, and the resulting debit or credit is either added or subtracted to an account called Retained Earnings, which is part of the Shareholders’ Equity section of the Statement of Financial Position. If Revenues are greater than Expenses during a period, the company will have generated a net income and a net Credit entry to Retained Earnings will result. If Expenses are greater than Revenues, the company will have generated a net loss and a net Debit balance to Retained Earnings will result. If you remember that Income and Expense accounts get closed to Retained Earnings (which we will discuss in further detail later) then you can see how recording sales and expenses will still keep the accounting equation in balance. For example, an debit entry to an expense account is viewed as a reduction of Equity and a credit entry to a revenue account is viewed as an increase in Equity, via the Retained Earnings Account. If we continue with our examples… (f) Say that the company from the above example has $30,000 in sales in its first

month. The journal entry would be:

Cash 30,000 Sales Revenue 30,000

The accounting equation is maintained since Assets are increased and Equity is increased:


+ 30,000 +30,000


(g) To incur these sales, the company sold all $15,000 worth of its inventory. The journal entry to record that would be:

Cost of Goods Sold 15,000 Inventory 15,000

Note that this entry removes the inventory from the company’s accounts, as they no longer have it on hand to sell. Note that Cost of Goods Sold is an expense account. The accounting equation remains in balance:


- 15,000 -15,000

The Statement of Financial Position

The Statement of Financial Position is a snapshot of a company’s financial position at a particular point in time. The Statement of Financial Position (also called the Balance Sheet) is, basically, an expanded form of the accounting equation:

The Statement of Financial Position

Assets = Liabilities & Shareholders’ Equity

Liabilities

Current Liabilities

Non-Current Liabilities

Current Assets

Shareholders’ Equity

Contributed Capital

Non-Current Assets

Retained Earnings

Assets are listed from most liquid to least liquid, as are liabilities, and both are divided into current and non-current based on their liquidity. Assets and liabilities that will come due or have to be settled within 12 months or one accounting cycle (whichever is longest) are classified as current, and all other assets and liabilities are classified as non-current.


Note, that in some cases you may have an asset or a liability that is partly current and partly non-current. In this case, you would break out the current portion and classify it as such, and classify the remainder as non-current. The classic example of this is breaking out the current portion of the long-term debt of a company. For example, if your loan balance is $200,000 and the agreement with the bank is that you will be required to pay $50,000 of this balance within the next year, this $50,000 would be classified as a current liability and the remaining $150,000 would be classified as a long-term liability. Typical accounts you will see on the Statement of Financial Position are: Current Assets: Cash – the most liquid of all assets, this account includes all currency and equivalents (bank drafts, money orders etc.). Accounts Receivable – the account is the sum total of all outstanding invoices which are owed to the company by its customers. Accounts Receivable is normally reported net of an Allowance for Uncollectible Accounts (discussed further in Chapter 3). Inventory – this account is a listing of all of the items that the company normally sells in its day-to-day activities. The inventory can either be purchased, complete, ready for re-sale, or manufactured by the company itself. A more detailed discussion of this account will take place Chapter 4. Prepaid Expenses – this account represents amounts that have been paid in cash for expenses that have not been incurred by the company. For example, when we take out an insurance policy, we normally pay the annual premium the day the policy takes effect. Because the policy has not yet expired, the cost of the policy will be classified as a prepaid expense. Non-current Assets:

Buildings – this account is a listing of all depreciable buildings owned by the company. The associated Accumulated Amortization contra account is normally shown directly below the asset account, and the asset is therefore shown net of accumulated amortization. More on this in Chapter 5. Equipment – this account is treated in the same manner as the Buildings account, but is a listing of all equipment owned and used by the company. Land – this account is a listing of all land held by the company. Note that amortization is never taken on land. Long-term investments – these are investments that are to be held for many years, and includes investments in bonds, stocks, other companies or special funds.


Intangible assets such as patents, trademarks and copyrights would be classified as long-term assets. Current Liabilities:

Accounts payable – a listing of all accounts that will be due to suppliers which are expected to be repaid within one year or one accounting cycle. Taxes payable – a listing of all taxes due within one year or one accounting cycle. Wages payable – a listing of all wages due to employees within one year or one accounting cycle. Note that the wages payable account is normally the result of an adjusting entry. Non-current liabilities:

Long-term debt including bonds and notes payable – this account is a listing of all debt which the company has incurred which is not due within one year or one accounting cycle. It is when the amount is due back to the lender that differentiates between current and non-current debt. Shareholders’ Equity:

Contributed Capital – this account contains any amounts which have been invested in the company by the company’s shareholders. Retained Earnings – this account represents the cumulative total of the net income of a company that has not been distributed to shareholders. The retained earnings account is adjusted at the end of each year to account for a company’s net income or loss. The retained earnings account reconciliation from the beginning of year to end of year balance is as follows:

Retained Earnings, beginning balance XXX Add Net Income for the year or deduct the Net Loss for the year ± XXX Less Dividends declared to shareholders - XXX

Retained Earnings, end of year XXX


The Income Statement

The income statement is a statement that shows how a company performed during one period, typically the fiscal year of the company. It takes the reader from total Revenues to Net Income, the amount left over after all relevant expenses have been taken into account. Income statements can take on one of two formats: single step and multi-step. Either one is acceptable under GAAP, however, most companies tend to use some form of a multi-step statement. The single step statement lists all revenues and then all expenses without breaking out any further subtotals. For example:

The Miller Company Income Statement

For the Period ended December 31, 20x8

Sales $100,000 Interest Income 3,000 Cost of Goods Sold (60,000) Operating Expenses (25,000) Income Tax Expense (8,000)

Net Income $10,000

The multi-step statement has multiple subtotals, and for the above company would look like the following:

The Miller Company Income Statement

For the Period ended December 31, 20x8

Sales $100,000 Cost of Goods Sold (60,000)

Gross Profit 40,000 Operating Expenses (25,000)

Operating Income 15,000 Interest Income 3,000

Net Income before Taxes 18,000 Income Tax Expense (8,000)

Net Income $10,000


The T-Account

Named for its shape, which resembles a capital “T”, a T-account is a tool used by accountants to keep track of entries that are made to individual accounts. When an entry is made and an account is to be debited, an entry is placed on the left-hand side of the T. When a credit is made, it is placed on the right hand sand. Thus, for every entry the left-hand entry must equal the right-hand entry in order for the Accounting Equation to hold true.

Accounts Receivable

Debit Credit

The following represent how increases and decreases in accounts get recorded:

Assets

Liabilities &

Shareholders’ Equity

+ -

- +

Expenses Revenues

+ -

- +


Comprehensive Example

Ian has worked at a music store for the last 20 years. After years of planning and saving, he has decided he is ready to go out on his own. January 2, 20x7, Ian’s Incredible Instruments Inc. Opened for business in a local mall. The following transactions took place during the fiscal year ended December 31, 20x7: 1. Ian invested $175,000, his entire life savings, into the company upon

incorporation, January 2, 20x7. He received 1,000 common shares of the Corporation, Ian’s Incredible Instruments, Inc..

2. Ian’s Incredible Instruments Inc. is located in the Meadowvale Mall. Ian signed a two-year lease with monthly rent of $8,000 due on the first of each month. The lease is in effect from January 2, 20x7 through December 31, 20x8. The lessor required Ian to pay the first and last month’s rent on January 2, 20x7.

3. The mall location is suitable for Ian’s retail needs, but is not large enough to store any extra inventory. An outside storage facility has been rented to fill this need. Rent is $1,200 per month, beginning February 1, 20x7, and was rented on a month-to-month basis. (Record the February rental payment only.)

4. Inventory of $120,000 was purchased on account.

5. An insurance policy, which covered the period of January 2, 20x7 through December 31, 20x7, was purchased for $5,760 cash.

6. Ian purchased furniture and fixtures for the store at an auction for $30,000. He paid cash.

7. Ian’s Incredible Instruments Inc.’s Sales for the first year were as follows: Cash sales - $430,000; Credit sales - $310,000

8. The company took out a loan for $200,000. The terms of the loan, which was taken out on June 1, 20x7, are for 5 years, with 10% annual interest due semi-annually. That is, the annual rate is 10%, however, interest payments are due every 6 months.

9. More inventory was purchased on account June 1, 20x7 for $350,000.

10. A total of $280,000 of the accounts receivable were collected throughout the year.

11. Having proven himself a good tenant, Ian was able to convince his landlord at the mall to give him additional storage space (at no extra cost), and was able to give up his off-site storage facility. He only rented the outside facility to the end of November, 20x7. (Record the payments made from March to November only.)


12. Additional cash disbursements for the year were as follows: Wages & salaries $165,000 Rent 88,000 Advertising 40,000 Miscellaneous expenses 23,000 Payments of accounts payable 120,000 Interest on bank loan 10,000

$446,000

13. The total cost of the inventory sold during the year was $300,000. 14. Ian declared and paid a dividend of $60,000 (note that a dividend is debited

against retained earnings). For each of the above, the appropriate journal entries would look like this: 1. To record Ian’s initial investment into the company.

Cash 175,000 Contributed Capital 175,000 2. To record the payment of first and last month’s rent on the lease. We know that

the first month’s rent will be “used up” in this year, and therefore it is an expense in this fiscal period. However, the deposit for the last month won’t be used until 2 years from now. This is what we call a prepaid expense.

Prepaid Rent 8,000 Rent Expense 8,000 Cash 16,000 3. To record the rent paid on the outside storage facility in February for one month. Rent Expense 1,200 Cash 1,200 4. To record the purchase of inventory on account. Inventory 120,000 Accounts Payable 120,000


5. To record purchase and payment of the insurance policy. Note that because it expires December 31, 20x7, the entire amount applies to the current fiscal year and therefore there is no prepaid portion.

Insurance Expense 5,760 Cash 5,760 6. To record the purchase of furniture and fixtures, for which cash was paid. Furniture and Fixtures 30,000 Cash 30,000 7. To record sales for the first year. Note that in reality, sales are recorded

individually as they are made. However, for the purposes of this example we will be entering them in one journal entry.

Cash 430,000 Accounts Receivable 310,000 Sales 740,000 8. Upon receiving the loan, two things will happen to Ian’s Incredible Instruments

Inc. First, they will get $200,000 cash from the bank; second, they will have an outstanding loan for the same amount. We will deal with the interest expense incurred on the loan in a separate entry.

Cash 200,000 Bank Loan 200,000 9. To record the purchase of inventory on account. Inventory 350,000 Accounts Payable 350,000 10. To record the collection of accounts receivable throughout the year. Note that as

we collect the cash, we must remove the receivable from our books, as they are no longer due to us. Hence, the credit to the Accounts Receivable account.

Cash 280,000 Accounts Receivable 280,000 11. To record the rental expense incurred from March through November.

(Remember, we already recorded the initial payment in February). $1,200/month x 9 months = $10,800.

Rent Expense 10,800 Cash 10,800


12. To record the various other cash disbursements made throughout the year. Note the following supporting calculations:

Rent Expense – 11 months x $8,000/month = $88,000 Interest on bank loan - $200,000 x (10% x year) = $10,000

Wages & Salaries Expense 165,000 Rent Expense 88,000 Advertising Expense 40,000 Miscellaneous Expenses 23,000 Accounts Payable 120,000 Interest Expense 10,000 Cash 446,000 13. To remove the inventory which was sold from the inventory account and record

the resulting Cost of Goods Sold expense. Cost of Goods Sold 300,000 Inventory 300,000 14. To record the dividend paid. Retained Earnings 60,000 Cash 60,000


The recording of the above journal entries in T-Accounts would be as follows:

Assets BALANCE SHEET Liabilities & Equity

Cash Prepaid Rent Accounts Payable

1 175,000 16,000 2 2 8,000 12 120,000 120,000 4

7 430,000 1,200 3 350,000 9

8 200,000 5,760 5 350,000

10 280,000 30,000 6

10,800 446,000

60,000

11

12

13

Accounts

Receivable

Bank Loan

515,240 7 310,000 280,000 10 200,000 8

30,000

Inventory

Furniture &

Fixtures

Contributed Capital

4 120,000 300,000 13 6 30,000 175,000 1

9 350,000

170,000

Retained Earnings

13 60,000

Expenses INCOME STATEMENT Revenues

Rent Insurance Sales

2 8,000 5 5,760 740,000 7

3 1,200

11 10,800

12 88,000

108,000

Wages &

Salaries

Expense

Advertising

Expense

12 165,000 12 40,000

Misc. Expenses Interest Expense

12 23,000 12 10,000

Cost of Goods

Sold

13 300,000


A trial balance of all of the closing balances of the above accounts would look like this:

Ian’s Incredible Instruments Inc. Trial Balance

As at December 31, 20x7

Debit Credit Cash $515,240 Accounts Receivable 30,000 Inventory 170,000 Prepaid Rent 8,000 Furniture and fixtures 30,000 Accounts Payable $350,000 Bank Loan 200,000 Contributed Capital 175,000 Retained earnings 60,000 Sales 740,000 Cost of Goods Sold 300,000 Rent Expense 108,000 Insurance Expense 5,760 Wages & Salaries Expense 165,000 Advertising Expense 40,000 Interest Expense 10,000 Miscellaneous Expenses 23,000

$1,465,000 $1,465,000


A multi-step income statement for Ian’s Incredible Instruments Inc. would look like this:

Ian’s Incredible Instruments Inc. Income Statement

for the year ending December 31, 20x7

Sales $740,000 Cost of Goods Sold 300,000

Gross Profit 440,000

Operating Expenses Rent Expense 108,000 Insurance Expense 5,760 Wages & Salaries Expense 165,000 Advertising Expense 40,000 Miscellaneous Expenses 23,000 341,760

Operating income 98,240 Interest Expense 10,000

Net income $88,240 Closing Accounts All revenue and expense accounts are closed out to zero at the end of each fiscal period. As such, they are referred to as temporary accounts. At the end of the year, all balances get returned to zero, and the offsetting amount is the net income (or loss) that gets recorded to retained earnings. The closing entry for Ian’s Incredible Instruments is as follows: Sales 740,000 Cost of Goods Sold 300,000 Rent Expense 108,000 Insurance Expense 5,760 Wages & Salaries Expense 165,000 Advertising Expense 40,000 Interest Expense 10,000 Miscellaneous Expenses 23,000 Retained Earnings 88,240


The Statement of Retained Earnings outlines the changes in the Retained Earnings account from the beginning of the year balance to the ending balance:

Ian’s Incredible Instruments Inc.

Statement of Retained Earnings for the year ending December 31, 20x7

Retained Earnings, January 1, 20x7 $ 0 Net income 88,240 Dividends (60,000)

Retained Earnings, December 31, 20x7 $ 28,240

We can now prepare a Statement of Financial Position for Ian’s Incredible Instruments:

Ian’s Incredible Instruments Inc. Statement of Financial Position

as at December 31, 20x7 ASSETS

Current Assets Cash $515,240 Accounts receivable 30,000 Inventory 170,000 Prepaid rent 8,000

723,240 Furniture and fixtures 30,000

$753,240

LIABILITIES AND SHAREHOLDERS’ EQUITY

Current liabilities Accounts payable 350,000 Long-term liabilities

Bank loan 200,000

550,000

Shareholders’ Equity Contributed Capital 175,000 Retained earnings 28,240

203,240

$753,240


Adjusting Entries

Most adjusting entries can be classified in one of two ways:

Prepayments – Cash is paid out or received before event occurs.

Accrual – Event has occurred, but cash has not been paid or received.

Expenses Prepaid Expenses – Cash is paid and an asset is recorded before it is used. The asset will then be allocated to future periods using adjusting entries. Examples: Prepaid rent/insurance, office supplies, plant & equipment

Accured Expenses – When an expense has been incurred, but not yet paid in cash, then both the liability and the expense are recorded in the amount relating to the current period. As the liability is paid in future periods, we will Debit the liability and Credit cash to record the payment. Examples: Payroll, Income taxes, Interest Expense, Utilities Expense

Revenues Unearned Revenue – Cash is received and a liabilitiy is recorded. As the company earns the revenue, i.e. performs the service or delivers the goods, an adjusting entry is made to remove the liability and record the revenue. Examples: Rent collected in advance, deposits on orders, subscriptions collected in advance and gift certificates sold.

Accrued Revenues – These entries are used then revenue has been earned, but will not be paid in the current period. The adjusting entry sets up an asset, a receivable, and records the revenue. As cash is received in payment in future periods, the receivable is removed. Examples: Credit sales, Rent Revenue, Interest Receivable


Example -

In examples 1-5, assume that the company’s year-end is December 31.

1. On August 1, 20x7 you pay $12,000 for an insurance policy that will cover the next 12 months. What would be the journal entry to record the purchase of the policy? What would be the adjusting journal entry at the end of the year?

To record the purchase of the policy:

Prepaid Insurance 12,000 Cash 12,000

At the end of the year you will have 7 months remaining on the policy. This means that 5 months have been used in the current period, and therefore should be an expense of the current period. The adjusting entry would be:

Insurance Expense 5,000 Prepaid Insurance 5,000

The balance that remains in the prepaid insurance account of $7,000 represents the portion of the insurance policy that is unexpired, i.e. that will expire in 20x8.

2. On January 1, 20x5 you had $3,800 in your office supplies inventory account.

During the year you purchased an additional $13,000 of office supplies. A physical count of the supplies on December 31, 20x5 reveals that you have $5,200 of supplies on hand. What would be the adjusting entry on December 31, 20x5?

To answer this question, it might be helpful to look at the T-Account for Office Supplies for the year:

Supplies Inventory

Opening Balance $ 3,800 Purchases 13,000 ???? Supplies Expense

Ending Balance $ 5,200

As the T-Account shows, we know our opening balance, what was purchased during the year, and what we have left at the end of the year. However, 3,800 + 13,000 does not equal 5,200. The missing piece to the puzzle is the amount of supplies that were used during the year. Therefore, solving the equation, the missing credit or Supplies Expense has to be 11,600.


The adjusting entry on December 31, 20x5 would be:

Supplies Expense 11,600 Office Supplies 11,600

3. You purchase new office furniture for a cost of $100,000 on January 1, 20x6.

You estimate that the furniture will last 10 years and have no salvage value at the end of its useful life. It is now December 31, 20x6. What would be your amortization expense and what would be the adjusting entry to record it?

The cost of the furniture needs to be spread out over its entire useful life. Therefore, instead of taking the full $100,000 as an expense this year, we will take $10,000 per year for the next 10 years, or $10,000 per year for the life of the furniture. Each and every year, the adjusting journal entry would be:

Amortization Expense 10,000 Accumulated Amortization 10,000

Note that the amortization expense account will appear on the income statement as an operating expense for the year. The Accumulated Amortization account, on the other hand, will appear on the Statement of Financial Position as a reduction of the related asset account, i.e. office furniture in this case. The long-term asset section of the Statement of Financial Position would be as follows:

Office Furniture $100,000 Less accumulated amortization (10,000)

$ 90,000

Because the Accumulated Amortization account is applied as a reduction of the related asset account, we call it a contra account to the Office Furniture account.

4. You own an apartment building and have a tenant whose parents have paid their rent for the entire year in advance. The apartment rents for $800/month. You received payment for the full year on May 1, 20x8. It is now December 31, 20x8. What is your adjusting entry?

On May 1, 20x8, when you received the revenue, you would have recorded an entry of:

Cash ($800 x 12) 9,600

Unearned Rental Revenue 9,600

As of December 31, you would have earned 8 of the 12 months of revenue. Therefore, the revenue to be recorded for the year would be 8 months x $800/month = $6,400. Furthermore, there would still be 4 months of unearned


revenue left. The balance in the Unearned Rental Revenue Account would have 4 months x $800/month = $3,200.

The adjusting entry on December 31, 20x8 would be:

Unearned Rental Revenue 6,400 Rental Revenue 6,400

According to the journal entries above, the balance in the Unearned Rental Revenue account will be equal to $9,600 – 6,400 = $3,200. This reconciles to our calculation above.

5. On August 1, 20x3 you take out a loan for $100,000. The loan agreement states

that interest will be charged at a rate of 8% annually, and interest and the principal will be due August 1, 20x4. It is December 31, 20x3. What is your adjusting entry to record interest expense for the year?

Looking at the terms of the loan, we can calculate that the annual interest on the loan will be equal to $100,000 x 8% = $8,000. However, as of December 31, 20x3, the loan has not been outstanding for the full 12 months, and furthermore, no cash has been paid for the interest expense.

The loan has been outstanding for 5 months, and therefore, only 5 months of interest pertain to the current period. That is, interest expense for 20x3 would be $8,000 x 5/12 = $3,333. The adjusting entry would be:

Interest Expense 3,333 Interest Payable 3,333

6. You last paid your employees on March 27, 20x6 (a Monday). Your average

weekly payroll is $80,000/week. It is March 31 (Friday), your year-end. What is the adjusting entry?

To calculate the adjusting entry, we have to first figure out how much needs to be accrued; that is, how much do we owe to our employees for the 4 days that we haven’t paid them?

If the average weekly payroll is $80,000, and our employees work 5 days a week, then our daily payroll rate can be calculated as $80,000/5 = $16,000. Our employees worked 4 days from the time of their last payday until the end of the year, therefore, the accrued wages payable will be $16,000 x 4 days = $64,000. The adjusting entry would be:

Wages Expense 64,000 Wages Payable 64,000


Note that this adjusting entry does two things: First, it gets onto our books the liability that we owe to our employees; second, it gets onto our books the expense that we have incurred during the last 4 days of the period. Just because you don’t pay cash for something does not mean that the expense wasn’t incurred. We MUST record all expenses relevant to the current period, whether we have paid for them or not.

Revenue Recognition and the Matching Principle

For a firm to recognize revenue, the following criteria must be met (with regards to the amount of revenue that is to be recognized): • the amount of revenue must be determinable, • the revenue must be earned (all significant acts must be completed), • collectibility is reasonably assured, and • all associated costs can be estimated. For most sales, the revenue recognition point takes place when the transaction takes place. If the goods are shipped to the customer under the terms FOB1 Shipping, then the goods belong to the customer the minute they are loaded on the truck and revenue can be recognized immediately. If the goods are shipped under the terms FOB Destination, then they belong to the customer only when they are delivered and therefore the revenue recognition point is when the goods are shipped. This can become an issue for goods that are in transit around the company’s year-end. The matching principle is related to the revenue recognition principle and states that all costs incurred to earn the revenue recognized must be recorded at the same time as the related revenues. In the case of a simple sale, this means that the cost of the goods sold become an expense the day the sale is made. However, this can get complicated when say, a 5-year warranty is provided with the product. In this case, as we will see later, the company must estimate the total warranty expense that will be expended on this product and accrue the full amount in the year of sale. Sales and Sales Contra Accounts

Whenever a sale is made, we credit the Sales account. But, the following transactions are related: • Sales Returns: whenever customers return merchandise for refund, instead of

debiting the sales account, we debit an account called ‘sales returns’. This allows the company to keep track of all sales returns separately from the original sale.

• Sales Discounts: if early payment discounts are offered to customers, whenever the discount is taken, then the amount of the discount gets debited to the Sales Discounts account. For example, assume that we make a sale of $1,000 and we offer a discount of 2% if the invoice is paid within 10 days. If the customer pays

1 FOB stands for ‘Free on Board’


within 10 days, they will pay us $980. The $20 discount will get debited to the Sales Discount account.

• Sales Allowances are when merchandise is sold to a customer which is slightly defective. A credit is granted to the customer, but the customer keeps the merchandise.

These three accounts are considered contra accounts to the Sales account and, when reported on the income statements, would be netted out against the Sales account.

Sales Sales returns

Normal

credit Balance

Merchandise returned

Sales Discounts Sales Allowances

Early

payment discounts

Customer keeps

merchandise but is given a

discount

Example – Assume the following transactions. • merchandise is shipped FOB Shipping to a customer. The selling price is $40,000.

Terms of payment are 2/10, n30, that is, a 2 % discount is offered if payment is made within 10 days, otherwise the full amount is payable in 30 days.

Accounts receivable $40,000 Sales $40,000

• merchandise whose sales price was $1,500 is returned to the company

Sales returns 1,500 Accounts receivable 1,500


• some of the merchandise was slightly damaged during before it was shipped. A credit of $2,500 is granted to the customer.

Sales Allowances 2,500 Accounts Receivable 2,500

• on the 9th day after the sale, payment of $35,280 is received.

Cash 35,280 Sales discounts 720 Accounts receivable 36,000

The Conceptual Framework

A strong theoretical foundation is essential if accounting practice is to keep pace with a changing business environment. Accountants are continuously faced with new situations and business innovations that present accounting and reporting problems. These problems must be dealt with in an organized and consistent manner. The conceptual framework plays a vital role in the development of new standards and in the revision of previously issued standards.

Users and their needs

Financial accounting standard setters have narrowed down the users of financial information to two broad groups: creditors and shareholders (both present and potential). This does not imply that there are no other users of financial statements. It would be impossible for financial statements to meet the needs of all users of financial statements, since these needs could conflict. Consequently, the focus of financial statements is to meet the needs of creditors and shareholders. These two groups are most likely to have the following primary needs: • forecast future cash flows: will the company have sufficient future cash flows to

meet future interest, principal and dividend payments?, and • what is the fallback position: does the company have sufficient assets to satisfy its

liabilities? To summarize, the objectives of financial reporting are as follows: • to provide information useful to present and potential users in making investment,

credit, or similar decisions; • to provide information to help in assessing cash flows, such as dividends, interest,

loan repayments, and so on; and • to provide information about the economic resources of a firm, claims on those

resources, and changes in those resources to help in assessing cash flows.


Qualitative Characteristics of Accounting Information There are two primary qualitative characteristics of accounting information: relevance and reliability. Relevance implies that accounting information can make a difference when making a decision – the user of financial statements is better off having the information than not having it. To be relevant, accounting information should meet the following criteria: • predictive value – information should be useful in predicting future outcomes. For

example, the income statement is generally structured by segregating recurring items against non-recurring items. The rationale is that income from recurring items is a best predictor of future income.

• feedback value – information presented today helps confirm previous decisions. • timeliness – information should be available to the users as quickly as possible.

For example, the rationale for providing interim reporting to shareholders is in part based on the timeliness principle: it is better to provide information on a quarterly basis as opposed to waiting for the annual results.

Reliability implies that the accounting information can be depended upon. This implies that the information provided should be useful to the users. To be reliable, accounting information should meet the following criteria: • verifiability – accounting professionals, when establishing the validity of an

accounting estimate should come to a consensus. Verifiability implies that independent measures using the same measurement method should yield approximately the same result.

• representational faithfulness – accounting information should portray the substance of transactions over their form. For example, assume a company issues a new type of security called a ‘Special Preferred Share’ which has a limited life (i.e. gets refunded in a pre-specified number of years) and pays a fixed rate of interest. One could argue that regardless of what you call this security, the representational faithfulness principle would argue that it meets all the characteristics of long-term debt and should be classified as such.

At times, the concept of relevance and reliability conflict. For example, consider the application of the historical cost principle which states that assets should get recorded at their original cost. If a company purchased a parcel of land in 1856 for $100, that land is recorded on the company’s books at $100 regardless of the fact that it may well be worth $10,000,000 today. The $100 is an established transaction and is reliable. From a shareholders’ perspective the value of $10,000,000 is far more relevant. Reliability wins in this case. Secondary qualitative characteristics – the following two characteristics (neutrality and comparability are qualified as secondary because they are desirable qualities of accounting information, but are not as important as relevance and reliability.


Freedom from bias (neutrality) – accounting information should be even-handed with respect to the impact of accounting information on users’ behaviour. Accounting rules should not provide the motivation for dysfunctional decisions. For example, when companies sell depreciable assets, a gain or loss arises when the proceeds on disposal differ from the net book value of the asset sold. Assume that existing equipment is technologically obsolete and a net present value analysis shows that if the equipment were to be replaced, the company would benefit economically from it (i.e. the project has a significantly positive net present value). The only problem is that if the asset were to be disposed of, the company would have to show a large loss on disposal. The manager responsible for making the decision may have a bias to not replace the equipment so that the loss does not appear on the financial statements. Here is an example of an accounting rule that could lead to dysfunctional economic decision making. Comparability implies that accounting information is comparable with previous periods (interperiod comparability or consistency) and comparable to other firms operating in the same industry (interfirm comparability). Consistency implies that accounting principles are applied from period to period in the same manner. That’s not to say that accounting principles cannot be changed, but changes should occur infrequently and only for valid reasons. Also, as we will see in Lesson 4, changes in accounting principles require retroactive adjustment and restatement of prior period financial statements. Modifying concepts Conservatism means that it is generally preferable that any possible errors be in the direction of understatement of net income. When accountants can choose between two equally acceptable accounting principles, the principle of conservatism implies that the one with the least favourable impact on net income should be the one chosen. The principle of conservatism also leads to the recognition of contingent losses but does not recognize any contingent gains. For example, we must estimate which accounts receivable are likely to become uncollectible in the future and establish an allowance for doubtful accounts. Conservatism is an effort to ensure that the risk or uncertainty inherent in business situations is adequately considered. Information benefits vs. information costs. When introducing an accounting principle, accounting policy makers should weigh the cost of implementing the accounting principle against the benefits that the implementation of such an accounting principle will provide users. Cost/benefit analysis is very difficult to quantify since most costs and benefits are intangible, but should be used as a way of thinking. Materiality implies that financial statements are not precise but are accurate enough that any potential errors of misstatements would not affect any user. For example, the financial statements of a company with net income of $10,000,000 would not be significantly affected if they were misstated by say, $100,000. The concept of materiality can play against the concept of timeliness. The principle of timeliness implies that the financial statements should be in the hands of users as soon as possible. Thus, it may be


possible that additional invoices are received after the financial statements are issued. This omission is justified on the basis of materiality. Other Principles Economic entity principle states that the financial statements of an entity should report all assets and liabilities under its control. This principle will be invoked when dealing with leases and intercorporate investments in later lessons. Also refer to the definition of an asset (later in this section). Going concern principle assumes that the entity will continue operating in the future. One of the basic assumptions when amortizing fixed assets over their useful lives is that the entity will be able to absorb future amortization charges. This assumption allows us to record long-term assets at their depreciable cost, otherwise they would have to be recorded at the lower of their depreciable cost or liquidation value. Monetary unit principle assumes that the value of the dollar does not change - i.e. a 1925 dollar is equivalent to a dollar today. Consequently, we can add assets together even if they were purchased in different years. This is probably one of the most flawed principles. Periodicity assumes that we can breakup the life of a business in separate reporting periods (years, quarters, months…) and report income and prepare a balance sheet for each of these periods. Historical Cost Principle is an extension of the conservatism principle and states that assets should be recorded at their original cost and never be subsequently written-up to their market values. Revenue Recognition Principle states that revenues should only be recorded when earned, the measurability of such revenues are reasonably certain and collectibility is reasonably assured. Matching principle assumes that when we record revenues, all associated expenses related to the recognition of these revenues are recorded also.


Elements of Financial Statements

The following definitions of the elements of financial statements are drawn from Section 1000 of the CICA Handbook. Assets are economic resources controlled by an entity as a result of past transactions or events and from which future economic benefits may be obtained. Assets have three essential characteristics: (a) they embody a future benefit that involves a capacity, singly or in combination

with other assets, in the case of profit oriented enterprises, to contribute directly or indirectly to future net cash flows, and, in the case of not-for-profit organizations, to provide services;

(b) the entity can control access to the benefit; and (c) the transaction or event giving rise to the entity's right to, or control of, the benefit

has already occurred. Liabilities are obligations of an entity arising from past transactions or events, the settlement of which may result in the transfer or use of assets, provision of services or other yielding of economic benefits in the future. Liabilities have three essential characteristics: (a) they embody a duty or responsibility to others that entails settlement by future

transfer or use of assets, provision of services or other yielding of economic benefits, at a specified or determinable date, on occurrence of a specified event, or on demand;

(b) the duty or responsibility obligates the entity, thereby leaving it little or no discretion to avoid it; and

(c) the transaction or event obligating the entity has already occurred. Equity is the ownership interest in the assets of a profit oriented enterprise after deducting its liabilities. While equity of a profit oriented enterprise in total is a residual, it includes specific categories of items, for example, types of share capital, contributed surplus and retained earnings. Revenues are increases in economic resources, either by way of inflows or enhancements of assets or reductions of liabilities, resulting from the ordinary activities of an entity. Revenues of entities normally arise from the sale of goods, the rendering of services or the use by others of entity resources yielding rent, interest, royalties or dividends. In addition, many not-for-profit organizations receive a significant proportion of their revenues from donations, government grants and other contributions. Expenses are decreases in economic resources, either by way of outflows or reductions of assets or incurrences of liabilities, resulting from an entity's ordinary revenue generating or service delivery activities.


Gains are increases in equity / net assets from peripheral or incidental transactions and events affecting an entity, and from all other transactions, events and circumstances affecting the entity except those that result from revenues or equity / net assets contributions. Losses are decreases in equity / net assets from peripheral or incidental transactions and events affecting an entity, and from all other transactions, events and circumstances affecting the entity except those that result from expenses or distributions of equity / net assets.


Problems with Solutions

Problem 1-1 Multiple Choice Questions

1. The proprietor of Front Street Drugs bought a computer for his personal use. He paid for the computer by writing a cheque on the company chequing account and charged the “Office Equipment” account. What accounting principle, assumption, or constraint was violated?

a) Continuity assumption b) Matching principle c) Materiality constraint d) Separate entity assumption 2. Nimto Inc. recently completed construction on a new 12-storey office building that

will be used partly for its own head office and partly for renting to three other tenants. The cost of the floor covering for the company offices was expensed, even though the floor covering has an estimated useful life of 5 years. What accounting principle, assumption, or constraint was violated?

a) Continuity assumption b) Matching principle c) Cost principle d) Time period assumption

3. While making a delivery, the driver of Fastrac Courier collided with another vehicle causing both property damage and personal injury. The party sued Fastrac for damages that could exceed Fastrac’s insurance coverage. Existence of the lawsuit was reported in the notes to Fastrac’s financial statements. What accounting principle, assumption or constraint is being applied in this situation?

a) Full-disclosure principle b) Conservatism principle c) Matching principle d) Unit-of-measure assumption


4. On July 1, 20x8, ABC Ltd. purchased a 4-year insurance policy and paid a premium of $40,000. ABC has a December 31 year end. Which of the following statements is true?

a) Under cash basis accounting, the Insurance expense for the period ending December 31, 20x8, will be $5,000.

b) Under accrual accounting, there will be a balance of $20,000 in the Prepaid insurance account on December 31, 20x9.

c) Under cash basis accounting, there will be a balance of $25,000 in the Prepaid insurance account on December 31, 20x9.

d) Under accrual accounting, there will be a balance of $35,000 in the Prepaid insurance account on December 31, 20x8.

5. In the rush to make it to a New Year’s party, Harry, the bookkeeper for Ytwok, failed to include $40,000 worth of inventory in the company’s December 31, 20x5, inventory count. The December 31, 20x5, financial statements, which included this error, showed Total assets of $999,999, Total liabilities of $500,000, and Total shareholders’ equity of $499,999. What would be the balance for Total assets on December 31, 20x5, after correcting for the inventory error?

a) $ 40,000 b) $ 959,000 c) $ 999,999 d) $1,039,999

6. M. Shaw included a $200,000 personal residence as an asset on the balance sheet of his company, Shaw’s Rent-all. What generally accepted accounting principle does this contradict?

a) Time period principle b) Cost principle c) Going concern principle d) Business entity principle

7. According to generally accepted accounting principles, financial statements should be prepared using which of the following?

a) Fair market values b) Historic costs c) Future values d) Replacement costs


8. K. Smart presented land and buildings on her company’s balance sheet based on the appraised value of these assets at December 31, 20x8. What generally accepted accounting principle does this contradict?

a) Time period principle b) Revenue recognition principle c) Objectivity principle d) Business entity principle


Problem 1-2

On July 2, 20x2, you decided to start up a new business – Heavenly Books Inc., an off-campus bookstore where students can purchase textbooks and supplies at reduced prices. The following are summary transactions for the period July 2, 20x2 to October 31, 20x2, the company’s year end. 1. You and several other shareholders invested $20,000 in return for shares in the

company. 2. A suitable location is found and rent is $1,000 per month. The first and last

month’s rent are due upon signing of the lease on July 2, 20x2. The lease agreement is for one year. In addition to the monthly rent, an annual charge equal to 1% of sales is due at the end of the year (i.e. on June 30, 20x3).

3. Furniture and fixtures are purchased at a cost of $15,000. These are purchased for

cash. 4. A bank loan in the amount of $20,000 was obtained on August 1, 20x2. Interest

payments are due on the 1st of each month. The annual interest rate is 9%. The loan agreement calls for repayments of $4,000 every 4 months with the first payment due November 1, 20x2.

5. Books and supplies of $50,000 was purchased on account. 6. An insurance policy was purchased for $1,200 cash. The policy takes effect on

July 2, 20x2 and expires on June 30, 20x3. 7. Sales for the period ended October 31, 20x2 were: Cash sales - $190,000 Sales on account - $6,000 8. A total of $4,000 of the sales made on account were collected. 9. An additional $120,000 of inventory was purchased on account.


10. Additional cash disbursements for the year were as follows:

Wages and salaries $36,000 Rent 3,000 Advertising 2,000 Miscellaneous expenses 1,500 Dividends to shareholders 10,000 Interest on bank loan 300 Payments on account re: purchases of inventory 130,000

$182,800

The following adjustments at year end must be made: 11. The furniture and fixtures are expected to last a total of 10 years with no salvage

value. The straight line method is to be used. 12. The adjustment for insurance expense. 13. The interest payable on the bank loan. Credit Accrued Liabilities. 14. Books costing $15,000 were returned to the publishers. 15. An inventory count shows that a total of $25,000 of inventory is on hand. 16. Invoices received but not yet paid amount to $700 for miscellaneous expenses.

Credit Accrued Liabilities. 17. Employees are owed a total of $600. Credit Accrued Liabilities. 18. Adjustment for rent payable. 19. The expected income tax rate is 30%. Credit Accrued Liabilities. Required –

a. Enter all the above transactions in T-Accounts. b. Prepare a trial balance c. Prepare the following statements: - Income Statement - Statement of Retained Earnings - Statement of Financial Position


Problem 1-3

On January 1, 20x6, Global Production, Inc., was started with $50,000 invested by the owners as capital stock. On December 31, 20x6, the accounting records contained the following selected amounts:

Accounts payable $ 7,100 Accounts receivable 14,900 Accumulated amortization – Office Equipment ? Bank loan, due December 31, 20x8 40,000 Cash 25,100 Capital stock 50,000 Cost of goods sold 84,000 Amortization expense 4,800 Dividends declared 2,100 Interest expense 3,600 Income tax expense 4,100 Insurance expense 2,300 Inventory 44,200 Income taxes payable 1,000 Office equipment 24,000 Prepaid insurance 1,100 Rent expense 21,300 Salary expense 18,000 Salaries payable 1,500 Sales 157,600 Sales returns 2,400 Supplies 2,500 Supplies expense 4,100 Telephone expense 3,500

Required –

Prepare the following for the year ended/as at December 31, 20x6: a. A multi-step income statement. b. A statement of retained earnings. c. A statement of financial position.


Problem 1-4

For each of the following isolated situations, prepare the appropriate adjusting entry. a) On June 1, you bought a piece of machinery for $50,000. The estimated useful

life of the machine is 8 years, with no salvage value estimated at that time. It is now December 31, your year-end. Record the adjusting entry for amortization for the year.

b) You sell subscriptions to your magazine, Kittens Quarterly, on a yearly basis for

the fee of $24/year. Issues come out in March, June, September and December. A new customer purchases a subscription in January. It is now April 30, your year-end. First, record the journal entry to record the receipt of the subscription fee in January, and then record the adjusting entry for the end of April.

c) You are a consultant, and you have provided your services Big Al’s Used Cars for

the past month. Today is the end of the accounting period, but you will not be billing Big Al until next month. You have provided $2,300 worth of services. What would the adjusting entry be?

d) You pay weekly salaries to your staff and your accounting period end falls on a

Wednesday. Your daily salary expense is $600. What adjusting entry must be recorded to account for the unpaid salaries?

e) You paid $5,000 for your annual property insurance policy eight months ago. It is

now your year-end. What is the appropriate adjusting entry? f) You have a contract to provide catering services for a local company, INC Inc.,

for their monthly staff meetings. The contract, which was signed June 1, stated that they would pay you $6,000 on June 1st and again on December 1st for providing these services for one year. What is the adjusting entry required if your year-end is December 31st?

g) Your company is moving into a new office on July 1st. Your year-end is June

30th. Part of your new lease agreement required you to pay your first month’s rent, $4,750, ahead of time. You signed the agreement and wrote the cheque on June 30th. What would be the entry to record this? What would be the entry you would make on July 31st to record rent for the month?


Problem 1-5

Below are four transactions that were completed during 20x5 by Doby Company. The annual accounting period ends on December 31. Each transaction will require an adjusting entry at December 31, 20x5. You are to provide the 20x5 adjusting entries required for Doby Company. a. On July 1, 20x5, Doby Company paid for a two-year insurance premium for a

policy on its equipment. Coverage of the insurance policy starts on July 1, 20x5. This transaction was recorded as follows:

Jul 1, 20x5 Prepaid Insurance $1,000 Cash $1,000

b. On December 31, 20x5 a tenant renting some office space from Doby Company

had not paid the rent of $500 for December. c. On September 1, 20x5, Doby Company borrowed $3,000 cash and gave a one-

year, 10 percent, note payable. The total interest of $300 is payable on the due date, August 31, 20x6. The note was recorded as follows:

Sep 1, 20x5 Cash $3,000 Note payable $3,000

d. Assume Doby Company publishes a monthly magazine. On October 1, 20x5, the

company collected $440 for subscriptions two years in advance. The subscription start on October 1, 20x5. The $440 collection was recorded as follows:

Oct 1, 20x5 Cash $440 Unearned subscription revenues $440


Problem 1-6

For the next set of questions, ensure your answer reflects the cumulative impact of all prior parts. Wild Corporation is formed on April 1, 20x6. Initial financing comes from the sale of 100,000 common shares at $10 per share cash. 1. What are the total assets of Wild Corporation immediately after it has been

formed and the shares sold? 2. What are the total liabilities of Wild Corporation at this point? 3. What is total shareholders’ equity at this point? On April 2, 20x6, Wild Corporation purchases a warehouse for $300,000 cash. 4. What are the total assets of Wild Corporation after this transaction? 5. What are the total liabilities of Wild Corporation after this transaction? 6. What is total shareholders’ equity after this transaction? On April 3, 20x6, Wild Corporation purchases 1,000 units of inventory for $20 per unit. The purchase is made “on account” with the company agreeing to pay for the goods within 30 days. Assume Wild Corporation uses a Perpetual Inventory System. 7. What are the total assets of Wild Corporation after this transaction? 8. What are the total liabilities of Wild Corporation after this transaction? 9. What is total shareholders’ equity after this transaction? On April 5, 20x6, Wild Corporation sells 200 units of inventory for $50 per unit. The customer pays cash. The company used the perpetual inventory method. 10. What are the total assets of Wild Corporation after this transaction? 11. What are the total liabilities of Wild Corporation after this transaction? 12. What is total shareholders’ equity after this transaction? (CGA Canada Adapted)


Problem 1-7

The following information was extracted from You Read Magazines Co. The company requires that customers pay the annual subscription fee for the magazine in advance.

General Ledger Account Subscriptions Received in Advance

Dr Cr

Balance January1, 20x7 80,000 Entries during 20x7 128,000 Entries during 20x7 120,000

Required – 1. What was the subscription revenue earned during 20x7? 2. What was the subscription revenue earned during 20x7 for which the subscription

fee was received in 20x6? 3. What was the subscription revenue earned during 20x7 for which the subscription

fee was received in 20x7? 4. What is the subscription revenue to be earned in 20x8 for which the subscription

fee had been received in 20x7? (CGA Canada) Problem 1-8

Identify the net effect of independent transactions (1) through (7) on assets, liabilities, shareholders’ equity and net income. Show increases by a plus, decreases by a minus, and no change by NC. Example: Shareholders’ Net

Assets Liabilities Equity Income

Interest accrued on notes payable was $500

NC

+500

-500

-500

Required – 1. Received from Smith a $10,000 90-day, 6% interest note in exchange for extending the due date on a receivable. 2. Received a $50,000 cash injection from one of the owners of the company. 3. Received $2,000 from a customer for an outstanding invoice. 4. Purchased for $500 cash an insurance policy for the following year. 5. Purchased new equipment by obtaining a $200,000 1-year, 7% note payable from the seller. 6. Interest accrued on the note payable was $1,400. 7. Interest accrued on note receivable was $1,000. (CGA Canada Heavily Adapted)


Problem 1-9

Mr. Cash, the proprietor of Error Margin was excited to learn about profit margin analysis and immediately applied his knowledge to evaluate his business. He was perplexed that the profit margin had improved in spite of his intuition to the contrary. He asked his friend Ronald to have a look at his analysis as follows: 20x6 20x7

Cash received for sales

$60,000

$70,000

Cash paid for purchases 40,000 35,000 Other Expenses 10,000 14,000

Net income $10,000 $21,000

Profit margin 16.66% 30%

On examination, Ronald found the following: 1. An amount of $5,000 received in 20x6 pertained to a sale made in 20x5. 2. At the end of 20x6, accounts receivable for sales made to customers totaling $20,000 had not yet been received. The $20,000 was received in 20x7 and was included in cash received for sales in 20x7. 3. There was no money due from customers at the end of 20x7. 4. Cash paid for purchases in 20x6 included an amount of $2,000 which was a deposit on goods that were to be purchased in 20x7. 5. At the end of 20x6 and 20x7, there were goods in inventory costing $3,000 and $5,000, respectively. 6. Other expenses in 20x7 included $1,000 of Mr. Cash’s personal expenses. Required -

1. Based on the above, calculate Sales, Purchases, Cost of goods sold, Net income and Profit margin for 20x6 and 20x7, using the accrual method of accounting. 2. Identify any two generally accepted accounting principles that were violated in Mr. Cash’s analysis. (CGA Canada)


Problem 1-10

Evergreen Inc. operates a tree farming business. It plants, maintains, and harvests evergreen trees. It sells the trees for cash, primarily during the Christmas season, in parking lots at select locations in major urban areas. It normally takes about 15 years for a tree to grow to a suitable size. The largest cost of this business is the cost of fertilizing, pruning and maintaining the trees over the 15-year period.

Required

a. Use the criteria for revenue recognition to explain when revenue should be recognized for this tree farming business.

b. How should the annual cost of fertilizing, pruning and maintaining the trees be accounted for? Explain.


Problem 1-11

V. Strait opened an architecture company; the following transactions were completed during December 20x6. Dec. 1 Issued 100 common shares of the new company, V. Strait Ltd., to V. Strait in exchange for $6,000 cash. Dec. 3 Purchased the office furniture and equipment of a retiring architect for

$4,000, paying $1,000 in cash and agreeing to pay the balance in six months. Dec. 7 Completed work for a client and immediately collected $680 in cash for the work done. Dec. 13 Completed work for JP Developers and sent them an invoice for $1,875. Dec. 17 Purchased office supplies on credit for $300. Dec. 28 Received $1,875 from JP Developers for the work completed on Dec. 13. Dec. 31 Paid $1,300 cash to the office secretary for December’s wages. Dec. 31 Paid $1,000 for rental of office space for December rent. Dec. 31 Performed a count of office supplies, which revealed that $200 of the $300

worth of office supplies purchased on December 17 were still on hand. Required –

a. Prepare journal entries for the above transactions b. What is operating income for V. Strait Ltd. for the month ending December 31,

20x6? (CGA Canada Adapted)


Problem 1-12

The following summarized transactions (in thousands of dollars) occurred during the year ended December 31, 20x2 for Ruiz Pharmacy: a. Merchandise inventory purchased on account was $520. b. Total sales were $900, of which 80% were on credit. c. The merchandise inventory as at December 31, 20x2 was $240. d. Collections from credit customers were $700. e. The notes receivables are from a major supplier of vitamins. Interest for twelve months on all notes was collected on May 1. The rate is 12% per annum. f. The principal on the current notes was collected on May 1, 20x2. The principal on the remaining notes is payable on May 1, 20x5. Cash disbursements were: g. To trade creditors, $500. h. To employees for wages, $193. i. For miscellaneous expenses such as store rents, advertising, utilities and supplies, which were all paid in cash, $189. j. For new equipment acquired on July 1, 20x2, $74. k. To the insurance company for a new three-year fire insurance policy effective September 1, 20x2, $36. l. To Revenue Canada for income taxes, $19. m. The board of directors declared cash dividends of $26 on December 15 to be paid

on January 21. The following adjustments were made on December 31, 20x2: n. For the interest on the note receivable. o. For insurance. p. For depreciation - depreciation expense for 20x2 was $30. q. Wages earned but unpaid, December 31, 20x2, $15 r. Total income tax expense for 20x2 is $20, computed as 40% of pretax income of $50. Required - 1. Post all of the above transactions in T-Accounts. 2. Prepare an income statement, statement of retained earnings and balance sheet for 20x2.


Problem 1-13

Peter is the owner and operator of Peter's Appliance Shop Ltd., Ottkancester’s largest independent household appliance store. Peter supplies appliances to retail customers as well as to builders of the many new homes and apartments that are going up in the community. Peter has been in business for five years. Peter’s balance sheet for August 31, 20x4, the company's year end, is shown below. Peter uses the financial statements mainly for tax purposes and to show the holders of the long-term notes.

Peter's Appliances Shop Ltd.

Balance Sheet As at August 31, 20x4

Assets Liabilities and shareholders' equity

Cash $ 30,000 Accounts payable $265,000 Accounts receivable 123,000 Taxes payable 20,000 Inventory 446,500 Interest payable 8,500 Prepaid rent 14,000 Long-term notes payable 100,000 Furniture and fixtures 190,000 Accumulated Capital stock 110,000 amortization -40,000 Retained earnings 260,000

$763,500 $763,500

It is now mid-September 20x5. Peter needs to prepare its financial statements for the year ended August 31, 20x5. The following information has been obtained about the fiscal year just ended: 1. Peter purchased appliances from suppliers for $850,000. All purchases were

made on account. 2. Sales during the year were $1,350,000. Cash sales were $775,000. The remainder

was on account, mainly to builders. 3. The cost of the appliances sold during fiscal 20x5 was $745,000. 4. Peter paid salaries and commissions to employees of $200,000. On August 31,

20x5, employees were owed $7,500 by Peter. 5. Peter collected $375,000 during the year from customers who purchased on

credit. 6. Peter paid suppliers $600,000 for appliances it purchased on credit. 7. During the year Peter paid the taxes it owed at the end of fiscal 20x4. During

fiscal 20x5 Peter paid $15,000 in installments on its taxes. At year end the accountant estimates that Peter owes an additional $12,000 in taxes.


8. Peter accepted $10,000 in deposits from customers who wanted a guarantee that their appliances would be delivered when they needed them. The deposits pertained to a particularly hard-to-get appliance. Peter expects that the appliances will be delivered in early November 20x5. These deposits were not included as part of cash sales.

9. Beginning July 1, 20x5 Peter pays $4,000 a month for the rent of its store. The terms of the lease require that rent be paid six months in advance on January 1 and July 1 of each year. Before July 1, 20x5 Peter paid $3,500 a month in rent. In addition, Peter must pay 2% of annual sales to the property owner 60 days after the year end. The prepaid rent at the beginning of the year represented 4 months of prepaid rent at the old location.

10. Peter recently redecorated his kitchen at home. He took a refrigerator, stove, and microwave that cost $4,500 from the store and installed them in his new kitchen. For accounting purposes, treat this as a dividend.

11. During 20x5 Peter purchased new capital assets (furniture and fixtures) for $25,000 cash.

12. Amortization expense for 20x5 is $22,000. 13. During the year Peter paid $8,500 in interest to the holders of the long-term notes.

Interest is paid annually on September 1. In addition to the interest payment, Peter paid $20,000 on September 1, 20x4 to reduce the balance owed on the long-term notes. The interest rate on the notes is 8.5%.

14. Peter paid $225,000 in cash for other expenses related to operating the business in fiscal 20x5.

Required –

Prepare an income statement, a statement of retained earnings and a balance sheet and a statement of cash flow for Peter's Appliance Shop Ltd. for the year ended August 31, 20x5.


2. Cash and Investments Cash

For accounting purposes, cash generally means any cash on hand, bank accounts, petty cash and any foreign currency on hand. Typically, every 30 days a company will receive a bank statement from the bank. The bank statement is a running total of all transactions that were made in the account since the last bank statement was produced. It starts with the opening bank balance and ends with the ending balance. Accompanying the bank statement are all the cheques that have cleared the bank account. The balance showing on the bank statement needs to be reconciled to the balance shown in the company’s cash account. This process is as follows:

1. Ensure that all cheques returned correspond to the amount entered into the cash account,

2. Prepare a list of cheques that were written but that have not yet cleared the bank account (outstanding cheques),

3. Identify any transactions that appear on the bank statement that have not been recorded in the cash account. For example, bank service charges, cheques deposited that are returned due to insufficient funds (NSF cheques), etc.. Prepare journal entries to record these items and post to the general ledger,

4. Compare all deposits recorded on the bank statement to those recorded in the cash account, and

5. Prepare a list of deposits that were made in the cash account but were not yet recorded on the bank statement (outstanding deposits).

The bank reconciliation starts with the balance per the bank statement, adds the outstanding deposits and deducts the outstanding cheques to arrive at the balance per books:

Balance per bank statement $XXX Add outstanding deposits XXX Less outstanding cheques -XXX

Balance per books $XXX


Example – The Parkes Company’s bank statement dated Aug 31, 20x7 shows the following: • ending balance of $45,673 • bank service charges not yet recorded by the company of $156 • returned cheque (NSF) from a customer in the amount of $788 • cheque # 345 was written for $323 and cleared the back for that amount. The

cheque was incorrectly written in the cash disbursement journal as $332. The correct amount is $323.

• the total outstanding cheques amount to $6,574 • a deposit made on August 31 in the amount of $3,545 was not recorded on the

bank statement • the general ledger cash account shows a balance of $43,579 (before any

adjustments above) The first thing we do is make adjustments to the cash account for items on the bank statement that have not yet been recorded: Bank service charges $156 Cash $156 To record the bank service charges for the month of August. Accounts receivable 788 Cash 788 To record the returned cheque. Cash ($332 – 323) 9 Accounts payable 9 To record the error in recording cheque # 345. The next step will be to calculate the revised cash balance: Cash balance, before adjustments $43,579 Less bank service charges (156) Less NSF Cheque (788) Add error on cheque # 345 9

Cash balance after adjustments $42,644

Finally, we prepare the bank reconciliation: Cash per bank, August 31, 20x7 $45,673 Add outstanding deposits 3,545 Less outstanding cheques (6,574)

Cash per books, August 31, 20x7 $42,644


Non Strategic Investments

Investments in the shares of another corporation can broadly be classified as non-strategic or strategic investments. Strategic investments occur when we take a significant equity position in another company and are in a position to either control the other company or significantly influence its strategic, operational or financial policies. By their very nature, strategic investments are classified as long-term investments. Non-strategic investments, the subject of this chapter, consist of passive investments in the shares of another company. These investments will either be classified as held for trading or available for sale securities. Held for trading investments are acquired or incurred principally for the purpose of selling or repurchasing it in the near term and are part of a portfolio of identified financial instruments that are managed together and for which there is evidence of a recent actual pattern of short-term profit taking. They are therefore specifically held for purposes of re-sale and are designated by management as such. They would normally be classified as current assets. An available for sale investment occurs whenever companies invests in equity securities that are not classified as held for trading and are not strategic investments. Available for sale investments also occur whenever debt securities are acquired with the intent of liquidating them before their maturity. The classification of available for sale investments as current or long-term assets depends on management intent. If management intends to hold these for a period of less than one year, they are classified as current assets, otherwise they are classified as long-term assets. Regardless of how they are classified, there is no difference in the accounting for these investments. For both types of investments, the accounting for investment income, and balance sheet valuation is the same: - interest accrued or dividends declared are recorded as investment income, - at the balance sheet date, the investments are carried at fair market value. Where the two methods differ is on how the adjustment to fair market value is recorded. • available for sale investments: any unrealized gains or losses are charged to Other

Comprehensive Income. Other Comprehensive Income becomes part of Shareholders' Equity. Any realized gains or losses are charged to Net Income;

• trading investments: all gains, whether realized or unrealized, are charged to Net Income.


Example - on June 30, 20x5 you purchase the shares of another company for $15,000. The investment is classified as an available for sale investment. On October 15, 20x5 we receive a dividend cheque for these shares in the amount of $600. At December 31, 20x5 (the balance sheet date), the fair market value of the shares is $16,500. On February 12, 20x6, you sell the investment for $16,900. The following journal entries will be recorded with regards to this investment: Jun 30, 20x5 Available for Sale Investments $15,000 Cash $15,000 Oct 15, 20x5 Cash 600 Investment income 600 Dec 31, 20x5 Available for Sale Investments 1,500 Unrealized holding gain 1,500 At December 31, 20x5, the unrealized gain will be part of Other Comprehensive Income and will be part of Shareholders' Equity: Shareholders Equity: Common Shares XXXX Retained Earnings XXXX Other Comprehensive Income Unrealized holding gains $1,500 Feb 12, 20x6 Cash $16,900 Unrealized holding gain 1,500 Gain on sale of investments 1,900 Available for Sale Investments $16,500 If the investment has been classified as a trading investment, then the following journal entries would have been recorded: Jun 30, 20x5 Held for Trading Investments $15,000 Cash $15,000 Oct 15, 20x5 Cash 600 Investment income 600

Dec 31, 20x5 Held for Trading Investments 1,500 Unrealized trading gain 1,500 Note: the difference is that the unrealized

trading gain is part of net income and gets closed out to retained earnings.


Feb 12, 20x6 Cash $16,900 Realized trading gain 400 Temporary Investments $16,500


Problems with Solution Problem 2-1

1. During May, a company received a cheque from a customer in payment of the

related account receivable. The cheque was written for the correct amount of $152, and it was deposited on May 18. The May bank statement listed the deposit at $512. How should this error be corrected on the May bank reconciliation?

a) Add $360 to the bank balance b) Add $360 to the book balance c) Subtract $360 from the bank balance d) Subtract $360 from the book balance

2. An analysis of the cash account for Swiss Company at December 31, 20x8 revealed the following details:

Balance in bank account $15,095 Customer cheques dated December 31, 20x8,

on hand but not yet deposited

9,700

Swiss Company cheques that have not cleared the bank account

3,200

What amount should be reported as cash in the current asset section of Swiss

Company’s balance sheet at December 31, 20x8? a) $15,095 b) $21,595 c) $25,095 d) $31,595


3. A company is preparing its May bank reconciliation. The ending balance on the May bank statement is shown as $4,225. At the end of the month, the following information was provided by company records and the monthly bank statement:

Bank service charges shown on the bank statement $15 NSF cheques from customers shown on the bank statement 48 Deposits in transit at the end of the month determined by

the company’s bookkeeper 63

A cheque for $43 (the correct amount) written by the company was recorded in the books at

34

What is the correct cash balance shown on the bank reconciliation? a) $4,279 b) $4,288 c) $4,312 d) $4,327

Problem 2-2

The following information for the month of December 20x6, with respect to cash activities, was gathered by Sarg Ltd.’s bookkeeper. Cash balance per books, December 1 $ 3,700 Cash received during December 77,000 Cash payments made during December 77,548 Cash balance per bank statement, December 31 6,300 Cheques outstanding, December 31 5,300 Bank service charges for December 52 Deposits in transit at December 31 1,700 Cheque issued by Sparg Ltd. deducted from Sarg’s account in error by the bank 580 A $1,200 cheque received from a customer on December 13 in payment of an account receivable was incorrectly recorded as 1,020 Required -

a. Prepare the December 20x6 bank reconciliation for Sarg. b. Prepare any adjusting journal entries that would result from the December 2006

bank reconciliation.


Problem 2-3

The March 31, 20x7, bank statement for Focus Ltd. showed a balance of $480. In preparing the bank reconciliation, the following information was determined: a) The following cheques are outstanding at March 31, 20x7: #501 for $780 and #533

for $1,200. b) The March 31, 20x7, deposit of $6,200 had not been received by the bank in time to

be included in the December bank statement. c) Bank service charges for December amounted to $35 and had not yet been recorded by Focus Ltd. d) Cheque #521 issued by Focus Ltd. in the amount of $620, for the cash purchase of office equipment, had been incorrectly recorded in the books of Focus Ltd. as $260. e) A $530 payment on account received from a customer was incorrectly recorded in the books of Focus Ltd. as $350. f) The balance in Focus Ltd.’s cash account according to its accounting records was $4,915. Required –

1. Prepare a bank reconciliation for Focus Ltd. at March 31, 20x7. 2. Prepare the necessary journal entry(ies) to bring Focus Ltd.’s cash account up to

date at March 31, 20x7. (CGA Canada)


Problem 2-4

During 20x0, Holdco Ltd. decided to invest in the shares of a number of "Hi-tech" companies. The data on Holdco Ltd.'s temporary investments at December 31, 20x0, is shown below:

Number Market Value as at

Temporary Investments Cost of Shares December 31, 20x0

Company Name

XYZ Computer $ 72,000 10,000 $ 70,000 Satellite Systems 51,000 20,000 63,000 Strategic Air Defence Systems 28,000 7,000 31,000 Generic Engineering 30,000 5,000 26,000 Cellulose Telephone 45,000 9,000 44,000 $226,000 51,000 $234,000

Recent discussions have brought to management's attention that there are different methods of accounting for temporary investments. Management is quite unfamiliar with these different methods and has approached you for this information. Required - a) As chief accountant for Holdco, advise management of two alternative methods of

accounting for temporary investments and indicate the effect each has on balance sheet and income statement information. Support your answers with calculations.

b) On January 10, 20x1, all the XYZ Computer shares are sold for $75,000, and all the

Strategic Air Defence Systems shares are sold for $35,000. Assuming these investments are classified as held for sale investments, write the journal entries to record the two sales.


Problem 2-5

Mable Company has a portfolio of temporary investments consisting of the following (all investments were purchased in 20x0):

December 31 Market Value

Cost 20x0 20x1 20x2

Security A $20,000 $18,000 $19,500 $16,000

B 14,000 12,500 14,000 10,500

C 32,000 29,800 28,500 31,000

$66,000 $60,300 $62,000 $57,500

Required -

a) Assuming these investments are classified as available for sale, calculate the balance in Other Comprehensive Income at the end of each year.

b) Assuming these investments are classified as trading investments, calculate the amount of unrealized trading gain or loss for each year.


3. Accounts Receivable Whenever credit is extended to customers for the provision of goods or services, an account receivable is created. Accounts receivable are, therefore, the aggregate of the unpaid invoices at any point in time. Accounts receivable are reported on the statement of financial position at their net realizable value (NRV), which is equal to the net amount of outstanding invoices the firm expects to recover. The net realizable value is equal to: Gross Accounts Receivable Less Allowance for Doubtful Accounts Calculating the Allowance for Doubtful Accounts

The allowance for doubtful accounts normally has a credit balance and is equal to the amount of accounts receivable that are expected to not be collected. There are two approaches to calculating the allowance for doubtful accounts: the balance sheet approach, where the allowance for doubtful accounts is estimated directly, and the income statement approach, whereby we estimate the amount of bad debt expense on the income statement. There are generally three approaches to estimating the allowance for doubtful accounts directly (balance sheet approach): 1. Aging of the accounts receivable listing

This involves grouping all outstanding receivables based on how long these have been outstanding. For example, assume the total receivables add up to $1,200,000 and that the aging of accounts receivable is as follows:

0 – 30 days $750,000 31 – 60 days 280,000 61 – 90 days 120,000 90 + days 50,000

$1,200,000

Based on past experience, the company estimates that 1% of current accounts will eventually become uncollectible, 3% of accounts between 31-60 days, 8% of accounts between 61-90 days and 40% of accounts over 90 days. The allowance for doubtful accounts at the end of the year will be:

0 – 30 days $750,000 x 1% $ 7,500 31 – 60 days 280,000 x 3% 8,400 61 – 90 days 120,000 x 8% 9,600 90 + days 50,000 x 40% 20,000

$45,500


2. As a percentage of the ending accounts receivable balance

This approach simply takes then ending accounts receivable balance and multiplies it by a percentage. For example, if the ending accounts receivable balance is $1,200,000 and the company estimates that 5% of these accounts will eventually become uncollectible, then the allowance for doubtful accounts at the end of the year will be $1,200,000 x 5% = $60,000.

3. Specific account identification

When a company has accounts receivable from a limited number of customers and has an intimate knowledge of these customers, it may be able to identify which specific accounts may become uncollectible. The sum of the estimated uncollectible accounts at any point in time will form the allowance for doubtful accounts.

The income statement approach is used whenever a company offers their customers revolving credit facilities (i.e. a department store which offers their customers a credit card). In this case, it would not be meaningful to age the accounts receivable listing, so we estimate the bad debt expense as a percentage of credit sales. Note that this approach does not estimate the allowance for doubtful accounts, but estimates the amount of bad debt expense. The journal entry to record bad debt expense under either the balance sheet or income statement approaches is: Dr. Bad Debt Expense Cr. Allowance for Doubtful Accounts Recording accounts written off

An account will generally be written off when (1) you receive a notice from a Trustee in Bankruptcy that you will receive an amount that is less than the amount owed, or (2) the amount is small and the cost of recovering the account is greater than the balance owed. Any accounts written off are written off against the allowance for doubtful accounts: Dr. Allowance for Doubtful Accounts Cr. Accounts Receivable Recording recoveries of accounts written off

When an account that was previously written off is subsequently recovered, we first reverse the journal entry made to write off the account:

Dr. Accounts Receivable Cr. Allowance for Doubtful Accounts


We then record the collection on the recovered accounts receivable: Dr. Cash Cr. Accounts Receivable Example – The Jasmine Company’s accounts receivable at the end of the year totaled $2,800,000. The balance in the allowance for doubtful accounts at the beginning of the year was $50,000. During the year, the following transactions took place: • accounts totaling $75,000 were written off, • previously written off accounts totaling $10,000 were recovered. The journal entry to record the accounts written off will be:

Allowance for doubtful accounts $75,000 Accounts receivable $75,000

The journal entry to record the recovery will first be to reverse the entry initially made when these accounts were written off:

Accounts receivable $10,000 Allowance for doubtful accounts $10,000

We then record the cash receipt on the accounts receivable:

Cash $10,000 Accounts Receivable $10,000

This will result in a $15,000 debit balance in the Allowance for Doubtful Accounts:

Allowance for

Doubtful Accounts

Write-offs $75,000 $50,000 Beginning Bal

10,000 Recoveries

$15,000

Ending balance before adjustment


In order to calculate the bad debt expense for the year, we will assume four independent scenarios: 1. The accounts receivable aging is as follows:

The allowance for doubtful accounts is estimated to be:

(1,800,000 x 1.5%) + (600,000 x 2.5%) + (250,000 x 6.0%) + (150,000 x 15.0%) = $79,500

The bad debt expense will be $94,500 since this is the entry required in the Allowance for Doubtful Accounts account to bring the account to a credit balance of $79,500: Bad Debt Expense $94,500 Allowance for Doubtful Accounts $94,500

2. Management estimates that 2.75% of the accounts receivable balance will be

uncollectible. The allowance for doubtful account should be established at $2,800,000 x 2.75% = $77,000. The journal entry to record bad debt expense will be:

Bad Debt Expense $92,000 Allowance for Doubtful Accounts $92,000

3. Using specific identification of accounts, management estimates that the

allowance for doubtful accounts should be $68,000. The journal entry to record bad debt expense will be:


Accounts Receivable

Estimated % Uncollectible

0 – 30 days 1,800,000 1.5% 31 – 60 days 600,000 2.5% 61 – 90 days 250,000 6.0% 90 + days 150,000 15.0%

$2,800,000


4. Management estimates that bad debt expense will be equal to 1.5% of total credit sales. Total credit sales for the year amounted to $6,000,000. Bad debt expense will then be equal to $6,000,000 x 1.5% = $90,000. The journal entry to record bad debt expense will be:


This will cause the allowance for doubtful accounts to have a credit balance of $15,000 dr. + $90,000 cr. = $75,000. Note that when using this approach, we are effectively estimating the bad debt expense for the year and the residual becomes the Allowance for Doubtful Accounts. In approaches 1-3, we were estimating the Allowance for Doubtful Accounts with the residual being bad debt expense.



Problem 3-1 – Multiple Choice Questions

1. A company estimated the needed balance in its account “allowance for doubtful accounts” by aging the accounts receivable. At the end of 20x8, the balance of the allowance account was $5,000. During 20x9, the company wrote off $500 and collected a $300 receivable that had been previously written off as uncollectible. At the end of 20x9, the aging schedule indicated that the balance of the allowance account should be $6,400. What is bad debt expense for 20x9?

a) $1,600 b) $1,900 c) $6,600 d) $6,900

2. A company reported the following items for 20x8: Accounts receivable balance, January 1, 20x8 $80,000 Allowance for doubtful accounts balance,

January 1, 20x8 (credit) (11,000)

Total credit sales during 20x8 400,000 Total collections on accounts receivable during 20x8 360,000 Uncollectible accounts written off during 20x8 20,000 Experience indicates that 4% of the uncollected accounts receivable at the end of

each year ultimately will be uncollectible. What should be the adjusting entry amount for doubtful accounts at December 31, 20x8

a) $4,000 b) $4,800 c) $7,000 d) $13,000 e) $13,800


3. A company had accounts receivable of $3,000 and an allowance for doubtful accounts of $125, just prior to writing off as uncollectible an account receivable of $30. What were the net realizable values of the accounts receivable as shown by the accounting records before and after the write-off?

Before After a) $2,875 $2,875 b) $2,875 $2,975 c) $3,000 $2,970 d) $3,000 $3,095

Problem 3-2

The following information relates to Merit Ltd. for the year ended December 31, 2004: Total sales $ 15,000,000 Cash sales 800,000 Credit sales 14,200,000 Cash collections from credit customers 11,900,000 Actual accounts receivable determined to be uncollectible and written off during the year 55,000 Recoveries of previously written off accounts receivable 3,000 Accounts receivable, January 1, 2004 1,000,000 dr. Allowance for doubtful accounts, January 1, 2004 63,000 cr. Required –

a. Provide the journal entry to write off actual accounts receivable determined to be uncollectible and recoveries, assuming the allowance method is used to account for uncollectible accounts.

b. Provide the December 31, 2004 adjusting journal entry to record bad debts, assuming the allowance method is used and uncollectible accounts are estimated to be of 1% of credit sales.

c. Provide the December 31, 2004 adjusting journal entry to record bad debts, assuming the allowance method is used and management estimates the allowance to be 3% of the closing Accounts Receivable balance.


Problem 3-3

Sigma Company began operations on January 1, 20x0. The Sigma Company calculates its allowance for doubtful accounts by aging the accounts receivable based on the following percentages:

Days Past

Invoice Date

Percent Estimated

To be Uncollectible

0 – 30 1% 31 – 60 5% 61 – 90 20% Over 90 80%

The following additional information relates to the years ended December 31, 20x1 and 20x0: 20x1 20x0

Credit Sales $3,000,000 $2,800,000 Collections (excluding recoveries) 2,915,000 2,400,000 Accounts written off 27,000 16,000 Recovery of accounts previously written off 7,000 - Days Past Invoice at December 31 - 0 – 30 277,000 234,000 31 – 60 80,000 90,000 61 – 90 60,000 45,000 Over 90 25,000 15,000 Required –

Prepare all journal entries to record the above transactions


Problem 3-4

EED Ltd. began operations on January 1, 20x6. The company uses the allowance method of accounting for bad debt expense. Based on industry averages and its experience in 20x6, EED Ltd. decided that an allowance equal to 5% of total accounts receivable would be sufficient to cover uncollectible accounts. On December 31, 20x6 there was a $2,000 credit balance in the allowance for doubtful accounts account and a $40,000 debit balance in the accounts receivable account. During 20x7 the following summarized transactions occurred: 1. Sold merchandise on credit for $500,000. 2. Wrote off uncollectible accounts receivable in the amount of $1,500. 3. Received cash of $400,000 in payment of outstanding accounts receivable. 4. On December 1, 20x7, an accounts receivable in the amount of $3,000 was converted to a 6-month promissory note to allow a cash-strapped customer some time to meet his obligations. The promissory note bears an interest rate of 12%.

Required - 1. Prepare journal entries to record the above transactions on the books of EED Ltd. In addition, prepare journal entries, if any, required at December 31, 20x7, to record bad debt expense for the year and accrue interest on the promissory note. 2. Suppose now that instead, EED Ltd. expects 2% of credit sales to be uncollectable.

With all other data being the same from above, prepare the journal entries, if any, required at December 31, 20x7 to record bad debt expense for the year.

(CGA Canada adapted)


4. Inventory A key part of determining the cost of the items that a company sells to its customers, as well as valuing the items that it has on hand to resell at any point in time, is the inventory system that it chooses. We will begin by looking at two fundamentally different types of systems, and then evaluate the different valuation methods a company can chose to determine the cost of inventory. The Perpetual Inventory System

The term perpetual means continuing without interruptions, or never ending. When we talk about a perpetual inventory system, we mean an inventory system that has no interruptions. What that means is that inventory is tracked constantly in a real-time basis. Each item that is purchased for resale gets debited to the inventory account. Furthermore, each time an item is sold is removed directly from the inventory account by crediting the inventory account and debiting the Cost of Goods Sold account. From time to time, a physical count of inventory will be taken to ensure accuracy of the perpetual records, and any adjustments that are needed will be made to the inventory account. Example: It is Little Company’s first year of business. On the first day, Little Company purchases $5,000 worth of inventory, paying cash. The journal entry would be: Inventory 5,000 Cash 5,000 The next day, Little Company purchases an additional $10,000 of inventory, this time on account. Inventory 10,000 Accounts Payable 10,000 Note that even though we are not paying cash, the effect on the inventory account is the same as the above journal entry. We still increase the inventory account by the amount of the purchase; we just create a payable instead of reducing our cash account.

After two weeks of business, Little Company makes its first big sale. They sell $4,000 worth of inventory to a customer for $6,000 cash. Note that unless a company is offering a discount to get rid of inventory or for some other reason, the amount the company generally receives from its customer should always be greater than the value of the inventory.


To record the sale, the journal entry would be: Cash 6,000 Sales Revenue 6,000

At this point, we have recorded the sale and the receipt of cash; however, we have not removed the items that were sold from our inventory account. To do this, the journal entry would be: Cost of Goods Sold 4,000 Inventory 4,000

This journal entry does two very important things. First, it removes the $4,000 worth of inventory from our Inventory Asset account. Second, it records the expense of the items that were sold. This expense account, Cost of Goods Sold (COGS), is used to keep track of all of the costs of all of the items a company sells in one period. Under the Perpetual system the COGS is a running total, as is the inventory account. This varies significantly from the Periodic Inventory System, which we will now turn our attention to. The Periodic Inventory System

Under the Periodic Inventory System, we do not keep a “running total” of inventory, nor do we keep a running total of COGS. Instead, we do a physical count of inventory at the end of the year to determine the amount to include on the Statement of Financial Position under “Inventory”. So what do we do with the purchases of inventory we make throughout the year? Throughout the year, as purchases are made of inventory they are tracked in a temporary account called “Purchases”. Continuing with the example above, that first purchase of inventory for $5,000 cash would be recorded, under a periodic inventory system, as: Purchases 5,000 Cash 5,000 The Purchases account keeps a running total for the year of all purchases of inventory made. However, Purchases has several contra accounts that track other expenses or discounts that may be associated with the purchases. These are:


Purchases Transportation – In Purchase Discounts

Normal Early debit Freight payment

balance charges discounts

Purchase Returns Purchase Allowances

We keep Merchandise merchandise returned but are

given a credit

Running totals are kept in each of the above accounts for the year. At the end of the year, the Purchase account and all contra accounts are closed out to zero. At the same time, the inventory account is adjusted to the appropriate ending balance, based on the physical count. The amount needed to balance the equation is the Cost of Goods Sold. The Cost of Goods Sold Equation is as follows: Beginning Inventory + Purchases (net of contra accounts) = Cost of Goods Available for Sale

- Ending Inventory = Cost of Goods Sold Example 1 –

Let us use the Little Company example from above. If you remember, the opening inventory was $0, as this is a new business. Purchases of $5,000 and $10,000 were made. The new journal entries would be: Purchases 5,000 Cash 5,000 Purchases 10,000 Accounts Payable 10,000 Let us suppose that those were the only purchases made during the year, and that at the end of the year a physical count of the inventory revealed that there was $11,000 worth of inventory on hand. To calculated COGS:


Beginning Inventory $ 0 + Purchases ($5,000 + 10,000) 15,000 - Ending Inventory (as per count) 11,000

= Cost of Goods Sold $4,000

Example 2 – Tetrie Company shows the following balances at the end of the year: Dr. Cr. Inventory $175,000 Purchases 2,700,000 Transportation-in 36,000 Purchase returns and allowances 48,000 Purchase discounts 27,000 Tetrie uses a periodic inventory system. A year-end count reveals that the ending inventory balance should be $360,000. The journal entry to record Cost of Goods sold at the end of the year would be as follows: Cost of Goods Sold (calculate to balance) 2,476,000 Purchase returns and allowances (close account) 48,000 Purchase discounts (close account) 27,000 Inventory ($360,000 – 175,000 = $185,000 increase) 185,000 Purchases (close account) 2,700,000 Transportation-in (close account) 36,000 Note that the Inventory balance given of $175,000 would be the ending inventory balance from last year. The balance is sitting at $175,000 and it should be, according to our count, $360,000. Therefore, in order to get the balance in the inventory account to $360,000 we must increase it (or debit it) by $185,000. Furthermore, the Purchases account and all of the associated contra accounts have been set back to $0. They are ready for the next fiscal year. Cost of goods sold can be independently calculated as follows: Beginning Inventory $175,000 + Purchases (2,700,000 + 36,000 – 48,000 – 27,000) 2,661,000

= Cost of Goods Available for Sale 2,836,000 - Ending Inventory (as per count) (360,000)

= Cost of Goods Sold $2,476,000


Inventory Valuation Methods

The above discussion of periodic vs. perpetual inventory systems dealt with how we track the inventory and purchases that flow through a company. We will now discuss how we attach value to the inventory; that is at what cost do we record the inventory and COGS. There are two different valuation methods that can be used to calculate the value of inventory: specific item valuation or cost flow assumption. Specific Item Valuation This method is used when inventory items can be specifically identified. That is, it is possible to track each item in inventory separately. Some examples of situations where this method would be possible are: when items have specific serial numbers, like a car dealership; or when a company has relatively few items in inventory that have a specific cost associated with them, like a jeweler. In this case, when the item is sold, we remove its specific cost from inventory and debit COGS at the carrying amount. Cost-Flow Assumption This method is used when items cannot be differentiated from one another, or when the value of the items is so small that it does not warrant the cost of tracking the specific item value. Under this method we can make one of two assumptions: that the first inventory that arrived is the first inventory that was sold (FIFO Method); that inventory is mixed all together and, therefore, we don’t know specifically which items are being sold so we use an average of some sort to determine cost. FIFO

Under the FIFO method, we assume that the “First In = First Out”. That is to say, the ending inventory is equal to the most recent purchases. Conversely, the COGS is equal to the opening inventory + earlier purchases. Note that regardless if a company is using a periodic or perpetual system, both the COGS and the ending inventory cost will be the same under the FIFO valuation method.


Example – On January 1, Lainey Company has 400 units in its opening inventory. They purchased these units for $1.00 each. Throughout the period, the following transactions took place:

January 3 Purchased 200 units @ $1.20 each January 5 Purchased 400 units @ $1.25 each January 10 Sold 700 units January 19 Purchased 300 units @ $1.10 each January 25 Sold 200 units

Under the FIFO periodic method, we first calculate the number of units in ending inventory = 400 units and then look at the most recent purchases in order to cost out the ending inventory: January 19 purchase = 300 units x $1.10 = $330 January 5 purchase = 100 units x $1.25 = $125 Total value of ending inventory = $330 + 125 = $455 Using the FIFO perpetual method, the ending inventory is calculated as follows:

Purchases (Sales) Balance

Date Units Unit Cost Total Cost Units Total Cost

Jan 1 400 $400 Jan 3 200 $1.20 $240 600 640 Jan 5 400 1.25 500 1,000 1,140 Jan 10 (400) 1.00 (400) (200) 1.20 (240) (100) 1.25 (125) 300 375 Jan 19 300 1.10 330 600 705 Jan 25 (200) 1.25 (250) 400 455 Note that the ending inventory result under FIFO is the same under both the periodic and perpetual methods. This is not a coincidence – both approaches always provide the same result. Cost of goods sold can be calculated in two ways. First, using the cost of goods sold equation:

Opening inventory $ 400 Purchases 1,070

Cost of goods available for sale 1,470 Less ending inventory (455)

$1,015

Secondly, we know that we sold a total of 700 + 200 = 900 units. Under FIFO, we sold


the units in opening inventory plus the first of the purchases we made through the year. So COGS would be calculated as the cost of the first 900 units. Opening Inventory 400 units @ $1.00 = $ 400 January 3 purchase 200 units @ $1.20 = $ 240 January 5 purchase 300 units @ $1.25 = $ 375 COGS 900units $1,015 Weighted-Average Method

There are two versions of this method; one is used when you have a periodic system, and one is used when you have a perpetual system. Annual Weighted-Average – Periodic Systems

Under a periodic system, you will remember that we do an inventory count once a year to determine the ending inventory balance. We then close out the purchase account and the associated contra accounts to determine what the COGS is. The annual weighted-average for periodic systems uses a similar methodology, that is, the total sum of the year’s activities are taken into account at the end of the year to make the determination of the value of inventory. Using this method, the unit cost of inventory items is determined using the following formula: Unit Cost = Cost of Goods Available for Sale/Units Available for Sale Example – On January 1, Lainey Company has 400 units in its opening inventory. They purchased these units for $1.00 each. Throughout the period, the following transactions took place:


Under the annual Weighted Average method, we calculate the average cost of inventory as follows:


Cost of Goods Available for Sale $ Units

Opening Inventory (400 units @ $1.00 each) $400 400 January 3 Purchase (200 units @ $1.20 each) 240 200 January 5 Purchase (400 units @ $1.25 each) 500 400 January 19 Purchase (300 units @ $1.10 each) 330 300

$1,470 1,300

Average unit cost = Cost of Goods Available for Sale/Units Available for Sale = $1,470/1,300 units = $1.13077/unit Ending Inventory = # units in inventory x unit cost = 400 units x $1.13077/unit = $452 COGS = # units sold x unit cost = 900 units x $1.13077/unit = $1,018 Alternatively, we can calculate COGS using the equation approach:



$1,018

Moving Weighted-Average – Perpetual Systems

You will remember that under a perpetual inventory system, when we make a purchase we debit the inventory account for the amount of the purchase. As such, we are keeping a running total in the inventory account. The moving weighted-average system of inventory valuation takes this into account. Under this system, the average unit cost is recalculated every time a purchase is made. Subsequently, whatever the unit cost is at the time of a sale, that is the unit cost after the last purchase previous to the sale, then that is the unit cost used to determine the COGS for that sale. Unit Cost = Cost of all goods on hand/number of units on hand.


Example – On January 1, Lainey Company has 400 units in its opening inventory. They purchased these units for $1.00 each. Throughout the period, the following transactions took place:


Remember, under this system we recalculate the unit cost each and every time we make a purchase. Unit Cost = Cost of all goods on hand/number of units on hand.


Date

Units

Unit Cost

Total Cost

Units

Unit Cost

Total Cost Jan 1 400 $1.00000 $400 Jan 3 200 $1.20000 $240 600 1.066671 640 Jan 5 400 1.25000 500 1,000 1.140002 1,140 Jan 10 (700) 1.14000 (798) 300 342 Jan 19 300 1.10000 330 600 1.120003 672 Jan 25 (200) 1.12000 (224) 400 448 1 Unit Cost = $640 / 600 2 Unit Cost = $1,140 / 1,000 3 Unit Cost = $672 / 600 Cost of goods sold is equal to the cost of goods sold for the two sales: $798 + 224 = $1,022 Alternatively, we can calculate COGS using the equation approach:



$1,022


Application of Lower of Cost or Market Rule

At the balance sheet date a company must compare the aggregate cost of its inventory to its aggregate market value. If the market value is less than cost, then the inventory must be written down to market value. Market value is defined as the net realizable value of the inventory – the sales price of the inventory item less any costs incurred to sell it. This rule ensures that companies will not overstate their inventory balances by keeping on record at cost inventory which may have decreased in value in the marketplace. Example –VenTure Ltd. is showing an ending inventory balance of $50,000. At the balance sheet date, the accountant determines that they could sell this inventory for $40,000. Furthermore, commissions of 10% would have to be paid to the sales team on any sale of this inventory. Show the journal entry to record the proper carrying value of the inventory. First of all, we must determine that the inventory’s net realizable value. The net realizable value of this inventory is: = Selling Price – Commission = $40,000 – ($40,000 X 10%) = $40,000 – 4,000 = $36,000 At present, the inventory account has a balance of $50,000. The net inventory balance that will be reported on the statement of financial position is $50,000 – 14,000 = $36,000. We do this by creating a contra account to inventory called ‘Allowance for decrease in value of inventory’. This account operates much like the Allowance for doubtful accounts in that it gets adjusted to the desired balance at year end. Inventory Loss 14,000 Allowance for decrease in value of inventory 14,000 Note that the Inventory Loss account will appear on the Income Statement and be registered as a loss for the company in this period. If, next year, the analysis reveals that no allowance is required, then the allowance will be debited by $14,000 to bring it to a zero balance, the credit will be to income.


Gross Profit Method

The Gross Profit Method of inventory valuation is used to estimate inventory when other data is not available to use one of the previous methods discussed. To understand the application of this method, we must first understand how to calculate the Gross Profit %.

Example – Assume the following: Sales 1,000,000 100% Cost of Goods Sold 600,000 60%

Gross Profit

400,000

40%

In the above example, the Gross Profit Ratio = 40%. If we did not have the COGS number, for whatever reason, but we did have the Gross Profit Ratio, we could estimate COGS by using the following formula: Gross Profit = Sales x Gross Profit Ratio = $1,000,000 x 40% = $400,000 If Sales are $1,000,000 and Gross Profit is $400,000, then we can estimate COGS as follows: COGS = Sales x (1 – gross profit ratio = $1,000,000 x (1 – 40%) = $1,000,000 x 60% = $600,000 Example – The Gennissen Company’s inventory were destroyed by a fire and you need to estimate the ending inventory. You are given the following information:

Sales to the date of the fire $1,200,000 Opening inventory 350,000 Purchases to the date of the fire 860,000 Gross Profit Ratio 25%

The estimated cost of goods sold = $1,200,000 x (1 – 25%) = $1,200,000 x 75% = $900,000 The estimated ending inventory is: $350,000 Opening Inventory + 860,000 Purchases

- 900,000 Ending Inventory = $310,000




1. On January 1, 20x8, Owl Enterprises had merchandise inventory on hand amounting to $60,000. During the year the company purchased $500,000 worth of inventory and took advantage of purchase discounts amounting to $6,000. In addition, the company returned merchandise costing $10,000 to suppliers and incurred $25,000 in shipping charges on merchandise purchased during the period. A year-end inventory count revealed merchandise on hand in the amount of $66,000. What was cost of goods sold for the year ending December 31, 20x8?

a) $478,000 b) $503,000 c) $515,000 d) $523,000

2. After completing its inventory count and making the appropriate adjusting journal entries, Fri. Ltd. discovered that a $6,000 computer purchased for the chief financial officer on December 27 had been recorded incorrectly as an inventory purchase. Which of the following statements correctly describes the effect of incorrectly recording the computer purchase on the financial statements?

a) Inventory is overstated by $6,000. b) Inventory is understated by $6,000. c) Shareholders’ equity is understated by $6,000. d) Shareholders’ equity is overstated by $6,000.

3. The December 31, 20x4, financial statements of Confu Ltd. included an adding error in the inventory count that resulted in ending inventory of $1,600,000 instead of the correct balance of $1,400,000. Which of the following statements is true with respect to the impact of this error on the December 31, 20x4, financial statements.

a) Liabilities would be overstated by $200,000. b) Assets would be understated by $200,000. c) Cost of goods sold would be understated by $200,000. d) Owners’ equity would be understated by $200,000.


4. Czech Ltd. shipped goods to a customer on December 30, 20x8, FOB Shipping. The customer received the goods on January 6, 20x9. The selling price of the goods was $57,000. The sale was recorded by Czech on January 2, 20x9. Czech had paid $42,000 for the goods and uses the periodic method to account for its inventory. Which of the following statements with respect to this transaction is true?

a) Income for 20x8 is understated by $42,000. b) Income for 20x9 is overstated by $42,000. c) Income for 20x9 is understated by $15,000. d) Revenues for 20x8 are understated by $57,000.

Problem 4-2

The following summarized transactions relate to Cozy Co., a shoe wholesaler, for the month of July 2006. The company uses a perpetual inventory system.

e. Sales totaled $80,000, all of which were made on credit with terms 2/10, n/30, FOB destination. Cozy sets the selling price on its shoes so that the cost of sales is equal to 70% of the selling price.

e. Transportation out paid on delivery of goods sold during the month equaled $1,200.

e. One customer returned goods with a sales value of $500 and was issued a credit note. All other sales made during the month were collected in the month with all customers taking advantage of the sales discount offered.

e. Merchandise was purchased at a cost of $50,000 during the month with terms 1/10, n/45, CIF destination.

e. All of the merchandise purchased during the month was paid for with Cozy taking advantage of the purchase discount offered.

Required –

Prepare the journal entries required to record the above events and transactions.


Problem 4-3

Anvil Rock Company had the following inventory and purchases for the month of May. Beginning Inventory/ Date Purchases Sales May 1 Beginning inventory 30 @ $10.00 = $ 300 May 5 Purchase 60 @ $11.50 = 690 May 14 Sale 20 @ $20.00 = $ 400 May 21 Purchase 35 @ $12.00 = 420 May 29 Sale 50 @ $22.00 = 1,100 Totals 125 $ 1,410 70 $ 1,500 Anvil Rock uses a perpetual inventory system. Required –

a. Calculate the cost of ending inventory for May, assuming a FIFO cost flow

system is used. b. Calculate the cost of ending inventory for May, assuming a weighted-average cost

flow method is used. c. Prepare the journal entries to record the May 29 sale on account, assuming a first-

in, first-out (FIFO) cost flow method is used. Problem 4-4

The following information concerns one of a company’s products, the Hawkeye: Date Transaction Quantity Price/Cost

Jan 1 Beginning Inventory 1,000 $12 Feb 5 Purchase 2,000 18 Feb 20 Sale 2,500 30 Apr 2 Purchase 3,000 23 Nov 4 Sale 2,000 33

Required –

Calculate the value of the ending inventory assuming the company uses: (a) periodic FIFO (b) perpetual moving average


Problem 4-5

On January 1, 20x5, the Music Store had 400 MP3 players in inventory with a cost of $48 per unit. During 20x5 the company made the following purchases of MP3 players:

February 21, 20x5 1,000 units at $50 each $50,000 June 15, 20x5 1,000 units at $52 each 52,000 October 15, 20x5 1,000 units at $58 each 58,000

Due to competitive pressures, the company was unable to pass on price increases to customers and thus maintained a selling price of $100 per unit throughout the year. The store had an excellent Christmas season with the result that only 70 MP3 players were left in inventory on December 31, 20x5.

Required –

Assuming the company uses a periodic inventory system, calculate gross profit for the year ending December 31, 20x5, under each of the following assumptions: a. Costs are assigned to inventory and cost of goods sold on a FIFO basis. b. Costs are assigned to inventory and cost of goods sold on a weighted average basis. (CGA Canada) Problem 4-6

Banff Mountain Equipment Ltd. (Banff) sells skiing and hiking equipment to retailers. After a very successful ski season and just as it was about to commence shipping its hiking equipment for the upcoming season, Banff lost all of its hiking equipment in a fire in March 20x8. Fortunately, the company’s insurance policy will cover 80% of the loss suffered in this fire. The loss is to be determined based on the cost of the inventory in accordance with generally accepted accounting principles. Corporate records disclose the following:

Inventory — January 1, 20x8 $150,000 Purchases (all on credit) during 20x8 480,000 Purchase returns 30,000 Payments to suppliers for purchases 440,000 Customs and duty on purchases 8,000 Sales (all on credit) at retail price 615,000 Sales returns at retail price 15,000 Cash collected from accounts receivable 580,000

Banff normally realizes a gross profit of 30% on its sales. It accounts for its inventory using a periodic inventory system.


Required –

Calculate the net loss from the fire. Show your calculations. (CGA Adapted) Problem 4-7

During June 20x8, Saret Ltd. performed the following transactions. June 1 Sold Whinr Ltd. $30,000 of merchandise on account with credit terms of 2/10, n/30. The cost of the merchandise inventory sold was $15,000. June 2 Whinr returned $10,000 of the merchandise inventory claiming it did not meet its needs. The cost of the merchandise inventory returned was $5,000. June 9 Whinr paid the balance due on the June 1 sale, taking advantage of the sales discount. June 12 Saret purchased merchandise inventory costing $42,000 on account. The supplier provided purchase credit terms of 1/15, n/60. The company uses a perpetual inventory system.

Required –

Prepare journal entries for the above transactions. Problem 4-8

The following information relates to Mejewel Ltd. inventory for 20x7: Beginning inventory, January 1, 20x7 20 units @ $900 each Purchases — February 20, 20x7 440 units @ $950 each Purchases — June 7, 20x7 200 units @ $1,050 each During the year, the company sold 600 units at an average price of $2,100 per unit. Ending inventory consisted of 60 units. The company uses a periodic inventory system.

Required -

1. Calculate the cost of goods available for sale. Show all your calculations. 2. Calculate December 31, 20x7, inventory value using the FIFO inventory pricing method. Show all your calculations. 3. Calculate December 31, 20x7, inventory value using the Weighted Average


inventory pricing method. Show all your calculations. (CGA Canada adapted) Problem 4-9

The following is a summary of selected transactions for Toyjoy Ltd. for the month of December 20x7. The company uses the periodic inventory method and the gross method of recording purchases. i) Purchased merchandise on account from Hirwin Toys for $80,000 under credit

terms of 3/15, n30, FOB shipping point. ii) Cash payments on merchandise purchased from Patel Inc. amounted to $48,500.

The payment of $48,500 represented payment of a $50,000 credit purchase, which was paid within the discount period of 3/15, n30.

iii) Received a $1,200 credit memorandum from a supplier on defective merchandise Toyjoy had purchased and returned. Toyjoy had not yet paid for the merchandise. iv) Toyjoy paid $3,000 in cash for freight charges on merchandise purchased during

the month.

Required -

a. Prepare journal entries for each of the above summarized transactions. b. Prepare a schedule of the cost of goods sold section of the income statement, assuming merchandise inventory on December 1, 20x7, amounted to $150,000 and a count of inventory on December 31, 20x7, revealed merchandise inventory on hand of $30,000. c. As the new controller, you have made it a policy to ensure that all purchase discounts are taken advantage of. The president has asked you to explain the benefits of taking advantage of purchase discounts because it often results in the company paying for merchandise before it has been sold, which has a negative impact on the company’s cash flow. Briefly explain the benefits.

(CGA Canada)


Problem 4-10

The following is a list of inventory errors which occurred in 20x6. None of the errors were explicitly discovered or corrected in 20x6 or 20x7 (some of the errors would automatically be corrected if normal accounting procedures were followed in 20x7). Assume the companies involved used a periodic inventory system and treat each situation independently. i) A company failed to include in its December 31, 20x6, inventory count $10,000 worth of goods which were in an off-site storage location. There were no errors in the December 31, 20x7 inventory count. ii) A $6,000 computer purchased on December 28, 20x6, for use by the sales manager was incorrectly accounted for as an inventory purchase. There were no errors in the December 31, 20x6 inventory count. iii) On December 28, 20x6, a company received, and included in the year end inventory count, goods costing $5,000. The company failed to record the purchase of these goods until January 15, 20x7.

Required - For each error, indicate the dollar amount of the overstatement (O) or understatement (U) in 20x6 Cost of Goods Sold, 20x6 Ending Inventory, 20x6 Retained Earnings, and for 20x7 Cost of Goods Sold. If the error has no effect (NE), then state so. Use the following format in answering this question. Error 20x6 Cost of

Goods Sold

20x6 Ending

Inventory

20x6 Retained

Earnings

20x7 Cost of

Goods Sold

(CGA Canada)


Problem 4-11

On January 13, 20x7, the Bamboo Brush store was destroyed in a fire. Luckily, the accounting records were kept in a separate location and the company was able to reconstruct the following information: Inventory at January 1, 20x7 $100,000 Inventory stored at another location, at January 13, 20x7 $ 5,000 Sales from January 1 to January 13 $ 60,000 Purchases from January 1 to January 13 $ 10,000 Gross profit percentage on sales 40% Required –

Calculate the cost of inventory destroyed by the fire.

(CGA Canada) Problem 4-12

The records of Egypt Company showed the following data relative to one of the major items being sold. Assume that the transactions occurred in the order given.

Unit

Units Cost

Beginning inventory 6,000 $7.95 Purchase No. 1 7,000 8.40 Sale No. 1 (at $24) 6,500 Purchase No. 2 8,000 9.00 Sale No. 2 (at $26) 5,500

Required -

For each assumption given, calculate the total dollar amount for ending inventory and cost of goods sold. a. Weighted-average, periodic inventory system b. Moving weighted average, perpetual system c. FIFO, periodic inventory system d. FIFO, perpetual inventory system


5. Long-term Assets Long-term assets generally comprise of any assets that will be converted to cash or used up in the business for periods exceeding one year. These generally comprise of: • land, • buildings, equipment and furniture and fixtures, • long-term investments in financial instruments (i.e. the shares or the long-term

debt of another company), and • intangible assets such as patents, copyrights and trademarks. We will only focus on the accounting for those long-term assets that are not investments in financial instruments, namely land, buildings, equipment, furniture and fixtures and intangible assets. The essential accounting issues in accounting for long-term assets can be summarized as follows: 1. When a long-term asset is acquired, what constitutes the cost of this asset, 2. When on-going expenditures are made in order to keep the asset in operable

condition, how do we account for these expenditures, 3. How do we allocate the cost of long-term assets over the periods these long-term

assets are put to use in the business, and 4. How do we account for the disposal of long-term assets. Cost of Long-Term Assets

The cost of a long-term asset is generally equal to all costs incurred in order to put the asset into productive use. These include, but are not limited to, the acquisition cost of asset, any costs of transportation to get the asset to its location and any installation costs. If you pay one price to acquire a group of assets (i.e. land and building), the cost of acquiring these assets needs to be allocated based on the relative fair market value of the assets acquired. For example, assume that you pay $500,000 for land and a building. An independent appraisal of the land and building are $150,000 and $450,000 respectively. The acquisition cost would be allocated to land and building as follows:

Individual Fair

Market Value per Appraisal

%

Allocation of

Purchase Price

Land $150,000 25% $125,000 Building 450,000 75% 375,000

$600,000 $500,000


The journal entry to record this transaction would be as follows:

Land $125,000 Building 375,000 Cash $500,000

Accounting for on-going expenditures

Once a long-term asset has been acquired, we often incur ongoing expenditures in order to maintain the asset. A determination has to be made whether the expenditure is required to maintain the asset in operable condition, in which case the expenditure should be expensed to the income statement, or whether the expenditure is a betterment of the asset and therefore needs to be capitalized to the cost of the asset on the Statement of Financial Position. For an expenditure to be considered a betterment it must meet one of the following four criteria:

i. the useful life of the asset is extended, ii. the rate of output of the asset is increased, iii. the operating costs of the asset are decreased, or iv. the expenditure enhanced the quality of the asset in a substantive way.

For example, any costs to maintain a truck, such as oil changes or brake replacements, would generally be considered to be repairs and would be expensed. However, if we were to replace the truck’s engine, then we would likely increase the useful life of the truck. We would therefore capitalize the cost of the new engine to the asset account. Accounting for the use of Long-Term Assets (Amortization of Long-Term Assets)

Long-term assets provide the ability of the company to generate future revenues. Consequently, the matching principle requires that the cost of long-term assets should be spread over the periods that the asset generated revenues. The process by which this is done is amortization of long-term assets. There are three general approaches to amortizing capital assets: 1. Straight-line method. This method allocates the cost of the asset over its estimated

useful life in equal amounts. The underlying assumption is that this asset generated revenues that are, more or less, equal over its useful life.

The annual amortization expense is calculated as follows: (Cost – Salvage Value) / Useful Life


The cost less the salvage value is called the amortizable base of the asset. We deduct the salvage value since we do not want to write down the asset below its salvage value.

2. Declining balance method. This method allocates the cost of the asset over its estimated useful life by taking higher amortization charges at the beginning of the asset’s useful life and lower amortization charges in the later years of the estimated useful life. The underlying assumption is that the asset generates higher revenues at the beginning of its life and that these revenues gradually decline as the asset is used up.

The annual amortization expense is calculated as follows: Net book value of asset x Amortization Rate (%)

The net book value of the asset is equal to the asset’s original cost less the total amortization taken on the asset to date (accumulated amortization). The amortization rate can either be given or you may be told that the company uses the double declining balance (DDB) method of amortization. The rate used for DDB is twice the straight-line rate. For example, if you are told that an asset has a useful life of 10 years, then the straight-line rate is 1/10 and the DDB rate is 1/10 x 2 = 20%.

3. Units of production method. This method allocates the cost of the asset over its estimated useful life based on the use made of the asset. This assumes that the use can be measured, i.e. machine hours, mileage. The underlying assumption is that the asset generates revenues based on usage, i.e. a truck rental company that bases rental charges on the mileage driven.

The annual amortization expense is calculated as follows: (Cost – Salvage Value) / Useful Life in units of production x Units of production expended during the period Example – Assume that an asset is purchased at a cost of $300,000. The asset’s estimated useful life is 8 years and the estimated salvage value of the asset is $35,000. The asset’s useful life can also be measured in terms of total machine hours of 150,000 hours. 1. Under the straight-line method, the annual amortization charge will be: ($300,000 – 35,000) / 8 = $31,125

The journal entry to record amortization expense will be as follows:

Amortization Expense $31,125 Accumulated Amortization $31,125


2. Under the declining balance method, the amortization charges for the 8 years will

be as follows. Note that we will assume double declining balance amortization at the rate of 1/8 x 2 = 25% per year.

Year

Net Book Value

Beginning of Year

Amortization

Expense @ 25%

Net Book Value

End of Year 1 $300,000 $75,000 $225,000 2 225,000 56,250 168,750 3 168,750 42,188 126,562 4 126,562 31,640 94,922 5 94,922 23,731 71,191 6 71,191 17,798 53,393 7 53,393 13,348 40,045 8 40,045 5,045 35,000

Note that the year 8 amortization is not equal to $40,045 x 25% = $10,011. If we had taken $10,011 of amortization in year 8, this would have resulted in a net book value at the end of the year that would be lower than the asset’s salvage value. Recall that we do not depreciate the asset below its salvage value. Therefore, the amortization taken in year 8 is the lesser of the calculated amortization of $10,011 or the amortization amount needed to bring the net book value down to the asset’s salvage value. The net book value at the end of any given year can be calculated directly as follows: Original Cost of Asset x (1 – a)n Where a = amortization rate n = number of years since acquisition For example, the net book value at the end of the 6th year is: $300,000 x 0.756 = $53,393.

3. Under the units of production method, the amortization charge per hour would be: ($300,000 – 35,000) / 150,000 hours = $1.7667 per hour.

Assume that the total number of hours of use in the first year is 18,000, then the amortization charge would be 18,000 hours x $1.7667 = $31,801.


Disposals of Long-Term Assets

On the date of disposal, we compare the net book value of the asset sold to the proceeds on disposal. The difference will be equal to the gain or loss on disposal. For example, assume that an asset was purchased on January 2, 20x3 for $250,000. The asset’s useful life was expected to be 10 years and the salvage value was estimated to be $20,000. The asset is sold at the end of 20x9 for $100,000. The net book value of the asset at the end of 20x9 is:

Original cost $250,000 Less Accumulated amortization ($250,000 – 20,000) / 10 = $23,000/year x 7 years (161,000)

Net book value $89,000

The gain on disposal of this asset is:

Proceeds on disposal $100,000 Less net book value 89,000

Gain on disposal $11,000

The journal entry to record the disposal of the asset is as follows:

Cash $100,000 Accumulated amortization 161,000 Asset 250,000 Gain in disposal 11,000

Changes in estimates If the estimates of the useful life and/or the salvage value of an asset change subsequent to its acquisition, the changes in estimates are applied prospectively from the date of the change in estimate onwards. For example, an asset costing $100,000 was purchased on January 2, 20x1. At the time, the asset’s useful life was expected to be 10 years with an estimated salvage value of $20,000. In 20x5, these estimates were revised as follows: the total estimated useful life of the asset is expected to be 15 years and the salvage value is expected to be $10,000. Assume straight-line amortization.


The net book value at the beginning of 20x5 is:

Original cost $100,000 Less Accumulated amortization ($100,000 – 20,000) / 10 = $8,000/year x 4 years (32,000)

$68,000

This net book value will then be amortized over the remaining useful life of the asset. Annual amortization charges for 20x5 and future years will be: (68,000 – 10,000) / 11 remaining years = $5,273 per year

Intangible Assets

Intangible assets are those assets that do not possess a physical quality (i.e. you cannot touch them or see them) and yet they represent costs incurred that meet the definition of an asset, i.e. they are expected to provide future benefits, are the result of a past transaction and are under the control of the company. Examples of intangible assets are: • trademarks – a name or symbol that identifies a company or a product, • patents – a legal right ensuring the company’s exclusive right to a product or

process, • copyrights – the protection of writings, musical compositions and works of art, • franchises – the exclusive rights to sell products or perform services, typical

within a certain geographical area • goodwill – the added value of a business attributable to factors such as reputation,

location or superior products. Note that only expenditures incurred by the company can be capitalized as intangible assets. Internally developed intangible assets cannot be capitalized on the Statement of Financial Position. For example, the trademark ‘Coca-Cola’ was never purchased by the Coca-Cola Company but rather, was developed internally. Consequently, if you look at Coca-Cola’s Statement of Financial Position, you will not see the value of its trademark listed as an asset. The accounting for intangible assets depends on whether these assets have limited or an unlimited life. Intangible assets whose life is limited should be amortized on a straight-line basis over their estimated useful lives. This need not coincide with the asset’s legal life. For example, assume that a patent is granted to a company at a cost of $100,000. The patent’s legal life is 17 years but it is expected that emerging technologies will make this


patent obsolete by the end of the 5th year. In this case, we would amortize the patent over 5 years. Intangible assets whose life is unlimited (i.e. some franchises, goodwill) are not amortized but instead subject to an annual impairment test. That is, the book value of the intangible asset is compared to its fair market value. If the fair market value is lower than book value and is not expected to recover, then the asset must be written down to the fair market value. Any impairment losses cannot be subsequently reversed if the fair market value of the asset subsequently is recovered.


Problem with Solutions Problem 5-1 – Multiple Choice Questions

1. Sinha, Brown and Das obtained a patent for their earnings forecasting software at a cost of $80,000 and spent $5,000 in legal costs defending it. The patent is valid for 17 years and has an estimated life of 10 years. What will be the annual amortization expense for patents?

a) $4,705.88 b) $5,000.00 c) $8,000.00 d) $8,500.00

Use the following information to answer questions 2 and 3: The Jasper Company has an old building which requires frequent repairs and

constant maintenance. At the beginning of 20x8, the situation was as follows: Building cost $200,000 Accumulated depreciation — building 150,000 Estimated remaining useful life 10 years Estimated salvage value at end of useful life $5,000 Jasper uses the straight-line method for calculating depreciation expense. 2. What is the amount of depreciation expense on the building for 20x8? a) $4,500 b) $5,000 c) $19,500 d) $20,000 3. A small room was built on the back of the building at a cost of $12,000. The room

was completed on June 30, and was used as office space commencing July 1, 1998. What is the impact of this expenditure on income before taxes for 1998?

a) Income will decrease by $12,000 b) Income will decrease by $6,000 c) Income will decrease by $1,200 d) Income will decrease by $632 e) Income will decrease by $600


4. A land site was acquired for $1,000,000. To acquire the land, a $60,000

commission was paid to a real estate agent. Costs of $15,000 were incurred to clear the land in preparation for construction of an office building. At what amount should the land be reported on the balance sheet?

a) $1,000,000 b) $1,015,000 c) $1,060,000 d) $1,075,000

5. On January 1, 20x7, Ireland Company purchased a machine that cost $20,000. It has an estimated 4-year life, and a 10% residual value. The machine is expected to be used for a total of 1,500 productive hours over the next 4 years. During 20x7, it was used 430 hours. What is amortization expense for 20x7 under the productive output method?

a) $4,500 b) $5,000 c) $5,160 d) $5,735

6. On January 1, 20x6, Stone and Wall Company bought equipment for $100,000. The equipment is expected to have a 5-year life and produce a total of 80,000 units. The Amortization expense for 20x6, using the straight-line method, was $18,000. During 20x6, production was 20,000 units. If the company were to use the units-of- production method instead of the straight-line method, what would be the balance reported for the net book value of the equipment at December 31, 20x6?

a) $67,500 b) $72,000 c) $77,500 d) $80,000

7. On July 1, 20x7, Yaari and Yosha Company bought a machine for $85,000 with an estimated life of 4 years and a salvage value of $5,000. If the company uses the double-declining-balance method for amortization, what would be the balance reported for the net book value of the machine at December 31, 20x7?

a) $40,000 b) $42,500 c) $63,750 d) $65,000


Problem 5-2

On January 1, 20x7, Resort Ltd. purchased a van to transport guests between the resort and a nearby airport. The van cost $65,000 and was expected to have a useful life of 5 years or 200,000 kilometers. At the end of its useful life, it was estimated that the van could be sold for $5,000. Required –

a. Prepare the adjusting journal entry to record amortization expense for the year

ended December 31, 20x7, assuming the company uses the straight-line method of amortization.

b. Prepare the adjusting journal entry to record amortization expense for the year ended December 31, 20x7 and 20x8, assuming the company uses the double-declining-balance method of amortization.

c. Prepare the adjusting journal entry to record amortization expense for the year ended December 31, 20x7, assuming the company uses the units-of-production method of amortization and that the van was driven 55,000 kilometers during the year.

d. During 20x8, management of the company decided that, as a result of heavy usage, the total life of the van would only be 4 years instead of the original estimate of 5 years. In addition, management felt that the van could only be sold for $2,000 at the end of its useful life. Prepare the adjusting journal entry to record amortization expense for the year ended December 31, 2008, assuming the company used the straight-line method of amortization.


Problem 5-3

The Connor Company had the following transactions over the life of an asset purchased on January 2, 20x3: Jan 2, 20x3 Purchased equipment for $60,000. The estimated useful life of the

asset is expected to be 5 years with a $10,000 salvage value. Dec 31, 20x3 Recorded amortization expense. Aug 31, 20x4 Routine repairs costing $600 were made to the equipment. Dec 31, 20x4 Recorded amortization expense. Apr 31, 20x5 Expenditures totaling $2,000 were made to the equipment. This

increased the quality of the asset’s output but did not change its useful life or the estimate of salvage value.

Dec 31, 20x5 Recorded amortization expense. Dec 31, 20x6 Recorded amortization expense. Sep 30, 20x7 The equipment was completely overhauled at a cost of $20,000.

This increased the useful life of the asset by three years. The original estimate of salvage value holds.

Dec 31, 20x7 Recorded amortization expense. Aug 31, 20x8 Sold the asset for $25,000. Required –

Record all of the above transactions assuming that the company uses the straight-line method.


Problem 5-4

On June 30, 20x7, MNO Co. bought a state of the art numerically-controlled lathe from GPL by trading in a dissimilar asset and paying $90,000 cash. The following additional information is available: Original cost of the old asset $ 50,000 Accumulated amortization at June 30, 20x7 38,500 Price of new lathe, 108,000 Market value of old asset on June 30, 20x7 15,500 Required –

Prepare the journal entry to record the purchase of the lathe. (CGA Canada, adapted) Problem 5-5

On July 1, 20x6, ABC Ltd. purchased a machine at a cost of $25,000, which included freight charges of $1,000. ABC had to spend $2,000 to install the machine. During the installation there was minor damage to the frame, and the repair cost for it amounted to $500. The machine was expected to have a life of 4 years and a salvage value of $3,000. On January 1, 20x8, the machine was sold for $20,000 cash. Required –

1. Prepare the journal entry to record the asset acquisition on July 1, 20x6. 2. Prepare the journal entry to record the amortization expense on December 31, 20x6. Assume a straight-line method of amortization. 3. Show, in good form, how the machine will be presented in the assets section of the balance sheet at December 31, 20x7. 4. Prepare the journal entry to record the sale of the machine on January 1, 20x8. (CGA Canada)


Problem 5-6

The following information pertains to the equipment acquired by Xie Co. on January 1, 20x6. Use this information to answer parts (a), (b), and (c). Cost $120,000 Estimated residual value $ 20,000 Estimated life 4 years Estimated production 40,000 units 20x6 actual production 9,000 units Required -

a. Determine the amortization expense for the year ending December 31, 20x6, assuming the company uses the: i) straight-line method ii) units-of-production method b. On January 1, 20x7, due to a preventative maintenance system that had been implemented, management felt that the total estimated life of the equipment would be 5 years with a total estimated production of 50,000 units. Accordingly, the estimates were revised. In 20x7, 12,000 units were produced. No change in estimated residual value was anticipated. Determine the amortization expense for the year ending December 31, 20x7, assuming the company uses the: i) straight-line method ii) units-of-production method c. On January 1, 20x8, the equipment was sold for $75,000. Prepare the journal entry to record the sale assuming the company uses the: i) straight-line method ii) units-of-production method


Problem 5-7

German Ltd. purchased Machine No. 103 on January 2, 20x3. The following information relates to this machine:

Invoice price $ 140,000 Credit terms* 2/10, n/30 Customs and duty costs $ 5,000 Preparation and installation costs $ 14,800

The company borrowed $150,000 to pay for the machine within the discount period and take advantage of the cash discount. It incurred interest costs of $12,000 on this loan during 20x3. Machine No. 103 has a physical life expectancy of 10 years with a salvage value of zero. However, German intends to use the machine for 8 years and hopes to sell it for $15,000 at that time. The president of German tells you to record a high amount of amortization in early years and a small amount of amortization in later years of the machine’s life. In this way, income can be minimized in 20x3. * this means that is we pay within 10 days, we get a 2% discount. Otherwise, we have to pay the full

invoice price within 30 days.

Required –

a. What amortization method could be used to abide by the president’s request? Is this method acceptable under generally accepted accounting principles? Explain.

b. Compute amortization expense for 20x3 using the straight-line method. c. Assume that the machine is sold on January 1, 20x6, for $100,000 cash. Prepare

the journal entry to record the sale assuming the straight-line method of amortization was used.


6. Liabilities To begin our discussion about liabilities we have to first differentiate between those liabilities that will come due within on year or accounting period (current liabilities) and those liabilities that will come due at a later point in time (long-term liabilities). Current Liabilities

A current liability is one that will be settled within one year or the business cycle of the firm, whichever is longer. We have already covered several of these when we did adjusting entries, however, we will go over the main types of current liabilities. Accounts Payable – these are liabilities that were incurred to purchase goods, services or supplies for the operation of the company. For example, a company purchases office supplies from a supplier for $2,000 on account. The entry would be:

Office Supplies 2,000 Accounts Payable 2,000

Wages/Salaries Payable – these are wages/salaries that are due to employees for hours worked, but have not been paid. Typically, the only time we see this account set up is at the end of a fiscal period when an adjusting entry must be made. For example, a company has a fiscal year end of March 31st. Employees were last paid on March 28th, and will not be paid again until April 4th. If the average daily wage expense is $1,000/day, the adjusting entry made March 31st would be:

Wage Expense 3,000 Wages Payable 3,000

Note that we are debiting the Wage Expense for $3,000, which represents the three days of work (3 x $1,000/day) that were performed in the period but not paid for. On April 4th, assuming the employees worked the full 7 days in the week, the entry would be:

Wage Expense (4 days x $1,000/day) 4,000 Wages Payable (to remove the adjusting entry) 3,000 Cash 7,000

This way, when the payment is made for the full week, $7,000, it is split appropriately and applied to the correct periods; $3,000 to last period and $4,000 to the new period. Current Portion of Long-term Debt – This is a current liability that is incurred when a company has long-term debt that requires a certain amount to be repaid within the next year year. For example, a company takes out a loan on January 1st for $10,000 with the terms set at 6% interest due annually. The principal must be repaid equally over 5 years. Interest and Principal payments are due December 31st of each year.


When the company takes out the loan, the journal entry would be as follows:

Cash 10,000 Long-term debt 10,000

If a Statement of Financial Position were prepared on the January 1, we would split the long-term debt as follows:

Current liabilities Current portion of long-term debt $2,000 Long-term liabilities Long-term debt 8,000

The debt is split into the portion that is due within the year, and that which is due later than one year. This ensures accurate reflection of the financial obligations of the company on the Statement of Financial Position. At December 31st, the interest expense for the year would be $600 ($10,000 x 6%). The journal entry would be as follows:

Long-term debt 2,000 Interest Expense 600 Cash 8,000

On the Statement of Financial Position, we will now show a balance in the Current Liabilities section of $2,000, and a balance in the Long-Term Liabilities section of $6,000. Employee Withholdings Payable – Employers are responsible for deducting income taxes, CPP and EI from employee’s paycheques. Deductions for each month are due on the 15th day of the following month. Not only must the company submit the employee’s portion, but they also must submit the employer portion of CPP and EI. The employer matches the employee’s contribution for CPP, and pays 1.4 times the employee deduction for EI. For example, a company pays its employees monthly. Wages total $100,000, and the employer ducted the following amounts from its employees’ cheques: Income Taxes, 27,000; CPP, $7,500; EI, $8,000. The entry to record payroll for the month would be:

Wages Expense 100,000 Employee Withholdings Payable ($27,000 + 7,500 + 8,000)

42,500

Cash 57,500


At the same time, the company would record its portion of payroll expenses due to the government:

CPP Expense ($7,500 x 100%) 7,500 EI Expense ($8,000 x 1.40) 11,200 Employee Withholdings Payable 18,700

Note that CPP Expense and EI Expense could be tracked separately, as done above, or simply lumped in with Wages Expense. On the 15th of the next month, the company pays the government:

Employee Withholdings Payable ($42,500 + 18,700)

61,200

Cash 61,200

Contingent Liabilities

One of the guiding principles of accounting is the idea of conservatism. This principle states that, when there are multiple options or positions or courses of action available to present financial statements or financial data that the most conservative approach should be taken. The justification is that the financial statements should not be misleading or give false hope or information to any reader. One of the resulting GAAP rules that stems from this idea of conservatism is the establishment of contingent liabilities. Contingent liabilities are those liabilities which are likely to be incurred in the future, but have not yet come to be. If a company knows that there will be a liability, and therefore a loss of some kind to the company, then they must disclose it when they know about it. A contingent loss should be recognized only when:

a) it is likely that a future event will confirm the loss, and b) the loss can be reasonably estimated.

If a contingency meets the first criteria but not the second, then it has to be disclosed through a note in the financial statements, but it does not have to be recognized. For example, your company is being sued for $400,000. Your lawyer says that previous case law in similar matters is not in your favor and you will likely lose and the judge will award the full amount to the plaintiff. You would record or recognize the FULL amount. The journal entry would be:

Unrecognized Loss on lawsuit 400,000 Contingent Liability – lawsuit 400,000


If, in the same scenario, your lawyer felt you would lose, but there was no legal precedent for the amount that would be awarded and therefore are unable to estimate the future loss. You would simply write a note in the financial statements disclosing the lawsuit, and the fact that you were likely to lose, but you would not have to record the loss or the liability. If, in the same scenario, your lawyer felt you would win, then you do not have to do anything because you do not meet either of the criteria for recording a contingent liability. Warranties & Premiums

Another of the guiding principles of accounting is the matching principle. This principle states that for all revenues generated in a specific period, all expenses related to those revenues should be recorded at the same time. This principle is the one that guides us when making adjusting entries at the end of the year with regards to expenses, such as wages, that have been incurred but not paid. Another example of matching has to do with warranties. When a company sells a product that has a warranty, they should try and estimate what the total warranty expense will be so that it can be matched and recorded in the period when the revenue was generated. The warranty expense is normally determined through evaluating historical data and coming up with a % of sales that represents the future warranty costs. For example, a company sells vacuum cleaners that come with a 2-year warranty. The company estimates that warranty expense, on average, is 4% of sales. Total Sales for the year totaled $300,000. The journal entry to record warranty expense for the year would be:

Warranty Expense ($300,000 x 4%) 12,000 Warranty Liability 12,000

This entry not only matches the expense to the period when the revenues were generated, but it also sets up a liability that will be drawn down as actual expenses are incurred over the life of the warranty. Continuing on with the same example, let’s assume that during the next year, the company pays $10,000 to repair various vacuum cleaners that are under warranty. The journal entry would be:

Warranty Liability 10,000 Cash/Inventory/Wages 10,000

Premium liabilities come to be when a company offers its customers some product or service through the redemption of coupons or some other device whereby the customer can receive goods/services in the future based on current sales. Again, in order to adhere to the matching principle, we must record the associated expense in the period when the


original sale is made. For example, for every $10 your customers spend, they receive 1 coupon. They can then redeem 10 coupons for a watch valued at $10. Based on past redemption data, you have determined that only 40% of your customers will redeem their coupons. Your sales for the year were $800,000. To record the premium liability at the end of the year, the journal entry would be:

Premium Expense* 32,000 Premium Liability 32,000 * $800,000/$10 = 80,000 coupons x 40% = $32,000

Whenever coupons are redeemed, the premium liability account is drawn down. Long-term Liabilities

Long-term liabilities are defined as liabilities that would not be reasonably expected to be liquidated within a year. These typically include long-term bonds, notes payable, long-term leases and pension obligations.

We will not get into a discussion of leases, pensions and other more complicated long-term liabilities in this section. We will instead focus on long-term bonds, one of the most frequently used financing instruments in business.

The Time Value of Money

Before we begin our analysis of accounting for bonds we must first discuss the concept of time value of money. The premise behind this is that a dollar today is not worth the same as a dollar received tomorrow, or a year from now, or ten years from now. If you are going to be receiving money in the future, then you are missing out on the opportunity to invest that money today and earn interest on it. Furthermore, you are taking on the risk that the money might not be repaid at all. The combination of these two facts results in a dollar today being worth more than a dollar received in the future. The farther in the future you are to receive the funds, the greater the “discount” or decrease in the dollar value will be. The format for solutions using a financial calculator is as follows:

N I/Y PV PMT FV

Enter 5 6 1000 Compute X

In the above example, we are trying the calculate the present value of $1,000 to be received in 5 years from now at an interest rate of 6%.


With the Texas Instruments BA II Plus, you need to do the following: - set the calculator to accept one payment per year as follows:

1 2ND N

You only need to do this once. - clear the Time Value of Money memory as follows:

2ND FV

You should do this every time you do a time value of money calculation. - enter the numbers above in the TVM memory registers - to solve, press CPT and the TVM register you are attempting to solve for, in this

case PV - the answer provided is -747.26. This means that if you were to invest $747.26

today (money out of pocket and therefore the negative sign) and invest it for 5 years at 6% compounded annually, the amount would grow to $1,000.

Calculating the Present Value of a Future Single Sum - Assume you are going to receive $10,000 from your mother 5 years from now. If the current and expected future rate of return is 6%, what is that $10,000 worth in “today’s dollars”?

N I/Y PV PMT FV

Enter 5 6 10000 Compute 7,472.58

Present Value of an Annuity - An annuity is defined as a series of identical cash flows that end at a specified time. Assume you inherit $1,000,000 from your favorite uncle. You want to be able to withdraw $60,000 per year for the next 30 years. If i=7%, how much of the $1,000,000 will you have to set aside in order to set up this annuity?

N I/Y PV PMT FV

Enter 30 7 60000 Compute X =

$744,542.47


Annuity Payment Calculation - You have retired with $675,000 in the bank. You expect to live another 25 years. Assume the rate is 7%, how much can you withdraw each year?

N I/Y PV PMT FV

Enter 25 7 675000 Compute X =

$57,992.10

Your company is purchasing a piece of equipment costing $80,000. The manufacturer is offering you financing at a rate of 6.5% on a 36-month loan. What is your monthly payment to the manufacturer going to be?

N I/Y PV PMT FV

Enter 3 6.5 80000 Compute X =

$30,206.06

Bonds

A bond is a financial instrument that is a contractual obligation by a company to pay a stated amount of money at some stated time in the future, as well as make interest payments on the stated amount. A few definitions:

Face Value – the stated amount of the bond and is equal to the redemption value of the bond on its maturity date.

Coupon – the amount of semi-annual interest payments to be made on the bond.

Coupon Rate – the stated interest rate to be paid on the face value. Coupon rate = Annual Coupon Payments/Face value

Yield-to-maturity (YTM) – the rate of return that bondholders expect on the bond given its risk. It is rare that the yield-to-maturity rate and coupon rate are the same. Also called the market rate.

If the YTM > Coupon Rate, then the bond will sell at a discount. This is because the buyer of the bond could get a higher rate on the open market (the YTM) than they can from investing in the bond (the Coupon Rate). The market takes this into consideration, and the bonds will sell for a value less than the face value of the bond. For example, if you issue a bond with a coupon rate of 5% and the YTM is 6%, then in order to sell your bonds you will have to sell them at less than face value because investors would be willing to pay face value if they could get a return of 6%. If the YTM < Coupon Rate, then the bond will sell at a premium. This is because the buyer of the bond gets a higher return by investing in the bonds, and therefore is willing


to pay more than face value for the bonds in order to reap this benefit. To calculate the value of a bond at any point in time:

N = Number of periods left until maturity I = YTM or Market Interest Rate (note that the YTM needs to be divided by two

since the coupon payments are made semi-annually) PMT = the semi annual coupon Payment FV = the Face Value of the bond Solve for PV

It is important to remember that bonds pay coupon payments semi-annually. As such, because PMT is equal to the payment made every six months, we must adjust the other factors in the formula to a “6-month” basis. N will equal the number of coupon payments left; not the number of years. Furthermore, the YTM is normally expressed as an annual rate; therefore it will have to be cut in to reflect the situation. The PMT & FV remain the same. Example - On January 1, 20x8 you issue $2,000,000 of bonds. Interest will be paid semi-annually on June 30 and December 31. The Coupon Rate = 5.8% and they mature in 10 years. YTM = 7%. How much would be raised through this bond issuance?

N I/Y PV PMT FV

Enter 20 3.51 580002 2000000 Compute X =

$1,829,451

1 YTM of 7% / 2 = 3.5% 2 $2,000,000 x 5.8% x = $58,000 coupon payment, every 6 months.

The Present Value of the bonds, or the amount that we would have received in proceeds would be equal to $1,829,451. This is less than the face value of $2,000,000. This is because our coupon rate of 5.8% is less than the market rate of 7%. In order to attract investors, we have to sell our bonds at a discount. The journal entry to record the sale would be as follows: Cash 1,829,451 Bonds Payable 1,829,451 Calculating Interest Expense on Bonds

It is now June 30th and the first coupon payment is due. We have already calculated that we will be writing a cheque for $58,000 to cover our coupon obligation. However, this $58,000 is not our interest expense.


The interest expense for a given period of time is calculated by multiplying the carrying value of the bonds for the period times the market interest rate or YTM. The difference between the Interest Expense and the Coupon Payment is either debited or credited to the Bonds Payable account depending on whether the bond was issued at a premium or a discount. Continuing our example, on June 30th, you would record the following journal entry: Interest Expense (1,829,451 x 7% x ) 64,031 Bonds Payable 6,031 Cash 58,000 Note that the $6,301 credit to Bonds Payable increases the carrying value of the bond payable account to (1,829,451 + 6,301) $1,835,482. This will be the amount used to calculate the interest expense on December 31st. On December 31st, the entry for interest expense would be: Interest Expense (1,835,482 x 7% x ) 64,242 Bonds Payable 6,242 Cash 58,000 After all 20 interest payments have been made, the balance in the Bonds Payable account will have been written up to $2,000,000, give or a take a few dollars for rounding. At the time of settlement, therefore, the journal entry will be: Bonds Payable 2,000,000 Cash 2,000,000




1. Which of the following is a characteristic of a contingent liability? a) It definitely exists as a liability but its amount and due date are

indeterminable b) It is accrued even though not reasonably estimated c) It is not disclosed in the financial statements d) It is the result of a loss contingency

2. Which of the following items is not a contingent liability? a) Premiums offered to customers b) A risk of loss to uninsured property due to fire or other casualty c) Additional wages that may be payable on a dispute now being arbitrated d) Estimated claims under a service warranty on products sold

3. On January 1, 20x7, Gallaghar Ltd. Issued $10 million face value, 10 year 8% bonds priced to yield 6%. Which of the following statements is correct? i) The bond was issued at a premium ii) The interest expense for the year will be more than $800,000 iii) The interest expense for the year will be less than $800,000 iv) The bond was issued at a discount

a) iv) only b) i) and iii) c) i) and ii) d) ii) and iv)


4. When should a contingent liability be accrued? a) When it is certain that funds are available to settle the disputed amount b) When an asset may have been impaired c) When the amount of the loss can be reasonably estimated, and it is likely

that an asset has been impaired or a liability incurred d) When it is likely that an asset has been impaired or a liability incurred, even

though the amount of the loss cannot be reasonably estimated 5. Assume that a manufacturing corporation has (1) good quality control, (2) a one-

year operating cycle, (3) a relatively stable pattern of annual sales, and (4) a continuing policy of guaranteeing new products against defects for 3 years that has resulted in material but rather stable warranty repair and replacement costs. How should any liability for the warranty be reported?

a) It should be reported as a long-term liability. b) It should be reported as a current liability. c) It should be reported as part current liability and part long-term liability. d) It need not be disclosed.

6. In an effort to increase sales, a company inaugurated a sales promotional campaign on June 30, 20x8, whereby it placed a coupon in each package of product sold, the coupons being redeemable for a premium. Each premium costs the company $2.00 and 5 coupons must be presented by a customer to receive a premium. The company estimated that only 30% of the coupons issued would be redeemed. For the 6 months ended December 31, 20x8, the following information is available:

Packages Sold 150,000 Premiums Purchased 10,000 Coupons Redeemed 23,500 What is the estimated liability for premium claims outstanding at

December 31, 20x8? a) $4,300 b) $8,600 c) $9,400 d) $18,000 e) $20,000


Problem 6-2

You run a computer repair company. In order to increase customer loyalty in this fiercely competitive environment you have started a coupon program. For each $10 your customers spend, then receive 1 coupon. They can redeem 15 coupons for a $25 iTunes gift card. You have been running this program for several years, and data shows that approximately 55% of your customers redeem their coupons. The following data relate to the past year: Sales $375,000 Premium Liability Account – Opening Balance 40,000

Coupons Actually Redeemed during the year 22,500 coupons Required –

What would be the journal entries to record the premium expense and the actual premium costs incurred? Problem 6-3

Company X provides a 3-year warranty on all of the products it sells. Sales for the current year were $3,000,000 and it is estimated that the warranty expense is equal to 5% of sales. The warranty liability at the beginning of the year was $165,000 and actual costs incurred to service warranties during the year amounted to $130,000. Required –

Prepare all journal entries related to the warranty for the current year. What is the balance in the warranty liability account at the end of the year?


Problem 6-4

On July 1, 20x1, Gamma Corporation issued bonds with a face value of $500,000 and a coupon rate of 10%. The bonds pay interest semi-annually on December 31 and June 30 and are due in five years. Assume that the going market interest rate for similar bonds on July 1, 20x1 is 8%. Required –

Prepare the journal entries to record the issue of the bonds on July 1, 20x1 and the first two interest payments. Problem 6-5

The Kaplan Corporation issued $10,000,000 of 8.5% coupon bonds on December 31, 20x4. The bonds mature in 15 years. Coupon payment dates are June 30 and Dec 31 of every year. The yield to maturity on December 31 was 8%. Assume that the Kaplan Corporation as a December 31 year end.

Required –

Prepare all journal entries with regards to this bond for the years 20x4 and 20x5. Problem 6-6

The following is the general ledger account for estimated warranties of McNeil and Grace Ltd., automobile dealers, for the year 20x7. The company issues warranty agreements immediately upon the sale of an automobile.

Warranty Liability

Dr Cr

Total debits during the year

$6,000

Opening balance Total credits during the year

$10,200

5,800

Required – 1. What is the dollar value of warranty repairs performed in 20x7? 2. What is the warranty expense for the year 20x7? 3. At December 31, 20x7, what is the estimated liability for future warranties? 4. At December 31, 20x6, what was the estimated liability for future warranties? (CGA Canada)


Problem 6-7

GHI Company issued $500,000 face value, three-year, 9% bonds on January 1, 20x6, and pays interest on July 1 and January 1. The bonds were sold at a yield of 8%. GHI’s year end is December 31.

Required

Prepare all journal entries for the life of this bond issue. (CGA Adapted) Problem 6-8

On July 1, 20x6, Alpha Beta Ltd. issued $1 million face value, 20 year, 12% coupon bonds. They were issued at a price of $1,171,591, to yield 10%. Interest on the bonds is paid semi-annually on December 31 and June 30. Required –

1. Show how the $1,171,591 was calculated. 2. Prepare the journal entry to record the issue of the bonds at July 1, 20x6. 3. Prepare the journal entry(ies) to record interest expense for the period ending December 31, 20x6. 4. Prepare the journal entry(ies) to record interest expense and coupon payment on June 30, 20x7. (CGA Canada adapted) Problem 6-9

On January 1, 20x7, Ardalan and Baker Inc. issued $1 million semi-annual, face value, 10-year, 8% bonds. The bonds were issued at a discount for $897,000, as the market rate was 10%. Required - If Adrdalan and Baker Inc. uses the effective interest method to calculate interest expense on these bonds, indicate whether each of the following statements would be true or false. a. The Interest Expense for the 1997 year will be more than $80,000. b. The Interest Expense for the 1997 year will be less than $100,000. c. The cash outflow towards interest on the bonds will be more than $80,000. d. The Interest Expense will be the same every year.

(CGA Canada adapted)


7. Shareholders’ Equity As mentioned in Chapter 1, Shareholders’ Equity is fundamentally made up of two elements: contributed capital and retained earnings. Contributed capital comprises of the investment made in the corporation by its shareholders. Shareholder investments will result in the company issuing shares to the investors – these shares can take the form of preferred shares or common shares. Retained earnings represent the cumulative earnings of the corporation less any dividend distributions to its shareholders. Common Shares

Common shares typically have the following features: • they provide the right to vote at annual meetings, • upon liquidation of the company, any cash remaining after all obligations have

been settled revert back to common shareholders, and • they are a perpetuity, meaning they never become due. The corporation is under no obligation to provide a financial return to common shareholders, that is, any dividend declarations are at the sole discretion of the company’s board of directors. Dividends become a liability of the corporation only when the board of directors declares them. Common shares can be issued for cash or any other asset. For example, if common shares are issued for $100,000 cash, then the journal entry would be:

Cash $100,000 Common shares $100,000

If common shares are issued in exchange for a parcel of land whose fair market value is $250,000, the journal entry would be:

Land $250,000 Common shares $250,000

When common shares are repurchased, the shares must be cancelled (i.e. a company cannot purchase its own common shares, hold them, and then re-sell them). The debit to the common shares account is equal to the weighted average book value per share times the number of shares retired. If the book value per share is less than the cash paid out to retire the shares, we credit an account called Contributed Surplus for the difference. If the book value per share is greater than the cash paid out to retire the shares, then the debit required to balance the journal entry is allocated as follows: • if there is any Contributed Surplus relative to common shares, it can be drawn

down,


• any remainder gets debited to Retained Earnings. Example – The Noor Company’s shareholders’ equity section at December 31, 20x6 was as follows:

Common shares, 1,000,000 shares outstanding $15,000,000 Retained earnings 12,000,000

The following transactions took place during the year:

Jan 15 Issued 100,000 common shares for $2,500,000 cash Mar 18 Issued 50,000 common shares in exchange for land valued at

$1,000,000 Apr 30 Retired 20,000 common shares at a total cost of $260,000 Jun 16 Issued 250,000 common shares for $7,500,000 cash Aug 18 Retired 10,000 common shares at a total cost of $280,000

The journal entries to record the above transactions are as follows: Jan 15 Cash $2,500,000 Common shares $2,500,000 Mar 18 Land 1,000,000 Common shares 1,000,000 Apr 30 Common shares (20,000 x $16.091) 321,800 Contributed surplus 61,800 Cash 260,000 1 Balance in common share account: = $15,000,000 + 2,500,000 + 1,000,000 = $18,500,000 Number of common shares outstanding: = 1,000,000 + 100,000 + 50,000 = 1,150,000 Book Value per common share: = $18,500,000 / 1,150,000 = $16.09 Jun 16 Cash 7,500,000 Common shares 7,500,000 Aug 18 Common shares (10,000 x $18.612) 186,100 Contributed surplus 61,800 Retained earnings 32,100 Cash 280,000


2 Balance in common share account: = $18,500,000 – 321,800 + 7,500,000 = $25,678,200 Number of common shares outstanding: = 1,150,000 – 20,000 + 250,000 = 1,380,000 Book Value per common share: = $25,678,200/ 1,380,000 = $18.61 Preferred Shares

Preferred shares have the following characteristics: • they are generally non-voting shares (voting privileges are typically only granted

if the corporation does not pay the annual preferred share dividend), • they carry a stated dividend per share, • like common shares, they are a perpetuity. Like common shares, the corporation is under no obligation to provide a financial return to common shareholders, that is, any dividend declarations are at the sole discretion of the company’s board of directors. Dividends become a liability of the corporation only when the board of directors declares them. However, in most cases preferred shares are cumulative. This means that if dividends are missed, any dividends in arrears due to preferred shareholders must be paid before any dividends can be paid to common shareholders. Example – The Jarvis Corporation’s shareholders’ equity as at December 31, 20x5 is as follows:

Common shares, 1,000,000 shares outstanding $35,000,000 Preferred shares, $8.00, cumulative, 100,000 shares outstanding

10,000,000

Retained earnings 40,000,000 The preferred share dividends were last paid on December 31, 20x3. It is now December 1, 20x6 and management wants to pay a dividend of $5 per common shares. First, the preferred dividends in arrears for 20x4 and 20x5 will have to be paid: 100,000 shares x $8.00 x 2 years = $1,600,000 Next, the preferred dividends for the year 20x6 must be paid: 100,000 shares x $8.00 x 1 year = $800,000


Finally, the dividend to common shareholders can be paid: 1,000,000 shares x $5 = $5,000,000 The total dividend to be declared will be: $1,600,000 + 800,000 + 5,000,000

= $7,400,000

Stock Splits

When the stock price of a corporation is high, the stock may become unattractive to small shareholders who have to disburse larger sums in order to acquire shares of the corporation. In order to reduce the share price, the company will split the stock. For example, a 2:1 split means that the number of shares outstanding will double. This will result in the share price dropping by half. If a shareholder owns 1,000 shares of shares before the split, this same shareholder will receive an additional 1,000 shares as a result of the stock split resulting in a total of 2,000 shares. There is NO journal entry required when a stock split is declared. All that happens is that the number of shares issued changes. Dividends

On the date a dividend is declared it becomes a legal liability of the company and the following journal entry is made:

Retained earnings XXX Dividends payable XXX

On the date of payment, the following entry is made:

Dividends payable XXX Cash XXX

Retained Earnings

Retained earnings represents the accumulated earnings of the corporation net of any dividends paid. Any premiums paid on retirement of shares are also charged to retained earnings.


The statement of retained earnings is as follows:

Retained earnings, beginning of year $ XXX Premium on redemption of shares -XXX Net income (loss) for the year ±XXX Dividends -XXX

Retained earnings, end of year $ XXX


Problems with Solutions Problem 7-1 – Multiple Choice Questions

1. XYZ Corporation has 150,000 common shares outstanding. The shares were selling at $30 each when management announced a three-for-two stock split. Which of the following statements will be true when the stock split is accounted for?

a) Retained earnings will be reduced by $4,500,000. b) Shareholders’ equity will increase by $3,000,000. c) The number of common shares outstanding will be 225,000. d) The number of common shares outstanding will be 250,000.


Problem 7-2

The articles of incorporation authorize Hilary and Sam Corporation, a new company, to issue 10,000 $6 non-cumulative preferred shares and 100,000 common shares. In its first month, Hilary and Sam Corporation completed the following transactions: February 2 Issued 9,000 common shares to Hilary and 12,000 shares to Sam in

return for cash equal to the shares’ market value of $6 per share. February 10 Issued 400 preferred shares to acquire a patent with a market value of

$40,000. February 15 Declared a 2 for 1 stock split. February 26 Issued 2,000 common shares for cash of $12,000. February 27 Declared cash dividends on the preferred shares. February 28 Declared cash dividends on the common shares in the amount of $0.32

per share.

Required -

1. Record the transactions in journal entry form. 2. Prepare the shareholders’ equity section of the Payne and Papineau Inc. balance

sheet as at February 28. Net income for the month was $56,000


Problem 7-3

M-F Inc. is authorized to issue 100,000 common shares and 50,000, $1.00, cumulative preferred shares. During the first year of operations the following events occurred:

a. Issued 1,000 common shares at $115 per share. b. Issued 2,000 preferred shares in exchange for equipment. The equipment had a

fair market value of $40,000. c. Issued 1,000 preferred shares at $20 each. d. Declared a cash dividend on preferred shares. e. Issued 1,500 common shares at $120 each. f. Paid the preferred dividend. g. Declared and paid a $5.00 common share dividend h. Convertible bonds with a face value of $50,000 and book value of $53,000 were

converted into 500 common shares. The convertible bonds were issued earlier in the year.

Net income was $64,000 for the year. Required -

1. Provide the journal entries for each transaction above. 2. Prepare the shareholders’ equity section of the Statement of Financial Position.


8. The Accounting Cycle Revisited The purpose of this chapter is to bring all of the accounting issues discussed in the previous chapters together in the form of integrative problems. There is no new material, just the integration of previously covered materials. Therefore, the only materials in this chapter are the problems with solutions. Enjoy!


Problem 8-1

The Haider Corporation’s post-closing trial balance at December 31, 20x5 was as follows: Dr. Cr.

Cash $36,000 Accounts receivable 176,000 Allowance for doubtful accounts $23,000 Inventory 320,000 Prepaid insurance 1,400 Land 40,000 Building 300,000 Accumulated amortization – building 120,000 Equipment 145,000 Accumulated amortization – equipment 38,000 Patents 34,000 Accounts payable 127,000 Salaries payable 5,600 Income taxes payable 12,000 Warranty liability 13,000 Bonds payable 419,600 Common stock 150,000 Retained Earnings 144,200

$1,052,400 $1,052,400

Additional information

1. The company uses a FIFO periodic inventory system. 2. The prepaid insurance is for a one year policy taken out in 20x5 that expires on

March 1, 20x6. 3. The building is being amortized on a straight-line basis over 40 years. 4. The equipment is being amortized using the double declining balance method.

The average useful life of equipment is 10 years. 5. The patent remaining useful life at December 31, 20x5 is 8 years. 6. The bonds were issued on January 2, 20x1. The face value of the bonds is

$400,000, the coupon rate is 6.5% and the yield to maturity at the time the bonds were issued was 6%. Coupon payment dates are on June 30 and Dec 31. The bonds mature on December 31, 20x20.

7. The company provides a one year warranty on its products. Warranty expense is estimated at 1.5% of sales.

8. There are 10,000 shares of common stock outstanding.


The following transactions took place during the year: 1. Total sales on account were $1,600,000. 2. Cash collections on accounts receivable totaled $1,520,000. 3. Accounts written off totaled $34,000. 4. Recoveries of previously written off accounts receivable totaled $5,000. 5. Inventory purchased on account totaled $960,000. 6. Inventory costing $16,000 was returned to suppliers. 7. On March15, an additional 3,000 common shares were issued for $75,000. Cash disbursements were as follows: 8. Payments on accounts payable $945,000 9. Payments for salaries 320,000 10. Interest payments on bonds payable 26,000 11. Purchase of equipment on January 2 30,000 12. Warranty repairs made to products sold 25,000 13. Payments to the Canada Revenue Agency for income taxes 40,000 14 Repurchase of 1,000 common shares on Aug 23 22,000 15. Insurance policy taken out on March 1 – one year policy. 2,400 16. Operating expenses paid 130,000 The following adjustments need to be made at year-end: 17. The accounts receivable aging schedule is as follows:

18. An adjustment is made for insurance expense. 19. Amortization expense on the building, equipment and patents. 20. The inventory was counted on December 31, 20x6 and the total cost of the

inventory was determined to be $378,000. The aggregate net realizable value of the inventory was determined to be $365,000.

21. The warranty expense for the year is accrued.

Accounts Receivable

Estimated % Uncollectible

0 – 30 days $144,000 3% 31 – 60 days 43,000 7% 61 – 90 days 23,000 20% 90 + days 12,000 50%

$222,000


22. Salaries payable at December 31, 20x6 amount to $6,700. 23. Dividends of $80,000 were declared and paid on December 15, 20x6. 24. The income tax expense is 40%. Required –

a. Prepare journal entries for the above transactions and enter all the above

transactions in T-Accounts. b. Prepare a trial balance c. Prepare the following statements: - Income Statement - Statement of Retained Earnings - Statement of Financial Position


Problem 8-2

Pacific Company adjusts and closes its books each December 31. It is now December 31, 20x5, and the adjusting entries are to be made. You are requested to prepare the adjusting entry that should be made for each of the following items (note that the original entries have been made, i.e. you do not need to provide the original entry): a. Credit sales for the year amounted to $320,000. The estimated loss rate on bad

debts is 3% of sales. b. Unpaid and unrecorded wages incurred at December 31 amounted to $4,800. c. The company paid a two-year insurance premium in advance on April 1, 20x5,

amounting to $9,600, which was debited to prepaid insurance. d. Machine A, which cost $80,000, is to be depreciated for the full year. The

estimated useful life is 10 years, and the residual value, $4,000. Use straight-line amortization.

e. The company rented a warehouse on June 1, 20x5, for one year. It had to pay the

full amount of rent one year in advance on June 1, amounting to $9,600, which was debited to rent expense.

f. The company received from a customer a 9% note with a face amount of $12,000.

The note was dated September 1, 20x5; the principal plus the interest is payable one year later. Notes receivable was debited, and sales revenue was credited on the date of sale, September 1, 20x5.

g. On April 1, 20x5, the company signed a $60,000, 10% note payable. On that date,

cash was debited and notes payable credited for $60,000. The note is payable on March 31, 20x6, for the face amount plus interest for one year.

h. The company purchased a patent on January 1, 20x5, at a cost of $11,900. On that

date, the patent account was debited and cash credited for $11,900. The patent has an estimated useful life of 17 years and no residual value.

i. On January 1, Pacific Corporation had a supplies inventory of $4,500. During the

year, supplies of $21,900 were purchased and debited to supplies expense. At the end of the year, inventory of $9,200 was on hand.

j. During the year, pacific Company sold 10,000 units of a product that was subject

to a warranty. Past history indicates that 3% of units sold require repairs at an average cost of $40 per unit. The sales have been recorded; costs incurred for the warranty to date, totalling $8,700, were debited to warranty liability when paid. No warranty expense has been recognized.


k. ABC Corporation wrote off a $16,000 bad debt. l. Pre-tax income has been computed to be $80,000 after all the above adjustments.

Assume an average income tax rate of 30%.


Problem 8-3

Anne Spier has prepared baked goods for resale for several years now. She started a baking business in her home and has been operating in a rented building with a storefront. Spier incorporated this business as MAS Inc. on January 1, 20x2, with an initial shares issue of 1,000 shares of common share for $2,500. Anne Spier is the principal shareholder of MAS Inc. Sales have increased 30%, annually since operations began at the present location, and additional equipment is needed to accommodate expected continued growth. Spier wishes to purchase some additional baking equipment and to finance the equipment through a long-term note from a commercial bank. Kelowna Bank & Trust has asked Spier to submit an income statement for MAS Inc. for the first five months of 20x2 and a balance sheet as of May 31, 20x2. Spier assembled the following information from the corporation's cash basis records for use in preparing the financial statements requested by the bank. 1. The bank statement showed the following 20x2 deposits through May 3l.

Sale of common shares $ 2,500 Cash sales 22,770 Rebates from purchases 130 Collections on credit sales 5,320 Bank loan proceeds 2,880

$33,600

2. The following amounts were disbursed through May 31, 20x2.

Baking materials $14,400 Rent 1,800 Salaries and wages 5,500 Maintenance 110 Utilities 4,000 Insurance premium 1,920 Equipment 3,000 Principal and interest payment on bank loan 312 Advertising 424

$31,466


3. Unpaid invoices at May 31, 20x2, were as follows.

Baking materials $ 256 Utilities 270

$ 526

4. Customer records showed uncollected sales of $4,226 at May 31, 20x2. 5. Baking materials costing $1,840 were on hand at May 31, 20x2. There were no

materials in process or finished goods on hand at that date. No materials were on hand or in process and no finished goods were on hand at January 1, 20x2.

6. The note evidencing the 3-year bank loan is dated January 1, 20x2, and states a

simple interest rate of 10%. The loan requires quarterly payments on April 1, July 1, October 1, and January 1 consisting of equal principal payments plus accrued interest since the last payment.

7. Anne Spier receives a salary of $750 on the last day of each month. The other

employees had been paid through Friday, May 25, 20x2, and were due an additional $240 on May 31, 20x2.

8. New display cases and equipment costing $3,000 were purchased on January 2,

20x2, and have an estimated useful life of five years. These are the only fixed assets currently used in the business. Straight line amortization is to be used for book purposes.

9. Rent was paid for six months in advance on January 2, 20x2. 10. A one-year insurance policy was purchased on January 2, 20x2 11. MAS Inc. is subject to an income tax rate of 20%. 12. Payments and collections pertaining to the unincorporated business through

December 31, 20x1 were not included in the corporation's records, and no cash was transferred from the unincorporated business to the corporation.

Required -

Using the accrual basis of accounting, prepare for MAS Inc.: (a) An income statement for the five months ended May 31, 20x2 (b) A balance sheet as of May 31, 20x2.


Problem 8-4

Morrow Wholesale has kept limited records and has never had an audit until 20x2. As the senior auditor in charge of the audit, you have been presented with the following information: a) Morrow is incorporated and initially sold 11,000 of its common shares for $25 per

share. There have been no other common share transactions. b) Cash balance in cheque book, December 31,20x1 $ 24,000

Deposits during 20x2: Cash sales $250,000 Proceeds of $5,000 note issued on July 1 and bearing interest at 12%, payable annually 5,000 Customer collections 146,000 Proceeds on sale of fully depreciated equipment (original cost, $20,000) 5,000

$406,000

Cheques written during 20x2: Purchases of merchandise $180,000 Salaries 10,000 Advertising (to be run in 20x3) 10,000 Miscellaneous expenses 5,500

$205,500

c) Morrow had no outstanding payables at the beginning of 20x2 but owes creditors

$36,000 for unpaid purchases of merchandise on December 31, 20x2. d) In 20x2 Morrow began selling on a cash-only basis. Receivables at the beginning

of 20x2 totalled $ 155,000. The uncollected receivables were written off as miscellaneous expenses in 20x2.

e) Morrow's cost of goods sold is 80 percent of sales. The inventory at the beginning of 20x2 was $80,000.

f) At the beginning of 20x2, equipment with a cost and accumulated depreciation of $80,000 and $20,000, respectively, was on hand. All equipment is depreciated on a straight-line basis over ten years with no estimated salvage value. The sale of equipment was made on December 30, 20x2.

g) Retained earnings at the beginning of 20x2 totalled $63,000. During the fourth quarter of 20x2, a cash dividend of $10,000 was declared and is to be paid in January 20x3.

h) Morrow's only other asset at the beginning of 20x2 was an investment in Honeydew common shares. During 20x2 these shares were exchanged for land and a gain of $4,000 was recognized.

i ) The income tax rate is 30 percent. j ) At the end of 20x2, sales salaries of $1,600 have accrued but have not been paid. Prepare an income statement for the year ended December 31, 20x2, and a balance sheet at December 31, 20x2, for Morrow Wholesale.


9. The Statement of Cash Flow The statement of cash flow shows a company’s inflows and outflows of cash during a particular period. This statement is broken into three distinct sections, and shows how a company’s actions have affected its net cash position throughout the period. Some students find the statement of cash flow to be a challenge because they are still thinking with an “accrual” mind. Most of what we do, as accountants, is based on the accrual system. Try to keep in mind that when you are working with this statement, your main concern is incoming and outgoing cash. Components of the Statement of Cash Flow

There are three sections to the statement of cash flow: Cash from Operations – this section shows how much cash is generated or used up by the firm in its daily operating business. There are two distinct methods in presenting cash flow from operations: the direct and the indirect method. GAAP suggests a preference for the direct method; however, either the direct or indirect methods can be used. Both methods will be covered later in this section.

Cash from Financing Activities – this section looks at any changes in the long-term liability and shareholders’ equity section of the Statement of Financial Position. If a company issues new debt, this generates cash; if a company pays off or retires debt this uses cash. If a company pays dividends, then this uses cash. If a company issues new shares, this generates cash. If a company retires shares, this uses cash Example - A company reports the following partial data from the previous year:

Partial Statement of Financial Position 20x8 20x7

Non-Current liabilities Bonds payable $ 400,000 $ 250,000 Mortgage payable 150,000 180,000 Shareholders’ Equity Common shares 650,000 450,000 Retained earnings 300,000 215,000 Additional information: Dividends of $150,000 were declared and paid to shareholders during the year.


The cash flow from financing can be calculated as follows:

Proceeds on issuance of bonds payable $ 150,000 Cash paid to reduce mortgage payable (30,000) Proceeds on issuance of common shares 200,000 Cash dividends paid (150,000)

$ 170,000

To calculate the company’s net income for 20x8, we analyze at the Retained Earnings Account: Opening Retained Earnings + Net Income - Dividends = Closing Retained Earnings In the above case, we know all numbers in this formula except Net Income. Rearranging the formula, we can calculate the Net Income. $215,000 + Net Income - $150,000 = $300,000 Net Income = $235,000 Alternatively, we know that retained earnings increased by a net of $85,000. Given that dividends decrease retained earnings, the net income for the year is $85,000 + dividends of $150,000 = $235,000. Cash flow from Investing Activities – this section discloses cash that was generated or used through the sale or purchase of long-term assets. Often, when dealing with this section, we have to reconcile the long-term asset accounts, and changes in them from one period to the next. Remember, when a sale of a long-term asset is made, we remove the asset and all associated accumulated amortization. The difference between the proceeds, or cash we receive, and the NBV (cost – accumulated amortization) is recorded as a gain/loss on sale. Example - A company is showing the following data regarding its last two fiscal periods:

Partial Statement of Financial Position 20x8 20x7

Non-Current assets Equipment $ 350,000 $ 300,000 Accumulated Amortization (180,000) (170,000) Furniture & Fixtures 100,000 75,000 Accumulated Amortization (10,000) (60,000) Land 100,000 0


Additional Information: • $50,000 worth of equipment was purchased for cash during the year. • the original fixtures, costing $75,000 with a NBV of $15,000, were sold at a gain

of $10,000. • new fixtures were purchased for $100,000 cash. • the land was obtained through issuing $100,000 worth of common shares to the

supplier. The cash flow from investing section of the Statement of Cash Flow would be as follows:

Purchase of Equipment ($50,000) Proceeds on sale of Fixtures* 25,000 Purchase of Fixtures (100,000)

($125,000)

* The cost of the fixtures was $75,000 and the accumulated amortization was $60,000 - giving a net book value of $15,000. If the gain on sale was $10,000, then the cash proceeds on the sale of fixtures would have to be $15,000 + 10,000 = $25,000. Note that because no cash exchanged hands for the purchase of the land, it does not appear in this section. All non-cash transactions are by definition excluded from the statement of cash flow. Cash Flow from Operations – Direct Method This method of determining cash flow from operations uses the income statement as its starting point, and essentially takes each income statement item and converts it into cash. There are a minimum of four main sub-sections in determining the cash flow from operations (note that these are a minimum, there can be as many as you want):

Cash collected from Customers (Sales ± changes in Accounts Receivable) Cash paid out to Suppliers & for Operating Expenses

(Cost of goods sold + Operating Expenses ± changes in inventory and prepaid expenses ± changes in non-cash current liabilities, excluding interest payable, income taxes payable and dividends payable)

Cash paid for Interest (Interest Expense ± changes in interest payable) Cash paid for Income Taxes (Income Tax Expense ± changes in income taxes payable)


Example – Calculate cash flow from operations – direct method.

Jack’s Joke Shop Inc.

Income Statement

For the Year ended December 31, 20x7

Sales revenue $660,000 Cost of Goods Sold 231,000

Gross Margin 429,000

Operating Expenses: Salaries Expense 200,000 Amortization Expense 5,000 Office and Administration Expenses 120,000

325,000

Operating income 104,000 Interest Expense 15,000

Net Income before taxes 89,000 Income tax Expense 21,600

Net Income $ 67,400

Jack’s Joke Shop Inc.

Comparative Unclassified Statement of Financial Position


20x7 20x6

ASSETS

Cash $76,000 $42,000 Accounts Receivable 27,000 21,000 Inventory 12,000 10,000 Capital assets 82,000 82,000 Less accumulated amortization (25,000) (20,000)

$172,000 135,000

LIABILITIES Accounts Payable

8,000

10,000

Salaries Payable 5,000 3,000 Interest Payable 2,000 1,000 Taxes Payable 14,000 2,000 Bonds Payable 39,000 46,000

68,000 62,000

SHAREHOLDERS’ EQUITY Common Stock

80,000

50,000

Retained Earnings 24,000 23,000

104,000 73,000

$172,000 $135,000


Cash collected from customers:

Sales $660,000 Less increase in accounts receivable (6,000)

$654,000

Why did we subtract the $6,000 increase in Accounts Receivable. We are not told what percentage of the total sales are made for cash, and which are made on credit, nor are we told how much of the 20x6 accounts receivable balance have been collected. However, because we are told the balance at December 31, 20x6 and the balance at December 31, 20x7, we can simply analyze the difference. If accounts receivable increased, then this means that sales have not yet been collected – that is, we accrued more sales than we collected, therefore we reduce sales to calculate cash collected from customers. Conversely, if accounts receivable decreased, then we collected more than we accrued and this would be added to sales. Cash paid to suppliers & for operating expenses:

Cost of goods sold $231,000 Plus increase in inventory 2,000 Plus Decrease in accounts payable 2,000

235,000

Salaries expense $200,000 Less increase in salaries payable (2,000) 198,000

Office & Administration Expenses 120,000

$553,000

Note that the starting point for each calculation is the following expense items: cost of goods sold, salaries expense, and office & administrative salaries. These comprise all of the expense items on the statement of financial position with the exception of amortization expense, which is a non-cash item and interest and income tax expense which will be dealt with separately. Note also that although we combined all three expense items in one single calculation, it would have been correct to show these as three separate line items in the cash flow from operations section of the Statement of Cash Flow:

- Cash paid out to suppliers - Cash paid out to employees - Cash paid out for office and administrative expenses

With regards to cash paid put to suppliers the starting point is cost of goods sold. The first thing we do is adjust it to obtain the purchases made during the period. In this case, the amount of our Inventory account increased by $2,000. This means that we purchased additional inventory that is now sitting in our warehouse, waiting to be sold. Therefore,


to calculate purchases, we have to add the $2,000 increase to COGS. Purchases for the year in this case would be $233,000 ($231,000 + 2,000). If, on the other hand, inventory decreased, then this means that we would have purchased less than what was sold and we would have decreased COGS in order to obtain purchases. In dealing with the change in accounts payable, if the Accounts Payable account decreases, like it did in the above example, then we have paid more to our suppliers than the purchases. This is why we add back the $2,000. Again, should the opposite have occurred, we would have subtracted the amount from COGS to get total money paid to suppliers. All other expenses, other than interest and taxes, are treated in the manner that the Salaries Expense was treated above. That is, you start with the Income Statement amount and then account for any changes in the associated statement of financial position account(s). Note, as in the case of Office & Administration Expenses above, there appears to be no associated statement of financial position account. If there is no such account, then you simply include the full expense amount as the cash paid for that expense. Any increase in liabilities, like salaries payable, is subtracted from the expense to get to the total cash paid, and any decrease in liabilities is added. Cash paid for interest:

Interest expense $15,000 Less increase in interest payable (1,000)

$14,000

In this case, interest payable went up which means that we accrued more interest than we paid, so we deduce the increase in interest payable to interest expense. Cash paid for taxes:

Income tax expense $21,600 Less increase in income taxes payable (12,000)

$9,600

The treatment for taxes is the same as for interest. That is, any increase in the Income Tax Payable account would be subtracted from the expense to get to the total cash paid, and any decrease would be added. In this example, we owe $12,000 more this December 31st than we did last. Therefore, we will subtract the $12,000 from our Interest Tax Expense to get the total cash paid for taxes.


To sum up:

Cash flow from operations Cash collected from customers $654,000 Cash paid to suppliers & for operating expenses (553,000) Cash paid for interest (14,000) Cash paid for taxes (9,600)

$ 77,400

Cash from Operations – Indirect Method

Under the Indirect Method, we start with the bottom line - Net Income. We then add back any non-cash items that may appear on the income statement. The most common of these are amortization expense and gains/losses on the sale of capital assets. We then add or subtract any changes in the non-cash current asset and liability accounts. This would include changes in accounts receivable, inventory, as well as all current payable accounts. Increases (decreases) in current assets are cash outflows (inflows. Increases (decreases) in current liabilities are cash inflows (outflows). Cash flow from Operations:

Net Income $ 67,400 Add back items not requiring a cash outlay Amortization expense

5,000

Adjust for non-cash working capital items: Increase in Accounts Receivable (6,000) Increase in Inventory (2,000) Decrease in Accounts Payable (2,000) Increase in Salaries Payable 2,000 Increase in Interest Payable 1,000 Increase in Taxes Payable 12,000

$77,400


To continue the example, let’s finish with the cash flow statement. Cash from Investing Activities

No activity $ 0

Cash from Financing Activities

Proceeds from issuance of Common Stock 30,000 Payment on Bonds Payable (7,000) Payment of Dividend* (66,400)

(43,400)

*Opening R/E + Net Income – Closing R/E = Dividends paid ($23,000 + 67,400 – 24,000 = 66,400)

Net Change in Cash ($77,400 + 0 – 43,400) 34,000 Opening Cash Balance – December 31, 20x6 42,000

Ending Cash Balance – December 31, 20x7 $ 76,000

Definition of Cash

For purposes of the statement of cash flow, the term ‘cash’ is defined as ‘cash and cash equivalents’. This includes cash, term deposits and any highly liquid assets (i.e. readily convertible to cash) subject to an insignificant risk of change in value.



Problem 9-1

The following is the Income Statement and comparative Statement of Financial Position for Ginger’s Cookies Ltd.

Ginger’s Cookies Ltd.

Income Statement

for the Year ended December 31, 20x6

Sales Revenue $750,000 Cost of Goods Sold 300,000

Gross Margin 450,000

Operating Expenses: Salaries expense 120,000 Amortization expense 7,000 Other 80,000

207,000

Operating income 243,000

Interest expense (32,000) Gain on Sale of Capital Assets 15,000 (17,000)

Net Income before taxes 226,000 Income tax Expense 79,100

Net Income $146,900


Ginger’s Cookies Ltd.

Comparative Unclassified Statement of Financial Position

as at December 31, 20x6

20x6 20x5

ASSETS Cash

$ 20,500

$ 19,200 Accounts Receivable 90,000 80,000 Inventory 47,000 40,000 Capital assets 125,000 45,000 Less Accumulated amortization (7,000) (40,000)

$275,500 $144,200

LIABILITIES Accounts Payable

$ 27,000

$ 14,800 Salaries Payable 10,000 2,400 Interest Payable 7,000 6,000 Taxes Payable 43,100 10,000 Bonds Payable 30,000 0

117,100 33,200

SHAREHOLDERS’ EQUITY Common Stock

50,000

50,000 Retained Earnings 108,400 61,000

158,400 111,000

$275,500

$144,200

Additional Information: on January 2, 20x6, the only piece of equipment, costing $45,000, was replaced by a new piece of machinery costing $125,000. Ginger’s paid cash for the equipment. Required –

a. Prepare a Statement of Cash Flow using the Direct Method. b. Prepare the Operations section of the Statement of Cash Flow using the Indirect

Method.


Problem 9-2

The comparative statements of financial position of McDuff Ltd. are shown below.

MCDUFF LTD.

Statement of Financial Position

December 31

20x3 20x2

Current assets

Cash $ 319,000 $ 353,000 Accounts receivable 888,000 999,000 Merchandise inventory 1,093,000 1,045,000 Prepaid expenses 43,000 32,000

2,343,000 2,429,000

Capital assets 5,711,000 5,326,000 Accumulated amortization (3,842,000) (3,695,000)

1,869,000 1,631,000

$ 4,212,000 $ 4,060,000

Current liabilities

Accounts payable $ 897,000 $ 909,000 Salaries and wages payable 82,000 119,000 Interest payable 30,000 35,000 Income taxes payable 45,000 28,000

1,054,000 1,091,000

Bonds payable 1,000,000 1,500,000 Mortgage payable 800,000 450,000

2,854,000 3,041,000

Shareholders’ equity

Common shares 850,000 700,000 Retained earnings 508,000 319,000

1,358,000 1,019,000

$ 4,212,000 $ 4,060,000


MCDUFF LTD.

Income Statement

For the year ended December 31, 20x3

Revenues $4,500,000 Cost of goods sold 2,400,000 Operating expenses 700,000 Salaries and wages expense 850,000

Operating income 550,000

Gain on retirement of bonds payable $ 13,000 Loss on disposal of assets (7,000) Interest expense (67,000) (61,000)

Net income before taxes 489,000 Income tax expense 250,000

Net income $239,000

Additional information 1. On April 15, 20x3, McDuff sold capital assets that cost $158,000, with a book

value of $87,000, for $80,000. 2. On August 31, 20x3, bonds with a net book value of $500,000 were retired for

$487,000. 3. Amortization expense is included in Operating expenses.

Required -

a. Prepare a cash flow statement for the year ending December 31, 20x3. Use the

indirect method to report the operating activities. b. Prepare the cash flow from operations section using the direct method.


Problem 9-3

The following data are available for HHC Ltd.

HHC LTD.

Income Statement

for the year ended December 31, 20x5 Sales

$ 218,000

Expenses: Cost of goods sold $ 165,000 Salaries expense 39,300 Insurance expense 2,800 Depreciation expense 7,800 Rent expense 5,300 Interest expense 1,200 221,400

Net loss $ (3,400)

Comparative partial balance sheets at December 31, 20x5 and 20x4 reveal the following: 20x5 20x4

Cash

$ 4,000

$4,700

Accounts receivable 5,800 4,300 Inventory 7,300 5,700 Prepaid insurance 600 500 Accounts payable 5,000 5,000 Salaries and wages payable 1,300 1,700 Long-term loan payable 10,000 8,000 Interest payable 600 500 Required -

Prepare the cash flow from operations section as it would appear on the Statement of Cash Flow using…

(a) The indirect method (b) The direct method

(CGA Canada, adapted)


Problem 9-4

Toram Ltd.’s comparative balance sheets at December 31, 20x5 and 20x6, and its income statement for the year ended December 31, 20x6 are as follows:

TORAM LTD.

Balance Sheets

Assets

Dec. 31

20x6 Dec. 31

20x5

Net

Change

Cash

$ 50,000

$ 26,000

$ 24,000

Accounts receivable 92,000 39,000 53,000 Inventory 119,000 87,000 32,000 Long-term investment 0 18,000 (18,000) Land 80,000 80,000 0 Buildings and equipment 463,000 475,000 (12,000) Accumulated amortization (123,000) (101,000) (22,000)

$ 681,000 $ 624,000 $ 57,000

Liabilities and Shareholders’ Equity

Accounts payable

$ 22,000

$ 40,000

$ (18,000)

Bonds payable 25,000 0 25,000 Preferred shares 85,000 85,000 0 Common shares 423,000 423,000 0 Retained earnings 144,000 86,000 58,000

$ 699,000 $634,000 $ 65,000

TORAM Ltd.

Income Statement

for the year ended December 31, 20x6 Sales

$ 900,000

Cost of goods sold 600,000

Gross profit 300,000 Operating expenses

$ 165,000

Amortization expense 43,000 Loss on sale of equipment 4,000 Gain on sale of long-term investment (12,000) 200,000

Net Income $ 100,000


During 20x6, the following transactions occurred: 1. Sold the long-term investment on January 1, 20x6, for $30,000. 2. Sold equipment for $7,000 cash that had originally cost $32,000 and had $21,000 of accumulated amortization. 3. Purchased equipment for $20,000 cash. 4. Issued $25,000 of bonds payable at face value. 5. Declared and paid a $50,000 cash dividend.

Required –

a. Prepare a Statement of Cash Flow using the Direct Method. b. Prepare the Operations section of the Statement of Cash Flow using the Indirect

Method. (CGA Canada adapted)


10. Financial Statement Analysis The broad purpose of financial statement analysis is to enable a user to make predictions about the firm that will assist his/her decision making. Published financial statements are the sources of information generally available to users. The nature of the analysis of financial statement information is primarily in the form of ratios. In order to predict the company's future dividend policy, the investor must predict those things that affect dividend policy. The following are the variables that affect a firm's future dividend policy:

1. Net cash flows from future operations.

2. Expected non-operating cash flows; i.e., from activities considered incidental to the firm's main function.

3. Future cash flows from changes in the levels of investments made by shareholders and creditors.

4. The amount of cash expected to be invested in the firm's long lived assets as well as in working capital.

5. The amount of future cash flow to service debt requirements; i.e., interest payments, repayment of principal, sinking fund provisions, etc.

6. The amount of future cash flow from random events such as windfall gain or casualties.

7. The firm's future policy regarding the holding of cash balances (for precautionary and liquidity reasons) in excess of those required to maintain the expected level of operations.

8. Management's attitude toward future cash dividend policy. Each of these eight variables that affect future dividend policy is in turn affected by others, which the investor would like to predict. However, published financial statements are historical in nature and do not provide the information we have just outlined. Nonetheless, historical information can be used to make projections and is sometimes extremely useful in this respect. The limitations of using historical information must, of course, be recognized. Financial Analysis Techniques

1. Horizontal (trend), Vertical and Percentage (common size) analysis


Horizontal analysis expresses financial data in terms of a single designated base period, or as compared to an amount of the preceding period. For example, the historical financial performance data for a company for the years 20x3 to 20x6 (all data is in millions of dollars) 20x3 20x4 20x5 20x6

Revenue $7,975 $8,509 $11,500 $13,619 Expenses 7,369 7,882 10,673 12,546

Net income before taxes 606 627 827 1,073 Income taxes 200 207 273 354

Net income $406 $420 $554 $719


Horizontal analysis of the data as a percentage of the year 20x3 amounts: 20x3 20x4 20x5 20x6

Revenue 100% 107% 144% 171% Expenses 100% 107% 145% 170%

Net income before taxes 100% 103% 136% 177% Income taxes 100% 104% 137% 177%

Net income 100% 103% 136% 177%

Horizontal analysis of the data as a percentage of the previous year's amounts: 20x3 20x4 20x5 20x6



Net income 100% 103% 132% 130%

Vertical Analysis (also referred to as common size financial statements), presents all the data in a financial statement as a percentage of a single line item. Generally, when performing vertical analysis on a balance sheet, all numbers are expressed as a percentage of total assets; on the income statement as a percentage of sales. Vertical analysis of the above data is as follows: 20x3 20x4 20x5 20x6



Net income 5% 5% 5% 5%

2. Ratio Analysis Ratio analysis is performed in order to evaluate the firm's liquidity, solvency, profitability and asset management: • liquidity: assessment of the firm's ability to meet current liabilities as they come

due, • solvency: ability of the firm to pay both current and long-term debt, • profitability: evaluation of manager's abilities in generating returns to capital

providers, • asset management (or activity ratios): how well are the firm's assets managed.


Liquidity Analysis - the following ratios are typically used in assessing the liquidity of a firm:

Current Ratio Current Assets ÷ Current Liabilities Quick Ratio (Acid-Test Ratio)

(Cash + Accounts Receivable + Temporary Investments) ÷ Current Liabilities

Defensive Interval Ratio

(Cash + Accounts Receivable + Temporary Investments) ÷ (Cash operating expenses ÷ 365)

Where Cash operating expenses = Cost of Goods Sold + Operating

Expenses - Depreciation The current ratio tells us how much current assets there are relative to current liabilities. The quick ratio tells us how much liquid current assets there are relative to current liabilities. The defensive interval tells us, all other things remaining equal, how many days the firm can survive without any cash inflow. Solvency Analysis - the following ratios are typically used in assessing the solvency of a firm:

Debt-to-Equity Ratio

Long-term Debt ÷ Shareholders' Equity

Times Interest Earned

Income before Interest and Taxes ÷ Interest expense

The debt-to-equity ratio must be compared (1) to the firm's historical data (interperiod) and/or (2) to other companies operating in the same industry or industry averages (interfirm). As Lesson 12 will show, it is wrong to say that the lower the debt-to-equity ratio, the better off the firm is. All firms have a theoretical optimal debt-to-equity ratio they should be aiming for. Firms whose debt-to-equity ratio is optimal will maximize the value of the firm and minimize their weighted average cost of capital. The problem is that the finance literature does not provide us with a mechanism to establish this optimal debt-to equity ratio. We tend to use the industry average as a surrogate for the optimal debt-to-equity ratio. Take the following two firms: Company A Company B Industry Average Debt-to-equity Ratio 0 2.5 3.0 Although, Company A is clearly more solvent than Company B, one could argue that Company B is better off than Company A since it's weighted average cost of capital should be lower.


The times interest earned ratio is a good judge of a firm's solvency. A firm with a times interest earned ratio of 2.0 is generating operating income that is only twice as high as interest charges. Such a firm's exposure to fluctuations in interest rates is high. Profitability Analysis - the following ratios are typically used in assessing the profitability of a firm:

Return on Sales Operating Income ÷ Sales Return on Assets Operating Income ÷ Average total assets Return on Equity Net Income ÷ Average shareholders' equity

The rationale for using operating income for the return on assets ratio is that this ratio is used to compare how well firms use their assets regardless of how the assets are

financed. When comparing two firms with different capital structures, the return on assets will be comparable. Using operating income also removes unusual items, extraordinary items, discontinued operations and income tax expense from the ratio. Also note that we are using averages in the denominators. This is the theoretically correct way to calculate the ratios. Whenever you divide an income statement number into a balance sheet number (or vice-versa), the balance sheet number must always be an average. However, there are times where this may be either impossible or impractical to do. In situations where you only have one year of data, it is impossible. When you have two years of data, you can calculate the ratios for one year only and you do not have any comparatives. In these situations, one can assume that the year-end balances are good surrogates for the average and simply use the year end balances. Note that multiple choice exams will always assume you use averages. Asset Management Ratios (activity ratios) - the following ratios are typically used in assessing the solvency of a firm:

Inventory turnover Cost of goods sold ÷ Average Inventory Days Sales in Accounts Receivable

Average Accounts Receivable ÷ (Net Credit Sales ÷ 365)

Total asset turnover

Sales ÷ Average total assets

The inventory turnover measures the number of times the inventory rolls over within a year. The days sales in accounts receivable tells us what the average number of days our accounts receivable have been outstanding. The total asset turnover tells us how many sales dollars are generated by each dollar of asset invested.


Often in an examination setting, you will be presented with a company's financial statements and the industry average accounts receivable and inventory turnover ratios. Given these, it is possible to perform some comparative analysis and, more importantly, determine how much cash could be generated by the company if it were able to reduce its accounts receivable and inventory balances. (More often than not, the question mentions that the company is cash strapped.) Limitations of Financial Statement Analysis Changes in ratios can only be interpreted by understanding the underlying economic events. For example a sudden increase in the current ratio may simply be due to the fact that a short-term bank loan was converted to a long-term loan. Ratios may change as a result of non-economic events that affect the financial statements e.g., change in accounting method or estimate Comparisons of a company’s ratios with another company’s or with industry averages involve certain restrictive assumptions: that all companies being compared are: • structurally similar • use the same (or similar) accounting principles • experience a common set of external influences


Problems with Solutions Problem 10-1 – Multiple Choice Questions

1. R Company’s net accounts receivable were $50,000 at December 31, 20x7, and $55,000 at December 31, 20x8. Net cash sales for 20x8 were $32,500. The accounts receivable turnover for 20x8 was 7.0. What were R’s total net sales for 20x8?

a) $227,500 b) $335,000 c) $367,500 d) $400,000

2. If current liabilities exceed current assets, what effect will a payment to a creditor (account payable) on the last day of the month have?

a) It will increase the current ratio b) It will decrease working capital c) It will increase working capital d) It will decrease the current ratio 3. Which of the following ratios measures long-term solvency? a) Quick Ratio b) Days sales in accounts receivable c) Debt to equity ratio d) Current ratio 4. During 20x8, a corporation purchased $540,000 of inventory and had sales of

$600,000. The beginning inventory for 20x8 was $30,000 and the ending inventory for 20x8 was $120,000. What was the inventory turnover for 20x8?

a) 4.5 b) 5.0 c) 6.0 d) 8.0


5. If current assets exceed current liabilities, a payment of an account payable has

what effect on working capital and the current ratio? Working Capital Current Ratio a) No effect Increase b) No effect No effect c) No effect Decrease d) Increase Decrease e) Decrease Decrease

6. Assuming stable business conditions, which of the following is consistent with a

decline in the number of days’ sales outstanding in a company’s accounts receivable at year end from one year to the next?

a) A tightening of the company’s credit policies b) The second year’s sales were made at lower prices than the first year’s sales c) A longer discount period and a more distant due date were extended to

customers in the second year d) A significant decrease in the volume of sales of the second year 7. When should an average amount be used for the numerator in computing a financial

ratio? a) When both the numerator and denominator are balance sheet items b) When the numerator is an income statement item and the denominator is a

balance sheet item c) When the numerator is a balance sheet item and the denominator is an

income statement item d) When both the numerator and the denominator are income statement items


8. A company disclosed the following information for the year ended December 31, 20x8:

Net cash sales $ 75,000 Net credit sales 125,000 Inventory at beginning of year 50,000 Inventory at end of year 62,500 Net income 12,500 Accounts receivable at beginning of year 40,000 Accounts receivable at end of year 22,500 What is this company’s days sales in accounts receivable for 20x8? a) 182 days b) 94 days c) 65 days d) 57 days 9. During 20x8, a company purchased $320,000 of inventory. The cost of goods sold

for 20x8 was $300,000, and the ending inventory at December 31, 20x8, was $60,000. What was the inventory turnover for 20x8?

a) 5.0 times b) 5.3 times c) 6.0 times d) 6.4 times


Problem 10-2

The comparative financial statements for the Kuehl Company are as follows.

Kuehl Company

Balance Sheets

as at December 31 …

20x5 20x4 20x3 ASSETS

Current Assets

Cash $12,000 $34,000 $25,000 Accounts receivable 275,000 220,000 200,000 Inventory 425,000 340,000 350,000

712,000 594,000 575,000 Fixed Assets – net 1,450,000 1,420,000 1,300,000

$2,162,000 $2,014,000 $1,875,000


Current liabilities $379,000 $371,000 350,000 Long-term debt 920,000 850,000 800,000

1,299,000 1,221,000 1,150,000

Shareholders’ Equity Common stock 300,000 300,000 300,000 Retained earnings 563,000 493,000 425,000

863,000 793,000 725,000

$2,162,000 $2,014,000 $1,875,000


Kuehl Company

Income Statements

for the year ended December 31 …

20x5 20x4

Sales $2,300,000 $1,900,000 Cost of goods sold 1,400,000 1,200,000

Gross margin 900,000 700,000 Operating expenses 550,000 400,000 Depreciation expense 120,000 100,000

Operating Income 230,000 200,000 Interest expense 60,000 50,000

Net income before taxes 170,000 150,000 Income taxes 60,000 52,000

Net income $110,000 $98,000

Required –

Prepare a full financial statement analysis for 20x4 and 20x5 for Kuehl Company.


Problem 10-3

The comparative financial statements for Rocky Mountain Camping Equipment Ltd. are as follows.

Rocky Mountain Camping Equipment Ltd.

Balance Sheets

as at December 31 …

20x7 20x6 20x5

ASSETS

Current Assets

Cash $37,000 $20,000 $24,000 Accounts receivable 480,000 524,000 300,000 Inventory 650,000 570,000 485,000

1,167,000 1,114,000 809,000 Fixed Assets – net 2,789,000 2,889,000 2,999,000

$3,956,000 $4,003,000 $3,808,000


Current liabilities $560,000 $524,000 $480,000 Long-term debt 820,000 800,000 700,000

1,380,000 1,324,000 1,180,000

Shareholders’ Equity Common stock 700,000 700,000 700,000 Retained earnings 1,876,000 1,979,000 1,928,000

2,576,000 2,679,000 2,628,000

$3,956,000 $4,003,000 $3,808,000


Rocky Mountain Camping Equipment Ltd.

Income Statements

for the year ended December 31 …

20x7 20x6

Sales $2,100,000 $1,700,000 Cost of goods sold 1,300,000 1,000,000

Gross margin 800,000 700,000 Operating expenses 635,000 463,000 Depreciation expense 100,000 100,000

Operating Income 65,000 137,000 Interest expense 60,000 56,000

Net income before taxes 5,000 81,000 Income taxes 2,000 30,000

Net income (loss) $3,000 $51,000

Required –

Prepare a full financial statement analysis for 20x6 and 20x7 for Rocky Mountain Camping Equipment Ltd.


11. SOLUTION TO PROBLEMS

Problem 1-1

1. d 2. b 3. a 4. d $40,000 – ($40,000/4 years x 6/12) = $35,000 5. d $999,999 + 40,000 = $1,039,999 6. d 7. b 8. c


Problem 1-2

Part (a)


Cash Accts. Receivable Accounts Payable

1 20,000 2,000 2 7 6,000 4,000 8 10 130,000 50,000 5

4 20,000 15,000 3 B 2,000 14 15,000 120,000 9

7 190,000 1,200 6 25,000 B

8 4,000 182,800

B 33,000 Prepaid Rent Accrued Liabilities

2 1,000 150 13

700 16

600 17

1,960 18

5,367 19

8,777 B

Prepaid Insurance Bank Loan

6 1,200 400 12 20,000 4

B 800

Inventory Common Stock

15 25,000 20,000 1

Furn. & Fixtures Acc. Amortization Retained Earnings

3 15,000 500 11 10 10,000



Purchases Purchase Returns Sales

5 50,000 170,000 15 15 15,000 15,000 14 196,000 7

9 120,000

B 0 0 B

Cost of Goods

Sold

Rent

15 130,000 2 1,000

10 3,000 18 1,960

B 5,960

Amortization Interest

11 500 10 300

13 150

B 450

Wages and

Salaries

Advertising

10 36,000 10 2,000 17 600

B 36,600

Insurance Miscellaneous

12 400 10 1,500

16 700

B 2,200

Income Taxes

19 5,367


Journal Entries – 1. Cash $20,000 Common Stock $20,000 2. Prepaid rent 1,000 Rent expense 1,000 Cash 2,000 3. Furniture and fixtures 15,000 Cash 15,000 4. Cash 20,000 Bank Loan 20,000 5. Purchases 50,000 Accounts Payable 50,000 6. Prepaid Insurance 1,200 Cash 1,200 7. Cash 190,000 Accounts receivable 6,000 Sales 196,000 8. Cash 4,000 Accounts receivable 4,000 9. Purchases 120,000 Accounts payable 120,000 10. Wages and salaries 36,000 Rent 3,000 Advertising 2,000 Miscellaneous expenses 1,500 Retained earnings 10,000 Interest 300 Accounts payable 130,000 Cash 182,800 11. Amortization expense 500 Accumulated amortization 500 $15,000 / 10 years x 4/12


12. Insurance expense 400 Prepaid insurance 400 $1,200 / 12 months x 4 months expired 13. Interest expense 150 Accrued liabilities 150 Accrual for the month of October:

$20,000 x 9% x 1/12

14. Accounts payable 15,000 Purchase returns 15,000 15. Cost of goods sold 130,000 Inventory 25,000 Purchase returns 15,000 Purchases 170,000 16. Miscellaneous expenses 700 Accrued liabilities 700 17. Salaries and wages 600 Accrued liabilities 600 18. Rent expense 1,960 Accrued liabilities 1,960 $196,000 x 1% 19. Income tax expense 5,367 Accrued liabilities 5,367 Net income before taxes = $17,890 Income tax expense = $17,890 x 30% =


b. Heavenly Books, Inc. Trial Balance As at October 31, 20x2 Debit Credit

Cash $33,000 Accounts receivable 2,000 Inventory 25,000 Prepaid Insurance 800 Prepaid rent 1,000 Furniture and fixtures 15,000 Accumulated amortization $ 500 Accounts payable 25,000 Accrued liabilities 8,777 Bank loan 20,000 Capital Stock 20,000 Retained earnings 10,000 Sales 196,000 Cost of goods sold 130,000 Rent 5,960 Amortization 500 Interest 450 Wages and salaries 36,600 Advertising 2,000 Insurance 400 Miscellaneous 2,200 Income taxes 5,367

$270,277 $270,277


c. Heavenly Books, Inc. Income Statement for the four months ended October 31, 20x2 Sales $196,000 Cost of goods sold 130,000

Gross profit 66,000

Operating expenses Rent 5,960 Amortization 500 Wages and salaries 36,600 Advertising 2,000 Insurance 400 Miscellaneous 2,200

47,660

Operating income 18,340 Interest expense 450


Net income $12,523

Heavenly Books, Inc. Statement of Retained Earnings for the four months ended October 31, 20x2 Retained earnings, July 2, 20x2 $0 Net income 12,523 Dividends (10,000)

Retained earnings, October 31, 20x2 $2,523


Heavenly Books, Inc. Statement of Financial Position as at October 31, 20x2 ASSETS

Current Assets Cash $33,000 Accounts receivable 2,000 Inventory 25,000 Prepaid insurance 800 Prepaid rent 1,000

61,800 Furniture and fixtures $15,000 Less accumulated amortization 500 14,500

$76,300


Current liabilities Accounts payable $25,000 Accrued liabilities 8,777 Current portion of bank loan 12,000

45,777

Bank loan 8,000

53,777

Shareholders’ Equity Capital stock 20,000 Retained earnings 2,523

22,523

$76,300


Problem 1-3

Global Productions Inc.

Income Statement

for year ended December 31, 20x6

Net sales ($157,600 – 2,400) $155,200 Cost of goods sold 84,000

Gross margin 71,200

Operating expenses Amortization 4,800 Insurance 2,300 Rent 21,300 Salaries 18,000 Supplies 4,100 Telephone 3,500 54,000

Operating income 17,200 Interest expense 3,600


Net income $9,500


Statement of Retained Earnings

for year ended December 31, 20x6

Retained Earnings - beginning $0 Net income 9,500 Dividends (2,100)

Retained Earnings - ending $7,400



Statement of Financial Position

as at December 31, 20x2

ASSETS

Current Assets

Cash $25,100 Accounts receivable 14,900 Inventory 44,200 Supplies 2,500 Prepaid insurance 1,100

87,800

Office equipment 24,000 Accumulated amortization 4,800 19,200

$107,000

LIABILITIES AND SHAREHODLERS' EQUITY

Current liabilities Accounts payable $7,100 Salaries payable 1,500 Income taxes payable 1,000

9,600 Bank loan 40,000

49,600

Shareholders' Equity Capital Stock 50,000 Retained earnings 7,400

57,400

$107,000


Problem 1-4

a) Annual amortization expense for the machinery would be = $50,000/8 years =

$6,250/year. However, you only had the machine in use for 7 months. Therefore, your amortization expense would be = $6,250 X 7/12 = $3,646 for the current period.

Amortization Expense 3,646 Accumulated Amortization 3,646

b) When you received the cash in January, the full amount would be recorded as an

Unearned Revenue liability.

Cash 24 Unearned Revenue 24

As of April 30, you would have sent out 1 of the 4 magazines in the subscription.

Therefore, you would have earned of the revenue. $24 X = $6. The journal entry would be:

Unearned Revenue 6 Subscription Revenue 6

c) You have earned the $2,300 revenue this accounting period, therefore, it is

appropriate for you to record it in this period. To do this you would set up a receivable, due from Big Al, in the amount of revenue earned during the period.

Accounts Receivable 2,300 Consulting Revenue 2,300

d) As of Wednesday, you will have accumulated 3 days worth of salaries that have

not been paid. However, as these expenses were incurred during the period, you must record them as an expense of that period. Therefore, we will record salaries expense and the accompanying salaries payable of $1,800.

Salary Expense 1,800 Salaries Payable 1,800

e) When you purchased the policy, you would have debited Prepaid Insurance and

credited Cash for the full amount of $5,000. You have used 8/12 of the policy, therefore you will remove $5,000 X 8/12 = 3,333 from Prepaid Insurance and record it as Insurance Expense for the period.

Insurance Expense 3,333 Prepaid Insurance 3,333


f) Each of the payments for $6,000 covers a 6-month period. The first payment that you received on June 1st would cover the catering for June – November. Therefore, that full amount would have been earned and recorded as revenue during the period. No adjustment is needed for this. However, the second payment that you received on December 1st covers the period of December – May. On December 1st, you would have debited Cash and credited Unearned Revenue by $6,000 each. You will have to adjust for that fact that 5/6 of the payment has not been earned i.e. $6,000 X 5/6 = $5,000 is unearned, or $1,000 has been earned and should be included in revenue for this period..

Unearned Revenue 1,000 Catering Revenue 1,000

g) The $4,750 you paid on June 30th represents Prepaid Rent, and would be recorded

as an asset on your accounts for the June30th period end.

Prepaid Rent 4,750 Cash 4,750

As of July 31st, you would have been in the premises for 1 month, and therefore

you would have incurred one month worth of Rent Expense. You would remove the Prepaid Rent account to reflect that fact that you have “used up” the rent.

Rent Expense 4,750 Prepaid Rent 4,750


Problem 1-5

a. Dec 31, 20x5 Insurance expense $250 Prepaid expense $250 $1,000 x 6/24 = $250 b. Dec 31, 20x5 Rent receivable (or accounts rec) 500 Rent income 500 c. Dec 31, 20x5 Interest expense 100 Interest payable 100 $300 x 4/12 = $100 d. Dec 31, 20x5 Unearned subscription revenues 55 Subscription revenues 55 $440 x 3/24 = $55 Problem 1-6

1. 100,000 x $10 = $1,000,000

2. $0

3. $1,000,000

4. $1,000,000 + 300,000 (bldg) – 300,000 (cash) = $1,000,000

5. $0

6. $1,000,000

7. $1,000,000 + (1,000 x $20)(inventory) = $1,020,000

8. 1,000 x $20 (accounts payable) = $20,000

9. $1,000,000

10. $1,020,000 + (200 x $50)(cash) – (200 x $20)(inventory) = $1,026,000

11. $20,000

12. $1,000,000 + 10,000 (sales) – 4,000 (COGS) = $1,006,000 Problem 1-7

1. Debit to Subscriptions Received in Advance = $180,000, the offsetting credit would

be to Subscriptions Revenue. 2. The opening balance in the Subscription Received in Advance account = $80,000. 3. Total amount received as revenue of $128,000 less the revenue earned for

subscription fees received in the previous year of 80,000 = $48,000. 4. $80,000 + 120,000 – 128,000 = $72,000 (the ending balance in the account).


Problem 1-8

Shareholders’ Net

Assets Liabilities Equity Income

1.

+10,000 -10,000

NC

NC

NC

Remove the receivable from A/R, and add a short-term note receivable.

2.

+50,000

NC

+50,000

NC

An increase in the cash account and an increase in the contributed capital account. 3.

+2,000 -2,000

NC

NC

NC

An increase in the cash account and a decrease in the accounts receivable account. 4.

+500 -500

NC

NC

NC

An increase in the prepaid insurance account and a decrease in the cash account. 5.

+200,000

+200,000

NC

NC

An increase in the equipment account and an increase in the notes payable account.

6.

NC

+1,400

-1,400

-1,400

An increase in the interest payable account and an increase in the interest expense account, therefore, the decrease in net income.

7.

+1,000

NC

+1,000

+1,000

An increase in the interest receivable account and an increase in interest revenue, and therefore both net income and retained earnings (part of shareholders’ equity)


Problem 1-9

1. 20x6 20x7

Sales Cash received for sales $ 60,000 $ 70,000 Less cash received for previous year sales (5,000) (20,000) Plus Sales not paid for in current year 20,000 0

Sales – accrual basis $ 75,000 $ 50,000

Purchases

Cash paid for purchases $ 40,000 $ 35,000 Less advance payment (2,000) 0 Plus prepaid purchases 0 2,000

Purchases – accrual basis $ 38,000 $ 37,000

Cost of Goods Sold

Beginning inventory $ 0 $ 3,000 Plus purchases 38,000 37,000

Cost of goods available for sale 38,000 40,000 Less ending inventory (3,000) (5,000)

$ 35,000 $ 35,000

Revised Income Statement -

Sales

$ 75,000

$ 50,000 Less Cost of Goods Sold 35,000 35,000

Gross margin 40,000 15,000 Other expenses 10,000 *13,000

Operating income $ 30,000 $ 2,000

Profit Margin (30,000/75,000) (2,000/50,000) 40% 4%

* 14,000 – 1,000 personal expenses

2. Revenue recognition principle – revenue must be recorded when earned, it can be measured, and the collectability is reasonably assured, not when cash payment is received. Mr. Cash violated this by recording “sales” on a cash basis. Matching principle – all expenses must be recorded in the same period as the revenue that the expenses were incurred to generate. Mr. Cash violated this principle by simply using cash paid for purchases instead of calculating the proper COGS. Economic entity principle – a business should only report on transactions that are under its control. By including his own personal expenses Mr. Cash crossed the line between “personal” and “business” and violated this principle.


Problem 1-10

a. Revenue should be recognized when the trees are sold to the customer during the

Christmas season because that is when the benefits and risks of ownership pass from the company to the customer. Until then, the company does not know whether any customers will buy their trees, or how much the customer will pay for the trees (measurement of amount). There is so much competition and one never knows how many trees will be sold. Some trees may have to be discarded if they do not sell. Also, at the time of the sale, cash is collected so there is no uncertainty as to collectability. The company has little or no risk once the tree is sold because it is very unlikely that the tree will be returned.

b. The annual cost of fertilizing, pruning and maintaining the trees should be capitalized as a cost of inventory. In effect, the trees are like work-in-process inventory. Then, when the trees are sold, all of these costs will be expensed as cost of goods sold. This is an example of the matching principle and the point of sale recognition method.


Problem 1-11

a. Dec 1 Cash $6,000 Capital Stock $6,000 Dec 3 Furniture and equipment 4,000 Cash 1,000 Note payable 3,000 Dec 7 Cash 680 Revenues 680 Dec 13 Accounts Receivable 1,875 Revenues 1,875 Dec 17 Office supplies 300 Accounts Payable 300 Dec 28 Cash 1,875 Accounts Receivable 1,875 Dec 31 Wage expense 1,300 Cash 1,300 Dec 31 Rent expense 1,000 Cash 1,000 Dec 31 Office supplies expense 100 Office supplies 100 b. Operating income for the month ending December 31, 20x6 would be:

= $680 Sales + 1,875 Sales – 1,300 Wages Expense - 1,000 Rent Expense - 100 Supplies Expense = $155


Problem 1-12


Cash

Accounts

Receivable

Accounts

Payable

B 21 500 g B 100 700 d g 500 100 B

b 180 193 h b 720 520 a

d 700 189 i

e 24 74 j E 120 120 E

f 100 36 k

19 l Note Rec - Cur Wages Payable

B 100 100 f h 8 8 B

E 14 15 q

15 E

Inventory Inc Taxes Payable

B 160 440 c l 4 4 B

a 520 5 r

E 240 5 E

Equipment Interest Receivable Dividends Payable

B 110 B 16 16 e 26 m

j 74 n 8

E 184 E 8

Acc Dep Prepaid Fire Ins. Capital Stock

66 B B 3 3 o 110 B

30 p k 36 4 o

96 E E 32

Note Rec - LT Retained Earnings

B 100 m 26 322 B



COGS Salaries and Wages Sales

c 440 h 185 900 b

q 15

E 200

Miscellaneous Insurance Interest Revenue

i 189 o 3 8 e

o 4 8 n

E 7 16 E

Depreciation Income Taxes

p 30 l 15

r 5

E 20


Ruiz Pharmacy

Income Statement for year ended December 31, 20x2 (000's)

Sales $900 Cost of goods sold 440

Gross margin 460

Operating expenses Salaries and wages 200 Miscellaneous 189 Insurance 7 Depreciation 30 426

Operating income 34 Interest revenue 16

Net income before taxes 50 Income tax expense 20

Net income $30

Ruiz Pharmacy

Statement of Retained Earnings for year ended December 31, 20x2

(000's)

Retained Earnings - beginning $322 Net income 30 Dividends (26)

Retained Earnings - ending $326


Ruiz Pharmacy

Balance Sheet as at December 31, 20x2

(000's)

ASSETS

Current Assets

Cash $14 Accounts receivable 120 Accrued interest receivable 8 Merchandise inventory 240 Prepaid fire insurance 32

414

Noncurrent assets Note receivable 100 Equipment 184 Accumulated depreciation (96) 88

188

$602

LIABILITIES AND SHAREHODLERS' EQUITY

Current liabilities Accounts payable $120 Accrued wages payable 15 Accrued income taxes payable 5 Dividends payable 26

166

Shareholders' Equity Paid-in Capital 110 Retained earnings 326

436

$602


Problem 1-13


Cash Accounts Rec. Accounts Pay

B 30,000 200,000 4 B 123,000 375,000 5 6 600,000 265.000 B

2 775,000 600,000 6 2 575,000 850,00 1

5 375,000 20,000 7 8 10,000 15,000 7 E 323,000 515,000 E

21,000 9

24,000 9 Inventory Taxes Payable

25,000 11 B 446.500 745,000 3 7 20,000 20,000 B

8,500 13 1 850,000 4,500 10 12,000 7

20,000 13

225,000 14 E 547,000 12,000 E

E 31,500 Prepaids Interest Payable

B 14.000 14,000 9 13 8,500 8,500 B

9 16,000 6,800 13

E 16,000 6,800 E

Furniture & Fixtures Acc. Depreciation Sal. And Com. Pay.

B 190,000 40,000 B 7,500 4

11 25,000 22,000 12

E 215,000 62,000 E

Customer Deposits

10,000 8

Rent Payable

27,000 9

Long-Term Notes

Payable

13 20,000 100,000 B

80,000 E

Capital Stock

110,000 B

Retained Earnings

10 4,500 260,000 B



COGS

Salaries and

Commissions

Sales

3 345,000 4 207,500 1,350,000 2

Rent Depreciation

9 14,000 12 22,000

9 21,000

9 8,000

9 27,000

E 70,000

Interest Other

13 6,800 14 225,000

Income Tax

7 15,000

7 12,000

E 27,000


Peter’s Appliance Shop Ltd.

Income Statement for the year ended August 31, 20x5

Sales $1,350,000 Cost of goods sold 745,000

Gross margin 605,000

Operating expenses - Salaries and commissions 207,500 Rent 70,000 Amortization 22,000 Other 225,000

524,500



Net income $46,700


Statement of Changes in Retained Earnings

for the year ended August 31, 20x5

Retained Earnings, Sep 1, 20x4 $260,000 Net income 46,700 Dividends -4,500

Retained Earnings, Aug 31, 20x5 $302,200



Balance Sheet

as at August 31, 20x5 ASSETS

Current Assets Cash $ 31,500 Accounts receivable 323,000 Inventory 547,000 Prepaid rent 16,000

917,500

Fixed Assets Furniture and fixtures 215,000 Less accumulated amortization -62,000

153,000

$1,070,500

LIABILITIES & SHAREHOLDER’S EQUITY

Current liabilities Accounts payable $515,000 Taxes payable 12,000 Salaries and commissions payable 7,500 Interest payable 6,800 Rent payable 27,000 Customer deposits 10,000

578,300 Long-term notes payable 80,000

658,300

Shareholder’s equity Capital Stock 110,000 Retained earnings 302,200

412,200

$1,070,500


Problem 2-1

1. c The balance on the bank statement will be overstated by $360. 2. b $15,095 + 9,700 – 3,200 = $21,595 3. b Balance per bank statement $4,225 Add deposits in transit 63

Balance per books $4,288

Problem 2-2

a. Cash balance per books, Dec 1 $3,700 Add cash received during December 77,000 Less cash payments made during December (77,548)

Cash balance per books, Dec 31, before adjustments 3,152 Less bank service charges (52) Add error in recording cheque ($1,200 - $1,020) 180

Adjusted cash balance per books, Dec 31 $3,280

Cash balance per bank, December 31 $6,300 Add Sparg cheque deducted in error 580 Add deposits in transit 1,700 Less outstanding cheques (5,300)

Cash balance per books $3,280

b. Cash $180 Accounts receivable $180 Bank service charges 52 Cash 52


Problem 2-3

1. Cash balance, before adjustments $4.915 Add error in cash receipt 180 Less bank service charges (35) Less error on cheque # 521 (360)

Cash balance after adjustments $4,700

Bank reconciliation - Cash per bank, March 31, 20x7 $ 480 Add outstanding deposits 6,200 Less outstanding cheques # 201 $780 # 533 1,200 (1,980)

Cash per books, March 31, 20x7 $4,700

2. Cash $180 Accounts Receivable $180 To record error in deposit made ($530 – 350 = $180). Bank service charges 35 Cash 35 To record bank service charges for the month. Office equipment 360 Cash 360 To correct error made in recording of purchase of office

equipment: $620 – 260 = $360.


Problem 2-4

a) The accounting for temporary investments depends on whether the company designates the investments as available for sale investments or trading investments. Trading investments are those that are held for re-sale as part of a portfolio of managed securities held for a short-term. Available for sale securities are defined by what they are not: they are not long-term investments nor are they trading investments. Either way, the securities have to be recorded at fair market value on the balance sheet at December 31, 20x0:

Unrealized

gain (loss)

XYZ Computer ($2,000) Satellite Systems 12,000 Strategic Air Defence Systems 3,000 Generic Engineering (4,000) Cellulose Telephone (1,000) $ 8,000 The difference in accounting treatment lies with how the net unrealized gain will

be recorded. If the securities are classified as available for sale, then the net unrealized gain will be part of the Other Comprehensive Income section of Shareholders' Equity. If the securities are classified as trading investments, then the net unrealized gain flows through net income.

b) Cash $75,000 Other Comprehensive Income $2,000 Temporary investments - XYZ Computer 70,000 Gain on sale of investments 3,000 Cash $35,000 Other Comprehensive Income 3,000 Temporary investments - Strategic Air Defence 31,000 Gain on sale of Investments 7,000


Problem 2-5

a) 20x0 20x1 20x2 Security A ($2,000) ($500) ($4,000) Security B (1,500) 0 (3,500) Security C (2,200) (3,500) (1,000)

($5,700) ($4,000) ($8,500)

b) In 20x0, an unrealized holding loss of $5,700 will be charged to net income. In 20x1, an unrealized holding gain of $1,700 ($5,700 - 4,000) will be credited to

net income. In 20x2, an unrealized holding loss of $4,500 ($4,000 – 8,500) will be charged to

net income.


Problem 3-1

1. a Balance in allowance account at the end of 20x9 before adjustment for bad

debts: $5,000 – 500 + 300 = $4,800 Bad debt expense = $6,400 – 4,800 = $1,600 2. d Balance in Allowance for Doubtful Accounts,

December 31, 20x8, before adjustment

$11,000 cr. Beginning Bal – 20,000 dr. Write offs $9,000 dr. Required balance at December 31: ($80,000 A/R Begin + 400,000 Sales – 360,000 Collections

– 20,000 Write offs) = $100,000 x 4%

4,000 cr.

Adjustment $13,000

3. a Before: $3,000 – 125 = $2,875 After: ($3,000 – 30) – (125 – 30) = $2,875

Problem 3-2

a. Allowance for doubtful accounts $55,000 Accounts receivable $55,000 Accounts receivable 3,000 Allowance for doubtful accounts 3,000 Cash 3,000 Accounts receivable 3,000 b. Bad debt expense ($14,200,000 x 0.5%) 71,000 Allowance for doubtful accounts 71,000 c. Accounts receivable balance, December 31, 2004: $1,000,000 Beg Bal + 14,200,000 Credit Sales

– 11,900,000 Collections – 55,000 Write-offs

$3,245,000 x 3%

Allowance for doubtful accounts, Dec 31, 2004 $97,350 cr. Balance in allowance before adjustment $63,000 cr. Beg Bal + 55,000 dr. Write-Offs

+ 3,000 cr. Recoveries

11,000 cr.

Adjustment required $86,350 cr.

Bad debt expense 86,350 Allowance for doubtful accounts 86,350


Problem 3-3

20x0 Accounts receivable $2,800,000 Sales $2,800,000 To record credit sales for 20x0 Cash 2,400,000 Accounts receivable 2,400,000 To record cash collections for 20x0 Allowance for doubtful accounts 16,000 Accounts receivable 16,000 To record accounts written off for 20x0 Bad debt expense 43,480 Allowance for doubtful accounts 43,480 To adjust the allowance for doubtful

accounts to an ending balance of $27,840 cr. (Schedule)

20x1 Accounts Receivable 3,000,000 Sales 3,000,000 To record credit sales for 20x1 Cash 2,915,000 Accounts receivable 2,915,000 To record cash collections for 20x1 Allowance for doubtful accounts 27,000 Accounts receivable 27,000 To record accounts written off for 20x1 Accounts receivable 7,000 Allowance for doubtful accounts 7,000 To record recoveries for 20x1 Cash 7,000 Accounts receivable 7,000 To record cash collections for 20x1 Bad debt expense 31,290 Allowance for doubtful accounts 31,290 To adjust the allowance for doubtful

accounts to an ending balance of $38,770 cr. (Schedule)


Accounts Receivable

Allowance for Doubtful

Accounts

20x0 2,800,000 2,400,000 16,000 43,480 20x0

16,000

Bal 384,000 27,480 Bal

20x1 3,000,000 2,915,000 27,000 7,000 20x1

7,000 27,000 31,290

7,000

Bal 442,000 38,770 Bal

Schedule – Calculation of the Allowance for Doubtful Accounts

December 31, 20x0 -

0 – 30 $234,000 1% $ 2,340 31 – 60 90,000 5% 4,500 61 – 90 45,000 20% 9,000 Over 90 15,000 80% 12,000

$384,000 $27,840

December 31, 20x1 - 0 – 30 $277,000 1% $ 2,770 31 – 60 80,000 5% 4,000 61 – 90 60,000 20% 12,000 Over 90 25,000 80% 20,000

$442,000 $38,770


Problem 3-4

1. Accounts receivable 500,000 Sales 500,000 Allowance for doubtful accounts 1,500 Accounts receivable 1,500 Cash 400,000 Accounts receivable 400,000 Note receivable 3,000 Accounts receivable 3,000 Accounts receivable balance, December 31, 20x7:

$40,000 Beg Bal + 500,000 Credit Sales – 1,500 Write-offs - 400,000 Collections – 3,000 Note Receivable Allowance for doubtful accounts, Dec. 31, 20x7

$135,500 x 5%

$6,775 cr.

Balance in allowance before adjustment: $2,000 cr. Beg Bal + 1,500 dr. Write-offs

500 cr.

Adjustment required $6,275 cr.

Bad debt expense 6,275 Allowance for doubtful accounts 6,275 Interest receivable 30 Interest income* 30 *(3,000 x 12% x 1/12) 2. Bad debt expense** 10,000 Allowance for doubtful accounts 10,000 **($500,000 x 2%)

Note: The allowance account will now be $500 + $10,000 = $10,500.


Problem 4-1

1. b Opening Inventory $60,000 Purchases – net: $500,000 – 6,000 – 10,000 + 25,000 509,000 Ending inventory (66,000)

Cost of goods sold $503,000

2. c 3. c 4. d Czech should have recorded this sale in 20x8 since the goods were shipped

FOB Shipping. Problem 4-2

a. Accounts receivable $80,000 Sales $80,000 Cost of goods sold ($80,000 x 70%) 56,000 Inventory 56,000 b. Delivery expense 1,200 Cash 1,200 c. Sales returns and allowances 500 Accounts receivable 500 Inventory ($500 x 70%) 350 Cost of goods sold 350 Cash ($79,500 x 98%) 77,910 Sales discounts 1,590 Accounts receivable 79,500 d. Inventory 50,000 Accounts payable 50,000 e. Accounts payable 50,000 Cash ($50,000 x 99%) 49,500 Inventory 500


Problem 4-3

a. Ending inventory = 55 units (35 units x $12.00) + (20 units x $11.50) = $650 Note that the results for FIFO periodic are the same as for FIFO perpetual.

b. Purchases (Sales) Balance

Date Units Unit Cost Total Cost Units Unit Cost Total Cost

May 1 30 $10.00 $300 May 5 60 $11.50 $690 90 11.00 990 May 14 (20) 11.00 (220) 70 770 May 21 35 12.00 420 105 11.3333 1,190 May 29 (50) 11.3333 (567) 55 623 c. Accounts receivable $1,100 Sales $1,100 Cost of goods sold 560 Inventory 560 (10 units x $10) + (40 units x $11.50) Problem 4-4

a. Ending balance = 1,500 units 1,500 units x $23 = $34,500

b. Purchases (Sales) Balance

Date Units Unit Cost Total Cost Units Unit Cost Total Cost

Jan 1 1,000 $12.00 $12,000 Feb 5 2,000 18.00 36,000 3,000 16.00 48,000 Feb 20 (2,500) 16.00 (40,000) 500 8,000 Apr 2 3,000 23.00 69,000 3,500 22.00 77,000 Nov 4 (2,000) 22.00 44,000 1,500 33,000


Problem 4-5

a.

Units

Beginning Inventory, January 1, 20x5 400 Purchases 3,000

Goods Available for Sale 3,400 Less Ending Inventory, December 31, 20x5 70

Units sold during year 3,330

FIFO Sales

3,330 x $100

$ 333,000

COGS 400 x $48 $ 19,200 1,000 x $50 50,000 1,000 x $52 52,000 930 x $58 53,940 175,140

Gross profit $ 157,860

b.

Weighted Average Sales

3,330 x $100

$ 333,000

COGS * 173,929

Gross Profit $ 159,071

*400

x $48

$ 19,200

1,000 x $50 50,000 1,000 x $52 52,000 1,000 x $58 58,000

3,400 $ 179,200

Weighted Average Cost per unit

Cost of Goods Sold

= $179,200/3,400 = $ 52.7059/unit = 3,330 x $ 52.7059 = $ 173,929


Problem 4-6

Net Sales = $615,000 – 15,000 Sales Returns $600,000 x 70% Estimated cost of goods sold $420,000

Opening Inventory $150,000 Net purchases: $480,000 – 30,000 Purchase Returns + 8,000 Customs and Duty

458,000

Cost of goods available for sale 608,000

Less Cost of goods sold 420,000 Estimated value of ending inventory $188,000

Net loss from fire = $188,000 x 20% $37,600

Problem 4-7

June 1 Accounts receivable 30,000 Sales 30,000

Cost of goods sold 15,000 Inventory 15,000 June 2 Sales returns 10,000 Accounts receivable 10,000

Inventory 5,000 Cost of goods sold 5,000 June 9 Cash 19,600

Sales discount ($20,000 x 2%) 400 Accounts receivable 20,000 June 12 Inventory 42,000 Accounts payable 42,000


Problem 4-8

1. Cost of goods available for sale:

20 units x $900 each 440 units x $950 each 200 units x $1,050 each

= = =

$ 18,000

418,000 210,000

$ 646,000

2. Ending inventory – FIFO: 60 units X $1,050 each = $ 63,000

3. Ending inventory – Weighted Average

Average unit cost = Cost of goods available for sale/Units available for sale

Average unit cost = $646,000/(20+440+200) Average unit cost = $646,000/660 units Average unit cost = $978.79/unit

Ending inventory = $978.79/unit x 60 units Ending inventory = $58,727


Problem 4-9

a. i) Purchases 80,000 Accounts Payable 80,000

ii) Accounts Payable 50,000 Cash 48,500 Purchase Discounts 1,500

iii) Accounts Payable 1,200 Purchase Returns 1,200

iv) Transportation-In 3,000 Cash 3,000 b. TOYJOY LTD.

Cost of Goods Sold Schedule

for the month ended December 31, 20x7

Merchandise inventory, December 1, 20x7 $ 150,000

Purchases $ 80,000 Less: Purchase returns and allowances (1,200) Less: Purchase discounts (1,500)

Net Purchases 77,300 Add: Transportation-In 3,000 80,300

Cost of goods available for sale

230,300

Less: Merchandise inventory, December 31, 20x7

30,000

Cost of goods sold

$200,300

c. The savings generated by purchase discounts generally make it worthwhile to

borrow to take advantage of the purchase discount. For example, it may cost a company 10% to borrow the funds, whereas the purchase discount may generate a savings which would equate to an effective interest rate much higher than 10%.

In December, discounts taken under a term of 3/15, n30 generated savings of $1,500 by paying 15 days early. If payment was not made within the discount period, the full amount of $50,000 would need to be paid on the due date. It would be equivalent to interest of $1,500 on a base amount of $48,500 (3.09%) for a 15-day period (30 days – 15 days). There are 24.3 15-day periods in a year (365/15), thus giving an annual percentage cost of missing the discount of 75.09% (3.09 24.3), much higher than the 10% borrowing rate.


Problem 4-10

Error 20x6 Cost of

Goods Sold

20x6 Ending

Inventory

20x6 Retained

Earnings

20x7 Cost of

Goods Sold

i) 10,000 O 10,000 U 10,000 U 10,000 U ii) 6,000 O N/A 6,000 U N/A

iii) 5,000 U N/A 5,000 O 5,000 O Problem 4-11

Sales, January 1 to January 13 $ 60,000 Inventory, January 1, 20x7 $ 100,000 Purchases, January 1 to January 13 10,000

Cost of goods available for sale 110,000 Less estimated ending inventory, January 13, 20x7 **74,000

Estimated Cost of Goods Sold* 36,000

Estimated Gross Profit ($60,000 x .40)

$24,000

* If Gross Profit = 40%, then COGS = 100% - 40% = 60%. Therefore, estimated COGS = $60,000 x .60 = $36,000 ** Cost of goods available for sale – COGS = Ending Inventory $110,000 – 36,000 = $74,000


Problem 4-12

a. Ending inventory = 6,000 + 7,000 – 6,500 + 8,000 – 5,500 = 9,000 Cost of goods available for sale = (6,000 x $7.95) + (7,000 x $8.40) + (8,000 x $9.00) = $178,500 Units available for sale = 6,000 + 7,000 + 8,000 = 21,000 Unit cost = $178,500 / 21,000 = $8.50 Ending inventory = 9,000 x $8.50 = $76,500 COGS = 12,000 x $8.50 = $102,000 b. Purchases (Sales) Balance

Units

Unit Cost

Total Cost

Units

Unit Cost

Total Cost 6,000 $7.95000 $47,700 7,000 $8.40000 $58,800 13,000 8.19231 106,500 (6,500) (53,250) 6,500 53,250 8,000 9.00000 72,000 14,500 8.63793 125,250 (5,500) (47,509) 9,000 77,741 COGS = $53,250 + 47,509 = 100,759 c. From Purchase # 2: 8,000 units @ $9.00 $72,000 From Purchase # 1: 1,000 units @ $8.40 8,400

Ending Inventory $80,400

Cost of goods sold - Cost of goods available for sale $178,500 Less ending inventory (80,400)

$ 98,100

d.


Units Unit Cost Total Cost Units Total Cost

6,000 $47,700 7,000 $8.40 $58,800 13,000 106,500 (6,000) 7.95 (47,700) 7,000 58,800 (500) 8.40 (4,200) 6,000 54,600 8,000 9.00 72,000 14,000 126,600 (5,500) 8.40 (46,200) 8,500 80,400


Problem 5-1

1. d) ($80,000 + 5,000)/10 = $8,500/year.

Note that we use the estimated useful life of the patent, and not the legal life of 17 years, because the purpose of amortization is to expense the cost of an asset of the period of time it is in use by the company.

2. a ($200,000 – 150,000 – 5,000) / 10 = $4,500 3. d It is assumed that the addition should be capitalized and depreciated since it

qualifies as a capital asset. Depreciation expense = $12,000 / 9.5 x = $600 4. d $1,000,000 + 60,000 + 15,000 = $1,075,000 5. c ($20,000 x 90%) / 1,500 x 430 = $5,160 6. c To move to the units-of-production method, we must first know the salvage

value of the machinery inherent in the problem. Estimated salvage value = $100,000 – (5 years x $18,000/year) = $10,000 Net book value = $100,000 – [($100,000 – 10,000) x (20,000/80,000)] Net book value = $77,500

7. c Double-declining-balance rate = x 2 = 50%

Net book value = $85,000 – ($85,000 x .5 x 6/12) Net book value = $63,750


Problem 5-2

a. Amortization expense $12,000 Accumulated amortization $12,000 ($65,000 – 5,000) / 5 years b. 20x7 Amortization expense 26,000 Accumulated amortization 26,000 $65,000 x 40% (1/5 x 2 = 40%) 20x8 Amortization expense 15,600 Accumulated amortization 15,600 ($65,000 – 26,000) x 40% c. Amortization expense 16,500 Accumulated amortization 16,500 ($65,000 – 5,000) / 200,000 x 55,000 d. Net book value = $65,000 – 12,000 = $53,000 Amortization expense for 20x8 = ($53,000 – 2,000) / 3 = $17,000 Amortization expense 17,000 Accumulated amortization 17,000


Problem 5-3

(a) Jan 2, 20x3 Equipment $60,000 Cash $60,000 Dec 31, 20x3 Amortization expense 10,000 Accumulated amortization 10,000 (60,000 – 10,000) / 5 Aug 31, 20x4 Repairs and maintenance expense 600 Cash 600 Dec 31, 20x4 Amortization expense 10,000 Accumulated amortization 10,000 Apr 31, 20x5 Equipment 2,000 Cash 2,000 Dec 31, 20x5 Amortization expense 10,500 Accumulated amortization 10,500 Original amount + amortization on

amount capitalized on April 31, 20x5:

$2,000 / 32 months remaining = $62.50 / month x 8 months = $500 + 10,000 = $10,500 Dec 31, 20x6 Amortization expense 10,750 Accumulated amortization 10,750 $10,000 + ($62.50 x 12 months) Oct 31, 20x7 Equipment 20,000 Cash 20,000 Dec 31, 20x7 Amortization expense 9,808 Accumulated amortization 9,808 See Schedule 1 Aug 31, 20x7 Amortization expense 4,656 Accumulated amortization 4,656 $582 x 8 months Cash 25,000 Accumulated amortization 55,714 Loss on disposal of equipment 1,286 Equipment 82,000


Schedule 1 Amortization expense for 20x7 -

Net book value of asset at Sep 30, 20x7 - Original cost of asset $60,000 Capitalization made on April 1, 20x5 2,000 Less Amortization expense 20x3 (10,000) 20x4 (10,000) 20x5 (10,500) 20x6 (10,750) 20x7 to Sep 30: $10,750 x 9/12 (8,062)

$12,688

Amortization expense – Sep 30 to Dec 31, 20x7 ($12,688 + 20,000 – 10,000) / 39 months = $582 per month x 3 months = $1,746 Total amortization expense for 20x7 = $8,062 + 1,746 = $9,808 Problem 5-4

Equipment (new lathe)* 105,500 Accumulated amortization (old equipment) 38,500 Equipment (old equipment) 50,000 Cash 90,000 Gain on sale of asset** 4,000 * Price of new lathe $108,000 Less trade-in value less fair market value of asset traded in: Trade in value: $108,000 – 90,000 $18,000 Less fair market value of asset traded in (15,500) (2,500)

Acquisition price of new lathe $105,500

** NBV of asset at time of exchange = $50,000 – 38,500 $11,500 Market value of asset 15,500

Gain on sale $ 4,000


Problem 5-5

1. Machinery 27,000* Cash 27,000

*25,000 Cost of machine + 2,000 Installation Charges = $27,000 The cost plus installation. The freight is included in the cost but the repair is not to be capitalized.

2. Amortization expense 3,000** Accumulated amortization - Machinery 3,000

**($27,000 – $3,000)/4 = $6,000/year $6,000 x 6/12 = $3,000 for 6-month period

3. Machinery $27,000 Less: accumulated amortization (9,000)

$18,000

4. Cash 20,000 Accumulated amortization – Machinery 9,000 Machinery 27,000 Gain on sale of assets 2,000


Problem 5-6

a. i. Straight-line method = (120,000 – 20,000)/4 = $25,000 ii. Units-of-production method = (120,000 – 20,000)/40,000 x 9,000

= $22,500 b. i. Straight-line method = (120,000 – 25,000 – 20,000)/(5-1) = $18,750 ii. Units-of-production method

= (120,000 – 22,500 – 20,000) / 41,000 x 12,000 = $22,683

c. i. Cash $75,000 Accumulated depreciation ($25,000 + 18,750) 43,750 Loss on disposal of equipment 1,250 Equipment $120,000 ii. Cash $=75,000 Accumulated depreciation ($22,500 + 23,683) 45,183 Gain on disposal of equipment 183 Equipment 120,000


Problem 5-7

a. A double-declining-balance amortization method could be used to abide by the

president’s request. Under this method, amortization is high in the first year and decreases in amount as years go by. This method is acceptable under GAAP if it properly reflects the pattern of benefits received from using the machine, i.e., if the machine generates less revenues as it gets older. If the machine does not provide decreasing benefits, then this method should not be used.

b. Costs capitalized: Invoice price $140,000 Less discount - $140,000 x 2% (2,800) Customs and duty costs 5,000 Preparation and installation costs 14,800

$157,000

Depreciation expense: ($157,000 – 15,000) / 8 = $17,750 Note that the interest charge of $12,000 cannot be capitalized to the

asset since the asset was purchased and not self-constructed.

c. Cost $157,000 Less accumulated depreciation: $17,750 x 3 years (53,250)

Net book value 103,750 Less proceeds on disposal (100,000)

Loss $ 3,750

Cash $100,000 Accumulated amortization 53,250 Loss on disposal 3,750 Machine 157,000


Problem 6-1

1. a 2. b 3. b) PV of bonds at issue: PMT=800,000; I=6%; N=10; FV=10,000,000

PV=$11,472,018. Interest expense for the year = $11,472,018 x 6% = $688,321

4. c 5. c 6. b Premium expense: 150,000 / 5 x $2 x 30% $18,000 Premium redemptions: 23,500 / 5 x $2 (9,400)

$ 8,600

Problem 6-2

The premium expense would calculated as follows: $375,000 /10 coupons /15 redemption ratio x $25 x 55% = $34,375 The journal entry to record the premium expense would be: Premium Expense 34,375 Premium Liability 34,375 The journal entry to record the actual costs incurred during the year would be: Premium Liability ((22,500/15) x $25/card) 37,500 Cash 37,500


Problem 6-3

The journal entry to record warranty expense is: Warranty expense ($3,000,000 x 5%) $150,000 Warranty Liability $150,000 The journal entry to record actual warranty costs incurred is: Warranty Liability 130,000 Cash, A/P, Inventory 130,000 The warranty liability at the end of the year will be $165,000 Opening Balance + 150,000 Warranty Expense – 130,000 Warranty Costs Incurred = $185,000.

Problem 6-4

The value of the bond issue will be as follows:

N I/Y PV PMT FV Enter 10 4 25000 500000 Compute X =

540,554

The journal entry to record the issuance of these bonds is as follows: July 1, 20x1 Cash $540,554 Bonds payable $540,554 The journal entry to record the interest payments using the effective interest method of amortization is as follows: Dec 31, 20x1 Interest expense (540,554 x 4%) 21,622 Bonds payable 3,378 Cash 25,000 The journal entry to record the interest payment of Jun 30, 20x2 would be as follows: Jun 30, 20x2 Interest expense (540,554 - 3,378) x 4% 21,487 Bonds payable 3,513 Cash 25,000


Problem 6-5

PV of bond issue: N = 30, I = 4, PMT = 425,000, FV = 10,000,000, Solve for PV = $10,432,301 Dec 31, 20x4 Cash $10,432,301 Premium on Bonds Payable $432,301 Bonds payable 10,000,000 Jun 30, 20x5 Interest expense ($10,432,301 x 4%) 417,292 Premium on Bonds Payable 7,708 Cash 425,000 Dec 31, 20x5 Interest expense* 416,984 Premium on Bonds Payable 8,016 Cash 425,000 * (10,432,301 – 7,708) x 4%

Problem 6-6

1. $6,000. The journal entry to record repairs as performed is debit Warranty liability, credit cash/inventory/etc. Therefore, the total debits to the account for the year is the total cost of repairs made during the year. 2. $5,800. The journal entry to record warranty expense is debit warranty expense credit warranty liability. Therefore, the total credits to the account for the year is the warranty expense for the year. 3. $10,200 – 6,000 + 5,800 = $10,000 4. $10,200


Problem 6-7

Proceeds on bond issue:

N I/Y PV PMT FV

Enter 6 4 22,500 500,000 Compute $513,105

Jan 1, 20x6 Cash $513,105 Bonds Payable $513,105 Jul 1, 20x6 Interest expense ($513,105 x 4%) 20,524 Bonds payable 1,976 Cash 22,500 Dec 31, 20x6 Interest expense

$513,105 – 1,976 = $511,129 x 4%

20,445

Interest payable 20,445 Jan 1, 20x7 Interest payable 20,445 Bonds payable 2,055 Cash 22,500 Jul 1, 20x7 Interest expense

$511,129 – 2,055 = $509,074 x 4%

20,363

Bonds payable 2,137 Cash 22,500 Dec 31, 20x7 Interest expense

$509,074 – 2,137 = $506,937 x 4%

20,277

Interest payable 20,277 Jan 1, 20x8 Interest payable 20,277 Bonds payable 2,223 Cash 22,500 Jul 1, 20x8 Interest expense

$506,937 – 2,223 = $504,714 x 4%

20,189

Bonds payable 2,311 Cash 22,500 Dec 31, 20x8 Interest expense

$504,714 – 2,311 = $502,403 x 4%

20,097

Interest payable 20,097


Jan 1, 20x9 Interest payable 20,097 Bonds payable 2,403 Cash 22,500 Bonds payable 500,000 Cash 500,000

Problem 6-8

1. N I/Y PV PMT FV

Enter 40 5 60000 1000000 Compute X =

$1,171,591

2. July 1, 20x6 Cash $1,171,591 Bonds payable $1,171,591 3. Dec 31, 20x6 Interest expense (1,171,591 x 5%) 58,580 Bonds payable 1,420 Cash (1,000,000 x 12% x 1/2) 60,000 4. June 30, 20x7 Interest expense (1,170,171* x 5%) 58,509 Bonds payable 1,491 Cash (1,000,000 x 12% x 1/2) 60,000

*Bonds payable balance as of June 30, 20x7 ($1,171,591 – 1,420)


Problem 6-9

The journal entries to record interest expense for 20x7 would be as follows: 1

st half of 20x7:

Interest expense ($897,000 x 10% x ) $44,850 Bonds payable 4,850 Cash ($1,000,000 x 8% x ) 40,000 2

nd half of 20x7:

Interest expense ($897,000 + 4,850) x 10% x $45,093 Bonds payable 5,093 Cash ($1,000,000 x 8% x ) 40,000 a. True. Interest expense for 20x7 = $44,850 + 45,093 = $89,943 b. False c. False. The cash outflow is $80,000 exactly. d. False. The interest expense will increase every year since the book value of the

bonds payable will also increase.


Problem 7-1

1. c 150,000 shares x 3/2 = 225,000 shares outstanding after the split.

Problem 7-2

1. February 2 Cash 126,000 Common Shares 126,000 February 10 Patent 40,000 Preferred Shares 40,000 February 15 No entry February 26 Cash 12,000 Common Shares 12,000 February 27 Dividends or R/E 2,400 Cash 2,400 February 28 Dividends or R/E 14,080 Cash 14,080 Number of common shares: Issued on Feb 2 21,000 Stock Split on Feb 15 21,000 Issues on Feb 26 2,000 44,000

x $0.32

$14,080 2. Shareholders’ Equity -

Common Shares, 44,000 shares issued and outstanding $ 138,000 Preferred Shares, $6, non cumulative, 400 shares issued and

outstanding 40,000

Retained Earnings ($0 + $56,000 - $2,400 - $14,080) 39,520

Total Shareholders’ Equity $217,520


Problem 7-3

1. a. Cash $115,000 Common Shares $115,000 b. Equipment 40,000 Preferred shares 40,000 c. Cash 20,000 Preferred shares 20,000 d. Dividends (or Retained Earnings) 3,000 Preferred Dividends Payable 3,000 e. Cash 180,000 Common shares 180,000 f. Preferred Dividends Payable 3,000 Cash 3,000 g. Retained earnings 12,500 Cash 12,500 h. Bonds payable 50,000 Premium on bonds payable 3,000 Common shares 53,000 2. Shareholders’ Equity - Common Shares, authorized 100,000,

issued and outstanding 3,000 $348,000

Preferred Shares, cumulative – authorized 50,000, issued and outstanding 3,000

60,000

Retained Earnings ($64,000 Net Income – 15,500 Dividends) 48,500

$456,500


Problem 8-1

a. 1. Accounts receivable $1,600,000 Sales $1,600,000 2. Cash 1,520,000 Accounts receivable 1,520,000 3. Allowance for doubtful accounts 34,000 Accounts receivable 34,000 4. Accounts receivable 5,000 Allowance for doubtful accounts 5,000 Cash 5,000 Accounts receivable 5,000 5. Purchases 960,000 Accounts payable 960,000 6. Accounts Payable 16,000 Purchase returns 16,000 7. Cash 75,000 Common stock 75,000 8. Accounts payable 945,000 Cash 945,000 9. Salaries payable 5,600 Salaries expense 314,400 Cash 320,000 10. Interest expense ($419,600 x 3%) 12,588 Bonds payable 412 Cash ($400,000 x 6.5% / 2) 13,000 Interest expense ($419,600 – 412) x 3% 12,576 Bonds payable 424 Cash ($400,000 x 6.5% / 2) 13,000 11. Equipment 30,000 Cash 30,000 12. Warranty liability 25,000 Cash 25,000


13. Income taxes payable 40,000 Cash 40,000 14. Common shares (1,000 x $17.31*) 17,310 Retained earnings 4,690 Cash 22,000 * Average book value per share

= $150,000 + 75,000 / (10,000 + 3,000) = $17.31

15. Prepaid insurance 2,400 Cash 2,400 16. Operating expenses 130,000 Cash 130,000 17. Bad debt expense 23,930 Allowance for doubtful accounts 23,930 The balance in the allowance for doubtful

accounts is: $23,000 cr. + 34,000 dr. + 5,000 cr. =

$6,000 dr. The balance in the allowance for doubtful

accounts should be:

$144,000 x 3% $4,320 43,000 x 7% 3,010 23,000 x 20% 4,600 12,000 x 50% 6,000 17,930 cr.

Bad debt expense $23,930 dr.

18. Insurance expense 3,400 Prepaid insurance 3,400 Balance in prepaid insurance account: $1,400 + 2,400 $3,800 Balance required: $2,400 x 2/12 400

Insurance expense $3,400


19. Amortization expense 39,150 Acc. amortization – building* 7,500 Acc. amortization – equipment** 27,400 Patents*** 4,250 * $300,000 / 40 = $7,500 ** ($145,000 – 38,000 NBV Beg +

30,000 Purchase) = $137,000 x 20% = $27,400

*** $34,000 / 8 = 4,250 20. Cost of goods sold 886,000 Inventory ($378,000 – 320,000) 58,000 Purchase returns 16,000 Purchases 960,000 Check: Opening inventory $320,000 Purchases – net ($960,000 – 16,000) 944,000 Cost of goods available for sale 1,264,000 Less ending inventory (378,000) Cost of goods sold $886,000 Inventory loss 13,000 Allowance for decline in value of

inventory

13,000 21. Warranty expense 24,000 Warranty liability 24,000 $1,600,000 x 1.5% 22. Salaries expense 6,700 Salaries payable 6,700 23. Retained earnings 80,000 Cash 80,000 24. Income tax expense 53,702 Income taxes payable 53,702 $134,256 x 40% = 53,702


Part (b)


Cash Accts Receivable Accounts Payable

B 36,000 945,000 8 B 176,000 1,520,000 2 6 16,000 127,000 B

2 1,520,000 320,000 9 1 1,600,000 34,000 3 8 945,000 960,000 5

4 5,000 13,000 10 4 5,000 5,000 4 126,000

7 75,000 13,000 10 E 222,000

30,000 11

25,000 12 Allow/Doubt Accts Salaries Payable

40,000 13 3 34,000 23,000 B 9 5,600 5,600 B

22,000 14 5,000 4 6,700 22

2,400 15 23,930 17 6,700 E

130,000 17,930 E

80,000 23

E 15,600 Inventory Inc Taxes Payable

B 320,000 13 40,000 12,000 B

20 58,000 53,702 24

E 378,000 25,702

Prepaid Insurance Land Warranty Liability

B 1,400 3,400 18 B 40,000 12 25,000 13,000 B

15 2,400 24,000 21

E 400 12,000

Building Acc Amort - Bldg Bonds Payable

B 300,000 120,000 B 10 412 419,600 B

7,500 19 10 424

127,500 E 418,764

Equipment Acc Amort - Equip Common Stock

B 145,000 38,000 B 14 17,310 150,000 B

11 30,000 27,400 19 75,000 7

E 175,000 65,400 207,690 E

Patents

Allowance for

Decline in Value of Inventory

Retained Earnings

B 34,000 4,250 19 13,000 20 14 4,690 144,200 B

E 29,750 23 80,000

59,510 E



Purchases Purchase Returns Sales

5 960,000 960,000 20 20 16,000 16,000 6 1,600,000 1

Cost of Goods Sold Salaries

20 886,000 9 314,400

22 6,700

E 321,100

Interest Warranty expense

10 12,588 21 24,000

10 12,576

E 25,164

Insurance Operating expenses

18 3,400 16 130,000

Bad Debt Expense Amortization exp.

17 23,930 19 39,150

Income Tax Exp. Inventory Loss

24 53,702 20 13,000


c. Haider Corporation

Trial Balance


Dr. Cr.

Cash $15,600 Accounts receivable 222,000 Allowance for doubtful accounts $17,930 Inventory 378,000 Allowance for decline in value of inventory 13,000 Prepaid insurance 400 Land 40,000 Building 300,000 Accumulated amortization – building 127,500 Equipment 175,000 Accumulated amortization – equipment 65,400 Patents 29,750 Accounts payable 126,000 Salaries payable 6,700 Income taxes payable 25,702 Warranty liability 12,000 Bonds payable 418,764 Common stock 207,690 Retained Earnings 59,510 Sales 1,600,000 Cost of goods sold 886,000 Salaries 321,100 Interest 25,164 Warranty expense 24,000 Insurance expense 3,400 Operating expenses 130,000 Bad debt expense 23,930 Amortization expense 39,150 Inventory loss 13,000 Income tax expense 53,702

$2,680,196 $2,680,196


d. Haider Corporation Income Statement for the year ended December 31, 20x6 Sales $1,600,000 Cost of goods sold 886,000

Gross profit 714,000

Operating expenses Salaries 321,100 Warranty 24,000 Insurance 3,400 Bad debts 23,930 Inventory loss 13,000 Amortization 39,150 Other operating expenses 130,000

554,580



Net income $80,554

Haider Corporation Statement of Retained Earnings for the year ended December 31, 20x6 Retained earnings, January 1, 20x6 $144,200 Net income 80,554 Premium on redemption of common shares (4,690) Dividends (80,000)

Retained earnings, December 31, 20x6 $140,064


Haider Corporation Statement of Financial Position as at December 31, 20x6 ASSETS

Current Assets Cash $ 15,600 Accounts receivable 204,070 Inventory 365,000 Prepaid insurance 400

585,070

Land 40,000

Building $300,000 Less accumulated amortization (127,500) 172,500

Equipment 175,000 Less accumulated amortization (65,400) 109,600

Patents – net 29,750

351,850

$936,920


Current liabilities Accounts payable $126,000 Salaries payable 6,700 Income taxes payable 25,702 Warranty liability 12,000

170,402

Bonds payable 418,764

589,166

Shareholders’ Equity Capital stock 207,690 Retained earnings 140,064

347,754

$936,920


Problem 8-2

a. Bad debt expense $9,600 Allowance for doubtful accounts $9,600 $320,000 x 3% b. Wages expense 4,800 Wages payable 4,800 c. Insurance expense 3,600 Prepaid insurance 3,600 $9,600 x 9/24 d. Amortization expense 7,600 Accumulated Amortization 7,600 ($80,000 – 4,000) / 10 e. Prepaid rent 4,000 Rent expense 4,000 $9,600 x 5/12 f. Interest receivable 360 Interest revenue 360 $12,000 x 9% x 4/12 g. Interest expense 4,500 Interest payable 4,500 $60,000 x 10% x 9/12 h. Amortization expense ($11,900 / 17) 700 Patents or Accumulated Amortization – Patents 700 i. Supplies inventory 4,700 Supplies expense 4,700 Increase in inventory = $9,200 – 4,500 j. Warranty expense 12,000 Warranty liability 12,000 10,000 x 3% x $40 k. Allowance for doubtful accounts 16,000 Accounts receivable 16,000 l. Income tax expense 24,000 Income taxes payable 24,000


Problem 8-3 MAS Inc. Income Statement for the five months ending May 31, 20x2 Sales (22,770 Cash Sales + 5,320 Collections on Credit Sales + 4,226 Uncollected Sales) $32,316 Cost of goods sold Purchases (14,400 Baking Materials Purchases - 130 Rebate + 256 Payable - 1,840 Ending Inventory)

12,686

Gross margin 19,630

Operating Expenses Rent (1,800 - 300 Prepaid) 1,500 Salaries and wages (5,500 + 240 Payable) 5,740 Maintenance 110 Utilities (4,000 + 270 Payable) 4,270 Insurance (1,920 - 1,120 Prepaid) 800 Advertising 424 Depreciation (3,000 / 5 x 5/12) 250

13,094

Operating Income 6,536 Interest (72 + 44)1 116

Net income before taxes 6,420 Provision for income taxes (6,420 x 20%) 1,284

Net income $5,136

1 Loan payment $312 Less interest: $2,880 x 10% x 3/12 72

Principal payment, April 1, 20x2 240

Loan balance, April 1, 20x2 (2,880 - 240) 2,640 Interest April & May - 2,640 x 10% x 2/12 $44


MAS Inc. Balance Sheet as at May 31, 20x2 ASSETS Current Assets Cash (33,600 - 31,466) $2,134 Accounts receivable 4,226 Inventory 1,840 Prepaid insurance 1,120 Prepaid rent 300

9,620

Fixed Assets Equipment 3,000 Accumulated depreciation -250

2,750

$12,370

LIABILITIES & SHAREHOLDER'S EQUITY Current Liabilities Accounts payable $526 Salaries payable 240 Income taxes payable 1,284 Interest payable 44 Current portion of note payable ($240 x 4) 960

3,054 Note payable (2,640 - 960) 1,680

4,734

Shareholder's Equity Common Stock 2,500 Retained earnings 5,136

7,636

$12,370


Problem 8-4

Morrow Wholesale


ASSETS

Current Assets

Cash $24,000 Marketable securities* 19,000 Accounts receivable 155,000 Inventory 80,000

278,000 Noncurrent assets Equipment 80,000 Accumulated depreciation (20,000) 60,000

$338,000

SHAREHODLERS' EQUITY

Shareholders' Equity Common stock $275,000 Retained earnings 63,000

$338,000

* Plug to balance.


Morrow Wholesale

Income Statement and Statement of Retained Earnings

for the year ended December 31, 20x2

Sales $250,000 Cost of goods sold ($250,000 x 80%) 200,000

Gross margin 50,000

Operating expenses Salaries (10,000 + 1,600) 11,600 Depreciation (80,000 ÷ 10) 8,000 Bad debts (155,000 - 146,000) 9,000 Miscellaneous 5,500 34,100

Operating income 15,900 Interest expense ($5,000 x 12% x 6/12) (300) Gain on sale of equipment 5,000 Gain on sale of securities 4,000

Net income before taxes 24,600 Income tax expense (30%) 7,380

Net income 17,220 Retained earnings, beginning of year 63,000 Dividends (10,000)

Retained earnings, end of year $70,220


Morrow Wholesale


ASSETS

Current Assets

Cash (24,000 + 406,000 - 205,500) $224,500 Inventory (Note 1) 96,000 Prepaid advertising 10,000

330,500 Noncurrent assets Land (19,000 + 4,000) 23,000 Equipment (80,000 - 20,000) 60,000 Accumulated depreciation (20,000 - 20,000 + 8,000) (8,000) 52,000

$405,500

SHAREHODLERS' EQUITY

Current liabilities Accounts payable $36,000 Accrued wages payable 1,600 Note payable 5,000 Interest payable 300 Dividends payable 10,000 Income taxes payable 7,380

60,280

Shareholders' Equity Common stock 275,000 Retained earnings 70,220

345,220

$405,500

Note 1 - Inventory Purchases of merchandise $180,000 A/P - ending 36,000 Purchases $216,000 Cost of goods sold = Opening inventory $80,000 Purchases 216,000 Less ending inventory (96,000)

$200,000


Problem 9-1

a. Ginger’s Cookies Ltd.

Statement of Cash Flow for the Year ended December 31, 20x6

Cash flow from operations Cash collected from customers ($7500,000 Sales

- 10,000 Increase in A/R)

$740,000 Cash paid out to suppliers ($300,000 COGS

+ 7,000 Increase in Inventory - 12,200 Increase in AP)

(294,800) Cash paid out for salaries

($120,000 Salaries Expense - 7,600 Increase in Salaries Payable)

(112,400) Cash paid out for other operating expenses (80,000) Cash paid out for interest ($32,000 Interest expense

- 1,000 Increase in Interest Payable)

(31,000) Cash paid out for income taxes ($79,100 Income tax expense

– 33,100 Increase in Income Taxes Payable)

(46,000)

175,800

Cash flow from investing Proceeds on sale of equipment (Note 1) 20,000 Purchase of equipment (125,000)

(105,000)

Cash flow from financing Issue of bonds payable 30,000 Dividends paid (Note 2) (99,500)

(69,500)

Increase in cash ($175,800 – 105,000 – 69,500) 1,300 Cash, beginning 19,200

Cash, ending $20,500

Note 1 – Proceeds on sale of equipment

Net book value of equipment ($45,000 – 40,000) $ 5,000 Gain on sale 15,000

Proceeds $20,000

Note 2 – Dividends paid

Net income $146,900 Less increase in Retained Earnings ($108,400 – 61,000) 47,400

$ 99,500


b. Cash flow from operations – indirect Net income $146,900 Adjust for noncash items Amortization expense 7,000 Gain on sale of capital assets (15,000) Adjust for changes in noncash working capital items Increase in Accounts Receivable (10,000) Increase in Inventory (7,000) Increase in Accounts Payable 12,200 Increase in Salaries Payable 7,600 Increase in Interest Payable 1,000 Increase in Income Taxes Payable 33,100

$175,800


Problem 9-2

a. McDuff Ltd. Statement of Cash Flow for the year ended December 31, 20x3 Cash flow from operations Net income $239,000 Adjust for non-cash items: Amortization expense1 218,000 Gain on retirement of bonds (13,000) Loss on disposal of assets 7,000 Adjust for changes in non-cash working capital items: Decrease in accounts receivable 111,000 Increase in merchandise inventory (48,000) Increase in prepaid expenses (11,000) Decrease in accounts payable (12,000) Decrease in salaries and wages payable (37,000) Decrease in interest payable (5,000) Increase in income taxes payable 17,000

466,000

Cash flow from investing Proceeds on sale of assets 80,000 Purchase of capital assets2 (543,000)

(463,000)

Cash flow from financing Redemption of bonds payable (487,000) Proceeds on issue of mortgage payable 350,000 Proceeds on issue of common shares 150,000 Cash dividends paid3 (50,000)

(37,000)

Decrease in cash (34,000) Cash, beginning of year 353,000

Cash, end of year $319,000

1 Accumulated Amortization, beginning of year $3,695,000 Amortization expense ? Accumulated Amortization on disposal: $158,000 – 87,000 (71,000)

Accumulated Amortization, end of year $3,842,000

Amortization expense = $218,000


2 Capital Assets, beginning $5,326,000 Additions ? Disposals (158,000)

Capital Assets, ending $5,711,000

Additions to capital assets = $543,000 3 Retained Earnings, beginning of year $319,000 Add net income 239,000 Less dividends ?

Retained Earnings, end of year $508,000

Dividends = $50,000 b. Cash flow from operations – Direct Cash collected from customers ($4,500,000 Sales

+ 111,000 Decrease in A/R)

$4,611,000 Cash paid out to suppliers ($2,400,000 COGS

+ 48,000 Increase in Inventory + 12,000 Decrease in AP)

(2,460,000) Cash paid out for operating expenses ($700,000

– 218,000 Amortization Expense + 11,000 Increase in Prepaid Expenses)

(493,000) Cash paid out for salaries and wages

($850,000 Salaries and Wages Expense + 37,000 Decrease in Salaries and Wages Payable)

(887,000) Cash paid out for interest ($67,000 Interest expense

+ 5,000 Decrease in Interest Payable)

(72,000) Cash paid out for income taxes ($250,000 Income tax expense

– 17,000 Increase in Income Taxes Payable)

(233,000)

$466,000


Problem 9-3

(a) HHC LTD.

Cash Flow Statement

for the year ended December 31, 20x5

Cash Flow from Operating Activities

Net Loss $ (3,400) Adjust for non-cash items Depreciation 7,800 Add (deduct) adjustments to non-cash current assets

and liabilities:

Increase in accounts receivable $ (1,500) Increase in inventory (1,600) Increase in prepaid Insurance (100) Decrease in salaries and wages payable (400) Increase in interest payable 100 (3,500)

$ 900

(b) Cash Flow from Operating Activities Cash collections from customers ($218,000 Sales – 1,500 Increase in Accounts Receivable) $216,500 Cash paid to suppliers ($165,000 COGS + 1,600 Increase in Inventory) (166,600) Cash paid to employees ($39,300 + 400 Decrease in Salaries and Wages Payable) (39,700) Cash paid for insurance ($2,800 + 100 Increase in Prepaid Insurance) (2,900) Cash paid for rent (5,300) Cash paid for interest ($1,200 – 100 Increase in Interest Payable) (1,100)

$900


Problem 9-4

a. Toram Ltd.

Statement of Cash Flow for the Year ended December 31, 20x6

Cash flow from operations Cash collected from customers ($900,000 Sales

- 53,000 Increase in A/R)

$847,000 Cash paid out to suppliers ($600,000 COGS

+ 32,000 Increase in Inventory + 18,000 Decrease in AP)

(650,000) Cash paid out for other operating expenses (165,000) Cash paid out for interest 0 Cash paid out for income taxes 0

32,000

Cash flow from investing Proceeds on sale of equipment (Note 1) 7,000 Proceeds on sale of long-term investment (Note 2) 30,000 Purchase of equipment (20,000)

17,000

Cash flow from financing Issue of bonds payable 25,000 Dividends paid (50,000)

(25,000)

Increase in cash ($32,000 + 17,000 – 25,000) 24,000 Cash, beginning 26,000

Cash, ending $50,000

Note 1 – Proceeds on sale of equipment

Net book value of equipment ($32,000 – 21,000) $ 11,000 Loss on sale (4,000)

Proceeds $7,000

Note 2 – Proceeds on sale of long-term investment

Net book value of investment $ 18,000 Gain on sale 12,000

Proceeds 30,000


b. Cash flow from operations – indirect Net income $100,000 Adjust for noncash items Amortization expense 43,000 Loss on sale of capital assets 4,000 Gain on sale of long-term investment (12,000) Adjust for changes in noncash working capital items Increase in Accounts Receivable (53,000) Increase in Inventory (32,000) Decrease in Accounts Payable (18,000)

$32,000


Problem 10-1

1. d Average receivables = ($50,000 + 55,000) / 2 = $52,500 Net credit sales for 20x8 = $52,500 x 7 = $367,500 Total net sales = $367,500 + 32,500 = $400,000 2. d No impact on working capital since the decrease in cash is equal to the

decrease in accounts payable. Impact is on the current ratio. Assume that CL = 250,000 and CA = 200,000

then the current ratio is 0.8. If the invoice paid is $20,000, then CL = 230,000 and CA = 180,000, the current ratio drops to 0.78.

3. c 4. c Average inventory = ($30,000 + 120,000) / 2 = $75,000 COGS = $30,000 + 540,000 – 120,000 = $450,000 Inventory turnover = $450,000 / 75,000 = 6 5. a Assume an initial amounts as follows: current assets - $100,000, current

liabilities - $80,000, current ratio = $100,000 / 80,000 = 1.25. Assume that a payment of $10,000 is made, the current ratio becomes $90,000 / 70,000 = 1.29 and working capital stays the same.

6. a 7. c 8. b Average receivables = ($40,000 + 22,500) / 2 = $31,250 Days sales in A/R = $32,250 / ($125,000 / 365) = 94 days 9. c Inventory increased by $20,000 ($320,000 purchased - $300,000 COGS) Beginning inventory = $60,000 – 20,000 = $40,000 Average inventory = ($60,000 + 40,000) / 2 = $50,000 Inventory turnover = $300,000 / 50,000 = 6.0 times


Problem 10-2

Liquidity Analysis:

20x5 20x4

Current Ratio 712,000 / 379,000 = 1.88 594,000 / 371,000 = 1.60 Quick Ratio (Acid-Test Ratio)

(12,000 + 275,000) / 379,000 = 0.76

(34,000 + 220,000) / 371,000 = 0.68


(12,000 + 275,000) ÷ (1,400,000 + 550,000) / 365 = 53.7 days

(34,000 + 275,000) ÷ (1,200,000 + 400,000_ / 365 = 70.5 days

Solvency Analysis:

20x5 20x4

Debt-to-Equity Ratio*

920,000 / 863,000 = 1.07

850,000 / 793,000 = 1.07

Times Interest Earned 230,000 / 60,000

= 3.83 200,000 / 50,000 = 4.00

* debt is defined as long-term debt in this case


Profitability Analysis 20x5 20x4 Gross Profit Percentage

$900,000 / 2,300,000 = 39.1% $700,000 / 1,900,000 = 36.8%

Return on Sales 230,000 / 2,300,000 = 10% 200,000 / 1,900,000 = 10.5% Return on Assets 230,000 /

[(2,162,000 + 2,014,000) / 2] = 11%

200,000 / [(2,014,000 + 1,875,000) / 2] = 10.3%

Return on Equity 110,000 /

[(863,000 + 793,000) / 2] = 13.3%

98,000 / [(793,000 + 725,000) / 2] = 12.9%

Asset Management (Activity Ratios) 20x5 20x4

Inventory turnover $1,400,000 / [(425,000 + 340,000) / 2] = 3.66

$1,200,000 / [(340,000 + 350,000) / 2] = 3.48

Days Sales in Accounts Receivable

[(275,000 + 220,000) / 2] / (2,300,000 / 365) = 39.2 days

[(220,000 + 200,000) / 2] / (1,900,000 / 365) = 40.3 days

Total asset turnover 2,300,000

/ [(2,162,000 + 2,014,000) / 2] = 1.10

1,900,000 / [(2,014,000 + 1,875,000) / 2] = .98


Problem 10-3

Liquidity Analysis:

20x7 20x6

Current Ratio 1,167,000 / 560,000 = 2.08 1,114,000 / 524,000 = 2.13 Quick Ratio (Acid-Test Ratio)

(37,000 + 480,000) / 560,000 = 0.92

(20,000 + 524,000) / 524,000 = 1.04


(37,000 + 480,000) ÷ (1,300,000 + 635,000) / 365 = 97.52 days

(20,000 + 524,000) ÷ (1,000,000 + 463,000) / 365 = 135.72 days

Solvency Analysis:

20x7 20x6

Debt-to-Equity Ratio*

820,000 / 2,576,000 = 0.32

800,000 / 2,679,000 = 0.30

Times Interest Earned 65,000 / 60,000

= 1.08 137,000 / 56,000 = 2.45

* debt is defined as long-term debt in this case


Profitability Analysis 20x7 20x6 Gross Profit Percentage

$800,000 / 2,100,000 = 38.1% $700,000 / 1,700,000 = 41.2%

Return on Sales 65,000 / 2,100,000 = 3.1% 137,000 / 1,700,000 = 8.1% Return on Assets 65,000 /

[(3,956,000 + 4,003,000) / 2] = 1.6%

137,000 / [(4,003,000 + 3,808,000) / 2] = 3.5%

Return on Equity 3,000 /

[(2,576,000 + 2,679,000) / 2] = 0.1%

51,000 / [(2,679,000 + 2,628,000) / 2] = 1.9%

Asset Management (Activity Ratios) 20x7 20x6

Inventory turnover $1,300,000 / [(650,000 + 570,000) / 2] = 2.13

$1,000,000 / [(570,000 + 485,000) / 2] = 1.90

Days Sales in Accounts Receivable

[(480,000 + 524,000) / 2] / (2,100,000 / 365) = 87.3 days

[(524,000 + 300,000) / 2] / (1,700,000 / 365) = 88.5 days

Total asset turnover 2,100,000

/ [(3,956,000 + 4,003,000) / 2] = 0.52

1,700,000 / [(4,003,000 + 3,808,000) / 2] = 0.44

Documents

39012773 Supplemental Book