Accounting Text and Cases 12 Ed.

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CHAPTER 3 BASIC ACCOUNTING CONCEPTS: THE INCOME STATEMENT ‘Changes from Eleventh Edition The chapter has been updated. The principal addition is a discussion of the Sarbanes-Oxley Act's CEO and CFO certification requirements, Additional topics include proforma earnings, EBITDA and SEC financial report certification and affirmation requirements, Approach Undoubtedly, the accrual idea is the most difficult of all basic accounting matters for the student to grasp. As a matter of fact, we sometimes say that the proper recognition of revenue and expense is the only important accounting problem, Although this is an exaggeration, it is not far from the truth, The text and cases in this chapter constitute only a beginning in understanding and it is to be expected that students will understand the matter thoroughly only after they have attacked it from several different angles. Sometimes we ask the class “Suppose a company received a lawyer's bill for $1,000, Explain all the different ways in which this bill could be recorded in the accounts.” The answer is that if the bill relates to services rendered in a prior year (or accounting period) but not recorded in that time, itis nevertheless an expense of the current year; if it represents a charge for a previous year that was recorded in that year, the payment of the bill merely represents a decrease in a liability; if it represents a charge in the current year, itis recorded as an expense; and if it represents a retainer for services to be rendered in the following year it is recorded as an asset, prepaid expense. It may be desirable to introduce a number of short questions of this type in order to hammer home the accrual concept. It is suggested, however, that problems relating to depreciation be deferred, as this is an intricate matter which is perhaps best left until Chapter 7. Students should always be required to use the word “revenue” rather than the word “income.” They may find it difficult to do this because “income” is still used erroneously in some published statements and in tax forms. ‘Some students confuse the special meaning of “consistency” in accounting with the general meaning of this term. In accounting, “consistency” means only that the same practice is followed this year as was followed last year. It does not mean that, for example, the treatment of inventories is consistent with the treatment of fixed assets. Cases Maynard Company (B) is a straightforward problem, although students may have some difficulty in deducing how the amounts are to be transformed from the cash basis to the accrual basis. Lone Pine Café (B) requires an income statement of the same company whose balance sheet was prepared in Chapter 2; itis fairly straightforward. Dispensers of California introduces the entire accounting eyele, with some judgmental issues. Accounting: Text and Cases 126 Instructor's Manual Amhons/Havskins/Merchant Pinetree Motel provides practice in applying the accrual concept, National Association of Accountants provides the opportunity to explore income concepts in the setting of a nonprofit organization, Problems Problem 3-1 Not an expense for June - not incurred. Expense for June Expense for June Expense for June Expense for June Not an expense for June - asset acquited. Problem 3-2 Revenues —$275,000 oS L640 oo a. Expenses Cost of goods s Rent Salaries Taxes Other. 246,315 Net income $28,685 Problem 3-3 Beginning inventory .....«..S27,00D... Purchases 78.000, Available for sale... seve Ending inventory Cost of goods sold ‘$74.00 Problem 3-4 a, (1) Sales, $85,000, Cost of goods Sold... A5,000... Gross margin, ©2007 MeGraw-Hillirwin Chapter 3 (2) 47 percent gross margin ($40,000 / $85,000) (3) 11 percent profit margin (9000/8500) ‘The Woden Corporation had a tax rate of 40 percent (86,000 / $15,000) on its pretax profit that represented 17.7 percent of its sales ($15,000 / $85,000). The company’s operating expenses were 82.3 percent of sales ($70,000 / $85,000) and its cost of goods sold was 53 percent of sales. The company’s ‘gross margin was 47 percent of sales ($40,000 / $85,000), Problem 3-5 Depreciation, Fach year for the next $ years depreciation will be charged to income No income statement charge. Land is not depreciated. Cost of goods sold. $3,500 charged to current year’s income. $3,500 charged to next year’s income. Subscription expense. $36 charged to current year. $36 charged to next year. Alternatively, $72 charged to current year on grounds $72 is immaterial. Problem 3-6 Asset value: October 1, 20X5 $30,000 December 31, 20X5 26,250 December 31, 20X6 11,250 December 31, 20X7 0 Expenses: 20X5 $3,750 ($1,250 x 3 months) 20X6 $15,000 ($1,250 x 12 months) 20X7 $11,250 ($1,250 x 9 months) (One month's insurance charge is $1,250 ($30, 000 / 24 months) Accounting: Text and Cases 126 Instructor's Manual Amhons/Havskins/Merchant Problem 3-7 QED ELECTRONICS COMPANY Income Statement for the month of April, —. Sales $33.400. Expenses: Bad debt5..oceonsnnsnrnner nnn Sa 6AS.u Pars, 3,700. Interest. ‘880. 10,000. ~ 800. Depreciation. 2,700. Selig eunuee sl 90. ‘Adiinistrativ 8200. Profit before taxes. Provision for taxes.. Net income ‘Truck purchase has no income statement effect. It is an asset Sales are recorded as eamed, not when cash is received. Bad debt provision of 5 percent related to sales on credit ($33,400 - $20,500) must be recognized. Wages expense is recognized as incurred, not when pi. March's utility bill is an expense of March when the obligation was incurred. Income tax provision relates to pretax income, Must be matched with related income, Problem 3-8 First calculate sales: Sales ($45,000 /(I - 45). Beginning inventory Purchase ‘Total available. Ending inventory. Cost of goods sold, Gross margin... S8L818% Irthe gross margin percentage is 45 percent, the cost of goods sold percentage must be 55 pereent, Once sales are determined, calculate net income: Net income ($81,818 x .1) $8,182 ©2007 MeGraw-Hillirwin Chapter 3 Next, prepare balance sheet Assets Current assets (850,000 x 1.6) .80,000, Current libilities Other assets Long term debt (8218,182 - $50,000). ....0seesral 38182 eer econ Total liabilities $90,000. Owners’ equity Beginning balance.......0.se $120,000. Plus net income. Ending balance. ‘Total liabilities Total assets, $218,182"... amd owners! eq. nnn $2LSLR2. anes "Total assets ~ Total liabilities and Owner's equity Problem 3-9 Sales LC 26,666,667 [LC 20,000,000 x (200 / 150)] January cash LC 1,000,000 [LC $00,000 x (200 / 100)] December cash LC 600,000 ‘At year-end the company was more liquid in terms of nominal currency (LC 600,000 versus LC 500,000) but in terms of the purchasing power of its cash it was worse off (LC 1,000,000 versus LC 600,000) Cases Case 3-1: Maynard Company (B) Note: This case is unchanged fram the Eleventh Edition Question 1 See below. Question 2 This question brings out the difference between cash accounting and accrual accounting. Cash increased by $31,677 whereas net income was $19,635. Explaining the exact difference may be too lifficult at this stage, but students should see that 1. The bank loan, a financing transaction, increased cash by $20,865 but did not affect net income. Cash collected on credit sales made last period ($21,798) also increased cash, but did not affect net income this period. (The same is truc of the collection of the $11,700 note receivable from Diane Maynard, but it was offset by the payments of the $11,700 dividend to Diane Maynard, the sole shareholder.) Accounting: Text and Cases 126 Instructor's Manual Amhons/Havskins/Merchant MAYNARD COMPANY INCOME STATEMENT, JUNE, Sales ($44,420 cash sales + $26,505 credit sales).. Less: Cost of sales *.. Gross Margin. Expenses Wages($5,660+82,202-81,974) .unssnessmnnsnnensnnnne SS, 88B nse Utilities. 900. Supplies (55,559+S1,671-S6,630). saison OO Insurance($3,150-$2,826 - 32H Depreciation ($157,950-8156,000)1(S5 928-85, 304), 2,574. Miscellancous. Income before income tax. Income tax expense ($7,224 - $5,700)... Net Income. Less: Dividends. Increase in retained earnings. *Cost of sales: Merchandise purchased for cash. ue SAATAS.. Merchandise purchased on credit % 21,315. Inventory, June | 20,835 Total goods available during June. 65.865. Inventory, June 30. 126,521. Cost of Sales, $39,345... fS213 15H88, 7h, 3. The purchase of equipment ($23,400) and other assets (S408) decreased cash but did not affect nt income (at least not by this full amount) this period 4, Credit sales made this period ($26,505) increased net income, but did not affect cash 5. Noncash expenses such as depreciation ($2,574) and insurance ($324) decreased net income but did not affect cash as they relate largely, if not wholly, to cash outflows made for asset acquisition in prior periods. (Exception: such expenses on an entity's first income statement are not related to prior period expenditures but they will be a much smaller amount than the first accounting period’s expenditures, Question 3 (a) $14,715 is incorrect because it is the amount of cash purchases rather than the cost of sales. The cost of cash purchases and cost of sales amounts would be equal for a period in which all purchases were for cash, and in which the dollar amount of beginning inventory was the same as the dollar amount of ending inventory, since Cost of Sales = Beginning Inventory + Purchases - Ending Inventory. (b) $36,030 is the sum of cash pure above, purchases equal cost of amounts are the same. ses ($14,715) and credit purchases ($21,315). As explained les for the period only if beginning and ending inventory ©2007 MeGraw-Hillirwin Chapter 3 Lone Pine Café (B} Note: This case is updated from the Eleventh Edition. Approach This case introduces students to preparation of an income statement based on analyzing transactions. At this stage, students are not expected to set up accounts in the formal sense. However, in effect they do so for those income statement items that did not coincide exactly with cash flows Question 1 A suggested income statement as required by Question 1 is shown below. The following notes apply to the income statement. 1. The student needs to refer back to Lone Pine Café (A) in order to construct the income statement oon the accrual basis. Amounts for sales on credit, purchases on credit, beginning and ending inventory, beginning and ending prepaid operating license, and depreciation expense are to be found there. Specifically: a, Sales revenues = $43,480 cash sales + $870 credit sales to ski instructors = $44,350, b. Food and beverage expense = $2,800 beginning inventory + $10,016 cash purchases + S credit purchases - $2,430 ending inventory ~ $11,969. 2. Since the entity is unincorporated, it is also correct (though less meaningful for evaluative purposes) to treat the $23,150 partners’ salaries as owners" drawings. This treatment would result in an income of $12,296 and a decrease in equity (after drawings) of $10,854. LONE PINE CAFE (B) INCOME STATEMENT FOR NOVEMBER 2, 2005, THROUGH. MARCH 30, 2006 Sales. $44,350. Expenses: Salaries to partners, Part-time employee wage Food and beverage supplies. ‘Telephone and electricity. Rent expense. Depreciation. Operating license expense... Interest. : Miscellaneous expenses Total expenses. (Loss)... Accounting: Text and Cases 126 Instructor's Manual Amhons/Havskins/Merchant Question 2 The income statement tells Mrs. Antoine that the partnership has suffered a $10,854 loss for the first five months of operation. This $10,854 loss is the correct figure for evaluative purposes, not the $12,296 income before partners” salaries. This assumes, of course, that nonowner salaries for the cook and table servers would also have been $23,150, which is questionable. It would appear that Lone Pine Cafe cannot support three partners, even at a bare level of sustenance ($23,150 was only an average of $1,543 per partner/employee per month). Of course the three owner/employees did receive room and board, for which no value has been imputed here. Case ensers of California, In Note: This is a new case for the Twelfth Edition Approach The case can be used for two class sessions, The first day is devoted to analyzing the accounting transactions, including a preliminary discussion of Hynes’ accounting policy decisions. The second class deals with preparing the financial statements and an analysis of how they may change if alternative accounting procedures had been adopted by Hynes ‘The first class should start with the case Question 1. Its purpose is to give the students a sense of the ‘managerial purpose of profit plans and a context for the later accounting discussions. ‘The use of the asset equals liability plus equity structure to answer Question 2 is recommended so that the instructor can 1) highlight the retained earnings link between net income and the balance sheet 2) illustrate how any accounting transaction can be analyzed using the basic accounting equation and 3) to lay the foundation for the debit-eredit framework material in Chapter 4, (At this point in the course debit and credit terminology and analysis should not be used.) Questions 3 and 4 require the preparation of an income statement and balance sheet. respectively. ‘Some instructors prefer to end the first class with a discussion of the balance sheet, including a completed balance sheet. Typically, these instructors want to leave time in the second class to discuss the relationship between net income and the change in cash on the balance sheet. Question 5 is designed to illustrate the role of ju sment in accounting for transactions. Answers to Questions Question | Profit plans are used for a variety of purposes. These include: + To force short range planning + Asa basis for evaluating performance and determining compensation. + To encourage coordination and communication between different organization units and levels. + Asa challenge to improve performance + Asa means for training managers + Asan early warning system and = Asa guide to spending, ©2007 MeGraw-Hillirwin Chapter 3 Question 2 ‘TN-Exhibit 1 presents an analysis of the planned transactions using the basic accounting equation framework. This analysis follows Hynes’ accounting policy. Question 3 TN-Exhibit 2 presents Hynes” profit plan using the Question | transaction analysis, The instructor should expect that most students will not calculate the cost of goods sold figure correctly. The instructor will have to explain that the components of the cost of manufactured goods includes direct materials and their conversion costs, including manufacturing equipment depreciation. The distinction between operating and finance costs in the income statement is another accounting practice most students will miss. Again, the instructor will have to explain this format and its rationale, which is to permit statement users to evaluate how well management has operated the company before considering the impact of their financing decisions. Question 4 ‘IN-Exhibit 3 presents the year-end balance sheet using the Question 1 transaction analysis, Equipment is reported net. Most students will follow this presentation. A better presentation is Equipment (cost) $85,000 Accumulated depreciation (8.500) Equipment (net) S765 ‘The patent is reported net. This is the correet presentation for intangible assets, ‘TN-Exhibit 4 presents a reconciliation of beginning (zero) and ending ($47,500) retained earnings. The instructor may want to share this exhibit with the students, It links the income statement to the balance sheet. It also illustrates that dividends are distributions of capital and not an expense. ‘The instructor should point out to students that many intra period transaction and repaying of the bank loan, do not appear on the end of the period balance sheet. ich as the borrowing Question 5 There are three accounting decisions that require Hynes to exereise judgment, They are: * Patent valuation + Patent amortization period + Equipment depreciation period Students might believe Hymes must exercise judgment in the accounting for the redesign and incorporation costs. Under current GAAP this is not the case, Redesign and organization costs must be expensed as incurred. Accounting: Text and Cases 126 Instructor's Manual Amhons/Havskins/Merchant ‘The patent can not be valued directly. There is no current liquid market for this type of patent. Hynes must value it indirectly. He chose to use the value of the company’s equity he received based on the cash paid by the investors for their equity interest to value the patent. This is an acceptable approach, Hopefully, the patent amoralization and depreciation periods represent Hynes’ best estimate of the related assets’ useful life (useful to Dispensers of California.) Students should be asked what would be the impact on the balance sheet and income statement if different lives had been used. So that students do not get the impression that differences in judgment are driven by a desire to manage earnings, the instructor should be careful during the discussion to remind the students that different reasonable life estimates can be made by responsible managers acting in good faith. Cash Flow Analysis, If the instructor wishes to incorporate some aspect of cash flows in the case discussion, TN-Exhibit 5 and 6 present two analysis of cash flows. TN-Exhibit 5 uses a cash receipts and distribution format. TN- Exhibit 6 uses a direct method statement of cash flows format. Instructors should not use the indirect ‘method at this point in the course. It confuses students. Chapter 11 introduces students to indireet method statement of cash flows. 10 Exhibit) Dispensers of California, Ine Balance Sheet Transaction Analysis Transactions Asets= Liable Eq 1a | Hynes investment + Patent 2000 * Commer Soe S120 (00 th | Otherness +Cish 00 + Comma Soe 00 2 operation cots Cash 2.00, [Rewind caning 500 3 | Equipment pckae Cas 45 (00 + Equipment $5,000 TT Redesign coats ~ Can S500 [Reid eamings S500 3) Component parspurhase “lnventory $212100 =Car 12100 @ | Bakba Cai $4.0 | “Bank on 0,000 Bank lm pid + Csh 30,00 | «Bk an 30, (00 Lan int Cash 0 + Rebined anings S10 7 [ Manufauing pyr = Ca 5145,000 Rebined arin $145,000 8 | Ofer mamactuing coats Cash 62,00, Robin earings $42,000 9 | Sling eer nd adniisaon Ca 968,000 Rebined earings 43000 UD [Ending vera (st of gods ad) lena $197,000 Rewind earings $157,000 U1 [Sales + Cash 59% 00 + Reine mings SS 12 | onpraion andredsign es fexpnsesas See anit incurred) 13 | Deprdaion — Faget SR00 Rewind earings 8500 14 [Pate amonzaon «Pan $7,000 Reine earings $1,000 15 | Ending won-n progres an eomplead See5, 7,8, lOand (3 ivory (nme) (st of god sold ** 16 [Dividends Cash S500 Rewind earings 000 17 [ooome Taxes FTaxespayatle 02800 [Rewind eamings $22500 * Begining compan put inenry $1 *Componentparssed 5197000 Rucines DU Manag all 14s.000 Toil aie 21200 Ober manufctuingerss 62,000 Ening components inerory KW Depeion sso Conpmens pars used 1m Cat goads sal ADs Aeconunting: Text and Cases 12e~ Insiructor’s Manual Anthony/Hawkins/ Merchant Exhil Dispensers of Californi 12-month Profit Plan Inc. Sales $598,500 Cost of goods sold ‘Components, $197,000 Mfg payroll 145,000 Other Mfg, 62,000 Depreciation 8,500 Gross margin $186,000 Selling, general and Administration 63,000 Patent 20,000 Redesign costs 25,000 Incorporation costs 2.500 Operating profit $75,500 Interest 300 Profit before taxes $75,000 Tax expense 22.500 ‘Net Income $52,500 Projected Year-end Balance Sheet Assets Liabilities Cash 378,400 ‘axes payable Components inventory 15,100 Current liabilities Current assets $93,500 Equipment (net) 76,500 Owner's Equity Patent (net) 100,000 Capital stock $200,000 Retained earnings 47,500, $270,000 ©2007 MeGraw-Hill/irwin New equity capital Incorporation Equipment Redesign Component parts Bank loan Bank loan Loan interest Manufacturing payroll Other manufacturing SG&A Sales Dividend Total Cash Reconciliation Receipts, Disbursements Ending Balance Dispensers of California, Inc. Change in Retained Earnings Beginning retained eamings, 80 Net income 52,500 Dividends 5.04 Ending retained earnings S47.500 Exhibit Dispensers of California, Inc. Cash Reconciliatio Receipts isbursements, $80,000 $2,500 85,000 25,000 212,100 30,000 598,500 $708,500 3630,100 3708,500 630.10 $78,400 Chapter 3 Aeconunting: Text and Cases 12e~ Insiructor’s Manual Anthony/Hawkins/ Merchant Exhil Dispensers of California, Inc. Statement of Cash Flows (Direct Method) Collections from customers $598,500 Payments to suppliers (212,100) Payments to employees (295,000) Legal payments (2,500) Interest 500) Operating cash flow $89,400 Equipment purchases 85,000) Investing cash flow 3(85,000) Bank loan 30,000 Repayment of bank loan (30,000) Capital 80,000 Dividends 5,000 Financing cash flow $75,000 ‘Change in cash 378,400 Beginning cash i Ending cash ‘$78,400 Note: This case is updated from the Eleventh Edition. Approach ‘This case treats the transition from cash to accrual accounting; also, the inherent difficulties in comparison of data with industry averages are illustrated. The ease does not require a full 80 minutes of

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