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Chapter 8 Valuation of Inventories A Cost-Basis ApproachInventory Costs-Companies generally account for the acquisition of inventories, like other a ssets, on a cost basis.Product costs-costs that attach to the inventory & recorded ininventory account. IE: Freight charges on goods, other direct costsof acquisition, & labor & other production costs incurred inprocessing the goods up to time of sale.

Period costs (costs that are indirectly related to acquisition orproduction of goods). IE: Selling expense, general & adminexpense arent included as part o f inventory cost. Interest CostCompanies usually expense interest costs.

Perpetual inventory system continuously track changes inInventory account. (Records all purchases & sales (issues) ofgoods directly in Inventory account as they occur)

Periodic inventory system, Determine quantity of inventory onhand periodically. COGAFS = Purchases Start + Purchase EndCOGS = COGAFS Ending Inventory.

In audit of ABC, you find physical inventory on 12/31/12 showed merchandise w/cost of $441,000. You discover following excludedfrom $441,000:1. Merchandise ($61,000), held by ABC on consignment. 2. Merchandise ($33,000), shipped by ABC f.o.b. destination toclient on 12/31/12. Client expected to receive on 1/6/13. 3. Merchandise ($46,000), shipped by ABC f.o.b. shipping point to client on12/29/2012. Client scheduled to receive on 1/2/13 4. Merchandise ($73,000) shipped by vendor f.o.b. destination on 12/30/12, & ABCreceived on 1/4/13. 5. Merchandise ($51,000) shipped by vendor f.o.b. shipping point on 12/31/12, & received by ABC on 1/5/13. Basedon info, calculate amount that should be on ABCs balance sheet at 12/31/12, for inventory. $441,000 + $33,000 + $51,000 = $525,000

LoBianco Companys record of transactions for the month of April was as follows. (A) Assuming periodic inventory records kept,

compute inventory at 4/30 using (1) LIFO & (2)

avg. cost.(1) LIFO (5,3004,500) 600 @ $6.00 =$3,600; 200 @ $6.08 = $1,216 ($3,600 + $1,216 =$4,816)Go to oldest inventory (800(600 @ $6.00) = (200@ $6.08))(2) Average Cost: Weighted-average cost per unit$33,655 / 5,300 units available = $6.35 avg. cost

per unit (600 units @ $6.35 = $5,080)(B) Assume perpetual inventory records are kept, determine inventory at 4/30 using (1) FIFO & (2) LIFO.

4/1: 600 500 = 100 @ $6.00

4/4:1,5001,300 = 200 @ $6.08

4/8: 800 600 = 200 @ $6.40

4/13:1,2001,200 = 0

4/21: 700 900 = -200 (200; 4/8)

April 29: 500 @ $6.79 = $3,395(c) Compute cost of goods sold assuming periodic inventory pr ocedures and inventory priced at FIFO.

(COG Available for sale) $33,655(Ending Inventory) $5,375 = (Cost of Goods Sold) $28, 280

Purchases Sales

April 1 600 @ $6.00 3,600 April 3 500 @ $10.004 1,500 @ 6.08 9,120 9 1,300 @ 10.008 800 @ 6.40 5,120 11 600 @ 11.00

13 1,200 @ 6.50 7,800 23 1,200 @ 11.0021 700 @ 6.60 4,620 27 900 @ 12.0029 500 @ 6.79 3,395 4,500

5,300 $33,655

(1) FIFO - Perpetual (Same as Periodic) (2) LIFO

100 @ $6.00 = $600

500 @ $6.79 = $3,395 200 @ $6.08 = $1,216

300 @ $6.60 = $1,980 500 @ $6.79 = $3,395

$3,395 + $1,980 = $5,375 $600 + $1,216 + $3,395 =$5,211

DateInventory at

Current PricesPriceIndex

End of year inventoryat base-year price

Split intoLayers

Ending Inventoryat Lifo Cost

2009 $220,000/ 100

(1.00)$220,000 $220,000 X 1.00 $220,000

December 31,2010

$256,800/

107(1.07)

$240,000 $220,000$ 20,000

X 1.001.07

$220,000$ 21,400$241,400

December 31,2011

290,000/

125(1.25)

$232,000 $220,000$ 12,000

X 1.001.07

$220,000$ 12,840$232,840

December 31,2012

325,000

/130

(1.30)

$250,000 $220,000$ 20,000$ 10,000

X 1.001.071.30

$220,000$ 21,400$ 25,840$267,200

LIFO Advantages: (1)Matches recent costs against current revenues to provide better measure of current earnings. (2) As long as price level increases &inventory quantities dont decrease, deferral of i ncome tax occurs in LIFO.(3)Because of de ferral of income tax, cash flow improves. Disadvantages: (1) reducedearnings, (2) understated inventory, (3) does not approximate physical flow of items except in peculiar situations, & (4) involuntary liquidation issues.

LIFO Reserve - Difference btwn. inventory method used for internal reporting purpo ses & LIFO is referred to as Allowance to Reduce Inventory to LIFO, orLIFO reserve. Change in LIFO reserve is referred to as LIFO effect. Companies shou ld disclose either LIFO reserve or replacement cost of inventory in financial

statements.

Effect of LIFO liquidations-LIFO liquidations match costs from preceding periods against sales r evenues reported in current dollars. This distorts net inco me& results in increased taxable income in the current period. LIFO liquidations can occur frequently when using a specific-goods LI FO approach.

(1) ABC uses periodic inventory system. For current month, beginning inventory consisted of 200 units @ cost $65 each. During month, company made2 purchases: 300 units at $68 each & 150 units at $70 each. ABC also sold 500 units during month. Using FIFO method, what is the amount of cost ofgoods sold for the month?Answer: $33,400.Beginning Inventory: 200 @ $65 = $13,000Purchases: 300 @ $68 = $20,400, 150 @ $70 = $10,500;

Sales: 500; (500 200 300 = 0) 150 units @ $70 left over ($13,000 + 20,400 + 10,500 = 43,900) - 150 @ $70 = $10,500 = $33,400 (2) ABCreported total assets of $1,600,000 & net income of $85,000 for current year. ABC determined that inventory was understated by $23,000 at beginningof year & $10,000 at end of year. What is corrected amount for total assets and net income for the year? Answer: $1,610,000 and $72,000. (3) LIFOliquidations can occur frequently when using a specific-goods approach. Answer: True (4) The dollar-value LIFO method measures any increases &decreases in a pool in terms of total dollar value and physical quantity of the goods. Answer: False(5) Purchase Discounts Lost is a financial expense &is reported in other expenses & losses section of income statement.Answer: 1. True (6) Use of LIFO provides a tax benefit in an industry where unitcosts tend to decrease as production i ncreases.Answer: False (7) Assuming no beginning inventory, what can be said about trend of inventory pricesif cost of goods sold computed when inventory is valued using FIFO method exceeds cost of goods sold when inventory is valued using LIFO method?

Answer: Prices decreased (8) During 2010 ABC transferred inventory to XYZ & agreed to repurchase the merchandise early in 2011. XYZ then used

inventory as collateral to borrow from Norwalk Bank, remitting the proceeds to ABC. In 2011 when ABC repurchased inventory, XYZ used the proceedsto repay its bank loan. This transaction is known as a(n) Answer: product financing arrangement. (9) What happens when inventory in base yeardollars decreases?Answer: LIFO layer is liquidated.Under dollar-value LIFO method, 1 pool may contain the entire inventory. However, companiesgenerally use several pools. In general, the more goods included in a pool, the more likely that increases in quantities of some goods will offsetdecreases in other goods in the same pool. Thus, companies avoid liquidation of the LIFO layers . It follows that having fewer pools means less costand less chance of a reduction of a LIFO layer.

Chapter 7 Cash & ReceivablesCash Cash UnrestrictedCash RestrictedCurrent/noncurrent Asset

Petty Cash & Change Fund Cash Reported as Cash

Short-term Paper Cash Equivalent < 3 months, often reported as cash

Short-term Paper Temp. Investment Maturity of 3 to 12 months

Post-dated check & IOUs Receivables Assumed to be collectible

Travel Advance Receivables Assumed collectible from employee/deduct salary

Postage Prepaid Expenses Office Supplies Inventory

Bank Overdraft Current Liability If right of offset exists, reduce cash

Compensating Balance Cash separately classified as deposit Current/Noncurrent in balance sheet. Disclose in notes.

Net Realizable ValueNet amount company expects to receive in cash. (NRV)Allowance Method: Ensure company state receivable @ NRV(Balance S.) Companies dont close Allowance for Doubtful Accounts atend of fiscal year. Direct Write-off: Immaterial

Direct Write-Off Method-Charge loss to bad Debt Expense,not appropriate

Bad Debt Expense 8,000Accounts Receivable 8,000

Allowance-Estimate uncollectible accounts at the end of eachperiod.

Bad Debt Expense 8,000Allowance for D. Acct 8,000

Allowance for D. Acct 1,000Accounts Receivable 1,000

Recording Write off of UncollectibleRecovery of Uncollectible ----------------

Accounts Receivable 1,000Allowance for D. Acct 1,000

Cash 1,000Accounts Receivable 1,000

Percentage of Sales-Income Statement

Bad Debt Expense 8,000Allowance for D. Acct 8,000

1% * $800,000 = $8,000

Percentage of Receivables-Balance Sheet

Composite rate -estimate of uncollectibleAging schedule-different % based on past experience to variousage categories

Credit Balance $800 before adjustment($37,650 - $800 = $36,850)

Bad Debt Expense 36,850Allowance for D. 36,850

Debit Balance of $200 before adjustment($37,650 + $200 = $37,850)

Bad Debt Expense 37,850Allowance for D. 37,850

Impairments-Note receivable considered impaired when probable that creditor will be unable to collect all amounts due (bothprincipal & interest) according to contract.

Fair Value Option-Receivable recorded @ FV,w/unrealizedholding gain/loss ( change in the FV of receivable from 1period to another, exclusive of interest revenue) reported aspart of net income.

Notes Receivable 19,000UHG/L-Income 19,000

Disposition of Receivable-To accelerate receipt of cash fromreceivables; owner may transfer accounts/notes receivables toanother company for cash. (Secured borrowing/Sale ofReceivables) Common sale to factor. (finance companies/ bankthat buy receivables from business for fee.

W/out Recourse-purchaser assumes risk of collectibility &absorbs credit losses. Out right sale of rcvbl. both in form(transfer of title) & substance (transfer of control).

Cash 460,000Due from Factor 25,000Loss on Sale of R. 15,000

Account (Note) R. 500,000

W/Recourse- seller guarantees to pay purchaser if debtor fails topay. To record seller uses financial components approach,

Cash received 460,000Due from Factor 25,000 485,000Less:Recourse liability 6,000Account (Note) R. 479,000

Net proceedscash/other assets received in sale less any liabilities incurred.Carrying (Book) ValueNet Proceeds = Loss on Sale of Receivables

Transfer of Receivables: Does it meet 3 conditions? 1.Transferred assets isolated from transferor 2.Transferee right to pledgeor sell asset 3. Transferor doesnt maintain control through repurchase agreement. If NO record as secured borrowing: a.Record liability b. Record interest expense. If YES: Is there continuing involvement? If YES: Record as Sale: A. Reducereceivables B. Recognize assets obtained & liabilities incurred. C. Record gain or loss. If NO: A. Reduce receivables B. Record gainor loss.

Accts. Receivable Turnover= Net Sales / Avg. Trade Receivables (net)Days to collect Accts. Receivable or Days Outstanding = Accts. Receivable Turnover / 365 Days

Items considered cash. To be reported as cash, an asset must be readily available for payment of current obligations & free from contractualrestrictions that limit its use in satisfying debts. Cash consists of coin, currency, & av ailable funds on deposit at bank. Negotiable instruments ie:money orders, certified checks, cashiers checks, personal checks, & bank drafts are also viewed as cash. Savings accounts usually classified as cash.

(1) ABC's checkbook balance on 12/31/10 was $21,200 & ABC held the following items in its safe on 12/31. (A) Check for $450 from XYZ received12/30/10, which was not included in the checkbook balance. (B) NSF check from JKL in amount of $900 that had been deposited at the bank, but wasreturned for lack of sufficient funds on 12/29. The check was to be redeposited on 1/3/11. Original deposit has been included in 12/31-checkbookbalance. (C) Coin & currency on hand amounted to $1,450. The proper amount to be reported on Finley's balance sheet for cash at 12/31/10 is

Answer: $21,200 + $450 $900 + $1,450 = $22,200. (2 ) In preparing its 5/31/10 bank reconciliation, ABC has the following info available: Balanceper bank statement, 5/31/10 $30,000; Deposit in transit, 5/31/10 $5,400; Outstanding checks, 5/31/10 $4,900, Note collected by bank in May$1,250 The correct balance of cash at 5/31/10 is Answer: $30,000 + $5,400 $4,900 = $30,500. (3)ABC factors $2,000,000 of its accountsreceivables w/out recourse for a finance charge of 5%. Finance company retains an amount equal to 10% of the accounts receivable for possibleadjustments. ABC estimates fair value of the recourse liability at $75,000. What would be recorded as a gain (loss) on transfer o f receivables?AnswerLoss of $100,000. ($2,000,000 .05 = $100,000) (4) ABC factored, w/recourse, $300,000 of accounts receivable w/XYZ. The finance charge is 3%, &5% was retained to cover sales discounts, returns, & allowances. ABC estimates the recourse obligation at $7,200. What amount should ABC report as

a loss on sale of receivables?Answer: ($300,000 .03) + $7,200 = $16,200. (5) Assuming that the ideal measure of short-term receivables in thebalance sheet is the discounted value of the cash to be received in the future, failure to follow this practice usually does not m ake the balance sheetmisleading becauseAnswer: the amount of the discount is not material.

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Chapter 9 Inventories: Additional Valuation Issues Chapter 10 Acquisition & Disposition of Property, Plant & EquipmentIdentify costs to include in initial valuation of property, plant, & equipment. Costs included in initial valuation of PP&E are as follows.Cost of land: Includes all expenditures made to acquire land & to ready it for use. Land costs include (1) purchase price; (2) closingcosts, ie: title to land, attorneys fees, & recording fees; (3) costs incurred in getting the land in condition for intended use, ie: grading,filling, draining, & clearing; (4) assumption of any liens, mortgages, or encumbrances on property; & (5) any additional landimprovements that have an indefinite life. Cost of buildings: Includes all expenditures related directly to their acquisition orconstruction. Costs include (1) materials, labor, & overhead costs incurred during construction, & (2) professional fees & buildingpermits. Cost of equipment: Includes purchase price, freight & handling charges incurred, insurance on equipment while in transit, costof special foundations if required, assembling & installation costs, & costs of conducting trial runs.

Describe accounting

treatment for the disposal ofPP&E. Regardless of time of

disposal, companies takedepreciation up to the date of

disposition, & then remove allaccounts related to retired asset.

Gains or losses on the

retirement of plant assets areshown in income statementalong w/other items that arise

from customary businessactivities. Gains or losses oninvoluntary conversions, ifunusual & infrequent, may be

reported as extraordinary items.

(a) Money borrowed to pay building contractor (signed a note) $(275,000) Notes Payable

(b) Payment for construction from note proceeds 275,000 Buildings

(c) Cost of land fill and clearing 10,000 Land

(d) Delinquent real estate taxes on property assumed by purchaser 7,000 Land

(e) Premium on 6-month insurance policy during construction 6,000 Buildings

(f) Refund of 1-month insurance premium because construction completed early (1,000) Buildings

(g) Architects fee on building 25,000 Buildings

(h) Cost of real estate purchased as a plant site (land $200,000 & building $50,000) 250,000 Land(i) Commission fee paid to real estate agency 9,000 Land

(j) Installation of fences around property 4,000 Land Improvement

(k) Cost of razing and removing building 11,000 Land

(l) Proceeds from salvage of demolished building (5,000) Land

(m) Interest paid during construction on money borrowed for construction 13,000 Buildings

(n) Cost of parking lots and driveways 19,000 Land Improvement

(o) Cost of trees and shrubbery planted (permanent in nature) 14,000 Land

(p) Excavation costs for new building 3,000 Buildings

Describe accounting problems associated w/interest capitalization. Only actual interest (w/modifications) should be capitalized. Rationale for this is thatduring construction, the asset is not generating revenue & there fore companies should defer (capitalize) interest cost. Once construction is completed, asset is

ready for its intended use & revenues can be earned. Any interest cost incurred in pur chasing an asset that is ready for its intended use should be expensed.

Sale of Plant Asset - Companies record depreciation for period oftime btwn. date of last depreciation entry & date of sale. IE: AssumeABC recorded depreciation on a machine costing $18,000 for 9 yearsat rate of $1,200 per year. If it sells the machine in the middle of the10th year for$7,000, ABC records depreciation to date of sale as:

Depreciation Expense ($1,200 * ) 600

Accumulated Depreciation-Machinery 600The entry for the sale of the asset then is:

Cash 7,000

Accumulated Depreciation-Machinery[($12,00 * 9) + 600] = 11,400

11,400

Machinery 18,000

Gain on Disposal of MachineryBook Value ($6,600) = ($18,000 - $11,400)

*(7,0006,600)

400*

Involuntary Conversion - Assets service terminated through ie:(fire, flood, theft, condemnation) Companies report differencebtwn amount recovered (ie: from a condemnation award orinsurance recovery), if any, & assets book value as gain/ loss.Some cases gains/losses may be reported as extraordinary itemsin income statement, if unusual & infrequent in nature.

IE: ABC had to sell plant in path of highway. For years statesought to purchase land on which the plant stood, but companyresisted. State exercised right of eminent domain, which courtsupheld. In settlement, ABC received $500,000, which exceeded$200,000 book value of plant & land (cost of $400,000 lessaccumulated depreciation of $200,000).

Cash 500,000

Accumulated Depreciation-PlantAssets 200,000

Plant Assets 400,000

Gain on Disposal of Plant Assets 300,000

(Disposition of Assets) On 4/1/12, ABC received condemnation award of $410,000 as compensation for forced sale of companys land& building, which stood in path of new highway. The land & building cost $60,000 & $280,000, respectively, when acquired. At 4/1/12,accumulated depreciation relating to the building a mounted to $160,000. On 8/1/12, ABC purchased a piece of replacement property forcash. The new land cost $90,000, & the new building cost $380,000. Prepare journal entries to record transactions on 4/1/12 & 8/1/12.

Book Value: (land) 60,000 + (bldg.) [$280,000 - $160,000] = $180,000Gain on Disposal = $410,000 - $180,000 = $230,000

Cash 410,000

Accumulated Depreciation - Buildings 160,000

Land 60,000

Buildings 280,000Gain on Disposal of Plant Assets 230,000

Land 90,000

Buildings 380,000Cash 470,000

(Nonmonetary Exchange) ABC purchased an electric wax melter on 4/30/13, by trading in its old gas model & paying balance in cash.

List price of new melter $15,800; Cash paid $10,000; Cost of old melter (5-year life, $700 residual value) $12,700; Accumulated depreciationold

melter (straight-line) $7,200; Secondhand fair value of old melter $5 ,200 Prepare journal entry(ies) necessary to record exchange, assuming exchange (a)has commercial substance, & (b) lacks commercial substance. Montgomerys year ends on 12/31, & depreciation has been recorded through 12/31/12.

Commercial substance:

Fair value of used melter $ 5,200

Cash Paid 10,000

Cost of Equipment

$15,200

Fair value of used melter 5,200

Cost of used melter $12,700

Less:Accumulated depreciation 8,000*

Book Value of used melter (4,700)

Accumulated Depreciation - Used Melter $ 500

Boot (cash received) >25% fair value of theexchange(Boot / Boot + Fairvalue of Other AssetsReceived) * Total Gain= Recognized Gain

$12,700 - $700 (residual value) = $12,000 / 5 = $2,400 (Straight-line)$2400 * (4/12 1/1 to 4/30) = $800; $7,200 + $800 = $8,000*

Depreciation Expense 800

Accumulated Depreciation Equipment 800

Lacks commercial substance same as has commercial

EquipmentMelter ($10,000 + $5,200) 15,200

Accumulated Depreciation - Used Melter 8,000

Melter (used) 12,700

Gain on disposal of Used Melter 500

Cash 10,000

1. Compute total gain/loss on transaction. This amount is equal to difference between fair value of as set given up & book value of asset given up.2. If a loss is computed in step 1, always reco gnize the entire loss. 3. If a gain is computed in step 1, (a) & exchange has commercial substance, recognize the

entire gain. (b) & exchange lacks commercial substance, (1) & no cash is involved, no gain is recognized. (2) & some cash is given, no gain is recognized.(3) & some cash is received, the fo llowing portion of the gain is recognized: (Boot / Boot + Fair value of Other Assets Received) x Total Gain**If the amount of cash exchanged is 25% or more, both parties recognize entire gain or loss.

Item

No.

Cost

per

Unit

Cost to

Replace

Estimated

Selling

Price

Cost of

Completion

& Disposal

Normal

Profit

NRV

Ceiling

NRV Less

NP

Floor

DMV

1320 $3.20 $3.00 $4.50 - $0.35 = $1.25 $4.15 $2.90 $3.00

1333 2.70 2.30 3.40 - 0.50 = 0.50 2.90 2.40 2.40

1426 4.50 3.70 5.00 - 0.40 = 1.00 4.60 3.60

3.70

1437 3.60 3.10 3.20 - 0.45 = 0.90 2.75 1.85 2.75

1510 2.25 2.00 3.25 - 0.80 = 0.60 2.45 1.85 2.00

1522 3.00 2.70 3.90 - 0.40 = 0.50 3.50 3.00 3.00

1573 1.80 1.60 2.50 - 0.75 = 0.50 1.75 1.25 1.60

1626 4.70 5.20 6.00 - 0.50 = 1.00 5.50 4.50 5.20

Ceiling Floor

Cost

per

Unit

Cost to

Replace

Designated

Market

Value

LCM by

Individual

Items Quantity

Total

Inventory

$4.15 $2.90 $3.20 $3.00 $3.00 $3.00 1,200 $3,600

2.90 2.40 2.70 2.30 2.40 2.40 900 2,160

4.60 3.60 4.50 3.70 3.70 3.70 800 2,960

2.75 1.85 3.60 3.10 2.75 2.75 1,000 2,750

2.45 1.85 2.25 2.00 2.00 2.00 700 1,400

3.50 3.00 3.00 2.70 3.00 3.00 500 1,500

1.75 1.25 1.80 1.60 1.60 1.60 3,000 4,800

5.50 4.50 4.70 5.20 5.20 4.70 1,000 4,700

23,870

Lower-of-cost-or-market rule is: Acompany values

inventory at LCM,w/market limited to an

amount that is notmore than NRV or lessthan net realizablevalue less a normal

profit margin.(Ceiling)NRV, prevents

overstatement of valueof obsolete, damaged,inventories. (Floor)

NRVLNP. Companies

shouldnt price inventory below floor, regardless of replacement cost. Deters understatement of inventory & overstatement of loss in current period. DMV isamount company compares to cost, always middle value of 3 amounts: replacement cost, NRV, & NRVLNP.

ABC uses gross profit method to estimate inventory for monthly reporting purposes. Info for the month of May:

Inventory, May 1 $ 160,000 Sales 1,000,000

Purchases (gross) 640,000 Sales returns 70,000

Freight-in 30,000 Purchase discounts 12,000

(a)Compute estimated inventory at 5/31, assuming gross profit is 25% of

sales.Beginning Inventory (at cost) $160,000

Purchases (at cost) 640,000

Freight-in 30,000

Purchase discounts (12,000)

Goods available (at cost) 818,000

Sales (at selling price) $1,000,000

Sales returns (70,000)

Net Sales (at selling price) 930,000

Less: Gross profit (25% of 930,000) 232,500

Sales (at cost) 697,500

Approximate inventory (at cost) $120,500

(b) Compute estimated inventory at 5/31, assuming gross profit is 25% of

cost. Gross profit on selling price: 25% / (100% + 25%) = 20%Beginning Inventory (at cost) $160,000

Purchases (at cost) 640,000

Freight-in 30,000

Purchase discounts (12,000)

Goods available (at cost) 818,000

Sales (at selling price) $1,000,000

Sales returns (70,000)

Net Sales (at selling price) 930,000

Less: Gross profit (20% of 930,000) 186,000

Sales (at cost) 744,000

Approximate inventory (at cost) $ 74,000

Inventory taken morning after large theft discloses $60,000 of goods on hand as of 3/12. The following data is available from the books:

Inventory on hand, March 1, $84,000; Purchases received, March 1 11, $75,000; Sales (goods delivered to customers) $120,000. Past recordsindicate sales are made at 50% above cost. Estimate inventory at close of business on 3/11 by gross profit method & determine amount of theft loss.

Beginning inventory $ 84,000

Purchases 75,000

Goods Available 159,000

Less: (120,000 / 1.5)

Cost + Gross profit = Selling PriceC + 0.50C = 120,00

1.50C = 120,000; C = 80,000 80,000

Inventory 79,000

Theft of goods (19,000)

Actual Inventory 60,000

Beginning inventory $ 84,000

Purchases 75,000

Goods Available 159,000

Sales 120,000

Less: Gross profit (33.33% of 120,000) 40,000Sales 80,000

Inventory 79,000

Actual Inventory 60,000

Theft of goods (19,000)

Gross Profit

on Selling

Price

0.50 / (1.00 +

0.50) = 0. 33 1/3%

Gross Profit on Selling Price Percentage Markup on Cost Gross Profit on Selling Price Percentage Markup on Cost

Given: 20% 0.20 / (1.00 - 0.20) = 25% 0.25 / (1.00 + 0.25) = 20% Given: 25%

Given: 25% 0.25 / (1.00 - 0.25) = 33.3% 0.50 / (1.00 + 0.50) = 33.3% Given: 50%

Inventory Turnover = Cost of Goods Sold / Average Inventory

Measures # of times on average a company sells inventory during period & measures the liquidity of the inventory.

Average days to sell inventory = Inventory Turnover / 365 days

Measure represents average # of days sales for which a company has inventory on hand.

Companies that keep inventory at lower levels w/higher turnovers than competitors, & still satisfy customers, are most successful.

(1) ABC had a gross profit of $360,000, total purchases of $420,000 & an ending inventory of $240,000 in its 1st year of operations.ABCs sales must be Answer: $540,000; [$540,000 + ($420,000 - $240,000) = $540,000] Gross Profit + COGS = Sales Revenue;COGS = Cost of goods available for sale during period Ending Inventory. (2) ABC sells product X for $40/unit, cost of 1 unit is$36, replacement cost is $34, the estimated cost to dispose a unit is $8 & normal profit is 40%. At what amount per unit should

product X be reported applying lower-of cost or market? Answer: $32 [NRV = $40 - $8 = $32; NRV-PM = $32 ($40 x 0.40) =$16, RC = $34, Cost = $36. (3) ABC estimates the cost of inventory at 3/31. Rate of markup on cost is 25%. Inventory 3/1 =$220,000, Purchases = $172,000, Purchase returns = $8,000, Sales during March = $300,000. The estimate of the cost of inventory3/31 is Answer: $144,000 [$300,000 / 1.25 = $240,000; ($220,000+ $172,000 - $8,000) - $240,000 = $144,000.

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Chapter 12 Intangible AssetsIntangible assets have 2 main characteristics.1. They lack physical existence. Tangible assets ie: PP&E have physical for m. Intangible assets derive their

value from the rights & privileges granted to company using them.2. They arent financial instruments. Assets ie: bank deposits, accounts receivable, & long-term investments in bonds & stocks also lack physical substance. Financial instruments derive their value fro m right (claim) to receive cash/cash equivalents

in the future & arent classified as intangibles. Intangible assets provide benefits over a period of years. Companies normally classify them as long-ter m assets.1. Marketing-related 2. Customer-related 3. Artistic-related 4. Contract-related 5. Technology-related 6. Goodwill.

Marketing-related-trademark or trade name is a word, phrase, or symbol that distinguishes or identifies a particular company or product. (Legal protection foran indefinite # of renewals for periods of 1 0 years each.) Company that uses o ne may consider it to have an indefinite life & doesnt amortize its cost. If

company buys one, it capitalizes cost at purchase price. If company develops one, it capitalizes costs related to securing it, ie: attorney fees, reg istration fees,design costs, consulting fees, & successful legal defense costs. It excludes R&D costs. When total cost of one is insignificant, a company expenses it.

Customer-related-result from interactions w/outside parties. IE: customer lists, order or production backlogs, & bot h contractual & noncontractual customerrelationships. IE: ABC acquires customer list for $6,000,000 on 1/1/12. ABC expects to benefit from info evenly over a 3-year per iod. In this case, customerlist is a limited-life intangible that ABC should a mortize on a straight-line basis.

What if ABC determines it can sell list for $60,000 to another company at end of 3 years? In that case, ABC should subtract this residual value from cost to

determine amortization expense for each year. Amortization expense would be $1,980,000, [(Cost) $6,000,000(Residual Value) $60,000 = (AmortizationBase) $5,940,000] Amortization expense per period: $1,980,000 ($5,940,000 / 3) Companies should assume a 0 residual value unless the assets useful life isless than the economic life & reliable evidence is available concerning the res idual value.

Jan 1,2012 Dec. 31, 2012, 2013, 2014

Customer List 6,000,000 Amortization Expense 2,000,000

Cash 6,000,000 Customer List (or Accumulated C. List Amortization) 2,000,000

(To record purchase of Customer List) (To record amortization Expense)

Artistic-related-copyright is a federally granted right that all authors, painters, musicians, sculptors, & other artists have in their creations & expressions. It isgranted for life of creator plus 70 years. It gives owner or heirs exclusive r ight to reproduce & sell an artistic or published work. Copyrights are not renewable.

Companies capitalize the costs of acquiring & defending a copyright. They amort ize any capitalized costs over useful life of the copyright if less than its legallife (life of the creator plus 70 years). Companies must expense the R&D that lead to a copyright as those costs are incurred.

Contract-related-represent value of rights that arise from contractual arrangements. IE: franchise & licensing agreements, construction permits, broadcastrights, & service or supply contracts. Franchise is a contractual arrangement under which franchisor grants fra nchisee right to sell certain product/services, touse certain trademarks or trade names, or to perform certain functions, usually w/in a designated geographical area. Another type of franchise arrangement, amunicipality (or other governmental body) allows a privately owned company to use public pro perty in performing its services. IE: Use of public waterways

for a ferry service, use of public land for telephone or electric lines, use of phone lines for cable TV, use of city streets for a bus line, or use of airwaves forradio or TV broadcasting. Such operating rights, obtained through agreements w/governmental units or agencies, are frequently referred to as licenses or

permits. Franchises & licenses may be for a definite period of time, for an indefinite period of time, or perpetual. Company securing franchise/license carriesan intangible asset account (entitled Franchise or License) on its books, o nly when it can identify costs w/the acquisition of the operating right. (IE: legal fees,

advance lump-sum payment) Company should amortize cost of a franchise (or license) w/a limited life as operating expense over life of franchise. It shouldntamortize a franchise w/an indefinite life nor a perpetual franchise; Company should instead carry such franchises at cost. Annual payments made under a

franchise agreement should be entered as operating expenses in the period in which they are incurred. These payments do not represent an asset since they donot relate to future rights to use the property.

Technology-related-patent gives holder exclusive right to use, manufacture, & se ll a product or process for a period of 20 years w/out interference or

infringement by others. If a company purchases a patent from inventor, purchase price represents its cost. Company can capitalize other costs incurred inconnection w/securing a patent, ie: attorneys fees & other unrecovered costs of succes sful legal suit to protect it, as part of patent cost. It must expense asincurred any R&D costs related to development of product, process, or idea that it subsequently patents. Companies should amortize cost of a patent over its

legal life or useful life (period in which benefits are rece ived), whichever is shorter. If they own a pa tent from the date it is granted, & expects patent to beuseful during its entire legal life, company should amortize it over 20 years. I f it appears that patent will be useful for shor ter period of time, ie: 5 years, it

should amortize its cost over 5 years. Companies capitalize costs of de fending copyrights. Accounting treatment for a patent defense is similar. A companycharges all unrecovered legal fees & ot her costs incurred in successfully defending a patent suit to Patents, an asset account. Such costs should be amortizedalong with acquisition cost over the remaining useful life of the patent. Companies often make small modifications or additions that lead to a new patent. Theeffect may be to extend life of patent. If new patent pro vides essentially same benefits, Company can apply unamortized costs of old patent to new patent. If

patent becomes impaired because demand drops for product, asset should be written down or written off immediately to expense.

Jan 1,2012 Dec. 31, 2012, 2013, 2014

Patents 180,000 Amortization Expense 9,000

Cash 180,000 Patents (or Accumulated Patent Amortization) 9,000

(To record Legal Fees Related to Patent) (To record amortization of Patent)

Goodwill-measured as excess of cost of purchase over fair value of identifiable net assets (assets less liabilities) purchased. IE: If ABC paid $2,000,000 topurchase XYZs identifiable net assets (w/a fair value of $1,500,000), Portofino records goo dwill of $500,000. Goodwill is measured as a residual. That iswhy goodwill is sometimes referred to as a plug, gap filler, or a master valuation account. Conceptually, goodwill represents future economic benefits arisingfrom other assets acquired in a business combination that arent individually identified & separately recognized. Often called most intangible of intangible

assets, because only identified w/business as a whole. Only way to sell goodwill is to sell business.Internally Created Goodwill. Goodwill generated

internally should not be capitalized in the accounts. Measuring components of goodwill is too complex, & associating any costs w/ future benefits is toodifficult. Purchased Goodwill. Goodwill is recorded only when an e ntire business is purchased. To record it, a company compares fair value of net tangible

& identifiable intangible assets w/purchase price of acquired business. Difference is goodwill. Goodwill is residualexcess of cost over fair value of theidentifiable net assets acquired. IE: ABC Fair Value: (Cash) $25,000 + (AR) $35,000 + (Inventory) $122,000+ (PP&E) $205,000+ (Patents) $18,000 (Liabilities) $55,000 = $350,000 (Fair Value of Net Assets) If purchase price is $400,000 Goodwill = $50,000 (Balance Sheet). Proc edure for valuation is

called master valuation approach. Goodwill write-off. Companies that recognize goodwill in a business combination consider it to have an indefinite life &should not amortize it. Although goodwill may decrease in value over time, predicting actual life of goodwill & an appropriate pattern of a mortization isdifficult. Companies adjust its carrying value only when goodwill is impaired. Bargain Purchase-Purchaser in a business co mbination pays less than fairvalue of identifiable net assets. Purchaser records this excess amount as a gain. (Company must disclose nature of gain.) Rules that apply to impairments of

PP&E also apply to limited-life intangibles.

Type of Intangible Asset Impairment Test

Limited life

LOI $40,000Patents $40,000

Recoverability Test, Then Fair Value Test (R. Test-If sum of expected future net cash flows (undiscounted) is less than car rying

amount of asset, company measures & recog nizes an impairment loss.)(Carrying AmountFair Value = I L) IE: CarryingAmount $60,000 Fair Value $20,000,= $40,000 Loss on Impairment.

Indefinite life other thangoodwill

Fair Value Test - If fair value is less than carrying amount, company recognizes impairment. IE: Carrying Amount $2,000,000Fair Value $1,500,000 = $500,000 Loss on Impairment. Company now reports it at $1,500,000 (Fair Value Amount) Even if

value increases in remaining years, they cant restore previously recognized impairment loss.

Goodwill Fair Value Test on reporting unit, then Fair Value Test on implied Goodwill (1st company compares fair value of repo rting unit to its carrying

amount, including goodwill. If fair value of reporting unit exceeds carrying amount, Goo dwill Not Impaired.)IE: Identifiable assets ($150,000)Goodwill ($90,000) Total Net Assets = $240,000. Fair Value = $190,000 < $24 0,000 Carrying Amount. There is impairment Fair Value

$190,000Net identifiable Assets excluding Goodwill $150,000 = $40,000 Implied value of Goodwill. $90,000 - $40,000 = $50,000 LOI

Chapter 11 Depreciation, Impairments & Depletion(Depreciation Computations) ABC purchased a new machine on 8/1/12. The cost of this machine was $150,000. The company estimated that themachine would have a salvage value of $24,000 at the end of its service life. Its life i s estimated at 5 years & working hours estimated at 21,000 hours.Year-end is December 31. Compute the depreciation expense under the following methods. Each of the following should be considered unrelated.

Depreciation Base

Original Cost $150,000

Less: Salvage value 24,000

Depreciation base $126,000

(a) Straight-line depreciation for 2012. $10,500

$25,000 x (5/12) = $10,500

(c) Sum-of-the-years-digits for 2013. $38,500

SOTYD method results in a decreasing depreciation charge based on a decreasing fraction of depreciable cost(original cost less salvage value). Each fraction uses sum of years as a denominator (5 + 4 + 3 + 2 + 1 = 15). Numerator is # of years of estimated liferemaining as of beginning of the year. N(N+1) / 2

YearDepreciation

BaseRemaining

Life in YearsDepreciation

FractionDepreciation

Expense2012 2013 Book Value,

End of Year

1 $126,000 5 5 / 15 $42,000 $42,000 x (5/12) = $17,500 $42,000 x (7/12) = $24,500 $108,000

2 $126,000 4 4 / 15 33,600 $33,600 x (5/12) = $14,000 74,400

$38,500

YearDepreciation

BaseRemaining

Life in YearsDepreciation

FractionDepreciation

Expense Book Value, End of Year

1 $126,000 5 5 / 15 $42,000 $108,000

2 $126,000 4 4 / 15 33,600 74,400

3 $126,000 3 3 / 15 25,200 49,200

4 $126,000 2 2 / 15 16,800 32,400

5 $126,000 1 1 / 15 8,400 24,000*

15** 15 / 15 $126,000 Salvage value*

(b) Activity method for 2012, assuming that machine

usage was 800 hours. :( )

(d) Double-declining-balance for 2013. $50,000

Year

Book Value ofAsset 1stof

Year

Rate onDecliningBalance*

DepreciationExpense

BalanceAccumulatedDepreciation 2012 2013 Year

Book Valueof Asset 1stof Year

Rate onDecliningBalance*

DepreciationExpense

BalanceAccumulatedDepreciation

Book Value,End of Year

1 150,000 40% 60,000 60,000$60,000 x(5/12) =$25,000

$60,000 x(7/12) =$35,000

1 150,000 40% 60,000 60,000 $90,000

2 90,000 40% 36,00 0 96,000$36,000 x(5/12) =$15,000

2 90,000 40% 36,000 96,000 54,000

$50,000 3 54,000 40% 21,600 117,600 32,400

4 32,400 40% 12,960 130,560 19,4405 19,440 40% 7,776 138,336 11,664

*Based on twice the straight-line rate of 20% ($25,200 / $126,000 = 20% x 2 = 40% (Straight-line Depreciation / Cost less Salvage) x 2 = Rate on Decl

ccounting for Impairment: Recoverability Test (If sum of expected future net cash flows, undiscounted, is less than carrying amount ofasset No Impairment) If IMPAIRMENT ASSETS HELD FOR USE: 1. Impairment loss: excess of carrying amount over fair value. 2.Depreciate on new cost basis. 3. Restoration of impairment loss not permitted.ASSETS HELD FOR DISPOSAL: 1. Impairment loss:excess of carrying amount over fair value less cost of disposal. 2. No depreciation taken. 3. Restoration of impairment loss permitted.IE: Expected future net cash flows from ABC equipment are $580,000 & carrying amount is $600,000 ($800,000 cost - $200,000 accumulated depreciation).

Carrying amount of the equipment $600,000

Fair value of equipment (525,000)

Loss on impairment $ 75,000

Loss on impairment 75,000

Accumulated Depreciation - Equipment 75,000

Recoverability Test: $580,000 (Expected future net cash flows) $600,000

(Carrying amount) Yes ImpairmentDifference between carrying amount of ABC asset & its fair value is impairmentloss. Assuming it has a fair value of $525,000. ABC reco rds impairment loss as:

ABCreports impairment loss as part of income fromcontinuing operations, inOther expenses & lossessection.

IE: Cost $9,000,000; Accumulated depreciation to date $1,000,000; Expected future net cash flows $7,000,000; Fair Value $4,400,000; Cost of disposal$20,000. Assume ABC will continue to use this. As of 12/31/12, equipment has a remaining useful life of 4 years.(a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2012.$9,000,000$1,000,000 = (Carrying Amount) $8,000,000(Fair Value) $4,400,000 + (Cost of Disposal) $20,000 = (Loss on impairment) $3,620,000

Loss on impairment (a) 3,620,000

Accumulated Depreciation-Equipment 3,620,000

(b) Prepare the journal entry to record depreciation expense for 2013.

No depreciation taken (c) Fair value of equipment at 12/31/13, is $5,100,000.Prepare the journal entry (if any) necessary to record this increase in fair value

Accumulated Depreciation-Equipment (c) 3,620,000

Recovery of Loss on Impairment 3,620,000

(Fair Value) $5,100,000(Cost of Disposal) $20,000 = $5,080,000

$5,080,000(Carrying Amount*) $4,380,000 = (Recovery of impairment loss)$700,000 [*$9,000,000 - $1,000,000 - $3,620,000 = $4,380,000]

To account for depletion of natural resources, co mpanies (1) establish depletion base & (2) write off reso urce cost. 4 factors part of esta blishing depletion base:(a) acquisition costs, (b) exploration costs, (c) development costs, & ( d) restoration costs. To write off resource co st, companies normally compute depletion on

the units- of-production method. Thus, depletion is a function of # of units w/drawn dur ing period. To obtain a cost per unit of product, the total cost of naturalresource less salvage value is divided by # o f units estimated to be in the resource deposit, to obtain a cost per unit of pro duct. To compute depletion, this cost

per unit is multiplied by the # of units w/drawn.

ABC owns 9,000 acres of timberland purchased in 2001, cost o f $1,400/acre. At time of purchase, land w/out timber was valued at $400/acre. 2002, ABC builtroads, w/a life of 30 years, cost of $87,000. Every year, ABC sprays to prevent disease, co st of $3,000/year & spends $7,000 to maintain roads. During 2003,Hernandez selectively logged & sold 700,000 board feet of timber, of the estimated 3,000,000 board ft. In 2004, ABC planted new seedlings to replace the t reescut at a cost of $100,000. (a) Determine the depreciation expense & cost of timber sold related to depletion for 2003. Depreciation Expense: $87,000 / 30 yrs.

= $2,900/year Cost of Timber Sold: $1,400 - $400 = $1,00 0; $1,000 * 9,000 = $9,000,000 value ($9,000,000 / 3,000,000 ft.) * 700,000 ft. = $2,100,000 (b) ABC

has not logged since 2003. If ABC logged & sold 900,000 board ft of timber in 2014, when timber (appraiser) estimated 5,000,000 board ft, determine cost oftimber sold related to depletion for 2014. Cost of Timber Sold: $9,000,000 - $2,100,000 = $6,900,000; $6,900,000 + $100,000 = $7,000,000; ($7,000,000 /5,000,000 ft.) * 900,000 ft. = $1,260,000

In March, 2010, Maley Mines Co. purchased a coal mine for $6,000,000. Removable coal is estimated at 1,500,000 tons. Maley is required to restore the land atan estimated cost of $720,000, and the land should have a value o f $630,000. The company incurred $1,500,000 of development c osts preparing the mine for

production. During 2010, 450,000 tons were removed and 300,000 tons were sold. The total amount of depletion that Maley should record for 2010

is

()

Asset Turnover = Net Sales / Average Total Assets; Profit Margin on Sales = Net Income / Net SalesRate of Return on Assets = Profit Margin on Sales x Asset Turnover OR Rate of Return on Assets = Net Income / Average Total Assets

7/30/2019 Final Review Notes Acct 101

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Chapter 13 Current Liabilities & ContingenciesEmployee-Related Liabilities-1. Payroll deductions. 2. Compensated absences. 3. Bonuses.

Payroll Deductions-Common types: taxes, insurance premiums, employee savings, & union dues. To extent that a company has not remitted amountsdeducted to proper authority at end of accounting period, it should recognize them as current liabilities. Social Security Taxes . Federal Old Age, Survivor, &Disability Insurance (OASDI). Come from taxes levied on employer & employee. Employers collect employees share by deducting it from employees grossay, & remit it to govt. along w/their share. Govt. taxes employer & employee at same rate, currently 6.2 %based on employees gross pay up to $106,800

annual limit. OASDI tax usually referred to as FICA (Federal Insurance Contribution Act). Combination of OASDI tax (FICA) & Federal Hospital InsuranceTax = Social Security tax. Combined rate for these taxes, 7.65% on employees wages to $106,800 & 1.45% in excess of $106,800, changes by Congress.Companies should report amount of unremitted employee & employer Social Secu rity tax on gross wages paid as a current liability. Unemployment Taxes

ll employers who meet following criteria are subject to Federal Unemployment Tax Act (FUTA): (1) those who paid wages of $1,500 or more during anycalendar quarter in year or pre ceding year, or (2) those who employed at least 1 individual on at least 1 day in each of 20 weeks du ring current or precedingcalendar year. Only employers pay unemployment tax. Rate is 6.2% on 1st $7,000 of compensation paid to each employee during calendar year.Employer

receives a tax credit not to exceed 5.4% for contributions paid to a state plan for unemployment compensation. Thus, if employer is subject to a statenemployment tax of 5.4% or more, it pays only 0.8% tax to federal govt. IE: ABC taxable payroll of $100,000, subject to Federal rate of 6.2% & state rate of

5.7%, however its stable employment experience reduces company state rate to 1%. State unemployment tax payment (1% * $100,000)=$1,000; FederalUnemployment tax [(6.2%-5.4%) * $100,000]=$800; $1,000-$800=$1,800 (Total federal & state unemployment tax). Companies pay federal & state

nemployment tax quarterly, and file a tax form annually. Because both taxes accrue on earned compensation, companies should record amount ofaccrued but unpaid employer contributions as an operating expen se & as current liability when preparing financial statements at year-end. Income Tax

Withholding. Federal & some state income tax laws require employers to w/ hold from employees pay applicable income tax due on those wages .Employeesay: Income tax w/holding, FICA taxes-employee share, & union dues. Employers Pay: FICA taxes-employer share, Federal & state unemployment.

ayroll IE: Assume weekly payroll of $10,000 entirely subject to FICA & Medicare (7.65%), federa l (0.8%) & state (4%) unemployment taxes, w/income taxw/holding of $1,320 & union dues of $88 deducted. The company reco rds the salaries & wages paid & employee pa yroll deductions as follows.

Employer must remit to govt. its share of FICA tax along w/amount ofFICA tax deducted from each employees gross compensation. It

should record all unremitted employer FICA taxes as payroll taxexpense & payroll tax payable.

Salaries and Wages Expense 10,000 Record Employer Payroll Taxes:

Withholding Taxes Payable 1,320 Payroll Tax Expense 1,245

FICA Taxes Payable 765 FICA Taxes Payable 765

Union Dues Payable 88 FUTA Taxes Payable 80

Cash 7,827 SUTA Taxes Payable 400

Gain contingencies-Claims/rights to receive assets (or have a liability reduced) whose existence is uncertain but which may become valid eventually. IE: 1.Possible receipts of monies (gifts, donations, asset sales, etc.) 2. Poss ible refunds from govt. in tax disputes. 3. Pending court cases w/a pro bable favorable

outcome. 4. Tax loss carryforwards. Except for tax loss carryforwards, don t record gain contingencies. Company discloses gain contingencies in notes onlywhen a high probability exists for realizing them.

Loss contingencies involve possible losses. Contingent liability-A liability incurred as a result of a loss contingency. They depend o n occurrence of 1 or more

future events to confirm either the amount payable, payee, date payable, o r its existence; these factors depend on a contingency. Likelihood of Loss-When a losscontingency exists, likelihood that the future event(s) will confirm the incurrence of a liability can range fro m probable to remote.Probable. Future event(s) arelikely to occur.Reasonably possible. Chance of the future event(s) o ccurring is more than remote but less than likely.Remote. Chance of the future event(s)occurring is slight. Companies should accrue an estimated loss from a loss contingency by a charge to expense & a liability recorded only if both ofollowing conditions are met. 1. Info available prior to issuance of financial statements indicates that it is probable that a liability has been incurred at the d ate

of financial statements. 2. The amount of the loss can be reaso nably estimated. To record a liability, a company doesnt need to know exact payee nor exact

date payable. They must know whether it is probable that it incurred a liability. To meet 2ndcriterion, a company needs to be ab le to reasonably determinean amount for liability. To determine a reasonable estimate of liability, a company may use its own experience, experience of other companies in the industry,engineering or research studies, legal advice, or educated guesses by qualified personnel. USUSALLY ACCRUED-Loss Related to: 1. Collectibility of

receivables 2. Obligations related to product warranties & defects 3. Premiums offered to customers.NOT ACCRUED-Loss Related to: 4. Risk of loss ordamage of enterprise property by fire, e xplosion, or other hazards 5. General or unspecified bus iness risks 6. Risk of loss from catastro phes assumed by property

& casualty insurance companies, including reinsurance companies MAY BE ACCRUED

* Loss Related to: 7. Threat of expropr iation of assets 8. Pending orthreatened litigation 9. Actual or possible claims and assessments** 10. Guarantees of indebtedness o f others 11. Obligations of commercial banks understandby letters of credit 12. Agreements to repurchase receivables (or the related property) that have been sold. *Should be accrued when both criteriarobable & reasonably estimableare met. **Estimated amounts of losses incurred prior to balance sheet date but settled subsequently should be accrued

as of balance sheet date.More common loss contingencies: 1. Litigation, claims, & assessments. 2. Guarantee & warranty costs. 3. Premiums & coupons. 4.Environmental liabilities. Companies dont record or report in notes to financial statements general risk contingencies inherent in business operations (ie:

possibility of war, strike, uninsurable catastrophes, or business recession). Litigation, Claims, & Assesments-Companies must consider following factors, indetermining whether to record a liability w/respect to pending or threatened litigation & actual or possible claims & assessments. 1. Time period in which

underlying cause of action occurred. 2. Pro bability of an unfavorable outcome. 3. Ability to make a reasonable estimate of amount of loss. To report a loss & aliability in financial statements, cause for litigation must have occurred on or before date of financial statements. It doesnt matter that the company became

aware of existence or possibility of lawsuit or claims after the date of financial statements but before issuing them. To evaluate probability of an unfavorableoutcome, a company considers following: nature of litigation; progress of the case; the o pinion of legal counsel; its own & others experience in similar cases;& any management response to the lawsuit. W/respect to unfiled suits & unasserted claims & assessments, a company m ust determine (1) degree of

probability that a suit may be filed or a claim or assessment may be asserted, & (2) probability of an unfavorable outcome. IE: Federal Trade Commission

investigates ABC for restraint of trade, & institutes enforcement proceedings. Private claims of triple damages for redress often follow such proceedings. ABC

must determine probability of claims being asserted & probability of triple damages being awarded. If both are probable, if loss is reasonably estimable, & if thecause for action is dated on or befor e date of financial statements, then ABC should accrue the liability. Guarantee & Warranty Costs-Warranty (productguarantee) is a promise made by seller to buyer to make good on a deficiency of quantity, quality, or performance in a pr oduct. Warranties & guarantees entail

future costs (after costs, post-sale costs). Companies should recognize this liability in accounts if they can reasonably estimate it & estimated amount of liabilityincludes all costs that company will incur after sale & delivery & that are incident to correct ion of defects or deficiencies required under warr anty provisions.Cash Basis-Companies expense warranty costs as incurred. (Seller or manufacturer charges warranty cost s to period in which it complies w/warranty. Thecompany doesnt record a liability for future costs arising from warranties, nor does it charge the period of sa le. Company uses cash-basis method when it

doesnt accrue a warranty liability in year of sale either because: 1. It isnt probable that liability has been incurred, or 2. It cant r easonably estimate theamount of liability. Accrual Basis-If its probable that customers will make warranty claims & a company can reasonably estimate costs involved, companymust use accrual method. Companies charge warranty costs to o perating expense in year of sale & sho uld use it whenever warranty is an integral & inseparable

part of sale & is viewed as a loss contingency. This approach isexpense warranty approach. IE: ABC begins production on new machine in 7/12 & sells 100units at $5,000 by, 12/31/12. Machine under warranty for 1 year. ABC estimates, based on past experience, that warranty cost will average $200/unit. Further,as a result of parts replacements & services rendered in compliance w/warranties, it incurs $4,000 in warranty costs in 2012 & $16,000 in 2013.

Recognition of warranty costincurred in 2013 (2012 sales):

Warranty liability 16,000Cash, Inventory, Accrued Pay

roll 16,000

If ABC applies cash-basis method, it reports $4,000 as warranty expense in 2012 & $16,000 as warranty expense in 2013. It records all of sale price as r evenue

in 2012. In many instances, application of the cash-basis method fails to r ecord warranty costs relating to products sold dur ing a given period w/revenuesderived from such products. It violates expense recognition principle. PREMIUMS- ABC offers its customers a bowl if they send in 4 boxtops from ABC boxes& $1.00. Company estimates that 60% of boxtops will be redeemed. In 2010, company sold 500,000 boxes & customers redeemed 220,000 boxtops rece iving

55,000 bowls. If the bowls cost ABC $2.50 each, how much liability for outstanding premiums should be r ecorded at the end of 2010? {[ (500,000 0.60)220,000] 4} $1.50 = $30,000. Pur chase of Bowl: Inventory of Premiums (Debit) 137,500 Cash (Credit) 137,500 Sales: Cash (Debit) Sales Revenue (Credit)

Redemption of boxtops: Cash (Debit) 500,000 / 4 = 125,000 * $1.00 = $125,000

July 2012December 2012 Recognition of warranty Expense July 2012December 2012

Cash or Accounts Receivable 500,000 Warranty Expense 4,000

Sales Revenue (100 * $5,000) 500,000 Cash, Inventory, Accrued Payroll (Warranty Costs) 4,000

Warranty Expense 16,000*

*(100 * $200 = $20,000$4,000 = $16,000) Warranty Liability (To accrue estimated warranty costs) 16,000

Chapter 14 Long-term Liabilitiesong-term debt-Probable future sacrifices of economic benefits ar ising from present obligations that are not payable w/in a year o r operating cycle of company,

whichever is longer. IE: Bonds, long-term notes & mortgages payable, pension & lease liabilities. Bond arises from a contract known as bond indenture. Bondrepresents promise to pay: (1) sum of money at a designated maturity date, plus (2) periodic interest at specified rate on maturity amount (face value). Main

purpose of bonds is to borrow for long term when amount of capital needed is too large for one lender to supply. Investment community (buyers) values a bond

at present value of its expected future cash flows, which co nsist of (1) interest & (2) pr incipal. Rate used to compute PV of these cash flows is the interest ratethat provides an acceptable return on an investment commensurate w/ issuers risk characteristics.Interest rate written in terms of the bond indenture) known

as stated, coupon, or nominal rate. Issuer of bonds sets this rate.Stated rate is expressed as a percentage of face value of bonds (aka par value, principalamount, or maturity value). If rate employed by investment community (buyers) differs fro m stated rate, PV of bonds computed by buyers ( & current purchase

price) will differ from face value of bonds. Difference between face value & PV of bonds determines actual price that buyers pay for bonds. Difference is eithera discount or premium.Discount-If bonds sell for less than face value. Premium-If bonds sell for more than face value. Rate of interest actually earned by

bondholders is called effective yield or market rate. If bonds sell at discount, effective yield exceeds stated rate. Conversely, if bonds sell at a premium,effective yield is lower than stated rate. There is an inverse relationship between market interest rate & pr ice of bond.IE: ABC issues $100,000 in bonds, due

in 5 years w/9% interest payable annually at year-end. At time of issue, the market rate for such b onds is 11%. PV of Principal: $100,000 x 0.59345 (Tbl. 2)= $59,345; PV of Interest Payments: $9,000 x 3.69590 (Tbl. 4) = $33,263.10; PV (Selling Price) of Bonds: $59,345 + $33,263.10 = $92,608.10. By paying

$92,608.10 at date of issue, investors realize an effect ive rate or yield of 11% over the 5-year t erm of bonds. These bonds sell at a d iscount of $7,391.90($100,000 - $92,608.10). Price at which bonds sell is typically stated as a per centage of face or par value of bonds. IE: ServiceMaster bonds sold for 92.6

(92.6% of par). If they had rece ived $102,000, then bonds sold for 102 (102% of par ). When bonds sell at less than face v alue, it means that investors demand

a rate of interest higher than stated rate.Investors receive interest at stated rate computed on face value, but they actually earn at an effective rate thatexceeds stated rate because they paid less than face value for bonds. Bonds Issued at Par on Interest Date-When a company issues bonds on an interest

payment date at par (face value), it accrues no interest. No premium or discount exists. The company simply records the cash proceeds & face value of bonds.

IE: If ABC issues at par 10-year term bonds w/a par value of $800,000, dated 1/1/2012, & bearing interest at an annual rate of 10% payable semiannually on 1/1& 7/1, it records the following entry. Cash (Debit) 800,000 Bonds Payable (Cred it) 800,000. ABC records the 1 st semiannual interest payment of $40,000($800,000 x 0.10 x (1/2)) on 7/1/12: Interest Expense (Debit) 40,000 Cash (Credit) 40,000. It records accrued interest expense at 12/31/12 (year-end): Interestexpense (Debit) 40,000 Interest Payable (Credit) 40,000. Bonds Issued at Discount or Premium on Interest Date-Discount: If ABC issues the $800,000 of

bonds on 1/1/12 at 97 (meaning 97% of par), it records the issuance: Cash ($800,000 x 0.97) (Debit) 776,000 Discount on Bonds Payable (Debit) 24,000 BondsPayable (Credit) 800,000. Because of its relation to interest, companies amortize discount & charge it to interest expense over period of time that bonds are

outstanding. Straight-line method amortizes a constant amount each interest period (in this case 20 interest periods). IE: Using bond discount of$24,000, ABC amortizes $1,200 to interest expense each period for 20 periods ($24,000 / 20). ABC records 1stsemiannual interest payment of $40,000($800,000 x 10% x12) & bond discount on 7/1/12 as follows: Interest expense (Debit) 41,200 Discount on Bonds Payable (Credit) 1,200 Cash (Credit) 40,000.At 12/31/12 ABC makes adjusting entry: Interest expense (Debit) 41,200 Discount on Bonds Payable ( Credit) 1,200 Interest Payable (Credit) 40,000. At end of

1st year, 2012, balance in Discount on Bonds Payable account is $21,600 ($24,000 - $1,200 - $1,200). Over the term of the bonds, balance in Discount on BondsPayable will decrease by same amount until it has 0 balance at maturity date of bonds. If bonds issued on 10/1/12 & fiscal year end s 12/31/12, then discount

amortized during 2012 is $600 ($24,000 x (3/12) x (1/10)) Premium: If ABC dates & sells 10-year bonds w/par value of $800,000 on 1/1/12, at 103, it records:Cash (Debit) ($800,000 x 1.03) 824,000 Premium on Bonds Payable (Cred it) 24,000 Bonds Payable (Credit) 800,000. W/ bond pr emium of $24,000, ABC

amortizes $1,200 to interest expense each period for 20 periods ($24,000 / 20). ABC records 1 st semiannual interest payment of $40,000 ($800,000 x 10% x 12)& bond premium on 7/1/12, as: Interest Expense (Debit) 38,800 Premium on Bonds Payable ( Debit) 1,200 Cash (Credit) 40,000. At 12/31/12 ABC makes

adjusting entry: Interest Expense (Debit) 38,800 Premium on Bonds Payable (Debit) 1,200 Interest Payable (Credit) 40,000. Amortization of a discount

increases interest expense. Amortization of a premium decreases interest expense. Issuer may call some bonds at a stated pr ice after a certain date,giving theissuing corporation opportunity to reduce its bonded indebtedness or take advantage of lower interest rates. Whether callable or not, a company must amortizeany premium or discount over bonds life to maturity because early redemption (call of bond) is not a certainty.

Debt to total assets = Total Debt / Total Assets; Measures percentage of total assets provided by creditors. Times interest earned = Income before

income taxes & interest expense / Interest Expense; Companys ability to meet interest payments as they come due.

If bonds are issued between interest dates, the entry o n the books of the issuing corporation could include a credit to Interest Expense. Replacement of existingbond issue w/new one is called refunding. (True) On 1/1/10, ABC sold property to XYZ. There was no established exchange pr ice for property, & ABC gave

XYZ a $2,000,000 0-interest-bearing note payable in 5 equal annual installments of $400,000, w/1 st payment due 12/31/10. The prevailing rate of interest for anote of this type is 9%. Present value of note at 9% was $1,442,000 at 1/1/10. What should be balance of Discount on Notes Payable account on books of ABCat 1/31/10 after adjusting entries are made, assuming effective-interest method is used? Answer: $2,000,000$1,442,000($1,442,000 .09) = $428,220. ABC issues $20,000,000, 7.8%, 20-year bonds to yield 8% on 1/1/210. Interest is paid on 6 /30 & 12/31. Proceeds from the bonds are $ 19,604,145. What is

interest expense for 2011, using straight-line amortization?Answer Feedback:($20,000,000 .078) + ($395,855 20) = $1,579,793. On 1/1/10, ABC issued 8-year bonds w/face value of $1,000,000 & stated interest rate of 6%, payable semiannually on 6/30 & 12/31. The bonds were so ld to yield 8%.Answer: PV of 1

or 16 periods at 4% 0.534, ($1,000,000 x 0.534 = $534,000) ABC borrowed money from a bank to build a building. The long-ter m note signed by ABC issecured by a mortgage that pledges title to the building as security for loan. ABC is to pay the bank $80,000 each year for 10 years to repay loan. Which of the

following relationships can you expect to apply to the situation?Amount of interest expense will decrease each period the loan is outstanding, while the

ortion of the annual payment applied to the loan principal will increase each period. In the recent year ABC had net income of $140,000, interest expense of

$40,000, and tax expense of $20,000. What was ABCs times interest earned ratio for the year? Answer: ($140,000 + $40,000 + $20,000) $40,000 = 5.0. On1/2/10, a calendar-year corporation sold 8% bonds w/face value of $600,000. These bonds mature in 5 years, & interest is paid semiannually on 6/30 & 12/31.

The bonds were sold for $553,600 to yield 10%. Using the effect ive-interest method of computing interest, how much should be charged to interest expense in

2010?Answer: $55,544; 1. $600,000 x .04 = $24,000, 2. $553,600 .05 = $27,680, 3. [$553,600 + ($27,680$24,000)] .05 = 27,864, 4. $27,680 + $27,864= $55,544

14-5 (Entries for Bond TransactionsEffective-Interest) Assume same info as in E14-4, except that ABC uses effective-interest method of amortizationor bond premium or discount. Assume an effective yield of 9.7705%. E14-4 ABC issued $800,000 of 10%, 20-year bonds on 1/1/13, at 102. Interest isayable semiannually on July 1 & January 1. ABC uses the straight-line method of amortization for bond premium o r discount. Prepare the journal entries

to record the following. (Round to the nearest dollar.)(a) The issuance of the bonds. (b) The payment of interest and related amortization on July 1, 2013.

(c) The accrual of interest and the related amortization on December 31, 2013.

Cash ($800,000 * 102%) $816,000 nterest Expense ($816,000 * 9.7705% * (1/2)) = $39,863.64 39,864

Bonds Payable 800,000 remium on Bonds Payable 136

Premium on Bonds Payable 16,000 Cash ($800,000 x 10% x (6/12)) = $40,000 40,000

nterest Expense ($816,000($40,000 - $39,864)) = $815,000 ($815,864 * 9.7705% * (1/2)) = $39,856.99 39,857

Premium on Bonds Payable 143

Interest Payable 40,000

Explain the accounting for long-term notes payable . Accounting procedures for notes and bonds are similar. Like a bond, a note is valued at thepresent value of its expected future interest and principal cash flows, with any discount or premium being similarly amortized over the life of the note.Whenever the face amount of the note do es not reasonably represent the present value o f the consideration in the exchange, a company must evaluate the ent irearrangement in order to properly record the exchange and the subsequent interest.