Financial and Managerial Accounting For

Chapter 1
Introducing Financial Accounting
Learning Objectives – coverage by question

Cases
Mini-
Exercises Problems and
Exercises
Projects
LO1 – Identify the users of

accounting information and
25 28, 34 49, 50
discuss the costs and benefits
of disclosure.
LO2 – Describe a company’s

27, 29, 32,
business activities and explain
19, 20, 21 36, 37, 38 47
how these activities are
33
represented by the accounting
equation.
LO3 – Introduce the four key

financial statements including 37, 38, 39,
the balance sheet, income 22, 23, 24 29, 30, 31 40, 41, 42, 46, 47, 49
statement, statement of
stockholders’ equity and 43, 44, 45
statement of cash flows.
LO4 – Describe the institutions

that regulate financial
26 34 50
accounting and their role in
establishing generally accepted
accounting principles.
46, 47, 48,

36, 43, 44,
LO5 – Compute two key ratios 32, 33
that are commonly used to 45 49
assess profitability and risk –
©Cambridge Business Publishers, 2017

Solutions Manual, Chapter 1 1-1
return on equity and the debt-
to-equity ratio.
LO6 – Appendix 1A – Explain

35
the conceptual framework for
financial reporting.

QUESTIONS
Q1-1. Organizations undertake planning activities that subsequently shape

three major activities: financing, investing, and operating. Financing is
the means used to pay for resources. Investing refers to the buying and
selling of resources necessary to carry out the organization’s plans.
Operating activities are the actual carrying out of these plans. (Planning
is the glue that connects these activities, including the organization’s
ideas, goals and strategies.)
Q1-2. An organization’s financing activities (liabilities and equity = sources of
funds) pay for investing activities (assets = uses of funds). An
organization cannot have more or less assets than its liabilities and
equity combined and, similarly, it cannot have more or less liabilities and
equity than its total assets. This means: assets = liabilities + equity. This
relation is called the accounting equation (sometimes called the balance
sheet equation, or BSE), and it applies to all organizations at all times.
Q1-3. The four main financial statements are: income statement, balance
sheet, statement of stockholders’ equity, and statement of cash flows.
The income statement provides information relating to the company’s
revenues, expenses and profitability over a period of time. The balance
sheet lists the company’s assets (what it owns), liabilities (what it owes),
and stockholders’ equity (the residual claims of its owners) as of a point
in time. The statement of stockholders’ equity reports on the changes to
each stockholders’ equity account during the year. Some changes to
stockholders’ equity, such as those resulting from the payment of
dividends and unrealized gains (losses) on marketable securities, can
only be found in this statement as they are not included in the
computation of net income. The statement of cash flows identifies the
sources (inflows) and uses (outflows) of cash, that is, from what sources
the company has derived its cash and how that cash has been used. All
four statements are necessary in order to provide a complete picture of
the financial condition of the company.
Q1-4. The balance sheet provides information that helps users understand a
company’s resources (assets) and claims to those resources (liabilities
and stockholders’ equity) as of a given point in time.
An income statement reports whether the business has earned a net
income (also called profit or earnings) or a net loss. Importantly, the
income statement lists the types and amounts of revenues and
expenses making up net income or net loss. The income statement
covers a period of time.
Q1-5. Your authors would agree with Mr. Buffett. A recent study of top financial
officers suggests they find earnings and the year-to-year changes in

earnings as the most important items to report. We would add cash flows
particularly from operations, and the year-to-year changes.

Q1-6. The statement of cash flows reports on the cash inflows and outflows
relating to a company’s operating, investing, and financing activities over
a period of time. The sum of these three activities yields the net change
in cash for the period. This statement is a useful complement to the
income statement which reports on revenues and expenses, but
conveys relatively little information about cash flows.
Q1-7. Articulation refers to the updating of the balance sheet by information
contained in the income statement or the statement of cash flows. For
example, retained earnings is increased each period by any profit
earned during the period (as reported in the income statement) and
decreased each period by the payment of dividends (as reported in the
statement of cash flows and the statement of stockholders’ equity). It is
by the process of articulation that the financial statements are linked.
Q1-8. Return refers to income, and risk is the uncertainty about the return we
expect to earn. The lower the risk, the lower the expected return. For
example, savings accounts pay a low return because of the low risk of a
bank not returning the principal with interest. Higher returns are to be
expected for common stocks as there is a greater uncertainty about the
realized return compared with the expected return. Higher expected
return offsets this higher risk.
Q1-9. Companies often report more information than is required by GAAP
because the benefits of doing so outweigh the costs. These benefits
often include lower interest rates and better terms from lenders, higher
stock prices and greater access to equity investors, improved
relationships with suppliers and customers, and increased ability to
attract the best employees. All of these benefits arise because the
increased disclosure reduces uncertainty about the company’s future
prospects.
Q1-10. External users and their uses of accounting information include: (a)
lenders for measuring the risk and return of loans; (b) shareholders for
assessing the return and risk in acquiring shares; and (c) analysts for
assessing investment potential. Other users are auditors, consultants,
officers, directors for overseeing management, employees for judging
employment opportunities, regulators, unions, suppliers, and appraisers.
Q1-11. Managers deal with a variety of information about their employers and
customers that is not generally available to the public. Ethical issues
arise concerning the possibility that managers might personally benefit
by using confidential information. There is also the possibility that their
employers and/or customers might be harmed if certain information is
not kept confidential.

Q1-12. Return on equity (ROE) is computed as net income divided by average
stockholders’ equity (an average of stockholders’ equity for the current
and previous year is commonly used, but the ratio is sometimes
computed only with beginning or ending stockholders’ equity). The return
on equity is a popular measure for analysis because it compares the
level of return earned with the amount of equity invested to generate the
return. Furthermore, it combines both the income statement and the
balance sheet and, thereby, highlights the fact that companies must
manage both well to achieve high performance.
Q1-13. While businesses acknowledge the increasing need for more complete
disclosure of financial and nonfinancial information, they have resisted
these demands to protect their competitive position. These companies
must weigh the benefits they receive from the market as a result of more
transparent and revealing financial reporting against the costs of
divulging proprietary information.
Q1-14. Generally Accepted Accounting Principles (GAAP) are the various
methods, rules, practices, and other procedures that have evolved over
time in response to the need to regulate the preparation of financial
statements. They are primarily set by the Financial Accounting
Standards Board (FASB), an entity of the private sector with
representatives from companies that issue financial statements,
accounting firms that audit those statements, and users of financial
information.
Q1-15. International Financial Reporting Standards (IFRS) are the accounting
methods, rules and principles established by the International
Accounting Standards Board (IASB). The need for IFRS stems from the
wide variety of accounting principles adopted in various countries and
the lack of comparability that this variety creates. IFRS are intended to
create a common set of accounting guidelines that will make the
financial statements of companies from different countries more
comparable.
The IASB has no enforcement authority. As a consequence, the strict
enforcement of IFRS is left to the accounting profession and/or securities
market regulators in each country. Many countries have reserved the
right to make exceptions to IFRS by applying their own (local)
accounting rules in selected areas. Some accountants and investors
argue that a little diversity is a good thing – variations in accounting
practice reflect differences in cultures and business practices of various
countries. However, one concern is that IFRS may create the false
impression that everyone is following the same rules, even though some
variation will continue to permeate international financial reporting.
Q1-16. The auditor’s primary function is to express an opinion on whether the
financial statements fairly present the financial condition of the company
and are free from material misstatements. Auditors do not prepare the

financial statements; they only audit them and issue their opinion on
them.

Q1-17.A The objectives of financial accounting are to provide information:
§ That is useful to investors, creditors, and other decision makers who
possess a reasonable knowledge of business activities and
accounting
§ To help investors and creditors assess the amount, timing and
uncertainty of cash flows. This includes the information presented in
the cash flow statement as well as other information that might help
investors and creditors assess future dividend and debt payments
§ About economic resources and financial claims on those resources.
This includes the information in the balance sheet and any supporting
information that might help the user assess the value of the
company’s assets and future obligations
§ About a company’s financial performance, including net income and
its components (i.e., revenues and expenses)
§ That allows decision makers to monitor company management to
evaluate their effective, efficient, and ethical stewardship of company
resources
Q1-18.A The four qualitative characteristics of accounting information are
relevance, reliability, consistency and comparability. Relevant
accounting information has the ability to make a difference in a decision.
Reliable accounting information is accurate and free of misstatement or
bias. These two characteristics are the primary drivers of the quality of
accounting information. Reliable information increases the confidence of
the decision maker. However, the information must also be relevant to
the decision at hand. These two characteristics can be at odds, in that
the most relevant information sometimes lacks reliability.
Comparability and consistency allow users to identify similarities and
differences between sets of economic phenomena. Comparability refers
to the use of similar accounting methods across companies, while
consistency refers to the use of similar methods over reporting periods.
Both improve the users’ ability to interpret the information by making
comparisons to other companies or earlier periods.

MINI EXERCISES
M1-19. (10 minutes)
($ millions)
Assets = Liabilities + Equity
$2,283.2 $1,321.8 $961.4
WhiteWave receives more of its financing from creditors ($1,321.8 million) versus
owners ($961.4 million). Its owner financing comprises 42.1% of its total
financing ($961.4 mil / $2,283.2 mil.).
M1-20. (10 minutes)
($ millions)
$90,055 $56,615 $33,440
Coca-Cola receives more of its financing from creditors ($56,615 million) than
from owners ($33,440 million). Its owner financing comprises 37.1% of its total
financing ($33,440 mil./ $90,055 mil.). This percentage has been decreasing;
several years ago, the percentage was 50%
M1-21. (15 minutes)
($ millions)
Hewlett-Packard $ 105,676 $ 78,020 (a) $ 27,656
General Mills $23,145.7 (b) $16,140.3 $7,005.4
Harley-Davidson (c) $ 9,405.0 $ 6,395.5 $3,009.5
The percent of owner financing for each company follows:

Hewlett-Packard, 26.2% ($27,656 mil./ $105,676 mil.);
General Mills, 30.3% ($7,005.4 mil./ $23,145.7 mil.);
Harley-Davidson, 32.0% ($3,009.5 mil./ $9,405.0 mil.).
The creditor percent of financing is computed as 100% minus the owner percent.
Therefore, Harley-Davidson is more owner-financed (32.0%) than the other two

firms, while Hewlitt-Packard has the highest percentage of creditor (non-owner)
financing (73.8% = 100% - 26.2%).

M1-22. (15 minutes)
For its annual report dated September 27, 2014, Apple reports the following
amounts (in $ millions):
$231,839 = $120,292 + $111,547
As shown, the accounting equation holds for Apple. Also, we can see that
Apple’s creditor financing is 51.9% of its total financing ($120,292 mil./$231,839
mil).
M1-23. (20 minutes)
NIKE
Statement of Retained Earnings
For Year Ended May 31, 2013
Retained earnings, May 31, 2012 ................................................................$5,526
Net income for the year ended May 31, 2013 ...............................................2,472
Common stock dividends .............................................................................. (727)
Other changes* ............................................................................................
(1,651)
Reinvested earnings, May 31, 2013 .............................................................
$5,620
*Includes $1,647 million for repurchase of common stock and $4 million for stock
purchased from employees.
Nike was more profitable 2014 versus 2013. Net income was $2,693 million in
2014 compared to $2,472 in 2013. Note: As reported in the text, ROE was
24.6% in 2014 compared to 23.0% in 2013.
M1-24. (20 minutes)
a. BS d. BS and SE g. SCF and SE

b. IS e. SCF h. SCF and SE
c. BS f. BS and SE i. IS and SE

M1-25. (10 minutes)
There are many stakeholders affected by this business decision, including the
following (along with a description of how):
• You/Manager—your reputation, self-esteem, and potentially your

livelihood can be affected.
• Creditors/Bondholders─ credit decisions based on inaccurate information
can occur.
• Shareholders—buying or selling shares based on inaccurate information
can occur.
• Management/Employees of your company—repercussions of your
decision extend to them; also, your decision may suggest an environment
condoning dishonesty
Indeed, our decisions can affect many more parties than we might initially realize.
M1-26. (10 minutes)
Internal controls are rules and procedures that involve monitoring an

organization’s activities, transactions, and interactions with customers,
employees and other stakeholders to promote efficiency and to prevent wrongful
use of its resources. They help prevent fraud, ensure the validity and credibility of
accounting reports, and are often crucial to effective and efficient operations.
The absence or failure of internal controls can adversely affect the effectiveness
of both domestic and global financial markets. Enron (along with other
accounting scandals) provided a case in point. Because the failure of internal
controls can have significant economic consequences, Congress is interested in
making sure that publicly- traded companies have adequate internal controls and
that any concerns about internal controls are properly reported.

EXERCISES
E1-27. (15 minutes)
($ millions) Assets = Liabilities + Equity

Motorola Solutions, Inc ...... $ 11,851 $ 8,162 $ 3,689
Kraft Foods Group, Inc. ..... $ 23,148 $17,961 $ 5,187
Merck & Co Inc. ................. $105,645 $53,319 $52,326
The percent of owner financing for each company follows:

Motorola Solutions, 31.1% ($3,689 mil./ $11,851 mil.);
Kraft Foods, 22.4% ($5,187 mil./ $23,148 mil.);
Merck & Co, 49.5% ($52,326 mil./ $105,645 mil.).
The creditor percent of financing is computed as 100% minus the owner percent.
Merck is more owner-financed, while Kraft is more creditor-financed.
E1-28. (15 minutes)
External users and some questions they seek to answer with accounting
information from financial statements include:
1. Shareholders (investors), who seek answers to questions such as:
a. Are resources owned by a business adequate to carry out plans?
b. Are the debts owed excessive in amount?
c. What is the current level of income (and its components)?
2. Creditors, who seek answers for questions such as:

a. Does the business have the ability to repay its debts?
b. Can the business take on additional debt?
c. Are resources sufficient to cover current amounts owed?
3. Employees (and potential employees), who seek answers to questions such

as:
a. Is the business financially stable?
b. Can the business afford to pay higher salaries?
c. What are growth prospects for the organization?

E1-29. (20 minutes)
($ millions)
a. Using the accounting equation:
Intel ................................... $92,358 $34,102 $58,256
b. Starting with the accounting equation at the beginning of the year:

JetBlue Airways................. $7,070 $5,182 $1,888
Using the accounting equation at the end of the year:

JetBlue Airways................. $7,350 $5,216 $2,134
($7,070+$280) ($5,182+$34)
Alternative approach to solving part (b):

ΔAssets($280) = ΔLiabilities($34) + ΔEquity(?)
where “Δ” refers to “change in.”
Thus: Δ Ending Equity = $280 - $34 = $246 and
Ending equity = $1,888 + $246 = $2,134
c. Starting with the accounting equation at the end of the year:

Walt Disney .......................
$81,241 $33,091 $48,150
($32,940+$151)
Using the accounting equation at the beginning of the year:

Walt Disney .......................
$74,898 $32,940 $41,958
($81,241-$6,343)

E1-30. (10 minutes)
Computation of dividends
Retained earnings, 2012 ......................................................................... $16,953
+ Net income .............................................................................................. 2,410
– Cash dividends ....................................................................................... (?)
= Retained earnings, 2013 ......................................................................... $17,952
Thus, dividends were $1,411 million for 2013. This dividends amount comprises
58.5% ($1,411/ $2,410) of its 2013 net income.
E1-31. (20 minutes)
COLGATE-PALMOLIVE COMPANY
Income Statement
For the year ended December 31, 2013
($millions)
Revenues $17,420
Cost of goods sold 7,219
Gross profit 10,201
Other expenses, including income taxes 7,791
Net income (or loss) $ 2,410
E1-32. (15 minutes)
a. Return on equity (ROE) = Net income / Average stockholders’ equity

= $2,410 / [($2,536 + $2,390)/2]
= 97.8%
b. Debt-to-equity = Total liabilities / Stockholders’ equity
= $11,340* / $2,536
= 4.47
*$11,340 = $13,876 - $2,536

E1-33. (150 minutes)
a. Return on equity (ROE) = Net income / Average stockholders’ equity

= €8,720 / [(€43,363 + €39,330)/2]
= 21.1%
b. Debt-to-equity = Total liabilities / Stockholders’ equity
= €125,155* / €43,363
= 2.89
*€125,155 = €168,518 - €43,363
E1-34. (20 minutes)
a. Financial information provides users with information that is useful in

assessing the financial performance of companies and, therefore, in setting
securities prices. To the extent that securities prices are accurate, the costs of
the funds that companies raise will accurately reflect their relative efficiency
and risk of operations. Those companies that can effectively utilize capital
better will be able to obtain that capital at a reasonable cost, and society’s
financial resources will be effectively allocated.
b. First, the preparation of financial statements involves and understanding of

complex accounting rules and a significant amount of assumptions and
estimation. Second, GAAP allows for differing accounting treatments for the
same transaction. And third, auditors are at a relative information
disadvantage vis-à-vis company accountants. As the capital markets place
increasing pressures on companies to perform, accountants are often placed
in a difficult ethical position to use the flexibility given to them under GAAP in
order to bias the financial results.
E1-35. (15 minutes)
1. e 6. g
2. f 7. j
3. i 8. c
4. a 9. d
5. h 10. b

PROBLEMS
P1-36. (40 minutes)
a.
Year Assets Liabilities Equity Net Income

2011 $138,354 $70,353 $68,001 $11,927
2012 $132,244 $68,209 $64,035 $10,904
2013 $139,263 $70,554 $68,709 $11,402
b. 2012 ROE = $10,904 / [($68,001+$64,035)/2] = 16.5%

2013 ROE = $11,402 / [($64,035+$68,709)/2] = 17.2%
P&G’s ROE increased in 2013, and was slightly above the median for Fortune
500 companies in both years.
c. 2012 debt-to-equity = $68,209 / $64,035 = 1.065

2013 debt-to-equity = $70,554 / $68,709 = 1.027
P&G’s debt-to-equity ratio also declined in 2013 and it is below the median for
Fortune 500 companies in both years.

P1-37. (30 minutes)
a.
GENERAL MILLS, INC.
Income Statement
($ millions)
Sales ....................................................................... $17,909.6
Cost of goods sold .................................................. 11,539.8
Gross profit ............................................................. 6,369.8
Other expenses, including income taxes ................ 4,508.5
Net income.............................................................. $ 1,861.3
GENERAL MILLS, INC.

Balance Sheet
May 25, 2014
($ millions)
Cash & cash equivalents $ 867.3 Total liabilities $16,140.3
Noncash assets 22,278.4 Stockholders’ equity 7,005.4
Total assets $23,145.7 Total liabilities and equity $23,145.7
GENERAL MILLS, INC.

Statement of Cash Flows
($ millions)
Net cash flows from operations .............................. $ 2,541.0
Net cash flows from investing ................................. (561.8)
Net cash flows from financing ................................. (1,824.1)
Effect of exchange rates on cash ........................... (29.2)
Net change in cash ................................................. 125.9
Cash, beginning year .............................................. 741.4
Cash, ending year .................................................. $ 867.3
b. $7,005.4 /$23,145.7 = 30.3% contributed by owners

P1-38. (30 minutes)
a.
ABERCROMBIE & FITCH
Income Statement
For Year Ended February 1, 2014
($ millions)
Sales ....................................................................... $ 4,116.9
Cost of goods sold .................................................. 1,541.5
Gross profit ............................................................. 2,575.4
Other expenses including income taxes ................. 2,520.8
Net income.............................................................. $ 54.6
ABERCROMBIE & FITCH

Balance Sheet
February 1, 2014
($ millions)
Cash asset $ 600.1 Total liabilities $ 1,121.5
Noncash assets 2,250.9 Stockholders’ equity 1,729.5
Total assets $ 2,851.0 Total liabilities and equity $ 2,851.0
ABERCROMBIE & FITCH

For Year Ended February 1, 2014
($ millions)
Net cash flows from operations .............................. $ 175.5
Net cash flows from investing ................................. (173.9)
Net cash flows from financing ................................. (40.8)
Effect of exchange rate changes on cash .............. (4.2)
Net change in cash ................................................. (43.4)
Cash, beginning year .............................................. 643.5
Cash, ending year .................................................. $ 600.1
b. $1,729.5 / $2,851.0 = 60.7% contributed by owners

$1,121.5 / $2,851.0 = 39.3% contributed by creditors

P1-39. (30 minutes)
TILLY’S, INC.
Income Statements
For years ended February 1, 2014 and February 2, 2013
($ thousands)
2014 2013
Sales $495,837 $467,291
Cost of goods sold 343,542 317,096
Gross profit 152,295 150,195
Other expenses, including income taxes 134,158 126,302
Net income $ 18,137 $ 23,893
TILLY’S, INC.
Balance Sheets
February 1, 2014 and February 2, 2013
($ thousands)
2014 2013
Cash asset $ 25,412 $ 17,314
Noncash assets 206,995 188,067
Total assets $232,407 $205,381
Total liabilities $ 91,484 $ 88,085

Stockholders’ equity 140,923 117,296
Total liabilities and stockholders’ equity $232,407 $205,381
TILLY’S, INC.
Cash Flow Statements
For years ended February 1, 2014 and February 2, 2013
($ thousands)
2014 2013
Cash flow from operating activities $43,794 $41,730
Cash flow from investing activities (37,530) (72,326)
Cash flow from financing activities 1,834 22,819
Change in cash 8,098 (7,777)
Cash balance, beginning of the year 17,314 25,091
Cash balance, end of the year $25,412 $17,314

P1-40. (30 minutes)
TESLA MOTORS, INC.

Income Statements
For years ended December 31, 2013 and 2012
($ thousands)
2013 2012
Sales $2,013,496 $ 413,256
Cost of goods sold 1,557,234 383,189
Gross profit 456,262 30,067
Other expenses, including income taxes 530,276 426,280
Net income (loss) $ (74,014) $ (396,213)
TESLA MOTORS, INC.

Balance Sheets
December 31, 2013 and 2012
($ thousands)
2013 2012
Cash asset $ 845,889 $ 201,890
Noncash assets 1,571,041 912,300
Total assets $2,416,930 $1,114,190
Total liabilities $1,749,810 $ 989,490

Stockholders’ equity 667,120 124,700
Total liabilities and stockholders’ equity $2,416,930 $1,114,190
TESLA MOTORS, INC.

Cash Flow Statements
For years ended December 31, 2013 and 2012
($ thousands)
2013 2012
Cash flow from operating activities $257,994 $(266,081)
Cash flow from investing activities (249,417) (206,930)
Cash flow from financing activities 635,422 419,635
Change in cash 643,999 (53,376)
Cash balance, beginning of the year 201,890 255,266
Cash balance, end of the year $845,889 $201,890

P1-41. (15 minutes)
CROCKER CORPORATION
Statement of Stockholders’ Equity
For Year Ended December 31, 2016
Contributed Retained Stockholders’
Capital Earnings Equity
December 31, 2015 ............................... $ 70,000 $ 30,000 $100,000
Issuance of common stock .................... 30,000 30,000
Net income ............................................ 50,000 50,000
Cash dividends ...................................... _______ (25,000) (25,000)
December 31, 2016 ............................... $100,000 $ 55,000 $155,000
P1-42. (15 minutes)
DP SYSTEMS, INC.
Common Retained Stockholders’
Stock Earnings Equity
December 31, 2015 ................................ $ 550 $2,437 $2,987
Net income ............................................. 859 859
Cash dividends ....................................... ____ (281) (281)
December 31, 2016 ................................ $ 550 $3,015 $3,565
P1-43. (15 minutes)
a. Return on equity is net income divided by average stockholders’ equity.

Nokia’s ROE: €-739 / [(€6,660 + €9,239)/2] = -0.093 or -9.3%.
b. Debt-to-equity is total liabilities divided by stockholders’ equity.

Nokia’s debt-to-equity: (€25,191 − €6,660) / €6,660 = 2.78.
c. Revenues less expenses equal net income. Taking the revenues and net
income numbers for Nokia, yields:
€12,709 million − Expenses = €-739 million.

Therefore, expenses must equal €13,448 million.

P1-44. (20 minutes)
a.
BEST BUY CO., INC.
Income Statement
For the year ended February 1, 2014
($ millions)
Sales revenue ………………………………… $42,410
Cost of goods sold ………………………….. 32,720
Gross profit …………………………………… 9,690
Other expenses, including income taxes …… 9,167
Net income (or loss) …………………………. $ 523
b. Best Buy’s ROE = $523 mil. / [($3,715 mil. + $3,989 mil.)/2] = 13.6%.
c. Best Buy’s debt-to-equity = ($14,013 - $3,989) / $3,989 = 2.51
P1-45. (20 minutes)
a.
FACEBOOK, INC.
Income Statement
For the years ended December 31, 2013 and 2012
($ millions)
2013 2012
Revenue $ 7,872 $ 5,089
Operating expenses 5,068 4,551
Gross profit from operations 2,804 538
Other expenses, including income taxes 1,304 485
Net income $ 1,500 $ 53
b. Stockholders’ equity: 2013 -- $17,895 mil. - $2,425 mil. = $15,470 mil.

2012 -- $15,103 mil. - $3,348 mil. = $11,755 mil.
2013 ROE = $1,500 mil. / [($15,470 mil. + $11,755 mil.)/2] = 11.0%.

2012 ROE = $53 mil. / [($11,755 mil. + $4,899 mil.)/2] = 0.6%.
c. 2013 debt-to-equity = $2,425 / $15,470 = 0.16.

2012 debt-to-equity = $3,348 / $11,755 = 0.28.
d. Beginning retained earnings + income – dividends = ending retained earnings

$1,659 mil. + $1,500 mil. – dividends = $3,159 mil.

Dividends = $0

CASES and PROJECTS
C1-46. (40 minutes)
a.
STARBUCKS CORPORATION
Income Statement
For the years ended September 29, 2013 and September 30, 2012
($ millions) 2013 2012
Sales revenue $ 14,892.2 $ 13,299.5
Cost of goods sold 6,382.3 5,813.3
Gross profit on sales 8,509.9 7,486.2
Other expenses, including income taxes 8,501.1 6,101.5
Net income $ 8.8 $ 1,384.7
b. 2013 stockholders’ equity: $11,516.7 mil. – $7,034.4 mil. = $4,482.3 mil.

2012 stockholders’ equity: $8,219.2 mil. -- $3,104.7 mil. = $5,114.5 mil.
2013 ROE: $8.8 / [($4,482.3 + $5,114.5)/2] = 0.2%

2012 ROE: $1,384.7 / [($5,114.5 + $4,387.3)/2] = 29.1%
c. 2013 debt-to-equity: $7,034.4 / $4,482.3 = 1.57

2012 debt-to-equity: $3,104.7 / 5,114.5 = 0.61
d. 2013 ROE restated: ($8.8 + $2,784.1) / [($4,482.3 + $2,784.1 + $5,114.5)/2] =

45.1%
The litigation charge of $2,784.1 is added to the net income number and to
the 2013 stockholders’ equity amount to arrive at this number. This does not
take into account the effect of income taxes. If we allow for a 35% tax rate,
the restated ROE is lower ($2,784.1 x 0.65 = $1,809.7):
2013 ROE restated: ($8.8 + $1,809.7) / [($4,482.3 + $1,809.7 + $5,114.5)/2] =
31.9%
e. The primary cost to Starbucks of disclosing information about the pending

litigation is that the disclosure may cause potential investors and creditors to
hold a less favorable view of the company. A secondary concern is that such
disclosure may actually affect the outcome of the litigation.

The primary benefit to disclosure is that by disclosing information about the
lawsuit before its completion, the company cannot be accused of withholding
relevant information from stakeholders. This prevents potential lawsuits from
investors or creditors and contributes to the company’s reputation for reliable
financial reporting.

C1-47. (40 minutes)
The Gap, Inc.
a. ROE = $1,280 / [($3,062 + $2,894)/2] = 43.0%
b. Debt-to-equity = ($7,849 - $3,062) / $3,062 = 1.56
Nordstrom, Inc.
a. ROE = $734 / [($2,080 + $1,913)/2] = 36.8%
b. Debt-to-equity = ($8,574 - $2,080) / $2,080 = 3.12
Nordstrom had the lower ROE and also relies more on debt than The Gap.
c.
THE GAP, INC.
2013 Income Statement
($millions)
Revenues $16,148
Gross profit 6,293
Net income (or loss) $ 1,280
NORDSTROM, INC.
2013 Income Statement
($millions)
Revenues $12,540
Gross profit 4,803
Net income (or loss) $ 734
The Gap: $6,293 / $16,148 = 39.0%

Nordstrom: $4,803 / $12,540 = 38.3%
d. The Gap earned a higher ROE than Nordstrom (43.0% vs. 36.8%), though
both are well above the median for the Fortune 500 in 2013. Nordstrom’s
debt-to-equity ratio is 3.12 vs. about 1.56 for The Gap. The Gap reported a
slightly higher gross profit per dollar of sales revenue (39.0% vs. 38.3% for
Nordstrom). These two percentages are very close, reflecting the similarity of
their retail operations. One important difference (not provided or apparent in

the information supplied) is that Nordstrom has a larger consumer credit
business than The Gap.

C1-48. (30 minutes)
a. JetBlue
ROE = $168 / {[($7,350-$5,216) + ($7,070 - $5,182)] /2} = 8.4%
Southwest
ROE = $754 / {[($19,345-$12,009) + ($18,596-$11,604)] /2} = 10.5%
b. JetBlue
Debt-to-equity = $5,216 / ($7,350 - $5,216) = 2.44
Southwest
Debt-to-equity = $12,009 / ($19,345 - $12,009) = 1.64
c. JetBlue
$168 / $5,441 = 3.1%
Southwest
$754 / $17,699 = 4.3%
d. JetBlue reported a profit of $168 million in 2013, whereas it had reported

losses as recently as 2008. JetBlue’s ROE was 8.4% for the year. In
comparison, Southwest earned an ROE of 10.5% in 2013. Both of these
ROE numbers are below the average for Fortune 500 companies. JetBlue
uses more creditor financing. Its debt-to-equity ratio is 2.44 compared to a
debt-to-equity ratio of 1.64 for Southwest. In addition, JetBlue’s reported net
income equaled 3.1% of revenues, while Southwest reported net income
equal to 4.3% of revenues. The numbers for both airlines reflect the poor
performance of the airline industry in general, resulting from high fuel costs,
high labor costs, and intense competition.
C1-49. (20 minutes)
a. $285,000 Assets - $45,000 Liabilities = $240,000 Net Assets. $72,000 Average

Annual Income / $240,000 Investment = 30% return. Seale's return would be
24% ($72,000 Average Annual Income / $300,000 Investment), assuming no
adjustment is made for Meg’s salary. (See part b.)
b. No. Withdrawals do not affect net income, because they are not part of the
firm's operating activities. However, in calculating Krey's return in part a, Seale
might wish to "impute" an amount for Krey's half-time work in computing Krey's
return on investment. Thus, if Seale believes that Krey's services are worth
$18,000 (half of the $36,000 salary she expects to pay a full-time manager),
annual income should be calculated at $54,000 instead of $72,000. If Seale

hires a full-time manager at $36,000, her return will be only 12% [($72,000 -
$36,000)/$300,000].

c. Yes, the difference between net income shown in the financial statements and
net income shown on the tax return can be legitimate, because income tax rules
for determining revenues and deductions from revenues differ from generally
accepted accounting principles. Seale may obtain additional assurance about
the propriety of the financial statements by engaging a licensed professional
accountant to audit the financial statements and render a report on them.
C1-50. (15 minutes)
It is important for a CPA to be independent when performing audit services

because third parties will be relying on the audited financial statements in making
decisions. The financial statements are the representations of the corporation's
management. The audit by a CPA adds credibility to the financial statements. Only
if third parties believe that the CPA is independent will a CPA be able to add
credibility to financial statements.
Jackie is not independent for two reasons: (1) her brother is president and chair of
the board of directors of the company to be audited and (2) Jackie is on the board
of directors of the company to be audited. The auditing profession takes the
position that Jackie's other activities for the company—consulting and tax work—do
not impair a CPA's independence. This last point may generate some discussion,
particularly in this case when the potential auditor is the same person (Jackie) who
is doing the consulting work. Usually, when the same CPA firm does both auditing
and consulting work, those tasks are assigned to different persons to ensure
auditor independence. Revised 04.05.16
Chapter 2
Constructing Financial Statements

Mini- Cases
Exercises Problems
Exercises and Projects

LO1 – Describe and construct the 16, 17, 19, 34 - 36,
balance sheet and understand how it 49 - 60, 62,
can be used for analysis. 21 - 27, 38 - 44, 46, 71
66, 67, 69
29 - 31 47
LO2 – Use the financial statement 57, 62,

effects template (FSET) to analyze 29 - 31 44 - 47
67, 69
transactions.
LO3 – Describe and construct the 49 - 51, 54,

19 - 23, 35, 39 - 44,
income statement and discuss how it 57, 61, 62, 71, 72
can be used to evaluate 28, 31 47
management performance. 67, 69
20, 22, 23,

LO4 – Explain revenue recognition,
accrual accounting, and their effects 25, 26, 28, 39, 44, 47 57, 62, 67, 69 71
on retained earnings. 29, 31
LO5 – Illustrate equity transactions 18, 21 - 24,

and the statement of stockholders’ 35 53, 66, 67, 69 71
27, 31
equity.
LO6 – Use journal entries and T-

accounts to analyze and record 32, 33 45, 48 57, 63, 68
transactions.
LO7 – Compute net working capital, 34, 36, 38, 52, 55, 56,
the current ratio, and the quick ratio, 41, 42, 46 59, 60
and explain how they reflect liquidity.

QUESTIONS
Q2-1. An asset is something that we own that is expected to provide future benefits. A liability
is a current obligation that will require a future sacrifice. Equity is the difference
between assets and liabilities. It represents the claims of the company’s owners to its
income and assets. The following are some examples of each:
Assets • Cash
• Receivables
• Inventories
• Plant, property and equipment
Liabilities • Accounts payable
• Accrued liabilities
• Notes payable
• Long-term debt
Equity • Contributed capital (common and preferred stock)
• Additional paid-in capital
• Earned capital (retained earnings)
• Treasury stock
Q2-2. The revenue recognition principle requires that revenues be recognized when earned.
Revenues are earned when the product has been delivered to the buyer and is usually
signified by a formal transfer of title. A good test of whether revenue has been earned
is whether the rights, risks and obligations of ownership have been transferred to the
buyer. If a service is involved, revenues are not earned until the service has been
provided. The expense recognition principle prescribes that expenses be recognized
when assets are diminished (or liabilities increased) as a result of earning revenue or
carrying out the company’s operations. When these two principles are followed, income
can be properly measured in a given accounting reporting period.
Q2-3. Accrual accounting entails the recognition of revenue under the revenue recognition
principle (record revenues when goods or services are transferred to the customer),
and the recognition of expenses when net assets decrease from the process of earning
revenue or supporting the company’s operations. The recognition of revenues or the
expenses does not require that cash be received or disbursed. For example, the
recognition of revenues on sale can lead to an account receivable, and wage expense
can be accrued using a wages payable (accrued) liability account.

Q2-4. The statement of stockholders’ equity provides information relating to all events that
impact stockholders’ equity during the period. It contains information relating to stock
sales and repurchases, net income, dividends, and the use of stock for other purposes
including occasional acquisition of assets. This statement, also referred to as the
statement of owners’ equity, also includes the effects of some transactions that are not
captured in the determination of net income. These items are included in what is called
“other comprehensive income.” One example of such an item is the loss or gain on the
translation of the assets and liabilities of foreign owned subsidiaries into United States
currency.
Q2-5. An asset must be “owned” and it must provide “future benefits.” Owning
means we have title to the asset (some leased assets are also recorded
on the balance sheet as we will discuss in Chapter 10). Future benefits
can mean the future inflows of cash. Or, it could relate to some other
benefit, such as the reduction of expenditures, an increase in another
asset, or the reduction of a liability.
Q2-6. Liquidity generally refers to cash. That is, how much cash do we have,
how much cash is being generated, and how much cash can we raise
quickly. Liquidity is essential to the survival of the business. After all, we
can only pay our loans with cash, and our employees will only accept
cash for their wages. Some assets are more liquid than others in the
sense that they can be converted more easily to cash. Money market
accounts and accounts receivable, which can be sold, provide examples.
Inventories are considered more liquid than plant assets. We will
address liquidity issues more formally in Chapters 4 and 9.
Q2-7. Current means that the asset will be liquidated (converted to cash) within
the next year (or the operating cycle if longer than 1 year).
Q2-8. Historical costs are used by accountants because they are less
subjective and, therefore, more reliable than using market values.
Market values can be biased for two reasons: first, we may not be able
to measure them accurately (consider our inability to accurately measure
the market value of a production facility, for example), and second,
managers may intervene in the reporting process to intentionally bias the
results in order to achieve a particular objective (i.e. enhancing the stock
price). The use of historical costs in accounting records does not negate
the importance of market values. For example, a firm offering to pledge
land as collateral for a loan will be expected to use the market value of
that land rather than its historic cost. The same would be true if a
corporation were considering the sale of the land. Finally, we shall see
that certain assets are reported at market value in the balance sheet;
securities that are available to be sold provide an example.

Q2-9. An intangible asset is an asset that we cannot touch. To be included on
the balance sheet, it has to meet the tests of an asset (e.g., we own it,
and it will provide future benefits). In addition, recognized intangible
assets are always acquired in a transaction with an independent party.
Internally generated intangible assets, however, are not recorded on the
balance sheet. Some examples are goodwill, patents and trademarks,
contractual agreements like royalties, leases, and franchise agreements.
All of the intangible assets, though not recorded if internally generated,
are recorded if purchased, as in an acquisition of another company, for
example.
Q2-10. Both the current ratio and quick ratio are measures of a firm’s ability to
pay its obligations as they come due; measures of a firm’s liquidity. The
current ratio is computed by dividing the firm’s current assets by its
current liabilities. Current ratios that exceed 1.0 are deemed to represent
a strong current liquidity position. The quick ratio is an even more
conservative measure of a firm’s liquidity as it excludes inventory from
the calculation. The quick ratio is computed by dividing the firm’s sum of
cash and cash equivalents,marketable securities and accounts
receivable by its current liabilities.
Q2-11. The three conditions necessary to recognize a liability are:
1. The liability reflects a probable future sacrifice on the part of the
organization.
2. The amount of the obligation is known or can be reasonably
estimated.
3. The transaction that caused the obligation has occurred.
Q2-12. Net working capital = current assets – current liabilities. Increasing the
amount of trade credit (e.g., accounts payable to suppliers) increases
current liabilities and reduces net working capital. As trade credit
increases, we are using someone else’s cash rather than our own. As a
business grows, its net working capital grows, as the growth of
inventories and receivables are generally greater than that of accounts
payable and accrued liabilities. Net working capital is an asset category
that must be financed just like fixed assets.
Q2-13. $700,000 Assets - $220,000 Liabilities = $480,000 Stockholders' equity
$480,000 Stockholders’ equity – $300,000 Common stock =
$180,000 Retained earnings

MINI EXERCISES
M2-14. (10 minutes)
Use the accounting equation.
a. Cash $ 8,000
Accounts receivable 23,000
Supplies 9,000
Equipment 138,000
178,000
Accounts payable $ 11,000
Common stock 110,000 121,000
Retained earnings $ 57,000
b. Retained Earnings:
December 31, 2015 $ 57,000
January 1, 2015 30,000
Increase 27,000
Add: Dividends 12,000
Net Income $ 39,000
M2-15. (5 minutes)
a. $200,000 - $85,000 = $115,000 equity

b. $32,000 + $28,000 = $60,000 assets
c. $93,000 - $52,000 = $41,000 liabilities
M2-16. (5 minutes)
a. $375,000 - $105,000 = $270,000 equity

b. $43,000 + $11,000 = $54,000 assets
c. $878,000 - $422,000 = $456,000 liabilities
M2-17. (5 minutes)
a. $450,000 - $326,000 = $124,000 equity

b. $618,000 - $165,000 = $453,000 liabilities
c. $400,000 + $200,000 + $185,000 = $785,000 assets

M2-18. (10 minutes)
a. no effect e. increase
b. decrease f. increase
c. decrease g. increase
d. no effect
M2-19. (15 minutes)
a. Balance sheet e. Balance sheet i. Income statement

b. Income statement f. Balance sheet j. Income statement
c. Balance sheet g. Balance sheet k. Balance sheet
d. Income statement h. Balance sheet l. Balance sheet
M2-20. (20 minutes)
a. Net income computation

Service revenue (record when earned) …………… $100,000
Wage expense …………………………………………. (60,000)
Net income ……………………………………………… $ 40,000
b. Yes, recognizing the wage liability would cause wage expense to increase by
$10,000 and net income would decrease by the same amount (before taxes).
M2-21. (10 minutes)
a. Balance sheet
b. Income statement, Statement of stockholders’ equity
c. Balance sheet
d. Income statement
e. Statement of stockholders’ equity
f. Statement of stockholders’ equity
g. Balance sheet
h. Income statement
i. Statement of stockholders’ equity, Balance sheet

M2-22. (10 minutes)
a. Balance sheet
b. Balance sheet
c. Income statement, Statement of stockholders’ equity
d. Statement of stockholders’ equity, Balance sheet
e. Balance sheet
f. Income statement
g. Balance sheet
h. Balance sheet
M2-23. (10 minutes)
a. Balance sheet
b. Income statement
c. Statement of stockholders’ equity, Balance sheet
d. Income statement
e. Statement of stockholders’ equity
f. Balance sheet
g. Balance sheet
h. Balance sheet
M2-24. (15 minutes)
Ending retained earnings = Beginning retained earnings + Net income –

Dividends + the effects of other adjustments. And, the ending retained earnings
for one period is the beginning retained earnings for the following period.
Fiscal year ending January 28,2013 February 2, 2014

Beginning retained earnings (deficit) $ 24 ($ 672)
Net income (loss) 753 903
Dividends paid 1,449 349
Ending retained earnings (deficit) ($ 672) ($ 118)

M2-25. (10 minutes)
a. Increase assets (Cash);

Increase equity (Service Revenues)
b. Increase assets (Office Supplies)
Increase liabilities (Accounts Payable)
c. Increase assets (Cash)
Increase equity (Contributed Capital or Common Stock)
d. Decrease liabilities (Accounts Payable)
Decrease assets (Cash)
e. Increase assets (Cash)
Increase liabilities (Notes Payable)
f. Increase assets (Accounts Receivable)
Increase equity (Service Revenues)
g. Increase assets (Office Equipment)
h. Decrease equity (Interest Expense)
i. Decrease equity (Utilities Expense)
M2-26. (10 minutes)
a. Increase assets (Office Equipment)

b. Increase assets (Accounts Receivable)
Increase equity (Service Revenue)
c. Decrease equity (Rent Expense)
d. Increase assets (Cash)
Increase equity (Service Revenue)
e. Increase assets (Cash)
Decrease assets (Accounts Receivable)
f. Increase assets (Office Equipment)
g. Decrease equity (Salaries Expense)

h. Decrease liabilities (Accounts Payable)
i. Decrease equity (Retained Earnings)
M2-27. (10 minutes)
JOHNSON & JOHNSON

Retained earnings, December 29, 2013 ............................................ $89,493

Add: Net income ............................................................................ 16,323
Less: Dividends ............................................................................... (7,768)
Other retained earnings changes .......................................... (803)
Retained earnings, December 28, 2014 ............................................ $97,245
M2-28. (10 minutes)
2015 2016
Revenues ..................................................................... $350,000 $ 0
Expenses ...................................................................... 200,000 0
Net income ................................................................... $150,000 $ 0
Explanation: All of the revenue is reported in 2015 when services are provided—
per the revenue recognition principle. Likewise, the expense is reported in 2015
when it is incurred—because a liability was incurred to generate the revenue.
The timing of receipts or payments of cash does not affect the recording of
revenues, expenses, and net income.

M2-29. (15 minutes)
Balance Sheet Income Statement

Cash Noncash Liabil- Contrib. Earned Net
Transaction Asset + Assets = ities + Capital + Capital Revenues - Expenses = Income
a. Issue stock for $20,000 +20,000 +20,000

cash. Cash = Common - =
Stock
b. Pay $2,000 rent in -2,000 +2,000
advance. Cash Prepaid = - =
rent
c. Purchase computer -7,000 +7,000

equipment for $7,000 Cash Computer = - =
cash. Equipment
d. Purchase inventory for +13,000 +13,000

$13,000 on account Inventory = Accts - =
Payable
e. Pay supplier of -13,000 -13,000

inventory in part d. Cash = Accts - =
Payable
Totals -2,000 + 22,000 = 0 + 20,000 + - =
M2-30 (15 minutes)

Cash Noncash Contrib. Earned Net
Transaction + = Liabilities + + Revenues - Expenses =
Asset Assets Capital Capital Income
a. Borrow €19,000 from +19,000 +19,000

local bank. Cash Note
= - =
Payable
b. Pay €3,000 insurance -3,000 +3,000

premium for covered for Cash Prepaid
= - =
following year. insurance
c. Purchase vehicle for -32,000 +32,000

€32,000 cash. Cash Vehicle = - =
d. Purchase and receive +2,500 +2,500

€2,500 of office Supplies Accts
supplies on account Inventory = Payable - =
(pay supplier later).
e. Place order for €1,000

of additional supplies to
be delivered next NO ENTRY = - =
month.
Totals -16,000 + 37,500 = 21,500 + 0 + 0 - =

M2-31. (15 minutes)

a. Receive merchandise -9,000 +9,000

inventory costing Cash Inventory
$9,000, purchased with = - =
cash
b. Sell half of inventory in -4,500 -4,500 +4,500 -4,500
(a) for $7,500 on credit. Inventory Cost of
Goods Sold
= - =
+7,500 +7,500 +7,500 +7,500
Accounts Revenue
Receivable
c. Place order for $5,000

of additional
merchandise inventory NO ENTRY = - =
to be delivered next
month.
d. Pay employee $4,000 -4,000 -4,000 +4,000 -4,000

for compensation Cash Wage
earned during the = - Expense =
month.
e. Pay $7,000 rent for use -7,000 -7,000 +7,000 -7,000

of premises during the Cash Rent
= - =
month. Expense
f. Receive full payment +7,500 -7,500

from customer in part b. Cash Accounts
Receivable
Totals -12,500 + 4,500 = + + -8,000 7,500 - 15,500 = -8,000

M2-32. (10 minutes)
a. Inventory (+A) ........................................................................... 9,000

Cash (-A) ........................................................................... 9,000
b. Cost of goods sold expense (+E, -SE) ..................................... 4,500

Inventory (-A) ...................................................................... 4,500
Accounts receivable (+A) ......................................................... 7,500
Sales revenue (+R, +SE) ................................................... 7,500
c. NO ENTRY
d. Wage expense (+E, -SE) .......................................................... 4,000

Cash (-A) ............................................................................ 4,000
e. Rent expense (+E, -SE) ............................................................ 7,000

Cash (-A) ............................................................................ 7,000
f. Cash (+A) …………………………………………………….. 7,500

Accounts receivable (-A) ……………………………….. 7,500
M2-33. (10 minutes)
+ Cash (A) - + Accounts Receivable (A) -

(f) 7,500 (a) 9,000 (b) 7,500 (f) 7,500
(d) 4,000
(e) 7,000
+ Cost of Goods Sold (E) -
(b) 4,500
+ Inventory (A) -
(a) 9,000 (b) 4,500
+ Wage Expense (E) -
(d) 4,000
- Sales (R) +
(b) 7,500
+ Rent Expense (E) -
(e) 7,000

EXERCISES
E2-34. (25 minutes)
Use the accounting equation to determine Retained Earnings as of May 31,

2015.
a. and b.
BEAVER, INC.
Balance Sheets
May 31, 2015 June 1, 2015
Assets
Cash $ 12,200 $ 3,200
Accounts receivable 18,300 18,300
Supplies 16,400 16,400
Equipment 55,000 70,000
Total assets $101,900 $107,900
Liabilities
Accounts payable $ 5,200 $ 5,200
Notes payable 20,000 33,000
Total liabilities 25,200 38,200
Stockholders' Equity
Common stock 42,500 42,500
Retained earnings 34,200 27,200
Total stockholders' equity 76,700 69,700
Total liabilities and stockholders' equity $101,900 $107,900
c. Net working capital = current assets – current liabilities

$32,700 = ($3,200 + $18,300 + $16,400) – $5,200

E2-35. (30 minutes)
Use the accounting equation and the information on changes in contributed

capital and retained earnings.
Beginning equity (= Beginning assets – Beginning liabilities)

+ Common Stock Issued
+ Net income (= Revenues – Expenses)
– Dividends
Ending equity (= Ending assets – Ending liabilities)
a. Equity, Beginning ($28,000 - $18,600) $ 9,400

Equity, Ending ($30,000 - $17,300) 12,700
Increase 3,300
Add: Net Capital Withdrawn ($5,000 - $2,000) 3,000
Net Income 6,300
Add: Expenses 8,500
Revenues $14,800
b. Equity, Beginning ($12,000 - $5,000) $ 7,000

Add: Net Capital Contributed ($4,500 - $1,500) 3,000
10,000
Add: Net Income ($28,000 - $21,000) 7,000
Equity, Ending $17,000
Assets, Ending $26,000

Equity, Ending 17,000
Liabilities, Ending, $ 9,000
c. Equity, Beginning ($28,000 - $19,000) $ 9,000

Add: Net Income ($18,000 - $11,000) 7,000
16,000
Less: Dividends 1,000
15,000
Equity, Ending ($34,000 - $15,000) 19,000
Common Stock Issued $ 4,000
d. Common Stock Issued $ 3,500

Net Income ($24,000 - $17,000) 7,000
10,500
Cash Dividends 6,500
Increase in Equity 4,000
Equity, Ending ($40,000 - $19,000) 21,000
Equity, Beginning 17,000
Add: Liabilities, Beginning 9,000

Total Assets, Beginning $26,000

E2-36 (30 minutes)
Use the accounting equation to determine stockholders’ equity balances.
a.
LANG SERVICES
Balance Sheets
December 31,
2015 2014
Assets
Cash $10,000 $ 8,000
Supplies 4,700 4,200
Equipment 32,000 27,000
Total assets $69,500 $56,700
Liabilities
Accounts payable $25,000 $25,000
Stockholders’ equity
Equity 42,700 30,100
b. Equity, December 31, 2015 $42,700

Equity, December 31, 2014 30,100
Increase 12,600
29,600
Less: Common Stock issued 5,000
Net Income for 2015 $24,600
c. Current ratio = ($10,000 + $22,800 + $4,700)/$25,000 = 1.50

Quick ratio = ($10,000 + $22,800)/$25,000 = 1.31
d. Lang’s liquidity position is satisfactory as its current ratio meets the industry
norm, and its quick ratio is also above the industry average. The firm appears
to have invested about the “right” amount in liquid assets—neither too much,
nor too little.

E2-37. (30 minutes)
Use the accounting equation to determine Retained Earnings balances.
a.
LYNCH SERVICES
Balance Sheets
December 31,
2015 2014
Assets
Cash $ 23,000 $ 20,000
Supplies 20,000 18,000
Land 40,000 40,000
Building 250,000 260,000
Equipment 43,000 45,000
Total assets $418,000 $416,000
Liabilities
Mortgage payable 90,000 100,000
Common stock 220,000 220,000
b.
Retained Earnings, December 31, 2015 $102,000
Retained Earnings, December 31, 2014 87,000
Increase during 2015 15,000
Add: Dividend for 2015 10,000
Net Income for 2015 $ 25,000

E2-38. (30 minutes)
Use the accounting equation to determine Retained Earnings as of September

30, 2015. The two transactions have the following effects:
• Equipment purchase increases the equipment asset by $11,000,

decreases the cash asset by $3,000, and increases the notes payable
liability by $8,000.
• Dividend payment decreases the cash asset by $3,000 and decreases the
retained earnings equity by $3,000.
a. and b.
BROWNLEE CATERING SERVICE
Balance Sheets
September 30, October 1,
2015 2015
Assets
Cash $10,000 $ 4,000
Supplies inventory 9,000 9,000
Equipment 34,000 45,000
Total assets $70,000 $75,000
Liabilities
Accounts payable $24,000 $24,000
Common stock 27,500 27,500
c. September 30 October 1
Current ratio (10,000 + 17,000 + 9,000) (4,000 + 17,000 + 9,000)
÷ 24,000 = 1.50 ÷ 24,000 = 1.25
Quick ratio (10,000 + 17,000) (4,000 + 17,000)

÷ 24,000 = 1.13 ÷ 24,000 = 0.88
d. Quite a few possibilities exist, from increasing long-term borrowing to issuing

new stock to selling unneeded equipment.

E2-39. (15 minutes)
Income statement Balance sheet

Sales................................
$30,00 Cash ........................................................
$ 8,000
0
Wages expense ................. Accounts receivable ................................
12,000 30,000
Net income (loss)............... $18,00 $38,00
Total assets .............................................
0 0
$12,00
Wages payable .......................................
0
Common stock .......................................
8,000
Retained earnings ................................
18,000
$38,00
Total liabilities and equity ........................
0
E2-40. (15 minutes)
a.
Procter & Gamble ($ millions) Amount Classification
Net sales ......................................................................

$ 83,062 I
Income tax expense ..................................................... 3,178 I
Retained earnings ........................................................ 84,990 B
Net earnings ................................................................ 11,785 I
Property, plant and equipment (net) ............................ 22,304 B
Selling, general and administrative expense ............... 25,314 I
Accounts receivable ..................................................... 6,386 B
Total liabilities............................................................... 74,290 B
Stockholders' equity ..................................................... 69,976 B
Net earnings from continuing operations 11,707 I
b. Total assets = Total liabilities + Stockholders’ equity

Total assets = $74,290 + $69,976 = $144,266

E2-41. (15 minutes)
a.
Shoprite Holdings Ltd (Rand millions) Amount Classification
Sales of merchandise R 102,204 I
Depreciation and amortisation 1,730 I
Reserves (Retained earnings) 13,218 B
Property, plant and equipment 13,576 B
Cost of goods and services 86,444 I
Trade and other payables 16,332 B
Total equity and liabilities 40,533 B
Total equity 17,283 B
Salaries, wages and service benefits 8,373 I
Total non-current assets 15,730 B
Total non-current liabilities 5,531 B
b. Total assets = Total liabilities and shareholders’ investment

Total assets = R 40,533 million.
c. Current ratio = Current assets/Current liabilities

= [R 40,533 – R 15,730] / [R 40,533 – R 17,283 – R 5,531]
= R 24,803 / R 17,719 = 1.40

E2-42. (15 minutes)
a.
El Puerto de Liverpool
Amount Classification
(Mexican peso thousands)
Total revenue $ 74,105,444 I
Retained earnings 50,347,782 B
Inventory 11,421,969 B
Administration expenses 19,397,781 I
Total assets 94,936,904 B
Long-term loans from financial institutions 921,456 B
Financing costs (expenses) 1,088,892 I
Total current assets 37,556,611 B
Total stockholders’ equity 54,827,332 B
Prepaid expenses 617,387 B
Total non-current liabilities 14,483,101 B
b. Total liabilities = Total assets - Stockholders’ equity

Total liabilities = $94,936,904 - $54,827,332 = $40,109,572
Current liabilities = $40,109,572 - $14,483,101 = $25,626,471
c. Quick ratio = [Cash + Marketable securities + Accts. receivable] / Current

Liabilities
= [Current assets – Inventory – Prepaid expenses] / Current
liabilities
= [$37,556,611 - $11,421,969 - $617,387] / $25,626,471
= 1.00

E2-43. (15 minutes)
a.
Kimberly-Clark ($ millions) Amount Classification
Net sales ......................................................................$19,724 I
Cost of goods sold ....................................................... 13,041 I
Retained earnings ........................................................ 8,470 B
Net income ................................................................ 1,595 I
Property, plant & equipment, net ................................ 7,359 B
Marketing, research and general expenses ................. 3,709 I
Accounts receivable, net .............................................. 2,223 B
Total liabilities............................................................... 14,527 B
Total stockholders' equity ............................................. 999 B
b. Total assets = Total liabilities + Stockholders’ equity

Total assets = $14,527 + $999 = $15,526
Total revenue – Total expenses = Net income

$19,724 – Total expenses = $1,595
Thus, Total expenses = $18,129
c. Debt-to-equity ratio = Total liabilities / Stockholders’ equity

= $14,527 / $999 = 14.54

E2-44. (15 minutes)
Transaction

(1) Receive €50,000 in +50,000 +50,000

exchange for common = - =
Cash Common
stock.
Stock
(2) Borrow €10,000 from +10,000 +10,000

bank.
Cash = Notes - =
Payable
(3) Purchase €2,000 of +2,000 +2,000

supplies inventory on
Inventory = Accounts - =
credit.
Payable
(4) Receive €15,000 cash +15,000 +15,000 +15,000

from customers for +15,000
Cash = Retained Revenue - =
services provided.
Earnings
(5) Pay €2,000 cash to - 2,000 - 2,000

supplier in part (3). = - =
Cash Accounts
Payable
(6) Receive order for future +3,500 +3,500

services with €3,500 = - =
Cash Unearned
advance payment.
Revenue
(7) Pay €5,000 cash - 5,000 - 5,000

dividend to = - =
Cash Retained
shareholders.
Earnings
(8) Pay employees €6,000 - 6,000 - 6,000 +6,000

cash for compensation - 6,000
Cash = Retained - Wages =
earned.
Earnings Expense
(9) Pay €500 cash for - 500 - 500 +500

interest on loan in (2). - 500
Cash = Retained - Interest =
Earnings Expense
Totals 65,000 + 2,000 = 13,500 + 50,000 + 3,500 15,000 - 6,500 = 8,500

E2-45. (20 minutes)
a.
1. Cash (+A) ................................................................................50,000
Common stock (+SE) ......................................................... 50,000
Receive €50,000 in exchange for common stock.
2. Cash (+A) ................................................................................10,000

Notes payable (+L) ............................................................. 10,000
Borrow €10,000 from bank.
3. Inventory (+A) ......................................................................... 2,000

Accounts payable (+L) ........................................................ 2,000
Purchase €2,000 supplies inventory on account.
4. Cash (+A) ................................................................................15,000

Revenue (+R, +SE) ............................................................ 15,000
Recognize €15,000 revenue for services provided.
5. Accounts payable (-L) ............................................................. 2,000

Cash (-A) ............................................................................ 2,000
Pay supplier €2,000 cash.
6. Cash (+A) ................................................................................ 3,500

Unearned revenue (+L) ...................................................... 3,500
Receive €3,500 advance from customer.
7. Retained earnings (-SE) ......................................................... 5,000

Cash (-A) ............................................................................ 5,000
Pay €5,000 cash dividend to shareholders.
8. Wages expense (+E, -SE) ...................................................... 6,000

Cash (-A) ............................................................................ 6,000
Pay employees €6,000
9. Interest expense (+E, -SE)...................................................... 500

Cash (-A) ............................................................................ 500
Pay €500 interest on note.

b.
+ Cash (A) - - Accounts Payable (L) +
(1) 50,000 2,000 (5) (5) 2,000 2,000 (3)
(2) 10,000 5,000 (7) 0 Bal.
(4) 15,000 6,000 (8)
(6) 3,500 500 (9) - Unearned Revenue (L) +
Bal. 65,000 3,500 (6)
3,500 Bal.
+ Supplies Inventory (A) - - Notes Payable (L) +

(3) 2,000 10,000 (2)
Bal. 2,000 10,000 Bal.
- Revenue (R) + - Common Stock (SE) +

15,000 (4) 50,000 (1)
15,000 Bal. 50,000 Bal.
+ Wages Expense (E) - - Retained Earnings (SE) +

(8) 6,000 (7) 5,000
Bal. 6,000 Bal. 5,000
+ Interest Expense (E) -

(9) 500

E2-46. (20 minutes)
a. and b.
BETTIS CONTRACTORS
Balance Sheets
June 30, July 2,
2015 2015
Assets
Cash $ 14,700 $ 2,200
Supplies 30,500 30,500
Current assets 54,400 41,900
Land 25,000 25,000
Equipment 98,000 108,000
Total assets $177,400 $174,900
Liabilities
Current liabilities 8,900 8,900
Common stock 100,000 100,000
c. CR = $54,400 / $8,900 = 6.11

QR = ($14,700 +$9,200) / $8,900 = 2.69
d. Bettis’ current ratio indicates a strong liquidity position. The firm might want to
consider investing some of its cash in assets that contribute to the firm’s
earning power. The quick ratio is reasonable as a company does not want to
tie up too much of its assets in a nonearning asset (cash). A quick glance at
the data indicates that the firm's liquidity position has weakened since June.

E2-47. (15 minutes)

Noncash Contrib. Earned Net
Transaction Cash Asset + = Liabilities + + Revenues - Expenses =
Assets Capital Capital Income
1. Receive $20,000 cash +20,000 +20,000

in exchange for = - =
Cash Common
common stock.
Stock
2. Purchase $2,000 of +2,000 +2,000

inventory on credit. = - =
Inventory Accts
Payable
3. Sell inventory for +3,000 +3,000 +3,000

$3,000 on credit. +3,000
Accounts = Retained Sales - =
Receivable Earnings
4. Record cost of goods -2,000 -2,000 + 2,000

sold in 3.
Inventory = Retained - COGS = - 2,000
Earnings Expense
5. Collect $3,000 cash +3,000 -3,000

from transaction 3.
Cash Accounts = - =
Receivable
6. Acquire $5,000 of +5,000 +5,000

equipment by signing = - =
Equipment Notes
a note.
Payable
7. Pay wages of $1,000 -1,000 -1,000 + 1,000

in cash. - 1,000
Earnings Expense
8. Pay $5,000 cash on a -5,000 -5,000

note payable.
Cash = Notes - =
Payable
9. Pay $2,000 cash -2,000 -2,000

dividend. = - =
Cash Retained
Earnings
TOTALS 15,000 + 5,000 = 2,000 + 20,000 + -2,000 3,000 - 3,000 = 0

E2-48. (20 minutes)
a.
1. Cash (+A) ................................................................................
20,000
Common stock (+SE) .......................................................... 20,000
2. Inventory (+A) ..........................................................................

2,000
Accounts payable (+L) ........................................................ 2,000
3. Accounts receivable (+A) ........................................................

3,000
Sales (+R, +SE) ................................................................ 3,000
4. Cost of goods sold (+E, -SE) ................................................... 2,000

Inventory (-A) ................................................................ 2,000
5. Cash (+A) ................................................................................

3,000
Accounts receivable (-A) ..................................................... 3,000
6. Equipment (+A) ................................................................ 5,000

Notes payable (+L).............................................................. 5,000
7. Wages expense (+E, -SE) ....................................................... 1,000

Cash (-A) ............................................................................. 1,000
8. Notes payable (-L) ................................................................5,000

Cash (-A) ............................................................................. 5,000
9. Retained earnings (-SE) .......................................................... 2,000

Cash (-A) ............................................................................. 2,000

b.
+ Cash (A) - - Common Stock (SE) +
(1) 20,000 1,000 (7) 20,000 (1)
(5) 3,000 5,000 (8)
2,000 (9)
- Sales Revenue (R) +
3,000 (3)
+ Inventory (A) -
(2) 2,000 2,000 (4)
+ Cost of Goods Sold (E) -
(4) 2,000
+ Accounts Receivable (A) -
(3) 3,000 3,000 (5)
+ Wages Expense (E) -
+ Equipment (A) - (7) 1,000
(6) 5,000
- Retained Earnings (SE) +

- Accounts Payable (L) + (9) 2,000
2,000 (2)
- Notes Payable (L) +

(8) 5,000 5,000 (6)

PROBLEMS
P2-49. (30 minutes)

a. Comcast, Target and Harley-Davidson are financed primarily by debt
(between 65% and 70% of total assets). Apple and Nike are financed more
by equity, 48% and 58%, respectively.
b. Apple and Nike both earned over 10% on assets. Possible reasons include
the firms’ ability to command a premium price for their brands and the ability
to outsource a significant amount of their production (and avoid investments
in productive capacity).
c. Apple has the highest estimated ROE at 35%. (The ROE is estimated
because we have only this year’s equity.) Harley-Davidson has the second
highest ROE at 29%, and Nike is at 25%. Both Apple and Nike are able to
reduce expenses through outsourcing production to Asia. All three
companies have strong brands suggesting marketing and pricing advantages.
P2-50. (30 minutes)
a. Hewlett-Packard is 74% debt financed while Apple is 52% debt financed. We

describe Hewlett-Packard as the more heavily leveraged firm. Some of the
difference can be attributed to HPQ’s expensive acquisitions that resulted in
subsequent write-offs.
b. Hewlett-Packard's net income to asset ratio is 5% while Apple’s is 17%. The

ratios are not close, which might not be expected given the similarities of their
activities. More heavily leveraged firms are open to greater risk and for this
reason, we might expect a greater return to be earned on Hewlett-Packard’s
assets to compensate for the higher risk. But that turns out not to be the
case. Apple’s return exceeds Hewlett-Packard’s, suggesting that Apple has
superior products or is more efficient in its operations.
c. Hewlett-Packard’s gross profit as a percent of sales is 24% while Apple’s is

39%. The implication is that Apple does have the more efficient production
operation and/or product designs that allow it to command a premium price
from consumers.

P2-51. (30 minutes)
a. Comcast is 67% financed with debt, while Verizon is 95% financed with debt.
High debt financing is not uncommon in an industry with large investments in
property, plant and equipment. Verizon’s debt percentage is particularly high
as it repurchased a significant portion of its common stock that had been held
by Vodafone Group, thereby reducing shareholders’ equity.
b. Comcast has the slightly higher net income to total asset ratio at 5.3%
compared to 4.1% for Verizon, but neither company is doing very well. The
cost of raising operating funds is probably larger than either firm’s current
return. Certainly one reason is the highly competitive market in which these
two firms operate.
c. Verizon has a slightly lower return on total assets while reporting much higher
leverage (debt), so it is likely that Comcast would have better access to
additional capital.
P2-52. (30 minutes)
a. 3M at 58% is the more heavily debt-financed firm. Abercrombie and Fitch is

the lowest debt financed at 45%. Apple is 52% financed by debt.
b. 3M has more working capital, even though it is a much smaller firm than
Apple. A better measure of the comparative differences in working capital is
the ratio of the firm’s current assets to its current liabilities. This ratio is
greatest for Abercrombie & Fitch at 2.4.
P2-53. (30 minutes)
a. BARTH COMPANY
Balance Sheet
December 31, 2015
Assets Liabilities
Cash $ 8,800 Accounts payable $ 7,500
Equipment 9,000
Land 50,000 Equity
Stockholders’ equity 78,700
Total assets $86,200 Total liabilities & equity $86,200

b. Increase in Equity ($78,700-$67,500) $11,200
c. Increase in Equity ($78,700-$67,500) $11,200

32,200
Less: Additional Investment 13,500
P2-54. (20 minutes)

a.
ANF JWN
Total assets (Total liabilities and equity) $2,505 $9,245
Total expenses (Sales – Net income) 3,692 12,786
Total expenses as percent of sales 98.6% 94.7%
($3,692/$3,744) ($12,786/$13,506)
b.
ANF JWN
Return on $52 $720
= 3.3% = 31.9%
average equity… [($2,505-$1,115)+$1,729]/2 [($9,245-$6,805)+$2,080]/2
P2-55. (30 minutes)
a.
Current Noncurrent Total Current Noncurrent Total
($ millions) Assets Assets Assets Liabilities Liabilities Liabilities Equity
2011 $6,283 $13,090 $19,373 $5,397 $8,727 $14,124 $5,249
2012 6,589 13,284 19,873 6,091 8,797 14,888 4,985
2013 6,550 12,369 18,919 5,848 8,215 14,063 4,856
2014 5,559 9,967 15,526 6,226 8,571 14,797 729
b. Kimberly Clark’s current assets most likely include cash, accounts receivable,
inventories, and prepaid assets.
Its long-term assets most likely include property, plant and equipment (PPE),
goodwill, and other intangible assets that have arisen from acquisitions.

c. 2011: Working capital = $6,283 - $5,397 = $886
Current ratio = $6,283 / $5,397= 1.16
2014: Working capital= $5,559 - $6,226 = $(667)
Current ratio $5,559 / $6,226 = 0.89
d. Kimberly Clark’s liquidity ratios have decreased over this four year period. In
2014, the working capital is negative, so the current ratio is less than one.
The company’s revenues have not changed much over the past four years,
and the company has reduced its investment in inventory. In addition, 2014’s
current liabilities contain a higher amount of Current Portion of Long Term
Debt than 2011’s.
P2-56. (30 minutes)
a.
2011 $10,244 $11,137 $21,381 $9,212 $7,888 $17,100 $4,281
2012 9,265 10,075 19,340 8,414 8,171 16,585 2,755
2013 8,959 9,302 18,261 8,185 8,337 16,522 1,739
2014 5,863 7,346 13,209 6,076 8,084 14,160 -951
b. We might reasonably predict inventories to comprise the bulk of its current

assets. In fact, SHLD’s inventory is more than 80% of its current assets.
c. 2011: $10,244 / $9,212 = 1.11; 2014: $5,863 / $6,076 = 0.96
d. SHLD’s deteriorating condition can been seen in the decline in current assets,
non-current assets and its shareholders’ equity. In fact, by the end of 2014,
SHLD’s shareholders’ equity was negative, indicating that the book value of
its liabilities exceeded the book value of its assets.

P2-57. (30 minutes)
a.
1. Issued common stock +7,000 +7,000
$7,000. = - =
Cash Common
Stock
2. Paid rent $750. -750 -750 +750
Cash = Retained - Rent = -750
Earnings Expense
3. Received $500 invoice +500 -500 +500

for advertising expense. = - = -500
Accounts Retained Advertising
Payable Earnings Expense
4. Borrowed $15,000 cash +15,000 +15,000

from bank. = - =
Cash Notes
Payable
5. $1,200 cash received for +1,200 +1,200 +1,200
services.
Cash = Retained Counseling - = +1,200
Earnings Services
Revenue
6. Billed clients $6,800 for +6,800 +6,800 +6,800

services. Retained
Accounts = Counseling - = +6,800
Earnings
Receivable Services
Revenue
7. Paid $2,200 cash for -2,200 -2,200 +2,200

salary. = - = -2,200
Cash Retained Salary
Earnings Expense
8. Paid $370 cash for -370 -370 +370

utilities. = - = -370
Cash Retained Utilities
Earnings Expense
9. Paid $900 cash -900 -900

dividend. = - =
Cash Retained
Earnings
10. Acquired land for -13,000 +13,000

$13,000. = - =
Cash Land
11. Paid $100 interest in -100 -100 +100

cash. = - = -100
Cash Retained Interest
Earnings Expense
Totals $5,880 + $19,800 = $15,500 + $7,000 + $3,180 $8,000 - $3,920 = $4,080

b. LAMBERT SERVICES
Income Statement
For the Month of December 2015
Counseling services revenue $8,000
Expenses
Rent expense $ 750
Advertising expense 500
Salary expense 2,200
Utilities expense 370
Interest expense 100
Total expenses 3,920
Net income $4,080
P2-58. (30 minutes)
a.
1. Cash (+A) ................................................................................
7,000
Common stock (+SE) .......................................................... 7,000
2. Rent expense (+E,-SE) ........................................................... 750

Cash (-A) ............................................................................. 750
3. Advertising expense (+E, -SE) ................................................

500
Accounts payable (+L) ........................................................ 500
4. Cash (+A) ................................................................................

15,000
Notes payable (+L).............................................................. 15,000
5. Cash (+A) ................................................................................

1,200
Counseling services revenue (+R,+SE) .............................. 1,200

6,800
Counseling services revenue (+R,+SE) .............................. 6,800
7. Salary expense (+E,-SE) ......................................................... 2,200

Cash (-A) ............................................................................. 2,200
8. Utilities expense (+E,-SE) ....................................................... 370

Cash (-A) ............................................................................. 370
9. Retained earnings (dividend paid) (-SE) ................................ 900

Cash (-A) ............................................................................. 900
continued next page

10. Land (+A) ................................................................................
13,000
Cash (-A) ............................................................................. 13,000
11. Interest expense (+E,-SE) 100

Cash (-A) ............................................................................. 100
b.
(1) 7,000 750 (2) 500 (3)
(4) 15,000 2,200 (7)
(5) 1,200 370 (8)
900 (9) - Notes Payable (L) +
13,000 (10) 15,000 (4)
100 (11)
- Common Stock (SE) +

+ Accounts Receivable (A) - 7,000 (1)
(6) 6,800

+ Land (A) - (9) 900
(10) 13,000
- Counseling Services Rev. (R) +

+ Rent Expense (E) - 1,200 (5)
(2) 750 6,800 (6)
+ Salary Expense (E) - + Advertising Expense (E) -

(7) 2,200 (3) 500
+ Interest Expense (E) - + Utilities Expense (E) -

(11) 100 (8) 370

P2-59. (30 minutes)
a.

2011 $44,988 $71,383 $116,371 $27,970 $11,786 $39,756 $76,615
2012 57,653 $118,411 176,064 38,542 $19,312 57,854 118,210
2013 73,286 $133,714 207,000 43,658 $39,793 83,451 123,549
2014 68,531 $163,308 231,839 63,448 $56,844 120,292 111,547
b. For a computer company we might reasonably expect inventories and cash to

be the predominant items in current assets. The reality is that inventory is not
a large dollar amount (less than 1% of total assets) because the company’s
business model depends on high inventory turnover—that is, it works
diligently to minimize the quantity of inventory to avoid product obsolescence.
The surprise is that 37% of Apple’s current assets are cash and short-term
marketable securities. Long-term assets are primarily concentrated in
financial securities, with property, plant and equipment a distant second.
c. The percentage of Apple’s assets that is financed with liabilities has increased
considerably over this time period. AAPL has started to pay shareholder
dividends and to repurchase its common stock, but it has borrowed money to
do so.
d. 2011: $44,988/$27,970 = 1.61;

2014: $68,531/$63,448 = 1.08
e. Apple’s current ratio is below the industry average. A probable cause of this
decrease is the increasing size of the company. Net working capital has
decreased in 2014. So, even though these measures have declined, the
monetary “cushion” of AAPL’s financial assets has continued to increase.

P2-60. (30 minutes)
a.
(RMB Current Noncurrent Total Current Noncurrent Total
millions) Assets Assets Assets Liabilities Liabilities Liabilities Equity
2012 27,899 19,311 47,210 11,751 3,941 15,692 31,518
2013 43,162 20,624 63,786 23,995 29,282 53,277 10,509
2014 67,833 43,716 111,549 37,384 34,426 71,810 39,739
b. Alibaba’s current assets are likely to be primarily comprised of cash,

accounts receivable, inventories and prepaid expenses.
Its long-term assets will likely be primarily comprised of property, plant
and equipment (PPE) for its operations, financial investments, and
goodwill and other intangible assets arising from acquisitions.
c. Current ratio: 2012: 27,899 / 11,751 = 2.37; 2014: 67,833 / 37,384 =

1.81
d. Working capital: 2012: 27,899 - 11,751 = 16,148; 2014: 67,833 - 37,384 =

30,449
P2-61. (30 minutes)
a.
Cost of Gross Operating Operating Other Net
($ millions) Revenues Goods Sold Profit Expenses Income Expense Income
2011 20,117 10,915 9,202 6,361 2,841 708 2,133
2012 23,331 13,183 10,148 7,079 3,069 858 2,211
2013 25,313 14,279 11,034 7,796 3,238 766 2,472
2014 27,799 15,353 12,446 8,766 3,680 987 2,693
b. The gross profit percentage (also called gross profit margin) for each year
follows:
Nike, Inc. Gross Profit Percentage

2011 ....................... 45.7%
2012 ....................... 43.5%
2013 ....................... 43.6%
2014 ....................... 44.8%

Nike’s sales, gross profit and net income have increased steadily over this
period, reflecting continued strength and an upward trend. The company's
operating expenses have increased, but not as much as gross profit.
c. Wages, advertising and promotion, and general and administration expenses

are likely to be the major cost categories for Nike.

P2-62. (30 minutes)
a.
Transaction Asset + Assets = Liabilities + Capital + Capital Revenues - Expenses = Income
1. Issued common stock for +$50,000 +$50,000
cash.
Cash = Common - =
Stock
2. Rent paid in cash $4,800. -4,800 -4,800 +4,800

Cash = Retained - Rent = -4,800
Earnings Expense
3. Invoice for entertainment +1,600 -1,600 +1,600

expense: $1,600. = Accounts - Entertainment = -1,600
Retained
Payable Expense
Earnings
4. Cash paid for advertising: -900 -900 +900
$900.
Cash = Retained - Advertising = -900
Earnings Expense
5. July insurance premium -1,800 +1,800

prepaid in cash: $1,800. = - =
Cash Prepaid
Insurance
6. Flight services collected +22,700 +22,700 +22,700
in cash; $22,700.
Cash Retained Flight
= - = +22,700
Earnings Services
Revenue
7. Billed for flight services ; +15,900 +15,900 +15,900

$15,900.
Accounts Retained Flight
Receivable = Earnings Services - = +15,900
Revenue
8. Paid $1,500 on accounts. -1,500 -1,500

Cash = Accounts - =
Payable
9. Received $13,200 on +13,200 -13,200
account. = - =
Cash Accounts
Receivable
10. Paid wages in cash: -16,000 -16,000 +16,000
$16,000.
Cash = Retained - Wages = -16,000
Earnings expense
11. Invoice received for fuel; +3,500 -3,500 +3,500

$3,500. = Accounts - = -3,500
Retained Fuel
12. Cash dividend paid; -3,000 -3,000

$3,000. = - =
Cash Retained
Earnings
TOTALS $57,900 + $4,500 = $3,600 + $50,000 + $8,800 $38,600 - $26,800 = $11,800

b. OUTBACK FLIGHTS
Income Statement
For the Month of June 2015
Revenue
Services fees earned $38,600
Expenses
Rent expense $ 4,800
Entertainment expense 1,600
Advertising expense 900
Wages expense 16,000
Fuel expense 3,500
Net income $11,800
Note: The insurance premium paid is for the next month (July) and is not an
expense at the end of June.
P2-63. (30 minutes)
a.
1. Cash (+A)................................................................................
50,000
Common stock (+SE) ......................................................... 50,000
2. Rent expense (+E,-SE) ...........................................................

4,800
Cash (-A) ................................................................ 4,800
3. Entertainment expense (+E,-SE) ................................ 1,600

Accounts payable (+L)........................................................ 1,600
4. Advertising expense (+E,-SE) ................................................900

Cash (-A) ................................................................ 900
5. Prepaid insurance (+A) ...........................................................

1,800
Cash (-A) ................................................................ 1,800
6. Cash (+A) ................................................................ 22,700

Flight services revenue (+R,+SE) ................................ 22,700

15,900
Flight services revenue (+R,+SE) ................................ 15,900
continued next page

8. Accounts payable (-L) .............................................................
1,500
Cash (-A) ................................................................ 1,500
9. Cash (+A)................................................................................
13,200
Accounts receivable (-A) .................................................... 13,200
10. Wages expense (+E,-SE) .......................................................

16,000
Cash (-A) ................................................................ 16,000
11. Fuel expense (+E,-SE) ...........................................................

3,500
Accounts payable (+L)........................................................ 3,500
12. Retained earnings (dividend paid) (-SE)................................ 3,000

Cash (-A) ................................................................ 3,000
b.
(1) 50,000 4,800 (2) (8) 1,500 1,600 (3)
(6) 22,700 900 (4) 3,500 (11)
(9) 13,200 1,800 (5)
1,500 (8)
16,000 (10) - Common Stock (SE) +
3,000 (12) 50,000 (1)
+ Accounts Receivable (A) - - Retained Earnings (SE) +

(7) 15,900 (9) 13,200 (12) 3,000
+ Prepaid Insurance (A) - - Flight Services Revenue (R) +

(5) 1,800 22,700 (6)
15,900 (7)
+ Rent Expense (E) - + Entertainment Expense (E) -

(2) 4,800 (3) 1,600
+ Advertising Expense (E) - + Wages Expense (E) -

(4) 900 (10) 16,000
+ Fuel Expense (E) -

(11) 3,500

P2-64. (30 minutes)
a.
($ millions) Revenues Revenues Profit Expenses Income Expense Income
2011 11,700 8,510 3,190 1,461 1,729 483 1,246
2012 13,277 9,732 3,545 1,547 1,998 614 1,384
2013 14,867 10,668 4,199 4,400 (201) ( 210) 9
2014 16,448 11,497 4,951 1,870 3,081 1,013 2,068
follows:
Starbucks, Inc. Gross Profit Percentage

2011 27.3%
2012 26.7%
2013 28.2%
2014 30.1%
SBUX gross profit percentage has improved in recent years after an earlier
decline in the late 2000s..
c. Selling, general and administrative expenses are the major operating

expense categories for Starbucks. Store expenses (rent, employee
compensation, coffee, etc.) are included in the Cost of Revenues category.
Operating expenses for 2013 included a litigation charge of $2.8 billion

resulting from a lawsuit filed by Kraft Global Foods.

P2-65. (30 minutes)
a.
(€ millions) Revenues Goods Sold Profit Expenses Income Expense Income
2011 €73,275 €51,046 €22,229 €14,012 €8,217 €2,072 €6,145
2012 77,395 55,470 21,925 15,210 6,715 2,565 4,150
2013 73,445 53,310 20,135 14,958 5,177 893 4,284
2014 71,920 51,165 20,755 14,038 6,717 1,344 5,373
follows:
Siemens AG Gross Profit Percentage

2011 30.3%
2012 28.3%
2013 27.4%
2014 28.9%
Siemens’ gross profit percentage increased in 2014 after having decreased

the previous two years. The decline reflects the difficult economic conditions
and Siemens’ declining sales over the period.
c. The principal items in Siemens’ operating expenses include selling and

general administrative expenses and research and development expenses.

P2-66. (25 minutes)
a.
GEYER, INC.
Income Statement
Service fees ................................................................ $67,600
Supplies expense ................................................................
$ 9,700
Insurance expense ................................................................
1,500
Salaries expense................................................................
30,000
Advertising expense ................................................................
1,700
Rent expense ................................................................
7,500
Miscellaneous expense ................................................................
200
Total expenses ................................................................ 50,600
Net income ................................................................ $17,000
b.
GEYER, INC.
Total
Balance at December 31, 2014 .............. $4,000 $6,200 $10,200
Stock issuance ................................ 1,400 1,400
Dividends .............................................. (13,500) (13,500)
Net income ............................................
_____ 17,000 17,000
Balance at December 31, 2015 .............. $5,400 $9,700 $15,100
c.
GEYER, INC.
Balance Sheet
December 31, 2015
Cash ...................................... $14,800 Accounts payable ................................
$ 1,800
Supplies ................................ 6,100 Notes payable ................................ 4,000
Total assets ........................... $20,900 Total liabilities ……………… 5,800
Common stock ………………. 5,400
Retained earnings* …………. 9,700
Total liabilities and equities .. $20,900
* $6,200 beginning balance + $17,000 net income - $13,500 dividend

P2-67. (45 minutes)
a & b.
Beginning Balances +5,000 +5,200 = +3,500 +5,500 +1,200 -
1. Paid $600 cash toward -600 -600

accounts payable
Cash = Accounts - =
Payable
2. Paid rent in cash: -3,600 -3,600 +3,600

$3,600 = - = -3,600
Cash Retained Rent
Earnings Expense
3. Billed clients $11,500 +11,500 +11,500 +11,500

Accounts = Retained Services - = +11,500
Receivable Earnings Revenue
4. $500 invoice received +500 -500 +500

for advertising = Accounts - = -500
Retained Advertising
5. Cash collected on +10,000 -10,000

account: $10,000 = - =
Cash Accounts
Receivable
6. Paid wages expense in -2,400 -2,400 +2,400

cash: $2,400 = - = -2,400
Cash Retained Wages
Earnings Expense
7. Invoiced for utility +680 -680 +680

expense: $680 = Accounts - = -680
Retained Utilities
8. Paid $20 cash for -20 -20 +20

interest on note = - = -20
Earnings Expense
9. Paid $900 cash dividend -900 -900
Cash = Retained - =
Earnings
10. Paid $4,000 cash for -4,000 +4,000
sound equipment = - =
Cash Equipment
TOTALS $3,480 + $10,700 = $4,080 + $5,500 + $4,600 $11,500 - $7,200 = $4,300

c.
SCHRAND AEROBICS, INC.
Income Statement
For Month Ended January 31, 2015
Services revenue ....................................................................................$11,500

Expenses ................................................................................................
Rent expense .....................................................................................
3,600
Advertising expense................................................................500
Wages expense .................................................................................
2,400
Interest expense ................................................................................
20
Utilities expense .................................................................................
680
Total expenses........................................................................................ 7,200
Net income ......................................................................................... $4,300
d.
SCHRAND AEROBICS, INC.
Common Retained Total

Stock Earnings Stockholders’
Equity
Balance at January 1, 2015 .................... $5,500 $1,200 $ 6,700
Stock issuance ................................
Dividends .............................................. (900) (900)
Net income ............................................
_____ 4,300 4,300
Balance at January 31, 2015 .................. $5,500 $4,600 $10,100
e.
Schrand Aerobics, Inc.
Balance Sheet
January 31, 2015
Cash ...................................... $ 3,480 Accounts payable .............................
$ 1,580
Accounts receivable .............. 6,700 Notes payable ................................ 2,500
Equipment ............................. 4,000 Total liabilities ................................
4,080
Total assets ……………. $14,180 Common stock ................................ 5,500
Retained earnings ............................ 4,600
Total liabilities and equity ..................
$14,180

P2-68. (30 minutes)
a.
1. Accounts payable (-L) ............................................................. 600

Cash (-A) ............................................................................. 600
2. Rent expense (+E,-SE) ........................................................... 3,600

Cash (-A) ............................................................................. 3,600

11,500
Services revenue (+R,+SE) ................................................ 11,500
4. Advertising expense (+E, -SE) ................................................

500
5. Cash (+A) ................................................................................

10,000
6. Wages expense (+E, -SE) ....................................................... 2,400

Cash (-A) ............................................................................. 2,400
7. Utilities expense (+E, -SE) ......................................................

680
8. Interest expense (+E, -SE) ......................................................20

Cash (-A) ............................................................................. 20
9. Retained earnings (-SE) .......................................................... 900

Cash (-A) ............................................................................. 900
10. Equipment (+A) ................................................................ 4,000

Cash (-A) ............................................................................. 4,000

b.
Beg. Bal. 5,000 600 (1) (1) 600 1,000 Beg. Bal.
(5) 10,000 3,600 (2) 500 (4)
2,400 (6) 680 (7)
20 (8) 1,580 End Bal.
900 (9) - Notes Payable (L) +
4,000 (10) 2,500 Beg. Bal.
End Bal. 3,480
2,500 End Bal.
+ Accounts Receivable (A) - - Common Stock (SE) +
Beg. Bal. 5,200 10,000 (5) 5,500 Beg. Bal.
(3) 11,500
End Bal. 6,700 5,500 End Bal.
+ Equipment (A) - - Retained Earnings (SE) +
(10) 4,000 (9) 900 1,200 Beg. Bal.
End Bal. 4,000 300 End Bal.
+ Wages Expense (E) - - Services Revenue (R) +

(6) 2,400 11,500 (3)
End Bal. 2,400 11,500 End Bal.
+ Rent Expense (E) - + Utilities Expense (E) -

(2) 3,600 (7) 680
End Bal. 3,600 End Bal. 680
+ Advertising Expense (E) - + Interest Expense (E) -

(4) 500 (8) 20
End Bal. 20
End Bal. 500

P2-69. (45 minutes)
a & b.

Beginning Balances +6,700 +14,800 = +3,100 +6,000 +12,400 =
1. Paid $950 cash for rent. -950 -950 +950

Cash = Retained - Rent = -$950
Earnings Expense
2. Received $8,800 cash +8,800 -8,800

on account.
Cash Accounts = - =
Receivable
3. $500 paid on accts. -500 -500

payable. = - =
Cash Accts
Payable
4. Received $1,600 cash +1,600 +1,600 +1,600

for services.
Cash = Retained Services - = +1,600
Earnings Revenue
5. Borrowed $5,000 signed +5,000 +5,000

note. = - =
Cash Notes
Payable
6. Billed $8,100 for +8,100 +8,100 +8,100

services. = - = +8,100
Accounts Retained Services
7. Paid $4,000 for cash -4,000 -4,000 +4,000

salary. = - = -4,000
Cash Retained Salary
Earnings Expense
8. Received invoice for +410 -410 +410

utilities: $410. = - = -410
Accts Retained Utilities
9. Paid $6,000 dividend. -6,000 -6,000

Cash = Retained - =
Earnings
10. Paid $9,800 cash for -9,800 +9,800

vehicle. = - =
Cash Vehicles
11. Paid $50 cash interest -50 -50 +50
on note. = - = -50
Earnings Expense
TOTALS $800 + $23,900 = $8,010 + $6,000 + $10,690 $9,700 - $5,410 = $4,290

c.
KROSS, INC.
Income Statement
Services revenue................................................................... $9,700
Rent expense………………………………………………... $ 950
Utilities expense……………………………………………. 410
Salary expense………………………………………….… 4,000
Interest expense………………………………………….… 50
Total expenses ...................................................................... 5,410
Net income ....................................................................... $4,290
d.
KROSS, INC.

Stock Earnings Stockholders’
Equity
Balance at January 1, 2015 .................... $6,000 $12,400 $18,400
Stock issuance ................................
Dividends .............................................. (6,000) (6,000)
Net income ............................................
_____ 4,290 4,290
Balance at January 31, 2015 .................. $6,000 $10,690 $16,690
e.
KROSS, INC.
Balance Sheet
January 31, 2015
Cash ......................................$ 800 Accounts payable ..............................

$ 510
Accounts receivable .............. 14,100 Notes payable ................................ 7,500
Equipment ............................. 9,800 Total liabilities ................................ 8,010
Total assets ...........................$24,700
Common stock ................................ 6,000

Retained earnings .............................
10,690
Total liabilities and equity ..................
$24,700

P2-70. (30 minutes)
a.
1. Rent expense (+E,-SE) ........................................................... 950
Cash (-A) ............................................................................. 950
2. Cash (+A) ................................................................................

8,800
3. Accounts payable (-L) ............................................................. 500

Cash (-A) ............................................................................. 500
4. Cash (+A) ................................................................................

1,600
Services revenue (+R,+SE) ................................................ 1,600
5. Cash (+A) ................................................................................

5,000
Notes payable (+L).............................................................. 5,000

8,100
Services revenue (+R, +SE) ............................................... 8,100
7. Salary expense (+E,-SE) ......................................................... 4,000

Cash (-A) ............................................................................. 4,000
8. Utilities expense (+E,-SE) .......................................................

410
9. Retained earnings (-SE) .......................................................... 6,000

Cash (-A) ............................................................................. 6,000
10. Vehicles (+A) ................................................................ 9,800

Cash (-A) ............................................................................. 9,800
11. Interest expense (+E,-SE) .......................................................50

Cash (-A) ............................................................................. 50

b.
+ Cash (A) - + Utilities Expense (E) -
Beg. Bal. 6,700 950 (1) (8) 410
(2) 8,800 500 (3)
(4) 1,600 4,000 (7)
(5) 5,000 6,000 (9)
9,800 (10) + Interest Expense (E) -
50 (11) (11) 50
+ Accounts Receivable (A) - - Accounts Payable (L) +

Beg. Bal. 14,800 8,800 (2) (3) 500 600 Beg. Bal.
(6) 8,100 410 (8)
+ Vehicles (A) - - Notes Payable (L) +

(10) 9,800 2,500 Beg. Bal.
5,000 (5)
- Common Stock (SE) +

6,000 Beg. Bal.
+ Rent Expense (E) - - Retained Earnings (SE) +

(1) 950 (9) 6,000 12,400 Beg. Bal.
+ Salary Expense (E) - - Services Revenue (R) +

(7) 4,000 1,600 (4)
8,100 (6)

CASES and PROJECTS
C2-71. (30 minutes)
a. WILDLIFE PICTURE GALLERY

Income Statement
For the month of March 2015
Revenues
Commissions earned $28,500
Expenses
Rent expense $ 900
Wages expense 4,900
Utilities expense 350
Delivery expense 1,700
Net income $20,650
b. WILDLIFE PICTURE GALLERY

For the month of March 2015
Balance at March 1, 2015 ....................... $ 0 $ 0 $ 0
Stock issuance ................................ 6,500 6,500
Dividends ..............................................
Net income ............................................
_____ 20,650 20,650
Balance at March 31, 2015 ..................... $6,500 $20,650 $27,150
c. WILDLIFE PICTURE GALLERY

Balance Sheet
March 2015
Assets Liabilities
Cash $51,200 Payable to artists** $12,500
Advance receivable* 500 Notes payable 10,000
Accounts payable 2,050
Total liabilities 24,550
Stockholders’ equity 27,150
Total liabilities and
Total assets $51,700 stockholders’ equity $51,700
* It is important to recognize that the Wildlife Picture Gallery is a separate entity from its
shareholder/operator, Sarah Penney. The $500 payment for airfare is not an expense of the
business, but rather a payment on behalf of an employee. Sarah will have to reimburse the

company or have the amount deducted in future compensation, as recognized in the advance
receivable asset for Wildlife Picture Gallery.
** 70% x ($95,000) – $54,000 is owed to artists.

C2-72. (30 minutes)
Andrea faces a dilemma when she prepares her expense reimbursement request.
She has, in essence, been asked by her supervisor to join him in overcharging
expenses to the company. Should Andrea not file a reimbursement request for the
Luxury Inn lodging costs, the company should question why she and her supervisor
stayed at different locations.
Discussion of this case should focus on the options available to Andrea. The
options include the following:
1. File an expense reimbursement request for the Luxury Inn and, therefore,
minimize the likelihood of jeopardizing her relationship with her supervisor.
2. File an expense reimbursement request for the Spartan Inn and let future
events take whatever course they follow.
3. Report the situation to her supervisor's boss.
4. Discuss the situation with her supervisor and indicate that she (Andrea) is not
comfortable with filing the Luxury Inn receipt. Perhaps encourage the
supervisor to seek a change in company policy to provide daily allowances for
lodging and meal costs rather than reimbursing actual costs.
5. Leave the employ of the company.
There is no single correct answer to the problem. The first choice is not a good
solution for the long run as it starts a slippery slope for Andrea, which is likely to
lead to further concessions to improper behavior and more serious problems.
Additional and more serious situations increase the chances her behavior is likely
to be discovered and she could be fired or even sent to jail. One would hope that
sleepless nights would intervene long before this time. It is better to draw the line
here. Talking to her supervisor is a good idea and perhaps instituting a policy that
avoids any temptation. Leaving the company would be a fallback choice if
discussion of the situation does not lead to a resolution of the situation that
preserves Andrea’s ethical requirements. Revised 04.17.17
Chapter 3

Adjusting Accounts
for Financial Statements

Mini- Cases
Exercises Problems

LO1 – Identify the major steps in the
accounting cycle.

21 - 23, 25, 33, 35, 40 - 42, 46,
LO2 – Review the process of 55 - 58
journalizing and posting transactions. 29, 30 36, 38 47, 52, 54

40 - 43,
LO3 – Describe the adjusting process 23, - 25, 32 - 36,
and illustrate adjusting entries. 46 - 49, 55 - 58
29, 30 38
52 - 54
40 - 42,
LO4 – Prepare financial statements
from adjusted accounts. 26 39 44, 47, 49, 50, 55, 58
53, 54

31, 33, 42, 44, 45,
LO5 – Describe the process of closing 27, 28, 30 55
temporary accounts. 37, 39 49 - 54

40, 42, 49
LO6 – Analyzing changes in 24, 25, 29 34 - 36, 38 55, 56
balance sheet accounts. 52 - 54


QUESTIONS

Q3-1. The five major steps in the accounting cycle are:

1. Analyze business activity using transaction analysis based on the related
source documents.
2. Record results of the transaction analysis chronologically in the general
journal and create a trial balance.
3. Adjust the recorded data to update all accounts for expense and revenue
recognition not previously recognized.
4. Report the adjusted financial data in the form of financial statements.
5. Close the books by posting the adjusting and closing entries, which “zero
out” the temporary accounts.

Q3-2. The fiscal year is the annual accounting period adopted by a firm. A firm using
a fiscal year ending on December 31 is on a calendar-year basis.

Q3-3. Examples of source documents that underlie business transactions are
invoices sent to customers, invoices received from suppliers, bank checks,
bank deposit slips, cash receipt forms, and written contracts.

Q3-4. A general journal is a book of original entry that may be used for the initial
recording of any type of transaction. It contains space for dates and for
accounts to be debited and credited, columns for the amounts of the debits
and credits, and a posting reference column for numbers of the accounts that
are posted.

Q3--5. When entries are posted, the page number and identifying initials of the
appropriate journal are placed next to the amounts in the appropriate
accounts. The account number is entered beside the related amount posted in
the journal's posting reference column. This procedure enables interested
users to trace amounts in the ledger back to the originating journal entry and
permits us to know which entries have been posted.

Q3-6. An adjusting journal entry is a journal entry made at the end of an accounting
period to reflect accural accounting. It usually affects a balance sheet account
and an incomd statement account and rarely involves cash.

Q3-7. A chart of accounts is a list of the accounts appearing in the general ledger,
with the account numbering system indicated. Normally the accounts are
classified as asset, liability, owners' equity, revenue, and expense accounts,
and often the numbering system identifies the account classification. For

example, a coding system might assign the numbers 100–199 to assets, 200–
299 to liabilities, and so on.

Q3-8. Many of the transactions reflected in the accounting records through the first
two steps of the accounting cycle affect the net income of more than one
period. Therefore, adjustments to the account balances are ordinarily
necessary at the end of each accounting period to record the proper amount
of revenue and to match expenses with revenue properly. This process is also
intended to achieve a more accurate picture of financial position by adjusting
balance sheet amounts to show unexpired costs, up-to-date amounts of
obligations, and so on.

Q3-9. 1. Allocating assets to expense to reflect expenses incurred during the
period. Example: Recording supplies used by debiting Supplies Expense
and crediting Supplies.

2. Allocating payments received in advance by crediting the revenue account
to reflect revenues earned during the period. Example: Recording service
fees earned by debiting Unearned Service Fees and crediting Service Fees
Earned.

3. Accruing expenses to reflect expenses incurred during the period that are
not yet paid or recorded. Example: Recording unpaid wages by debiting
Wages Expense and crediting Wages Payable.

4. Accruing revenues to reflect revenues earned during the period that are
not yet received or recorded. Example: Recording commissions earned by
debiting Commissions Receivable and crediting Commissions Earned.

Q3-10. Jan. 31 Insurance expense (+E, -SE) 78
Prepaid insurance (-A) 78
To record insurance expense for January ($1,872/24 = $78).

Q3-11. A contra account is an account that is related to, and deducted from, another
account when financial statements are prepared or when book values are
computed. Accumulated depreciation is deducted from the cost of a
depreciable asset in computing and portraying the asset's book value.

Q3-12. The building is five years old by the end of 2015, so the accumulated
depreciation of $800,000 represents five years of depreciation at an annual
rate of $160,000 ($800,000/5). If the annual depreciation is $160,000, then
the expected life of the building must be 25 years.

At the end of 2022, the building will be twelve years old, and the accumulated
depreciation will be 12×$160,000, or $1,920,000. The book value of the
building (defined as original cost less accumulated depreciation) will be
$2,080,000.


Q3-13. (a) Jan. 1 Cash (+A) 9,720
Subscriptions received in advance (+L) 9,720
To record receipt of two-year subscriptions.

(b) Jan. 31 Subscriptions received in advance (-L) 405
Subscriptions revenue (+R,+SE) 405
To record subscription revenue earned during
January ($9,720/24 = $405).

Q3-14. Jan. 31 Wages expense (+E, -SE) 190
Wages payable (+L) 190
To record unpaid wages for Jan. 30–31
[($475/5) × 2 = $190].

Q3-15. Jan. 31 Interest receivable (+A) 360
Interest income (+R,+SE) 360
To record interest earned during January.

Q3-16. The temporary accounts—sometimes called nominal accounts—are closed at
year-end. They consist principally of the income statement accounts (expense
and revenue accounts). (The Income Summary account and the Dividend
account are also closed if they are used.)

Q3-17. Step 1) Close revenue accounts: Debit each revenue account for an amount
equal to its balance, and credit the Retained Earnings account for
the total of revenues.
Step 2) Close expense accounts: Credit each expense account for an amount
equal to its balance, and debit the Retained Earnings account for the
total of expenses.

Q3-18. A post-closing trial balance ensures that an equality of debits and credits has
been maintained throughout the adjusting and closing procedures and that
the general ledger is in balance to start the next period. Only balance sheet
accounts appear in a post-closing trial balance. Depreciation Expense and
Supplies Expense are temporary accounts that should have been closed and
should not appear in the post-closing trial balance.


Q3-19. The cost principle and the matching concept support Dehning's handling of
its catalog costs. Prepaid Catalog Costs is an asset account that is initially
recorded at the amount that the catalogs cost Dehning. This is consistent with
the cost principle that states that assets are initially recorded at the amounts
paid to acquire the assets. The catalogs help Dehning generate sales revenues.
The matching concept states that the catalog costs should be matched as
expenses with the revenues they help generate. Dehning does this by
expensing the catalog costs over their estimated useful lives.

Q3-20. (a) Supplies Expense ($825 + $260 − $630 = $455) for the period is omitted
from the income statement, overstating net income by $455 (ignoring
taxes).

(b) Both Supplies and Owners' Equity are overstated by $455 on the January
31 balance sheet (again, before considering taxes).


MINI EXERCISES

M3-21. (45 minutes)

a.

June 1. Invested $12,000 +12,000 +12,000
cash. = - =
Cash Common
Stock
June 2. Paid $950 cash for -950 -950 +950

June rent. = - Rent Expense = -950
Cash Retained
Earnings
June 3 Purchased $6,400 +6,400 +6,400
of office equipment
Office = Accounts - =
on account.
Equipment Payable
June 6. Purchased $3,800 -1,800 +3,800 +2,000

of supplies; $1,800
Cash Supplies = Accounts - =
cash, $2,000 on
Payable
account.
June 11. $4,700 billed for +4,700 +4,700 +4,700

services. =
Accounts Retained Service Fees - = +4,700
Receivable Earnings Earned
June 17. Collected $3,250 on +3,250 -3,250

accounts. = - =
Cash Accounts
Receivable
June 19. Paid $3,000 on -3,000 -3,000
office equipment = Accounts - =
Cash
account.
Payable
June 25. Paid cash dividend -900 -900
of $900. = - =
Cash Retained
Earnings
June 30. Paid $350 utilities. -350 -350 +350

Cash = Retained - Utilities = -350
Earnings Expense
June 30. Paid $2,500 -2,500 -2,500 +2,500

salaries. -2,500
Cash = Retained - Salaries =
Earnings Expense
TOTALS 5,750 + 11,650 = 5,400 + 12,000 + 0 4,700 - 3,800 = 900

b. June 1 Cash (+A) 12,000
Common stock (+SE) 12,000
Owner invested cash for stock.

2 Rent expense (+E, -SE) 950
Cash (-A)
950
Paid June rent.

3 Office equipment (+A) 6,400
Accounts payable (+L) 6,400
Purchased office equipment on account.

6 Supplies (+A) 3,800
Cash (-A) 1,800
Purchased $3,800 of supplies; paid $1,800 down
with balance due in 30 days.

11 Accounts receivable (+A) 4,700
Service fees earned (+R,+SE) 4,700
Billed clients for services.

17 Cash (+A) 3,250
Accounts receivable (-A) 3,250
Collections from clients on account.

19 Accounts payable (-L) 3,000
Cash (-A) 3,000
Payment on account.

25 Retained earnings (-SE) 900
Cash (-A) 900
Issued dividends.

30 Utilities expense (+E, -SE) 350
Cash (-A) 350
Paid utilities bill for June.

30 Salaries expense (+E, -SE) 2,500
Cash (-A) 2,500
Paid salaries for June.


c.
+ Cash (A) - + Supplies (A) -
June 1 12,000 950 June 2 June 6 3,800
17 3,250 1,800 6
3,000 19
900 25
350 30 + Office Equipment (A) -
2,500 30 June 3 6,400

+ Accounts Receivable (A) - - Accounts Payable (L) +
June 11 4,700 3,250 June 17 June 19 3,000 6,400 June 3
2,000 June 6

- Common Stock (SE) + - Retained Earnings (SE) +
12,000 June 1 June 25 900

June 2 950

- Service Fees Earned (R) + + Utilities Expense (E) -
4,700 June 11 June 30 350

+ Salaries Expense (E) -
June 30 2,500


M3-22. (45 minutes)

a.

April 1. Invested $9,000 in +9,000 +9,000
cash. = - =
Cash Common
Stock
April 2. Paid $2,850 cash -2,850 +2,850

for lease.
Cash Prepaid Van = - =
Lease
April 3. Borrowed $10,000. +10,000 +10,000

Cash = Note - =
Payable
April 3. Purchased $5,500 -2,500 +5,500 +3,000

equipment for
Cash Equipment = Accounts - =
$2,500 cash with
Payable
rest on account.
April 4. Paid $4,300 cash -4,300 +4,300

for supplies. = - =
Cash Supplies
April 7. Paid $350 cash for -350 -350 +350

ad. -350
Cash = Retained - Ad. Expense =
Earnings
April 21. Billed $3,500 for +3,500 +3,500 +3,500

+3,500
services =
Accounts Retained Cleaning Fees - =

April 23. Paid $3,000 cash on -3,000 -3,000
account. = Accounts - =
Cash
Payable
April 28. Collected $2,300 on +2,300 -2,300
account. = - =
Cash Accounts
Receivable
April 29. Paid $1,000 cash -1,000 -1,000

dividend. = - =
Cash Retained
Earnings
April 30. Paid $1,750 cash -1,750 -1,750 +1,750

for wages. -1,750
Earnings Expense
April 30. Paid $995 cash for -995 -995 +995

gas. -995
Cash = Retained - Van Fuel =
Earnings Expense
TOTALS 4,555 + 13,850 = 10,000 + 9,000 + -595 3,500 - 3,095 = 405

b. April 1 Cash (+A) 9,000
Owner invested cash for stock.

2 Prepaid van lease (+A) 2,850
Cash (-A) 2,850
Paid six months' lease on van.

3 Cash (+A) 10,000
Notes payable (+L) 10,000
Borrowed money from bank for one year at
10% interest.

3 Equipment (+A) 5,500
Cash (-A) 2,500
Purchased $5,500 of equipment; paid $2,500 down
with balance due in 30 days.

Cash (-A) 4,300
Purchased supplies for cash.

7 Advertising expense (+E, -SE) 350
Cash (-A) 350
Paid for April advertising.

Cleaning fees earned (+R, +SE) 3,500
Billed customers for services.

Cash (-A) 3,000
Payment on account.

28 Cash (+A) 2,300
Collections from customers on account.

29 Retained earnings (-SE) 1,000
Cash (-A) 1,000
Issued cash dividends.

30 Wages expense (+E, -SE) 1,750
Cash (-A) 1,750
Paid wages for April.

30 Van fuel expense (+E, -SE) 995
Cash (-A) 995
Paid for gasoline used in April.



c.
April 1 9,000 2,850 April 2 April 21 3,500 2,300 April 28
3 10,000 2,500 3
28 2,300 4,300 4
350 7 + Prepaid Van Lease (A) -
3,000 23 April 2 2,850
1,000 29
1,750 30 + Equipment (A) -
995 30 April 3 5,500

+ Supplies (A) - - Notes Payable (L) +
April 4 4,300 10,000 April 3

- Accounts Payable (L) + - Retained Earnings (SE) +
April 23 3,000 3,000 April 3 April 29 1,000

- Common Stock (SE) + - Cleaning Fees Earned (R) +
9,000 April 1 3,500 April 21

+ Advertising Expense (E) - + Wages Expense (E) -
April 7 350 April 30 1,750

+ Van Fuel Expense (E) -
April 30 995


M3-23. (20 minutes)

a.

1. Received $20,100 in +20,100 +20,100
advance for contract Cash Unearned
work. = Service Fees - =

Jan. 1 Cash (+A) 20,100
Unearned service fees (+L)
20,100
To record fee received in advance.

b.

2. Adjusting entry for work -3,350 +3,350 +3,350
completed by Jan. 31. Unearned Retained Service Fees
= Service Fees Earnings - = +3,350

Jan. 31 Unearned service fees (-L) 3,350
Service fees (+R, +SE)
3,350
To reflect January service fees earned on
contract ($20,100/6 = $3,350).

c.
3. Adjusting entry for fees +570 +570 +570
earned but not billed. Fees Retained Service Fees
Receivable = Earnings - = +570

Jan. 31 Fees receivable (+A) 570
Service fees (+R, +SE)
570
To record unbilled service fees earned
at January 31.


M3-24. (15 minutes)

1.

1. Adjusting entry for -185 -185 +185
prepaid insusrance Prepaid Retained Insurance
Insurance = Earnings - Expense = -185

Jan. 31 Insurance expense (+E, -SE) 185
Prepaid insurance (-A)
185
To record January insurance expense
($6,660/36 = $185).

2.
2. Adjusting entry for -1,080 -1,080 +1,080
supplies used Supplies Retained Supplies
Inventory = Earnings - Expense = -1,080

Jan. 31 Supplies expense (+E, -SE) 1,080
Supplies inventory (-A)
1,080
To record January supplies expense
($1,930 − $850 = $1,080).

3.
Cash Noncash Contra Liabil- Contrib. Earned Net
Transaction + Assets - = + + Revenues - Expenses =
Asset Assets ities Capital Capital Income
3. Adjusting +62 -62 +62
entry for Accumulated Retained Depreciation -62
depreciation of - Earnings - Expense =
Depreciation
equipment.

Jan. 31 Depreciation expense—Equipment (+E, -SE) 62
Accumulated depreciation—Equipment (+XA, -A)
62
To record January depreciation on office equipment ($5,952/96 =
$62).


4.

4. Adjusting entry for rent -875 +875 +875
Unearned Retained Rent Revenue
= Rent Earnings - = +875
Revenue

Jan. 31 Unearned rent revenue (-L) 875
Rent revenue (+R, +SE)
875
To record portion of advance rent earned in January.

5.
5. Adjusting entry for +490 -490 +490
accrued salaries Salaries Retained Salaries
= Payable Earnings - Expense = -490

Jan. 31 Salaries expense (+E, -SE) 490
Salaries payable (+L)
490
To record accrued salaries at January 31.

M3-25. (15 minutes)

(All amounts in thousands of Mexican pesos.)
a.
Inventory purchases (total) +44,998,092 +44,998,092
Inventory Accounts
= Payable - =

Inventories (+A)……………………………………. 44,998,092
Accounts payable (+L)……………………… 44,998,092
To record total purchases made at various dates.

b. Beginning AP balance + Purchases – Payments = Ending AP balance.
So, 10,288,069 + $44,998,092 - Payments = $11,454,374. Thus, Payments =
$43,831,787



c.

Adjusting entry for cost of –44,134,370 –44,134,370 +44,134,370
goods sold for 2013. Inventory = Retained - Cost of Goods = –44,134,370
Earnings Sold

* Beginning Inv balance + Purchases – Cost of goods sold = Ending Inv balance. So, $10,558,247 +
$44,998,092 – COGS = $11,421,969. Thus, COGS = $44,134,370

Cost of goods sold (+E, -SE)…………………................... 44,134,370
Inventories (-A)…………………………………
44,134,370
To record cost of goods sold for the year ended 12/31/2013.

(Note: the COGS figure can be verified from the firm’s financial statements. Purchases cannot be so
determined, but could be established by working backwards. See M3-29.)

M3-26. (15 minutes)

ARCHITECT SERVICES COMPANY

Stock Earnings Stockholders’ Equity
Balance at December 31, 2014 ........................$30,000 $18,000 $48,000
Stock issuance ..................................................... 6,000 6,000
Dividends ............................................................... (9,700) (9,700)
Net income ............................................................ _____ 29,900 29,900
Balance at December 31, 2015 ........................$36,000 $38,200 $74,200

M3-27. (5 minutes)

Ending balance = Beginning balance + Credit from closing revenue – Debit from closing
expenses: $137,600 = $99,000 + $347,400 - $308,800


M3-28. (15 minutes)

a.
Date 2015
Desc
ription
Debit
Credi
t
Dec. 31 Commissions revenue (-R) 84,900
Retained earnings (+SE) 84,900
To close the revenue account.
Wages expense (-E) 36,000
Insurance expense (-E) 1,900
Utilities expense (-E) 8,200
Depreciation expense (-E) 9,800
To close the expense accounts.

Closing the revenue and expense accounts into retained earnings has the effect of
increasing the retained earnings balance by an amount equal to net income
(revenue minus expenses). The balance of Smith’s Retained Earnings after closing
entries are posted is:
$101,100 credit ($72,100 + $84,900 - $55,900).

b.
+ Wages Expense (E) - + Utilities Expense (E) -
Bal. 36,000 36,000 (2)Dec. 31 Bal. 8,200 8,200 (2) Dec. 31
Bal. 0 Bal. 0

+ Insurance Expense (E) - - Commissions Revenue (R) +

Bal. 1,900 1,900 (2)Dec. 31 (1)Dec. 31 84,900 84,900 Bal.
Bal. 0 0 Bal.

+ Depreciation Expense (E) - - Retained Earnings (SE) +
Bal. 9,800 9,800 (2)Dec. 31 (2)Dec. 31 55,900 72,100 Bal.
Bal. 0 84,900 (1)Dec.31
101,100 Bal. Dec.31


M3-29. (30 minutes)

(All amounts in $ millions.)

a.
Cash Contrib. Earned Net
Transaction Asset + Noncash Assets = Liabilities + Capital + Capital Revenues - Expenses = Income
Recognize cost of goods sold -62,752 -62,752 +62,752
Merchandise = Retained - Cost of Goods = -62,752
Inventory Earnings Sold

Cost of goods sold (+E,-SE) ............................................................................. 62,752
Merchandise Inventory(-A) ..................................................................... 62,752
To recognize the cost of goods sold.

b. Beginning Inv balance + Purchases – Cost of goods sold = Ending Inv balance. So
$7,411 + Purchases - $62,752 = $8,299. Thus purchases = $63,640

Recording inventory +63,640 +63,640
purchases. Merchandise = Account - =
Inventory Payable

Merchandise inventory(+A) .......................................................................... 63,640
Accounts payable (+L) ............................................................................... 63,640
To recognize the purchases on account.

c. Beginning AP balance + Purchases – Payments = Ending AP balance.
So, $15,133 + $63,640- Payments = $16,459. Thus, Payments = $62,314


M3-30 (10 minutes)
a.

a. Dec. 31 Interest earned. +600 +600 +600
Interest = Retained Interest - = +600
Receivable Earnings Income

Dec. 31 Interest receivable (+A) 600
Interest income (+R, +SE) 600
To record accrued interest income.

b. Dec. 31 Interest income (-R) 2,400
To close the Interest Income account.

c.
c. Jan. 31 Receipt of $900 +900 -600 +300 +300
interest Cash Interest = Retained Interest - = +300

2016
Jan. 31 Cash (+A) 900
Interest receivable (-A) 600
To record cash receipt of interest.


EXERCISES

E3-31. (30 minutes)

a.
Dec. 31 Service fees earned (-R) 80,300

Rent expense (-E) 20,800
Salaries expense (-E) 45,700
Supplies expense (-E) 5,600

b.
+ Rent Expense (E) - + Supplies Expense (E) -
Bal. 20,800 20,800 (2) Bal. 5,600 5,600 (2)
Bal. 0 Bal. 0
+ Depreciation Expense (E) -
Bal. 10,200 10,200 (2)
Bal. 0

+ Salaries Expense (E) - - Service Fees Earned (R) +
Bal. 45,700 45,700 (2) (1) 80,300 80,300 Bal.
Bal. 0 0 Bal.

(2) 82,300 67,000 Bal.
80,300 (1)
65,000 Bal.

Brooks Consulting earned a loss during the period (expenses exceeded
revenues by €2,000), so the ending retained earnings is lower than the
beginning retained earnings (even though no dividends were paid).


E3-32. (30 minutes)
a.
Cash Noncash Contra Contrib. Earned Net
Transaction Asset + Assets - Assets = Liabilities + Capital + Capital Revenues - Expenses = Income
1. Adjusting entry - +610 = -610 - +610 = -610
for depreciation:
Accumulated Retained Depreciation
equipment.
Depreciation Earnings Expense
2. Adjusting entry - = +390 -390 - +390 = -390

for utilities
Utilities Retained Utilities
expense.
3. Adjusting entry -700 - = -700 - +700 = -700
for rent expense.
Prepaid Rent Retained Rent
Earnings Expense
4. Adjusting entry - = -468 +468 +468 - = +468

for premium
Unearned Retained Premium
revenues.
Premium Earnings Revenue
Revenue
5. Adjusting entry - = +965 -965 - +965 = -965

for wage
Wages Retained Wages
expense.
6. Adjusting entry +300 - = +300 +300 - = +300

for interest
Interest Retained Interest
earned.
TOTALS 0 + -400 - 610 = 887 + 0 + -1,897 768 - 2,665 = -1,897

b. 1. Depreciation expense—Equipment (+E,-SE) 610
Accumulated depreciation—Equip (+XA, -A) 610
To record depreciation for the period.

2. Utilities expense (+E, - SE) 390
Utilities payable (+L) 390
To record accrued utilities expense.

3. Rent expense (+E,-SE) 700
Prepaid rent (-A) 700
To record rent expense for the month ($2,800/4 = $700).

4. Unearned premium revenue (-L) 468
Premium revenue (+R,+SE) 468
To record premium revenue earned [($624/12) × 9 = $468].

5. Wages expense (+E,-SE) 965
To record accrued wages at the end of the period.

6. Interest receivable (+A) 300
Interest income (+R,+SE) 300

To accrue interest earned but not yet received.

E3-33. (15 minutes)

a.

a. Adjusting entry for +4,700 -4,700 +4,700 -4,700
salaries expense. = Salaries Retained - Salaries =

2015
Dec. 31 Salaries expense (+E,-SE) 4,700
Salaries payable (+L) 4,700
To record accrued salaries payable.

b. 31 Retained earnings (-RE) 250,000
Sa
To close the Salaries Expense account.

c.

c. Paid salaries. -12,000 +4,700 -7,300 +7,300 -7,300
Cash = Salaries Retained - Salaries =

2016
Jan. 7 Salaries payable (-L) 4,700
Salaries expense (+E,-SE) 7,300
Cash (-A) 12,000
To record payment of salaries.

E3-34. (20 minutes)

a. Balance, January 1 = $960 + $800 − $620 = $1,140.

b. Amount of premium = $82 × 12 = $984.
Therefore, five months' premium ($984 − $574 = $410) has expired by January 31.
The policy term began on and has been in effect since September 1, 2015.

c. Wages paid in January = $3,200 − $500 = $2,700.

d. Monthly depreciation expense = $8,700/60 months = $145.
Fields has owned the truck for 18 months ($2,610/$145 = 18).



E3-35. (30 minutes)

a.
1.7/31 Adjusting entry for -475 = -475 - +475 = -475
rent expense.
Prepaid Rent Retained Rent Expense
Earnings
2. 7/31 Adjusting entry for -210 = - 210 - +210 = -210
ad. expense.
Prepaid Retained Advertising
Advertising Earnings Expense
3. 7/31 Adjusting entry for -1,900 Supplies -1,900 - +1,900 = -1,900
supplies expense. Inventory
Retained Supplies
Earnings Expense
4. 7/31 Adjusting entry for +800 +800 +800 - = +800
fees revenue.
Fees Receivable Retained Refinish.
Earnings Revenue
5. 7/31 Adjusting entry for -300 +300 +300 - = +300
fees revenue.
Unearned Retained Refinish.
Refinish. Fees Earnings Revenue
TOTALS 0 + -1,785 = -300 + 0 + -1,485 1,100 - 2,585 = -1,485

b. July 31 Rent expense (+E,-SE) 475
To record July rent expense ($5,700/12 = $475).

31 Advertising expense (+E,-SE) 210
Prepaid advertising (-A) 210
To record July advertising expense ($630/3 = $210).

31 Supplies expense (+E,-SE) 1,900
Supplies inventory (-A) 1,900
To record supplies expense for July
($3,000 − $1,100 = $1,900).

31 Fees receivable (+A) 800
Refinishing fees revenue (+R,+SE) 800
To record unbilled revenue earned during July.

31 Unearned refinishing fees (-L) 300
Refinishing fees revenue (+R,+SE) 300
To record portion of advance fees earned in July ($600/2 = $300).


c.
+ Prepaid Rent (A) - + Supplies (A) -
Bal. 5,700 475 (1) Bal. 3,000 1,900 (3)
Bal. 5,225 Bal. 1,100

+ Prepaid Advertising (A) - - Unearned Finishing Fees (L) +
Bal. 630 210 (2) (5) 300 600 Bal.
Bal. 420 300 Bal.

+ Fees Receivable (A) - - Refinishing Fees Revenue (R) +
(4) 800 2,500 Bal.
800 (4)
300 (5)
3,600 Bal.

+ Supplies Expense (E) -
(3) 1,900

+ Advertising Expense(E) -
(2) 210

(1) 475


E3-36. (30 minutes)

(All amounts in $ thousands.)
a.
Recognize inventory +1,644,692 +1,644,692
purchases Inventory = Accounts - =
Payable

Inventory (+A) ..................................................................................................... 1,644,692*
Accounts payable (+L) ................................................................................ 1,644,692
To recognize inventory purchases.
* Beginning Inv balance + Purchases – Cost of goods sold = Ending Inv. So, $426,962 + Purchases
- $1,541,462= $530,192. Thus, purchases = $1,644,692

b. Beginning compensation payable + Compensation expense – Compensation paid =
Ending compensation payable, so
$74,747 + $650,000 – Payments = $49,878
Payments = $674,869

c. The balances of accrued compensation on February 1, 2014 and February 2, 2013
are reported as a current liability.

E3-37. (30 minutes)

a. Dec. 31 Service fees earned (-R) 92,500
Interest income (-R) 2,200
To close the revenue accounts.

Advertising expense (-E) 4,300
Income tax expense (-E) 9,900


b.
- Retained Earnings (SE) + - Service Fees Earned (R) +
(2) 64,700 42,700 Bal. (1) 92,500 92,500 Bal.
94,700 (1) 0 Bal.
72,700 Bal. - Interest Income (R) +
(1) 2,200 2,200 Bal.
0 Bal.

+ Salaries Expense (E) - + Advertising Expense (E) -
Bal. 41,800 41,800 (2) Bal. 4,300 4,300 (2)
Bal. 0 Bal. 0
+ Depreciation Expense (E) - + Income Tax Expense (E) -
Bal. 8,700 8,700 (2) Bal. 9,900 9,900 (2)
Bal. 0 Bal. 0

E3-38. (15 minutes)

a.
Cash Noncash Contrib. Net
Transaction Asset + Assets = Liabilities + Capital + Earned Capital Revenues - Expenses = Income
(1) Collect +200,000 = +200,000 - =
deposits from Cash Customer
customers. Deposits
(2) Recognize +547,245 = -199,414 +746,659 +746,659 - = +746,659
income on Cash Customer Retained Sales
completed Deposits Earnings Revenue
customer
orders.

(1) Cash (+A) ……………………………………………… 200,000
Customer deposits* (+L) ……………………… 200,000
To record unearned customer deposits.

(2) Customer deposits* (-L) ..................................................................................
199,414 **
Cash (+A)………………………………………………… 547,245
Sales revenue (+R, +SE) ............................................................................. 746,659
To record sales revenue and recognized deposits earned.
* Also sometimes called Unearned Customer Deposits
** $59,098 + $200,000 – Deposits earned = $59,684; Deposits earned = $199,414.


b.

Record inventory purchases +349,182 +349,182
Inventory = Accounts - =
Payable

Inventory (+A) ................................................................................................... 349,182
Accounts Payable (+L) ............................................................................. 349,182
To recognize inventory purchases. BI +Purchases – EI = COGS. So
$137,256 + Purchases - $146,275 = $340,163.
Thus: Cost of acquiring inventory =$349,182

c. Customer Deposits are reported as a current liability.

E3-39. (40 minutes)

a.
SOLOMON CORPORATION
Income Statement
Service fees earned ............................................................................................................................................... $71,000
Rent expense ........................................................................................................................................................... (18,000)
Salaries expense ..................................................................................................................................................... (37,100)
Depreciation expense……………………………….…………….. (7,000)
Net income ............................................................................................................................................................... $ 8,900

SOLOMON CORPORATION

Common Retained Total Stockholders’
Balance at December 31, 2014 ......................................... $43,000 $20,600* $63,600
Stock issuance ..........................................................................
Dividends .................................................................................... (8,000) (8,000)
Net income ................................................................................. _______ 8,900 8,900
Balance at December 31, 2015 ......................................... $43,000 $21,500 $64,500

*12,600 + 8,000 The dividend was paid and debited to retained earnings prior to the end of the period.

continued next page


SOLOMON CORPORATION
Balance Sheet
December 31, 2015
Assets Liabilities
Cash $ 4,000 Notes payable $ 10,000
Accounts receivable 6,500 Total Liabilities 10,000
Equipment $ 78,000
Less:Accumulated
depreciation 14,000 64,000 Owners’ Equity
Common stock 43,000
Retained earnings 21,500
Total Liabilities and Owners’
Total Assets $74,500 Equity $74,500

b.
1. Service fees earned (-R) .................................................................................
71,000
Retained earnings (+SE) ........................................................................... 71,000

2. Retained earnings (-SE) ..................................................................................
18,000
Rent expense (-E) ........................................................................................ 18,000

3. Retained earnings (-SE) ..................................................................................
37,100
Salaries expense (-E) ................................................................................. 37,100

4. Retained earnings (-SE) ..................................................................................7,000
Depreciation expense (-E) ...................................................................... 7,000

The cash dividend has already been paid and is already reflected in the adjusted trial
balance.

c. Only the T-accounts affected by closing process are shown here.

+ Depreciation Expense (E) - - Service Fees Earned (R) +
Bal. 7,000 7,000 (4) (1) 71,000 71,000 Bal.
Bal 0 0 Bal.

+ Salaries Expense (E) - + Rent Expense (E) -
Bal. 37,100 37,100 (3) Bal. 18,000 18,000 (2)
Bal. 0 Bal 0

(2-4) 62,100 12,600 Bal.
71,000 (1)
21,500 Bal.





PROBLEMS

P3-40. (90 minutes)

a.b. and d.
Apr. 1 11,500 2,880 Apr. 1 Apr. 12 5,500 4,900 Apr. 18
5 1,800 6,100 2 30 4,000
18 4,900 1,000 2 Bal. 4,600
675 29
100 30 + Supplies (A) -
2,500 30 Apr. 5 1,200
Bal. 4,945 Unadj. bal. 1,200 800 (d) Apr. 30
Adj. bal. 400
+ Prepaid Insurance (A) -
Apr. 1 2,880 + Trucks (A) -
Unadj. bal. 2,880 120 (d) Apr. 30 Apr. 2 6,100
Adj bal. 2,760 Bal. 6,100

+ Equipment (A) - - Accounts Payable (L) +
Apr. 2 3,100 2,100 Apr. 2
Bal. 3,100 1,200 5
3,300 Bal.

- Roofing Fees Earned (R) + - Unearned Roofing Fees (L) +
5,500 Apr. 12 1,800 Apr. 5
4,000 30 Apr. 30 (d) 450 1,800 Unadj. bal
9,500 Unadj. bal. 1,350 Adj. Bal
450 (d) 30
9,950 Adj. Bal.

+ Supplies Expense (E) - - Common Stock (SE) +
Apr. 30 (d) 800 11,500 Apr. 1
Adj. Bal. 800 11,500 Bal.

+ Advertising Expense (E) - + Fuel Expense (E) -
Apr. 30 100 Apr. 29 675
Bal. 100 Bal. 675


continued next page


+ Insurance Expense (E) - + Wages Expense (E) -
Apr. 30 (d) 120 Apr. 30 2,500
Adj. Bal. 120 Bal. 2,500
+ Depreciation Expense – Equip. (E) - - Accumulated Deprec. – Equip. (XA) +
Apr. 30 (d) 35 35 (d) Apr. 30
Adj. Bal. 35 35 Adj. Bal.

+ Depreciation Expense - Trucks (E) - - Accumulated Deprec. – Trucks (XA) +
Apr. 30 (d) 125 125 (d) Apr. 30
Adj. Bal. 125 125 Adj. Bal

b.
Apr. 1. Cash received for +11,500 = +11,500 - =
stock. Cash Common
Stock
Apr. 1. Purchase liability -2,880 +2,880 = - =
insurance. Cash Prepaid
Insurance
Apr. 2. Purchase truck for -6,100 + 6,100 = - =
cash. Cash Truck
Apr. 2. Purchase -1,000 +3,100 = +2,100 Accts - =
equipment. Cash Equipment Payable
Apr. 5. Purchase supplies + 1,200 = +1,200 Accts - =
on account. Supplies Payable
Apr. 5. Cash in advance for +1,800 = +1,800 - =
roofing repairs. Cash Unearned
Roofing Fees
Apr. 12. Bill customers for +5,500 Accts = +5,500 +5,500 Roofing
- = +5,500
services. Receivable Retained Fees Revenue
Earnings
Apr. 18. Collected cash on +4,900 -4,900 Accts = - =
account. Cash Receivable
Apr. 29. Paid cash for fuel. -675 Cash = -675 Retained - +675 Fuel = -675
Earnings Expense
Apr. 30. Paid cash for ads. -100 Cash = -100 Retained - +100 Ad. = -100
Earnings Expense
Apr. 30. Paid cash wages. -2,500 = -2,500 - +2,500 Wages = -2,500
Cash Retained Expense
Earnings
Apr. 30. Bill customers for +4,000 = +4,000 +4,000 Roofing - = +4,000
services. Accounts Retained Fees Earned
Receivable Earnings
Totals 4,945 + 17,880 = 5,100 + 11,500 + 6,225 9,500 - 3,275 = 6,225

continued next page

Date 2015 Description Debit Credit
Apr. 1 Cash (+A) 11,500
Common stock (+SE)
11,500
Owner invested cash.

1 Prepaid insurance (+A) 2,880
Cash (-A)
2,880
Paid two-year premium on liability insurance policy.

2 Trucks (+A) 6,100
Cash (-A)
6,100
Purchased used truck for $6,100 cash.

2 Equipment (+A) 3,100
Cash (-A)
1,000
Accounts payable (+L)
2,100
Purchased ladders and other equipment, $1,000 down with
$2,100 balance due in 30 days.

Accounts payable (+L)
1,200
Purchased supplies on account.

5 Cash (+A) 1,800
Unearned roofing fees (+L)
1,800
Received advance payment for services.

Roofing fees earned (+R,+SE)
5,500

18 Cash (+A) 4,900
Accounts receivable (-A)
4,900
Collection on account from customers.

29 Fuel expense (+E,-SE) 675
Cash (-A)
675
Paid truck fuel bill for April.

30 Advertising expense (+E,-SE) 100
Cash (-A)
100
Paid for April newspaper advertising.


Cash (-A)
2,500
Paid wages.

Roofing fees earned (+R, +SE)
4,000
Billed customeers for services.


c.
LOUGEE ROOFING SERVICE
Unadjusted Trial Balance
April 30, 2015
Debit Credit
Cash $ 4,945
Accounts Receivable 4,600
Supplies 1,200
Prepaid Insurance 2,880
Trucks 6,100
Equipment 3,100
Accounts Payable $ 3,300
Unearned Roofing Fees 1,800
Common Stock 11,500
Roofing Fees Earned 9,500
Fuel Expense 675
Advertising Expense 100
Wages Expense 2,500

$26,100 $26,100

d.
1. Recognize -120 - = -120 - +120 = -120
one month of
Prepaid Retained Insurance
insurance
Insurance Earnings Expense
expense.
2. Recognize -800 - = -800 - +800 = -800
supplies
Supplies Retained Supplies
expense.
Earnings Expense
3. Recognize - +125 = -125 - +125 = -125
depreciation
expense –
Trucks.
4. Recognize - +35 = -35 - +35 = -35
depreciation
expense on
equipment.
5. Recognize - = -450 +450 +450 - = +450
roofing fees
Unearned Retained Roofing Fees
earned.
Roofing Earnings Earned
Fees
Totals 0 + -920 - 160 = -450 + 0 + -630 450 - 1,080 = -630

continued next page





April 30 Insurance expense (+E,-SE) 120
To record April insurance expense ($2,880/24 months = $120).

30 Supplies expense (+E,-SE) 800
Supplies (-A) 800
To record April supplies expense ($1,200 − $400 = $800).

30 Depreciation expense—Trucks (+E,-SE) 125
Accumulated depreciation—Trucks (+XA,-A) 125
To record April depreciation on trucks.

30 Depreciation expense—Equipment (+E,-SE) 35
Accumulated depreciation—Equipment (+XA,-A) 35
To record April depreciation on equipment.

30 Unearned roofing fees (-L) 450
Roofing fees earned (+R,+SE) 450
To record portion of advance payment earned in April
($1,800/4 = $450).

P3-41. (40 minutes)

SNAPSHOT COMPANY
December 31, 2015

a.
Debit Credit
Cash $2,150
Prepaid Rent 12,600
Supplies 4,250
Equipment 22,800
Accounts Payable $1,910
Unearned Photography Fees 2,600
Common Stock 24,000
Photography Fees Earned 34,480
Wages Expense 11,000
Utilities Expense 3,420 ______
$62,990 $62,990


b.
1. Fees earned +925 - = +925 +925 - = +925
but not
Fees Retained Photo Fees
received.
2. Recognize - +2,280 = -2,280 +2,280 = -2,280
depreciation
expense for
one year.
3. Recognize - = +400 -400 - +400 = -400
utilities
Utilities Retained Utilities
expense.
4. Recognize -6,300 - = -6,300 - +6,300 = -6,300
rent expense
for year.
Earnings Expense
5. Recognize - = -2,600 +2,600 +2,600 - = +2,600
photo Unearned Retained
Photo Fees
revenues. Photo Fees Earnings
Earned
6. Recognize -990 - = -990 - +990 = -990
insurance
expense.
7. Recognize -2,730 - = -2,730 - +2,730 = -2,730
supplies
expense.
Earnings Expense
8. Recognize - = +375 -375 - +375 = -375
wages
expense.
Totals 0 + -9,095 - 2,280 = -1,825 + 0 + -9,550 3,525 - 13,075 = -9,550

c.
Dec. 31 Fees receivable (+A) 925
Photography fees earned (+R, +SE) ` 925
To record revenue earned but not billed.

31 Depreciation expense (+E,-SE) 2,280
Accum. depreciation—Equipment (+XA, -A) 2,280
To record depreciation for the year
($22,800/10 years = $2,280).

To record estimated December utilities expense.
31 Rent expense (+E, -SE) 6,300

Prepaid rent (-A) 6,300
To record rent expense for the year
($12,600/2 years = $6,300).

31 Unearned photography fees (-L) 2,600
Photography fees earned (+R, +SE) 2,600
To record advance payments earned during the year.

31 Insurance expense (+E, -SE) 990
To record insurance expense for the year
($2,970/3 years = $990).

31 Supplies expense (+E,-SE) 2,730
Supplies (-A) 2,730
To record supplies expense for the year
($4,250 − $1,520 = $2,730).

31 Wages expense (+E, -SE) 375
Wages payable(+L) 375
To record unpaid wages at December 31.


d.
Unadj. bal. 2,150 1,910 Unadj. bal.
Adj. bal. 2,150 1,910 Adj. bal.
+ Accounts Receivable (A) - - Unearned Photo Fees (L) +
Unadj. bal. 3,800 Dec.31 (5) 2,600 2,600 Unadj. bal.
Adj. bal. 3,800 0 Adj. bal.
+ Fees Receivable (A) - - Utilities Payable (L) +
Dec. 31 (1) 925 400 (3) Dec.31
Adj. bal. 925 400 Adj. bal.
+ Prepaid Rent (A) - - Wages Payable (L) +
Unadj. bal. 12,600 6,300 (4) Dec.31 375 (8) Dec.31
+ Prepaid Insurance (A) - - Common Stock (SE) +
Unadj. bal. 2,970 990 (6) Dec.31 24,000 Unadj. bal.
Adj. bal. 1,980 24,000 Adj. bal.
+ Supplies (A) - - Photo Fees Earned (R) +
Unadj. bal. 4,250 2,730 (7) Dec.31 34,480 Unadj. bal
Adj. bal. 1,520 925 (1) Dec.31
2,600 (5) Dec.31
38,005 Adj. bal.
+ Equipment (A) - + Wages Expense (E) -
Unadj. bal. 22,800 Unadj. bal. 11,000
Adj. bal. 22,800 Dec.31 (8) 375
Adj. Bal. 11,375
- Accum. Depreciation – Equip. (XA) + + Utilities Expense (E) -
2,280 (2) Dec.31 Unadj. bal. 3,420
2,280 Adj. Bal. Dec.31 (3) 400
Adj. Bal. 3,820
+ Supplies Expense (E) - + Depreciation Expense – Equip. (E) -
Dec. 31 (7) 2,730 Dec.31 (2) 2,280
Adj. bal. 2,730 Adj. Bal. 2,280
+ Insurance Expense (E) - + Rent Expense (E) -
Dec. 31 (6) 990 Dec.31 (4) 6,300
Adj. bal. 990 Adj. Bal. 6,300


P3-42. (90 minutes)

a.
1. Recognize rent -775 Prepaid
- = -775 Retained - +775 Rent = -775
expense. Rent Earnings Expense
2. To recognize -1,700 - = -1,700 - +1,700 = -1,700

supplies Supplies Retained Supplies
expense. Earnings Expense
3. To recognize - +74 Accum. = -74 Retained - +74 = -74
depreciation Deprec. Earnings Depreciation
expense. Expense
4. To recognize - = +210 -210 Retained - +210 Wages = -210
wages Wages Earnings Expense
expense. Payable
5. To recognize - = +300 -300 Retained - +300 = -300
utilities Utilities Earnings Utilities
expense. Payable Expense
6. To recognize +380 - = +380 Retained +380 Service
- = +380
fees earned. Accounts Earnings Fees
Receivable Earned
Totals 0 + -2,095 - 74 = 510 + 0 + -2,679 380 - 3,059 = -2,679

b.
June 30 Rent expense (+E, -SE) 775
To record June rent expense ($3,100/4 months = $775).

30 Supplies expense (+E, -SE) 1,700
Supplies (-A) 1,700
To record June supplies expense (2,520 − $820 = $1,700).

30 Depreciation expense—Equip (+E, -SE) 74
Accum. depreciation—Equipment (+XA, -A) 74
To record June depreciation ($4,440/60 months = $74).

To record unpaid wages at June 30.

To record estimated June utilities expense.

30 Accounts receivable (+A) 380
Service fees earned (+R, +SE) 380
To record fees earned but not billed in June.



c.
Unadj. bal 1,180 760 Unadj. bal
+ Accounts Receivable (A) - - Wages Payable (L) +
Unadj. bal 450 210 (4) Jun.30
Jun. 30 (6) 380 210 Adj. bal.
Adj. bal. 830
- Utilities Payable (L) +
300 (5) Jun.30
300 Adj. bal.
+ Prepaid Rent (A) - - Retained Earnings (SE) +
Unadj. bal 3,100 775 (1) Jun.30 5,300 Unadj. bal.
Adj. bal. 2,325

+ Rent Expense (E) - - Common Stock (SE) +
Jun.30 (1) 775 2,000 Unadj. bal
Adj. bal. 775 2,000 Adj. bal.

+ Supplies (A) - - Service Fees Earned (R) +
Unadj. bal 2,520 1,700 (2) Jun.30 4,650 Unadj. bal
Adj. bal. 820 380 (6) Jun.30
5,030 Adj. bal.
+ Equipment (A) - + Wages Expense (E) -
Unadj. bal 4,440 Unadj. bal 1,020
Adj. bal. 4,440 Jun.30 (4) 210
Adj. bal. 1,230
- Accum. Depreciation – Equip.(XA) + + Utilities Expense (E) -
74 (3) Jun.30 Jun.30 (5) 300
74 Adj. Bal. Adj. bal. 300

+ Supplies Expense (E) - + Depreciation Expense - EQPT (E) -
Jun. 30 (2) 1,700 Jun.30 (3) 74
Adj. bal. 1,700 Adj. bal. 74


d.
MURDOCK CARPET CLEANERS
Income Statement
For Year Ended June 30, 2015
Revenues
Service fees…………………………………….… $5,030
Expenses
Rent expense…………………………………… $ 775
Wages expense………………………………… 1,230
Supplies expense………………………………… 1,700
Utilities expense…………………………………. 300
Depreciation expense…………………………… 74
Total expenses…………………………………… 4,079
Net income………………………………………… ................................................................
$ 951

MURDOCK CARPET CLEANERS
Balance Sheet
June 30, 2015
Assets Liabilities
Cash $ 1,180 Accounts payable $ 760
Accounts receivable 830 Wages payable 210
Supplies 820 Utilities payable 300
Prepaid rent 2,325 Total Liabilities 1,270
Equipment $ 4,440
Less: Accumulated 74 4,366 Owners’ Equity
depreciation
Common stock 2,000
Total Assets $9,521 Total Liabilities and Owners’ Equity $9,521


e.
1. Retained earnings (-SE) ................................................................................ 775
Rent expense (-E) ........................................................................................ 775

2. Retained earnings (-SE) ................................................................................. 1,700
Supplies expense (-E) ................................................................................ 1,700

3. Retained earnings (-SE) ................................................................................. 1,230
Wages expense (-E) .................................................................................... 1,230

4. Retained earnings (-SE) ................................................................................. 300
Utilities expense (-E ) ................................................................................ 300

5. Retained earnings (-SE) ................................................................................. 74
Depreciation expense (-E) ....................................................................... 74

6. Service fees earned (-R) ................................................................................. 5,030
Retained earnings (+SE) .......................................................................... 5,030

- Retained Earnings (SE) + + Rent Expense (E) -
5,300 Bal. Bal. 775 775 1.
1. 775 0
2. 1,700
3. 1,230 + Supplies Expense (E) -
4. 300 Bal. 1,700 1,700 2.
5. 74 5,030 6. 0
6,251 Bal.

+ Wages Expense(E) - + Utilities Expense (E) -
Bal. 1,230 1,230 3. Bal. 300 300 4.
0 0

+ Depreciation Expense (E) - - Service Fees Earned (R) +
Bal. 74 74 5. 6. 5,030 5,030 Bal.
0 0


P 3-43. (30 minutes)

a.
1. Accrue salary - = +720 -720 Retained - +720 = -720
expense. Salaries Earnings Salaries
Payable Expense
2. Accrue - = +200 -200 Retained - +200 = -200
interest Interest Earnings Interest
3. Accrue fees +900 Fees - = +900 Retained +900 Printing - = +900
receivable. Receivable Earnings Revenue
4. Accrue -400 Prepaid - = -400 - +400 = -400

maintenance Maintenance Retained Maint.
5. Accrue ad. -300 - = -300 - +300 Ad. = -300
Expense. Expense
Prepaid Retained
Advertising Earnings
6. Accrue rent - = +160 Rent -160 - +160 Rent = -160
expanse. Payable Retained Expense
Earnings
7. Accrue +38 Interest - = +38 Retained +38 Interest - = +38
interest Receivable Earnings Revenue
revenue.
8. Accrued - +2,175 = -2,175 - +2,175 = -2,175
depreciation Accumulated Retained Depreciation
expense. Depreciation Earnings Expense
Totals 0 + +238 - 2,175 = 1,080 + 0 + -3,017 938 - 3,955 = -3,017


b.
Date Description Debit Credit
Dec 31 Salaries expense (+E, -SE) 720
Salaries payable (+L) 720
To accrue salaries at December 31 ($1,800 × 2/5 = $720).

31 Interest expense (+E, -SE) 200
Interest payable (+L) 200
To accrue interest expense at December 31.

31 Fees receivable (+A) 900
Printing revenue (+R, +SE) 900
To record revenue earned but not yet billed.

31 Maintenance expense (+E ,-SE) 400
Prepaid maintenance (-A) 400
To record December maintenance expense.

To record December advertising expense
($900 × 1/3 = $300).

Rent payable (+L) 160
To accrue one-half month's rent expense
[(400 × $0.80)/2 = $160].

31 Interest receivable (+A) 38
To accrue interest earned in December.

31 Depreciation expense—Equipment (+E, -SE) 2,175
Accum. depreciation—Equipment (+XA) 2,175
To record annual depreciation on equipment.


P3-44. (40 minutes)

a.
TRUEMAN CONSULTING INC.
Income Statement
For the Year Ended December 31, 2015
Revenue
Service fees earned $58,400
Expenses
Rent expense $12,000
Salaries expense 33,400
Supplies expense 4,700
Insurance expense 3,250
Depreciation expense—Equipment 720
Total Expenses 54,700
Net Income $ 3,700

TRUEMAN CONSULTING INC.
Common Retained Total Stockholders’
Balance at December 31, 2014 ........................ $1,000 $3,305 $4,305
Stock issuance .........................................................
Dividends ................................................................
Net income ............................................................... _____ 3,700 3,700
Balance at December 31, 2015 ........................ $1,000 $7,005 $8,005

TRUEMAN CONSULTING
Balance Sheet
December 31, 2015

Assets Liabilities
Cash $ 2,700 Accounts payable $ 845
Accounts receivable 3,270 Long-term notes payable 7,000
Supplies 3,060 Total Liabilities 7,845
Prepaid insurance 1,500
Equipment $ 6,400 Owners’ Equity
Less: Accumulated 1,080 5,320 Common stock 1,000
depreciation



b.

Salaries expense(-E) 33,400
Depreciation expense—Equip (-E) 720
Interest expense (-E) 630

P3-45. (30 minutes)

a.
Miscellaneous income (-R) 4,200


b. After the closing entries are posted, Retained Earnings has a $45,700 credit
balance ($19,100 + $26,600 net income).


c.
Wilson Company
Post-Closing Trial Balance
December 31, 2015
Debit Credit
Cash $8,500
Equipment 72,000
Accumulated Depreciation $12,000
Accounts Payable 600
Income Tax Payable 8,800
Common Stock 25,000
Retained Earnings ______ 45,700
$92,100 $92,100

P3-46. (30 minutes)

a.
1. Recognize -400 = -400 - +400 = -400
Advertising
expense.
2. Accrue wage = +1,300 -1,300 - +1,300 = -1,300

expense.
Wages Retained Wages Expense
Payable* Earnings
3. Recognize -1,140 = -1,140 - +1,140 = -1,140

insurance
expense.
4. Recognize = -2,400 +2,400 +2,400 - = +2,400

service fees
Unearned Retained Service Fees
earned.
Service Fees Earnings Earned
5. Recognize +1,000 = +1,000 +1,000 - = +1,000

rent revenue.
Rent Receivable Retained Rental
Earnings Income
Totals 0 + -540 = -1,100 + 0 + 560 3,400 - 2,840 = 560

*Assumes wages earned had not been accrued or recognized yet as an expense.

continued next page



Dec. 31 Advertising expense (+E, -SE) 400
Prepaid advertising (-A)
400
To record advertising expense ($1,200 − $800 = $400).

Wages payable (+L)
1,300
To record accrued wages.

31 Insurance expense (+E, -SE) 1,140
Prepaid insurance (-A)
1,140
To record insurance expense ($3,420 − $2,280 = $1,140).

31 Unearned service fees (-L) 2,400
Service fees earned (+R, +SE)
2,400
To recognize unearned fees as earned
($5,400 − $3,000 = $2,400).

31 Rent receivable (+A) 1,000
Rental income (R, +SE)
1,000
To record rent earned but not yet recorded.

b.

1. Pay wages of -2,400 = -1,300 -1,100 - +1,100 = -1,100
$2,400.
Cash Wages Retained Wages

2. Receipt of +1,000 -1,000 = - =

$1,000 rent
Cash Rent
revenue.
Receivable

Date 2016 Description Debit Cre
Jan. 4 Wages payable (-L) 1,300
Wages expense (+E, -SE) 1,100
Cash (-A) 2,400
To record payment of wages.

4 Cash (+A) 1,000

Rent receivable (-A) 1,000
To record collection of rent.


P3-47. (90 minutes)

For part d, the adjusting entries are indicated by the numbers 1-5. The unadjusted trial
balance required in part c is calculated before the adjusting entries are made.

a., b. and d.

6/1 24,000 4,400 6/1 9,480 6/1
6/2 6,400 875 6/2
6/30 7,800 930 6/2
3,600 6/12 - Salaries Payable (L) +
1,240 6/15 725 2.
520 6/18
3,600 6/26
1,500 6/30 - Unearned Service Fees (L) +
21,535 5. 3,200 6,400 6/2
3,200
+ Accounts Receivable (A) -
6/10 5,800 7,800 6/30 - Common Stock (SE) +
6/28 5,200 24,000 6/1
3,200

+ Prepaid Advertising (A) - - Retained Earnings(SE) +
6/2 930 310 4. 6/30 1,500
620

+ Office Supplies (A) - + Supplies Expense (E) -
6/1 2,840 1,310 1. 1. 1,310
1,530

+ Office Equipment (A) - + Travel Expense (E) -
6/1 11,040 6/15 1,240

- Acc. Depreciation – Off. Equip (XA) + + Depreciation Expense(E) -
115 3. 3. 115

continued next page


+ Advertising Expense (E) - + Rent Expense (E) -
4. 310 6/2 875

+ Salaries Expenses (E) - - Service Fees Earned (R) +
6/12 3,600 5,800 6/10
6/26 3,600 5,200 6/28
2. 725 3,200 5.
7,925 14,200
+ Postage Expense (E) -
6/18 520

b.
6/1. Investment for +24,000 = +24,000 - =
common stock. Cash Common Stock
6/1. Purchase of -4,400 Cash + 11,040 = +9,480 Accounts - =
assets for cash & Office Payable
on account. Equipment
+2,840
Supplies
6/2. Pay rent $875. -875 Cash = -875 Retained - +875 Rent = -875
Earnings Expense
6/2. Purchase $930 -930 Cash +930 Prepaid = - =
of advertising in Advertising
advance.
6/2 Signed research +6,400 Cash = +6,400 - =
contract. Unearned
Service Fees
6/10. Bill +5,800 = +5,800 +5,800 Service - = +5,800
customers for Accounts Retained Fees Earned
services. Receivable Earnings
6/12. Paid -3,600 Cash = -3,600 Retained - +3,600 Salaries = -3,600
salaries. Earnings Expense
6/15. Paid travel -1,240 Cash = -1,240 Retained - +1,240 Travel = -1,240
expenses. Earnings Expense
6/18. Paid -520 Cash = -520 Retained - +520 Postage = -520
postage. Earnings Expense
6/26. Paid -3,600 Cash = -3,600 Retained - +3,600 Salaries = -3,600
salaries. Earnings Expense
6/28. Bill +5,200 = +5,200 +5,200 Service - = +5,200
customers for Accounts Retained Fees Earned
services. Receivable Earnings
6/30. Collect +7,800 Cash -7,800 = - =
service fees. Accounts
Receivable
6/30. Cash -1,500 Cash -1,500 Retained -
dividend paid. Earnings

continued next page

June 1 Cash (+A) 24,000
Owner invested cash for common stock.

1 Office equipment (+A) 11,040
Office supplies (+A) 2,840
Cash (-A) 4,400
Purchased equipment and supplies;
$4,400 cash paid with the remainder due in 60 days.

Cash (-A) 875
Paid June rent.

2 Prepaid advertising (+A) 930
Cash (-A) 930
Paid three months' advertising in advance.

2 Cash (+A) 6,400
Unearned service fees (+L) 6,400
Received two months' fees in advance on six-month contract.

Service fees earned (+R, +SE) 5,800

Cash (-A) 3,600
Paid two weeks' salaries to employees.

15 Travel expense (+E, -SE) 1,240
Cash (-A) 1,240
Paid business travel expenses.

18 Postage expense (+E, -SE) 520
Cash (-A) 520
Paid postage for questionnaire mailing.

Cash (-A) 3,600
Paid two weeks' salaries to employees.

continued next page


June 28 Accounts receivable (+A) 5,200

30 Cash (+A) 7,800
Collections from customers on account.

Cash (-A) 1,500
Declared and paid dividends.

c.
MARKET-PROBE
June 30, 2015
Debit Credit
Cash $21,535
Office Supplies 2,840
Prepaid Advertising 930
Office Equipment 11,040
Unearned Service Fees 6,400
Common Stock 24,000
Retained Earnings* 1,500
Service Fees Earned 11,000
Salaries Expense 7,200
Rent Expense 875
Travel Expense 1,240
Postage Expense 520 ______
$50,880 $50,880

* The negative (debit) balance in Retained Earnings reflects the dividend paid.


d.
a. Recognize -1,310 - = -1,310 - +1,310 = -1,310
supplies
Office Supplies Retained Supplies
expense.
Earnings Expense
b. Recognize - = +725 -725 - +725 = -725
salaries
Salaries Retained Salaries
expense.
c. Accrue - +115 = -115 - +115 = -115
depreciation Depreciation
Accumulated Retained
expense. Expense
Depreciation Earnings
d. Recognize -310 - = -310 - +310 = -310
advertising
expense.
e. Recognize - = -3,200 +3,200 +3,200 - = +3,200
earned
Unearned Retained Service
service fees.
Service Fees Earnings Fees Earned

June 30 Supplies expense (+E, -SE) 1,310
Office supplies (-A) 1,310
To record supplies used during June ($2,840 − $1,530 = $1,310).

30 Salaries expense (+E, -SE) 725
Salaries payable (+L) 725
To record unpaid salaries at June 30.

30 Depreciation expense—Office equipment (+E, -SE) 115
Accum. deprec. Off. equipment (+XA, -A) 115
To record June depreciation ($11,040/96 mo. = $115).

To record one month's advertising expense.

30 Unearned service fees (-L) 3,200
To record one month's fees earned, received in advance.


P3-48. (40 minutes)

DELIVERALL
December 31, 2015
a.
Debit Credit
Cash $ 2,300
Prepaid Advertising 1,680
Supplies 6,270
Equipment 42,240
Notes Payable $7,500
Accounts Payable 2,700
Common Stock 9,530
Mailing Fees Earned 86,000
Wages Expense 38,800
Rent Expense 6,300
Utilities Expense 3,020 ________
$105,730 $105,730

b
1. Recognize -1,540 - = -1,540 - +1,540 = -1,540
advertising Prepaid Retained Advertising
expense. Advertis- Earnings Expense
ing
2. Recognize - +5,280 = -5,280 - +5,280 = -5,280
depreciation Accum. Retained Depreciation
expense. Deprec. Earnings Expense
3. Recognize - = +325 Accts -325 Retained - +325 = -325
utilities Payable Earnings Utilities
expense. Expense
4. Accrue wages - = +1,200 -1,200 - +1,200 = -1,200
expense. Wages Retained Wages
5. Recognize -4,750 - = -4,750 - +4,750 = -4,750
supplies Supplies Retained Supplies
6. Accrue - = +450 -450 Retained - +450 = -450
7. Recognize - = +430 Accts -430 Retained - +430 Rent = -430
rent Payable Earnings Expense
expense*.

*(1/2% × $86,000 = $430). The rent for the year ($6,300 = $525 x 12) has already been recognized in the accounts. See the beginning balances given
in the problem statement.

continued next page



Dec. 31 Advertising expense (+E, -SE) 1,540
Prepaid advertising (-A) 1,540
To record 11 months' advertising expense
($1,680 × 11/12 = $1,540).

31 Depreciation expense (+E, -SE) 5,280
Accumulated depreciation (+XA, -A) 5,280
To record depreciation for the year
($42,240/8 years = $5,280).
.
Accounts payable (+L) 325
To record estimated December utilities expense.

Wages payable (+L) 1,200
To record unpaid wages at December 31.

Supplies (-A) 4,750
To record supplies expense for the year
($6,270 − $1,520 = $4,750).

31 Interest expense (+E, -SE) 450
To record accrual of interest expense at Dec. 31.

To record additional rent owed under lease
(1/2% × $86,000 = $430).


c. Only the T-accounts needed to enter the adjustments are provided.

- Accounts Payable (L) + + Prepaid Advertising (A) -
2,700 Bal. Bal. 1,680 1,540 1.
325 3.
430 7.
+ Supplies (A) -
Bal. 6,270 4,750 5.

- Accumulated Depreciation–Equip (XA) + +Advertising Expense (E) -
5,280 2. 1. 1,540

- Interest Payable (L) + + Rent Expense (E) -
450 6. Bal. 6,300
7. 430

- Wages Payable (L) + + Wages Expense (E) -
1,200 4. Bal. 38,800
4. 1,200

+ Depreciation Expense (E) - + Utilities Expense (E) -
2. 5,280 Bal. 3,020
3. 325

+ Interest Expense (E) - + Supplies Expense (E) -
6. 450 5. 4,750


P3-49 (60 minutes)

a.

Cash Noncash Contrib. Earned
Transaction Asset + Assets - Contra Assets = Liabilities + Capital + Capital Revenues - Expenses = Net Income
1. Recognize -795 - = -795 - +795 = -795
rent expense.
Earnings Expense
2. Recognize -1,980 - = -1,980 - +1,980 = -1,980
supplies
expense.
Earnings Expense
3. Accrue - +335 = -335 - +335 = -335
depreciation
expense.
4. Accrue wages - = +560 -560 - +560 = -560
payable.
5. Recognize - = +390 -390 - +390 = -390
utilities
Accounts Retained Utilities
expense.
6. Recognize - = -500 +500 +500 - = +500
service
Unearned Retained Service
revenue.
Service Earnings Revenue
Revenue

Mar. 31 Rent expense (+E, -SE) 795
To record March rent expense ($4,770/6 months = $795).

Supplies (-A) 1,980
To record March supplies expense ($3,700−$1,720 = $1,980).

31 Depreciation expense—Equipment (+E, -SE) 335
Accumulated depreciation—Equipment (+XA, -A) 335
To record March depreciation ($36,180/108 months = $335).

To record unpaid wages at March 31.

To record estimated March utilities expense.

31 Unearned service revenue (-L) 500
Service revenue (+R, +SE) 500
To record revenue received in advance that was earned in March.



b. Not all the T-accounts given are needed to enter the adjustments required. Also,
the closing entries required in part d are referenced by 1c, 2c etc.

- Accounts Payable (L) + + Prepaid Rent (A) -
2,510 Bal. Bal. 4,770 795 1.
390 5. Bal. 3,975
2,900 Bal.
+ Supplies (A) -
Bal. 3,700 1,980 2.
Bal. 1,720
- Acc Depreciation - Equipment (XA) + - Unearned Service Revenue (L) +
335 3. 6. 500 1,000 Bal.
500 Bal.

-Service Revenue(R) + + Rent Expense (E) -
6c. 12,860 12,360 Bal. 1. 795 795 1c.
500 6.
2. 1,980 1,980 2c.

+Depreciation Expense (E) - +Wages Expense (E) -
3. 335 335 3c. Bal. 3,900
4. 560 4,460 4c.

+ Utilities Expense (E) - - Wages Payable (L) +
5. 390 390 5c. 560 4.

1c. 795
2c. 1,980
3c. 335
4c. 4,460
5c. 390
12,860 6c.
4,900 7c.


c.
WHEEL PLACE COMPANY
Income Statement
For Month Ended March 31, 2016
Service revenue…………………………………….……... $12,860
Expenses:
Utilities expense…………….…………………..………… $390
Supplies expense…………..……………………………… 1,980
Wages expense……………..…………………………..… 4,460
Depreciation expense………………………………….… 335
Rent expense……………………………………………... 795 7,960
Net income …………………………………………………... $4,900

Wheel Place Company
BALANCE SHEET
March 31, 2016
Assets Liabilities
Cash $ 1,900 Accounts payable $ 2,900
Accounts receivable 3,820 Wages payable 560
Supplies 1,720 Unearned service revenue 500
Prepaid rent 3,975 Total Liabilities 3,960
Equipment $ 36,180
Less:Accumulated 335 35,845 Owners’ Equity
depreciation
Common stock 38,400


d.
1c. Retained earnings (-SE) ............................................................................ 795
Rent expense (-E) .................................................................................. 795

2c. Retained earnings (-SE) ............................................................................ 1,980
Supplies expense (-E) .......................................................................... 1,980

Depreciation expense (-E) ................................................................. 335

4c. Retained earnings (-SE) ............................................................................ 4,460
Wages expense (-E) .............................................................................. 4,460

Utilities expense (-E) ............................................................................ 390

6c. Service revenue (-R) ................................................................................. 12,860
Retained earnings (+SE) ..................................................................... 12,860

The closing journal entries are shown in the T-accounts in part b.


P3-50. (30 minutes)

a.
TRAILS, INC.
Income Statement
Revenues
Subscription revenue $ 168,300
Advertising revenue 49,700
Total revenues $218,000
Expenses
Printing and mailing expense 85,600
Rent expense 8,800
Supplies expense 6,100
Insurance expense 1,860
Depreciation expense 5,500
Income tax expense 1,600
Net income $8,310

TRAILS, INC.

Total
Common Retained
Stockholders’
Stock Earnings
Equity
Balance at December 31, 2014 ....................... $25,000 $23,220 $48,220
Stock issuance .....................................................
Dividends ..............................................................
Net income ............................................................ _____ 8,310 8,310

continued next page


TRAILS, INC.
Balance Sheet
December 31, 2015
Assets Liabilities
Cash $3,400 Accounts payable $ 2, 100
Accounts receivable 8,600 Unearned subscription revenue 10,000
Supplies 4,200 Salaries payable 3,500
Prepaid insurance 930 Total liabilities 15,600
Office equipment $66,000
Less: Stockholders' equity
Accum. depreciation 11,000 55,000
Common stock $25,000
Total stockholders' equity 56,530
_______ Total liabilities and
Total assets $72,130 stockholders' equity $72,130

b.
Dec. 31 Subscription revenue (-R) 168,300
Advertising revenue (-R) 49,700

Printing and mailing expense (-E) 85,600


P3-51. (30 minutes)

a.

Advertising expense(-E) 6,000
Depreciation expense—Trucks(-E) 4,000
Depreciation expense—Equipment (-E) 800
b. The balance in Retained Earnings after closing entries are posted is $29,250
credit ($15,550 + $13,700).

c.
MAYFLOWER MOVING SERVICE
December 31, 2015
Debit Credit
Cash $ 3,800
Supplies 2,300
Prepaid Advertising 3,000
Trucks 28,300
Accumulated Depreciation—Trucks $10,000
Equipment 7,600
Accumulated Depreciation—Equipment 2,100
Unearned Service Fees 2,700
Common Stock 5,000
Retained Earnings ______ 29,250
$50,250 $50,250


P3-52. (20 minutes)

a.
1. Recognize -1,800 = -1,800 - +1,800 = -1,800
maintenance
Prepaid Retained Maintenance
expense.
Maintenance Earnings Expense
2. Recognize supplies -5,200 = -5,200 - +5,200 = -5,200
expense.
Earnings Expense
3. Accrue earned = -4,500 +4,500 +4,500 - = +4,500
commissions.
Unearned Retained Commission
Commission Earnings Fees Earned
Fees
4. Earned but unbilled +2,800 = +2,800 +2,800 - = +2,800
commission fees.
Fees Receivable Retained Commission
Earnings Fees Earned
5. Rent expense. = +913 -913 - +913 = -913
Rent Payable Retained Rent Expense
Earnings

b.
1. Recognize -2,800 Fees = +1,800 +1,800 - = +1,800
maintenance Receivable Retained Commission
expense. Earnings Fees Earned
+4,600
Accounts
Receivable
2. Recognize supplies -913 Cash -5,200 Supplies = -913 Rent - =
expense. Payable


c.
Dec. 31 Maintenance expense (+E, -SE) 1,800
Prepaid maintenance (-A) 1,800
To record four months' maintenance expense
[($2,700/6) × 4 = $1,800].

Supplies (-A) 5,200
To record supplies expense ($8,400 − $3,200 = $5,200).

31 Unearned commission fees (-L) 4,500
Commission fees earned (+R, +SE) 4,500
To transfer fees earned from unearned fees
($8,500 − $4,000 = $4,500).

31 Fees receivable (+A) 2,800
Commission fees earned (+R, +SE) 2,800
To record fees earned but not yet billed.

Rent payable (+L) 913
To record additional 2015 rent
[1% × ($84,000 + $4,500 + $2,800) = $913].

2016
Jan. 10 Accounts receivable (+A) 4,600
Fees receivable (-A) 2,800
Commision fees earned (+R, +SE) 1,800
To record billings on Jan. 10, 2016.

10 Rent payable (-L) 913
Cash (-A) 913
To record payment of contingent rent from 2015.


P3-53. (60 minutes)

a.
1. Cash sales. +145,850 - = +145,850 +145,850 - = +145,850
Cash Retained Sales
Earnings Revenue
2. Record inventory +2,500 - = +76,200 -73,700 - +73,700 = -73,700

purchased and Inventories Accounts Retained Cost of
used. Payable Earnings Goods Sold
3. Recognize recent -77,300 - = -77,300 - =
payments on A/P. Cash Accounts
Payable
4. Recognize rent -24,000 +200 Prepaid - = -23,800 - +23,800 = -23,800
paid and rent Cash Rent Retained Rent
5. Recognize wage -12,500 - = +250 Wages -12,750 - +12,750 = -12,750
expense and Cash Payable Retained Wages
wages paid. Earnings Expense
6. Recognize - +1,700 = -1,700 - +1,700 = -1,700
depreciation Accum. Retained Deprec.
expense. Deprec. Earnings Expense

b.

1. Cash (+A) ................................................................................................ 145,850
Sales revenue (+R,+SE) ................................................................ 145,850

2. Inventories (+A) ................................................................................................
2,500
Cost of goods sold (+E, -SE) ................................................................73,700*
Accounts payable (+L) ................................................................ 76,200

Or, make two separate entries with the same net effect:
Inventory (+A) ................................................................................................
76,200
Accounts payable (+L) ................................................................ 76,200

Cost of goods sold (+E, -SE) ................................................................73,700*
Inventory (-A) ................................................................................................
73,700
*73,700 = 12,000 +76,200 – 14,500.

3. Accounts payable (-L) ................................................................................................
77,300*
Cash (-A) ................................................................................................ 77,300
*77,300 = 5,200 +76,200 – 4,100.

continued next page


4. Prepaid rent (+A) ................................................................................................
200*
Rent expense (+E, -SE) ................................................................................................
23,800*
Cash (-A) ................................................................................................ 24,000
* $23,800 = $3,800 + ($24,000 ÷12) x (10) and 200 = $24,000 – $3,800 – ($24,000 ÷12) x (10).
The rent expense for the first two months of the year is $3,800. But the rate for March 1,
2015 through February 29, 2016 is $2,000 per month. So, for the last ten months of 2015, the
rent expense is $20,000, making the total rent expense $23,800 for 2015.

5. Wages expense (+E,-SE) ................................................................................................
12,750*
Cash (-A) ................................................................................................ 12,500
Wages payable (+L) ................................................................................................ 250
* 12,750 = 12,500 + (350 – 100).
6. Depreciation expense (+E,-SE) ................................................................1,700
Acc. depreciation – Equipment (+XA, -A) ................................ 1,700

c, e. The closing entries required in part e are also included here and indicated by
the letter e before the relevent entry.

+ Cash (A) - + Inventories (A) -
Bal. 8,500 Bal. 12,000
1. 145,850 77,300 3. 2. 2,500
24,000 4. Bal. 14,500
12,500 5.
Bal. 40,550 + Prepaid Rent (A) -
Bal. 3,800
+ Equipment (A) - 4. 200
Bal. 7,500 Bal. 4,000
Bal. 7,500

- Accumulated Depreciation Equip.(XA) + - Wages Payable (L) +
3,000 Bal. 100 Bal.
1,700 6. 250 5.
4,700 Bal. 350 Bal.

-Accounts Payable (L)+ -Owners’ Equity (SE)+
5,200 Bal. 23,500 Bal.
3. 77,300 76,200 2. 33,900 e.
4,100 Bal. 57,400 Bal.

continued next page


-Sales Revenue (R)+ +Cost of Goods Sold (E)-
145,850 1. 2. 73,700
e. 145,850 73,700 e.
0 Bal. Bal. 0

+Rent Expense (E)- +Depreciation Expense(E)-
4. 23,800 6. 1,700
23,800 e. 1,700 e.
Bal. 0 Bal. 0

+Wages Expense (E)-
5. 12,750
12,750 e.
Bal. 0

d,and e.

Part d is easier to complete if the closing entries required in part e are journalized
and entered in the T-accounts. The appropriate T-account entries for part e have
been made earlier and indicated by the letter e.

Sales revenue (-R) .................................................................................................................
145,850
Cost of goods sold (-E) ................................................................................................ 73,700
Rent expense (-E) ................................................................................................ 23,800
Wages expense (-E) ................................................................................................ 12,750
Depreciation expense (-E) ................................................................................................ 1,700
Owners’ equity ..........................................................................................................................
33,900
To close temporary revenue and expense accounts.

FISCHER CARD SHOP
Income Statement
For the Year ended December 31, 2015
Sales revenue $145,850
Gross profit 72,150
Other expenses:
Wages expense 12,750
Total other expenses 38,250
Net income $33,900


continued next page

FISCHER CARD SHOP
Balance Sheets
As of December 31, 2014 2015
Assets:
Cash $ 8,500 $ 40,550
Inventories 12,000 14,500
Prepaid rent 3,800 4,000
Total current assets 24,300 59,050
Equipment 7,500 7,500
Accumulated depreciation (3,000) (4,700)
Equipment, net 4,500 2,800
Total assets $ 28,800 $ 61,850
Liabilities and owners’ equity:
Wages payable 100 350
Owners’ equity 23,500 57,400
Total liabilities and owners’ equity $ 28,800 $ 61,850

P3-54. (120 minutes)

a, b. The T-accounts follow the journal entries and the FSET.


12/1 Investment for +20,000 = +20,000 - =
common stock. Cash Common
Stock
12/2. Rent paid in cash. -1,200 = -1,200 Retained - +1,200 Rent = -1,200
Cash Earnings Expense
12/2 Purchase supplies +1,080 = +1,080 - =
on account. Supplies Accounts
Payable
12/3 Office equipment -4,700 +9,500 Office = +4,800 - =
bought for 4,700 Cash Equipment Accounts
cash and rest on Payable
account.
12/8. Paid for supplies. -1,080 = -1,080 - =
Cash Accounts
Payable
12/14 Paid wages in -900 Cash = -900 Retained - +900 Wages = -900
cash. Earnings Expense
12/20 Received cash for +3,000 = +3,000 Retained +3,000 - = +3,000
consulting Cash Earnings Consulting
services. Revenue
12/28 Paid wages in -900 Cash = -900 Retained - +900 Wages = -900
cash. Earnings Expense
12/30 Bill clients for +7,200 Fees = +7,200 Retained +7,200 - = +7,200
consulting. Receivable Earnings Consulting
Revenue
12/30 Paid cash -1,800 = -1,800 Retained - =
dividends. Cash Earnings

continued next page

Adjusting Cash Noncash Contra Liabi- Contrib. Earned Net
Entries Asset + Assets - Assets = lities + Capital + Capital Revenues - Expenses = Income
1. Record -370 Supplies - = -370 Retained - +370 = -370
supplies Earnings Supplies
expense. Expense
2. Accrue wages - = +270 -270 Retained - +270 Wages = -270
expense. Wages Earnings Expense
Payable
3. Record - +120 = -120 Retained - +120 = -120
depreciation Accum. Earnings Depreciation
expense. Deprec. Expense
4. Recognize +2,250 Fees - = +2,250 +2,250 - = +2,250
accrued Receivable Retained Consulting
consulting Earnings Revenue
fees.

c. Transactions:

Dec. 1 Cash (+A) 20,000
Invested $20,000 cash in the business.

2 Rent expense (+E, -SE) 1,200
Cash (-A) 1,200
Paid rent for December.

Purchased various supplies on account.

Dec. 3 Office equipment (+A) 9,500
Cash (-A) 4,700
Purchased $9,500 of office equipment, $4,700 cash
down payment and balance due in 30 days.

Cash (-A) 1,080
Payment on account.

Cash (-A) 900
Paid assistant's wages.

20 Cash (+A) 3,000
Consulting revenue (+R, +SE) 3,000
Cash received for services.

continued next page



Dec. 28 Wages expense (+E, -SE) 900
Cash (-A) 900
Paid assistant's wages.


Cash (-A) 1,800
Issued and paid $1,800 in dividends.

b, c, and g.

The adjusting entries requested are included and are denoted by the letter a
followed by a number 1 through 5. The closing entries requested in part g are
indicated by the letter g.

+ Cash (A) - +Supplies(A)-
12/1 20,000 1,200 12/2 12/2 1,080 370 1a
12/20 3,000 4,700 12/3 Bal. 710
1,080 12/8
900 12/14
900 12/28
1,800 12/31
Bal. 12,420 +Office Equipment (A) -
12/3 9,500
-Wages Payable(L) +
2a. 270

-Accumulated Depreciation+
-Common Stock(SE)+
Office Equipment (XA)
120 3a. 20,000 12/1

- Accounts Payable (L) + +Rent Expense (E) -
12/8 1,080 1,080 12/2 12/2 1,200 1,200 g.
4,800 12/3 Bal. 0
4,800 Bal.

continued next page


- Retained Earnings (SE)+ + Wages Expense (E) -
12/31 1,800 12,450 g. 12/14 900 2,070 g.
g. 3,760 12/28 900
2a. 270
6,890 Bal. Bal. 0

-Consulting Revenue(R)+ +Fees Receivable (A)-
3,000 12/20 12/30 7,200
7,200 12/30 4a. 2,250
g. 12,450 2,250 4a. Bal. 9,450
Bal. 0
+Depreciation Expense(E)- 1a. 370 370 g.
3a. 120 120 g. Bal. 0
Bal. 0

d.
RHOADES TAX SERVICES
December 31, 2015
Debit Credit
Cash $12,420
Fees Receivable 7,200
Supplies 1,080
Common Stock 20,000
Retained Earnings (Dividend) 1,800
Consulting Revenue 10,200
Wages Expense 1,800
Rent Expense 1,200 ______
$35,000 $35,000


e. Adjusting Entries:

Dec. 31 Supplies expense (+E, -SE) 370
Supplies (-A) 370
To record December supplies expense ($1,080 − $710).

To reflect unpaid wages at December 31.

31 Depreciation expense (+E, -SE) 120
Accumulated depreciation (+XA, -A) 120
To record December depreciation.

To record unbilled service revenue (30 × $75).

Adjusted Trial Balance
December 31, 2015
Debit Credit
Cash $12,420
Supplies 710
Accumulated Depreciation $120
Wages Payable 270
Common Stock 20,000
Retained Earnings 1,800
Consulting Revenue 12,450
Supplies Expense 370
Wages Expense 2,070
Rent Expense 1,200
Depreciation Expense 120 ______
$37,640 $37,640


f.
Income Statement
Revenue
Consulting revenue $12,450
Expenses
Wages expense $ 2,070
Rent expense 1,200
Supplies expense 370
Depreciation expense 120
Net income $ 8,690

Total
Balance at December 1, 2015 .......................... $0 $0 $0
Stock issuance ..................................................... 20,000 20,000
Dividends .............................................................. (1,800) (1,800)
Net income ............................................................ ______ 8,690 8,690

Balance Sheet
December 31, 2015
Assets Liabilities and Equity
Cash $12,420 Accounts payable $ 4,800
Fees receivable 9,450
Wages payable 270
Supplies 710
Total liabilities 5,070
Total current assets 22,580
Office equipment $ 9,500
Less:
Accum. depreciation 120 Common stock
9,380 20,000

Total liabilities and stockholders’

Total assets $31,960 equity $31,960


g.
Dec.31 Consulting revenue (-R) 12,450

Supplies expense (-E) 370
Depreciation expense (-E) 120

h.
December 31,2015
Debit Credit
Cash $12,420
Supplies 710
Accumulated Depreciation $ 120
Wages Payable 270
Retained Earnings 6,890
Common Stock 20,000
$32,080 $32,080



CASES and PROJECTS

C3-55. (90 minutes)

a1. Entries in the FSET are first shown for the initial deposits and checks. These are
entries 1- 8. Entries a - f are the adjusting entries that would be made at the end of
the three months. The expenditures for rent and salaries are assumed to have been
initially debited to expense accounts.

Transaction Asset + Assets - Assets = ities + Capital + Capital Revenues - Expenses = Income
1. Investment +50,000 - = +50,000 - =
for common Cash Investment
stock.
2. Collections +81,000 - = +81,000 +81,000 Sales - = +81,000
from Cash Retained Revenue
customers. Earnings
3. Bank +10,000 - = +10,000 - =
borrowing. Cash Loans
Payable
4. Rent expense. -24,000 - = -24,000 - +24,000 = -24,000
Cash Retained Rent
Earnings Expense
5. Purchased -25,000 +25,000 - = - =
equipment. Cash Equipment
6. Purchased -62,000 +62,000 - = - =

inventory. Cash Inventory
7. Paid salaries. -6,000 - = -6,000 - +6,000 = -6,000

Cash Retained Salaries
Earnings Expense
8. Paid other -13,000 - = -13,000 - +13,000 = -13,000
expenses. Cash Retained Misc.
Earnings Expenses
a. Recognize +9,000 - = +9,000 +9,000 Sales - = +9,000
credit sales. Retained Revenue
A/R
Earnings
b. Adjust rent +12,000 - = +12,000 - -12,000 Rent = +12,000
expense. Prepaid Rent Retained Expense
Earnings
c. Accrue - = +3,000 -3,000 - +3,000 = -3,000
salaries Salaries Retained Salaries
expense. Payable Earnings Expense
d. Recognize -41,000 - = -41,000 - +41,000 Cost = -41,000
cost of goods Inventory Retained of Goods
sold. Earnings Sold
e. Accrue - +1,250 = -1,250 - +1,250 = -1,250
depreciation Accumulated Retained Deprec.
expense. Depreciation Earnings
Expense

f. Accrue - = +300 -300 Retained - +300 = -300
expense*. Payable Expense

continued next page

a2. Journal entries are shown only for the adjustments a-f.

a. Accounts receivable (+A) 9,000
Sales revenue (+R, +SE) 9,000
To recognize sales on account.

b. Prepaid rent (+A) 12,000
Rent expense (-E, +SE) 12,000
To recognize remaining prepaid rent and correct rent expense.

c. Salaries expense (+E, -SE) 3,000
Salaries payable (+L) 3,000
To recognize unpaid salaries earned during September.

d. Cost of goods sold (+E, -SE) 41,000
Merchandise inventory (-A) 41,000
To recognize cost of sales; ($62,000 - $21,000).

e. Depreciation expense (+E, -SE) 1,250
Accumulated depreciation (+XA, -A) 1,250
To accrue depreciation on the fixtures and equipment
($25,000/60) x (3).

f. Interest expense (+E, -SE) 300
To accrue interest on bank loan assumed taken out 7/1/2008.
($10,000) x (0.12) x (1/4).


b. T-accounts: The opening balances shown are the amounts in the accounts prior to
the entry of the adjustments described in items a through f. The cash balance
represents the deposits made, $141,000, less the checks drawn, $130,000.

+ Cash (A) - + Merchandise Inventory (A) -

Bal. 11,000 Bal. 62,000 41,000 d.

+ Prepaid Rent (A) -
b. 12,000
+ Equipment (A) -
Bal. 25,000

- Accumulated Deprec.-Equip. (XA) + - Salaries Payable (L) +
1,250 e. 3,000 c.

+ Accounts Receivable (A) - - Owners’ Equity (SE) +
a. 9,000 50,000 Bal.

- Sales Revenue (R) + + Cost of Goods Sold (E) -
81,000 Bal. d. 41,000
9,000 a.

+ Rent Expense (E) - + Depreciation Expense (E) -
Bal. 24,000 12,000 b. e. 1,250

+ Other Expense (E) - - Bank Loan Payable (L) +
Bal. 13,000 10,000 Bal.

+ Salaries Expense (E) -
Bal. 6,000 - Interest Payable (L) +
c. 3,000 300 f.

f. 300


c.
SEASIDE SURF SHOP
Income Statement
July 1, 2015 to September 30 ,2015

Sales revenue $90,000
Gross margin 49,000
Expenses:
Misc. expenses 13,000 35,550
Net income $13,450

SEASIDE SURF SHOP
Balance Sheet
September 30, 2015
Assets
Current assets
Cash $11,000
Inventory 21,000
Prepaid rent 12,000
Total current assets 53,000

Fixtures and equipment, net 23,750
Total assets $76,750

Liabilities and owners’ equity
Current liabilities
Salaries payable $3,000
Bank loan payable 10,000
Interest payable 300
Total current liabilities 13,300

Owners’ equity* 63,450
Total liabilities and owners’ equity $76,750
*$50,000 + $13,450


d. Chapter 1 introduced the return on equity ratio as a simple performance
measure that can be used to evaluate how well this new business is doing. The
return on equity is calculated as the ratio of net income to average total equity.
In this case, the return on equity for the three-month period was 23.7% =
$13,450 / [($50,000+ $63,450)/2]. This is a very good return for a three-month
period and equates to 95% annualized. However, the favorable performance
evaluation should be tempered by a few caveats:

(1) Because this business appears to be a sole proprietorship, any “salary” paid
to the owner is not deducted from net income. Instead, cash payments to the
owner are treated as dividends (or withdrawals). As a consequence, any
services provided by the owner to the business would not be reflected among
the expenses reported in the income statement, and net income would be
overstated.

(2) No expense is reported in the income statement for income taxes. This is
consistent with the business being a sole proprietorship, in which income
taxes are levied against the owner as an individual taxpayer. Again, this
makes “net” income appear to be larger than it otherwise might be.

(3) Retail businesses are notoriously seasonal. That is, sales (and profits)
fluctuate from season to season. A business such as this one would likely
have its highest sales in the second and third quarters. This seasonality must
be considered when we try to annualize quarterly results like these. Once
the business has operated for a year or two, the owner would likely have a
better idea about how seasonal fluctuations affect sales and returns and
would be better able to interpret quarterly performance measures.

(4) Finally, Seaside’s cash position is precarious. The firm has burned through most
of the $60 thousand cash raised to begin the business and is likely to have
trouble replacing its inventory as well as paying its bills. Perhaps they can
convince lenders to come to its rescue. If not, the firm will not last another
three months.


C3-56. (15 minutes)

a. The following analysis shows how the relevant information affects total assets,
liabilities, and owners’ equity of the firm:

Assets Liabilities Owners Equity
Per original balance sheet $88,500 $45,900 $42,600
Percentage of debt equity 51.9% 48.1%
1. Recognition of insurance expense ($4,500 ×
1/2 = $2,250) (2,250) (2,250)
2. Depreciation correction (5% ×
$68,500 = $3,425) 3,425 3,425
3. (No adjustment required)
4. Unbilled services performed 6,000 6,000
5. Advance consulting fee earned ($11,300 × 1/2
= $5,650) (5,650) 5,650
6. Recognition of supplies expense ($13,200 −
$4,800 = $8,400) (8,400) ______ (8,400)
Revised totals $87,275 $40,250 $47,025
Percentage of debt and equity 46.1% 53.9%

Revised debt-to-equity ratio: $40,250/$47,025 = 0.86
Original debt-to-equity ratio: $45,900/$42,600 = 1.08

b. Apparently, the loan agreement has not been violated.


C3-57. (30 minutes)

a. Discussion of this case may consider the following ethical considerations facing
Javetz:

1. Balancing the long-run interests of the firm (securing the international
contract) against the short-run requirement to present accurately the financial
data of the company for the current year (recording $150,000 adjusting entry).

2. Compromising the confidentiality of the contract negotiations (by disclosing
the contract negotiations to additional persons) versus compromising her
professional responsibilities (by omitting a significant year-end adjusting
entry).

3. Jeopardizing her position with the firm (by revealing information the president
wants kept secret) versus risking possible future legal action by parties relying
on the firm's financial statements (by not revealing a significant accrued
expense and accrued liability in the financial statements).

b. Discussion of this case should also note that outside auditors frequently access
confidential data and disclosing the contract negotiations to the auditor should not
represent a significant breach of confidentiality. Perhaps Javetz can achieve a
reasonable solution to her dilemma by suggesting that an adjusting entry be
recorded and described in very general terms (for example, labeling the liability
Payable to Consultants and indicating it is for marketing research and
development). Such an adjustment would permit the disclosure of the significant
liability without revealing important details to anyone else within or outside the
company.


C3-58. (30 minutes)

a,b,c and d.

FSET:

Cash Noncash Contrib. Earned
Transaction Asset + Assets = Liabilities + Capital + Capital Revenues - Expenses = Net Income
a1. Recognize prepaid -62,550 +62,550 = - =
catalog costs.
Cash Prepaid
Catalog Costs
a2. Advertising credits + 849 = +849 +849 - = +849

received.
Advertising Retained Advertising
Credits Earnings Credits
Receivable Revenue
b. Recognize -62,138 = -62,138 - +62,138 = -62,138

advertising expense.
Prepaid Retained Catalog
Catalog Costs Earnings Expenses
c. Recognize -336 = -336 - +336 = -336

expiration of
Advertising Retained Expense:
advertising credits.
Credits Earnings Expiration of
Receivable Advertising
Credits
d1. Sales of gift +19,175 = +19,175 - =

certificates.
Cash Unearned
Gift
Certificate
Revenues
d2. Recognize sales = - 18,230 +18,230 +18,230 - = +18,230

using gift
Unearned Retained Gift Certificate
certificates.
Gift Earnings Revenues
Certificate
Revenues

Journal Entries:

a1. Prepaid catalog costs (+A) 62,550
Cash (-A) 62,550
To record catalog printing costs.

a2. Advertising credits receivable (+A) 849
Advertising credits revenue (+R, +SE) 849
To recognize advertising credits earned.

b. Catalog expense (+E, -SE) 62,138
Prepaid catalog costs (-A) 62,138
To regognize catalog expense ($3,894 + $62,550 - $4,306).

c. Advertising credit expiration expense (+E, -SE) 336
Advertising credits receivable (-A) 336
To record the expiration of advertising credits ($21 + $849 - $534).

Advertising credits expire either because they were used to advertise or, if there was a
time limitation to their use, the time limit expired.

d1. Cash (+A) 19,175
Customer deposits (+L) 19,175
To recognize gift certificates sold but not yet redeemed.

d2. Customer deposits (-L) 18,230
Gift certificate revenues (+R, +SE) 18,230
To recognize revenues based on redeemed gift certificates
($6,108 +$19,175 - $7,053).

2
Chapter 4

Reporting and Analyzing Cash Flows

Mini- Cases
Exercises Problems
21 - 24, 29 58, 59
LO1 – Explain the purpose of the

statement of cash flows and classify
cash transactions by type of business
activity: operating, investing and
financing

LO2 – Construct the operating 34, 38, 41, 43,
activities section of the statement of 25, 27, 30, 31 47, 49, 51, 53 59
44
cash flows using the direct method.

LO3 – Reconcile cash flows from
21, 23, 45, 46, 48,
operations to net income and use the 35, 42, 44 57, 58, 59
indirect method to compute operating 25 -28 50 - 54, 56
cash flows.

LO4 – Construct the investing and
46, 48,
financing activities sections of the 36 - 40, 42 57, 58, 59
statement of cash flows. 50 - 54, 56

LO5 – Compute and interpret ratios
that reflect a company’s liquidity and 32, 33, 35, 43 50, 52, 55, 56 59
solvency.

LO4 – Appendix 4A: Use a spreadsheet
to construct the statement of cash 55
flows.



QUESTIONS

Q4-1. Cash equivalents are short-term, highly liquid investments that firms
acquire with temporarily idle cash to earn interest on these excess funds.
To qualify as a cash equivalent, an investment must (1) be easily
convertible into a known cash amount and (2) be close enough to maturity
so that its market value is not sensitive to interest rate changes (generally,
investments with initial maturities of three months or less). Three
examples of cash equivalents are treasury bills, commercial paper, and
money market funds.
Q4-2. Cash equivalents are included with cash in a statement of cash flows
because the purchase and sale of such investments are considered to be
part of a firm's overall management of cash rather than a source or use of
cash. Similarly, as statement users evaluate cash flows, it may matter very
little to them whether the cash is on hand, deposited in a bank account, or
invested in cash equivalents.
Q4-3. Operating activities
Inflow: Cash received from customers
Outflow: Cash paid to suppliers

Investing activities
Inflow: Sale of equipment
Outflow: Purchase of stocks and bonds

Financing activities
Inflow: Issuance of common stock
Outflow: Payment of dividends
Q4-4. a. Investing; outflow.
b. Investing; inflow.
c. Financing; outflow.
d. Operating (direct method, not shown separately under indirect
method); inflow.
e. Financing; inflow.
f. Operating (direct method, not shown separately under indirect
method); inflow.
g. Operating (direct method, not shown separately under indirect
method); outflow.

h. Operating (direct method, not shown separately under indirect
method); inflow.


Q4-5. This is a noncash investing and financing event. It must be reported in a
supplementary schedule to the statement of cash flows.
Q4-6. Noncash investing and financing transactions are disclosed as
supplemental information to a statement of cash flows because a secondary
objective of cash flow reporting is to present information about investing
and financing activities. Noncash investing and financing transactions,
generally, affect future cash flows. Issuing bonds payable to acquire
equipment, for example, requires future cash payments for interest and
principal on the bonds. On the other hand, converting bonds payable into
common stock eliminates future cash payments related to the bonds.
Knowledge of these types of events, therefore, should be helpful to users of
cash flow data who wish to assess a firm's future cash flows.
Q4-7. A statement of cash flows helps external users assess the amount, timing,
and uncertainty of future cash flows to the enterprise. These assessments
help users evaluate their own future cash receipts from their investments
in, or loans to, the firm. A statement of cash flows shows the periodic cash
effects of a firm's operating, investing, and financing activities.
Distinguishing among these different categories of cash flows helps users
compare, evaluate, and predict cash flows. With cash flow information,
creditors and investors are better able to assess a firm's ability to settle its
liabilities and pay its dividends. Over time, the statement of cash flows
permits users to observe and analyze management's investing and
financing policies. A statement of cash flows also provides information
useful in evaluating a firm's financial flexibility (which is its ability to
generate cash to respond to unanticipated needs and opportunities).
Q4-8. The direct method presents the net cash flow from operating activities by
showing the major categories of operating cash receipts and cash payments
(such as cash received from customers, cash paid to employees and
suppliers, cash paid for interest, and cash paid for income taxes). The
indirect (or reconciliation) method, in contrast, presents the net cash flow
from operating activities by applying a series of adjustments to the accrual
net income to convert it to a cash basis.
Q4-9. Under the indirect method, depreciation is added to net income because, as
a noncash expense, it was deducted in computing net income. Adding
depreciation to net income, therefore, eliminates it from the cash-basis
income amount. Amortization and depletion expenses are handled the
same way.
Q4-10. Under the indirect method, the $98,000 cash received from the sale of the
land will appear in the cash flows from investing activities section of the
statement of cash flows. In addition, the $28,000 gain from the sale will be
deducted from net income as one of the adjustments made to determine the
net cash flow from operating activities.


Q4-11. Net income $
88,000
Add (deduct) items to convert net income to cash basis
Subtract change in accounts receivable 13,000
Subtract change in inventory (9,000)
Add change in accounts payable (3,500)
Add change in income tax payable 1,500
Net cash provided by operating activities $ 96,000
Q4-12. The separate disclosures required for a company using the indirect method
in the statement of cash flows are (1) cash paid during the year for interest
(net of amount capitalized) and for income taxes, (2) all noncash investing
and financing transactions, and (3) the policy for determining which highly
liquid, short-term investments are treated as cash equivalents.
Q4-13. The statement of cash flows will show a positive net cash flow from
operating activities if operating cash receipts exceed operating cash
payments. This could happen, for example, if noncash expenses (such as
depreciation and amortization) exceed the net loss. It would also happen if
operating cash receipts exceed sales by more than the loss or if operating
cash payments are less than accrual expenses by more than the loss (or
some combination of these events).
Q4-14. Sales $925,000
+ Accounts receivable decrease 14,000
= Cash received from customers $939,000
Q4-15. Wages expense $ 86,000
+ Wages payable decrease 1,100
= Cash paid to employees $ 87,100
Q4-16. Advertising expense $ 43,000
+ Prepaid advertising increase 1,600
= Cash paid for advertising $ 44,600
Q4-17. Under the direct method, the $5,100 cash received from the sale of
equipment will appear in the cash flows from investing activities section of
the statement of cash flows.
Q4-18. The separate disclosures required for a company using the direct method
in the statement of cash flows are (1) a reconciliation of net income to net
cash flow from operating activities, (2) all noncash investing and financing
transactions, and (3) the policy for determining which highly liquid,
short-term investments are treated as cash equivalents.


Q4-19. The operating cash flow to current liabilities ratio is calculated by dividing
net cash flow from operating activities by average current liabilities. This
ratio is a measure of a firm's ability to liquidate its current liabilities.
Q4-20. The operating cash flow to capital expenditures ratio is calculated by
dividing a firm's cash flow from operating activities by its annual capital
expenditures. A ratio below 1.00 means that the firm's current operating
activities are not providing enough cash to cover the capital expenditures.
A ratio above 1.0 is normally considered a sign of financial strength.



MINI EXERCISES

M4-21. (5 minutes)

a. Positive adjustment
b. Negative adjustment
c. Negative adjustment
d. Positive adjustment
e. Positive adjustment

M4-22. (10 minutes)

a. Cash flow from an operating activity.
b. Cash flow from an investing activity.
c. Cash flow from an investing activity.
d. Cash flow from an operating activity.
e. Cash flow from a financing activity.
f. Cash flow from a financing activity.
g. Cash flow from an investing activity.

M4-23. (15 minutes)

DOLE FOOD COMPANY, INC.
Selected Items from the Cash Flow Statement
1 Long-term debt repayments Financing
2 Change in receivables Operating
3 Depreciation and amortization Operating
4 Change in accrued liabilities Operating
5 Dividends paid Financing
6 Change in income taxes payable Operating
7 Cash received from sales of assets and businesses Investing
8 Net income Operating
9 Change in accounts payable Operating
10 Short-term debt borrowings Financing
11 Capital expenditures Investing


M4-24. (10 minutes)

a. (3) Cash flow from a financing activity.
b. (1) Cash flow from an operating activity.
c. (4) Noncash investing and financing activity.
d. (1) Cash flow from an operating activity.
e. (1) Cash flow from an operating activity.
f. (5) None of the above (a change in the composition of cash and cash equivalents).

M4-25. (30 minutes)

a.
Accts.
Trans- Cash Receiv- Inven- Accts. Contrib. Earned
action Asset + able + tories = Payable + Capital + Capital Revenue - Expenses = Net Income
(1) + +507,400 + = + + +507,400 +507,400 - = +507,400
(2) +91,500 + + = + + +91,500 +91,500 - = +91,500
(3) + + –320,100 = + + –320,100 - +320,100 = –320,100
(4) + + –63,400 = + + –63,400 - +63,400 = –63,400
(5) + + +351,600 = +351,600 + + - =
(6) -47,700 + + +47,700 = + + - =
(7) +483,400 + –483,400 + = + + - =
(8) –340,200 + + = –340,200 + + - =
(9) -172,300 + + = + + -172,300 - +172,300 = -172,300
Total +14,700 + +24,000 + +15,800 = +11,400 + + +43,100 +598,900 - +555,800 = +43,100

b. Net income was €43,100 (from the net income column), and cash flow from
operating activities was €14,700 (from the cash column).

c. 1. Accounts receivable increased by €24,000,
2. Inventories increased by €15,800, and
3. Accounts payable increased by €11,400.


d. The accounting equation is kept with every entry, so it is kept for the totals over
the period.

Cash flow + change in accounts receivable + change in inventory
= Change in accounts payable + net income.

This relationship can be presented in the following indirect method cash flow
from operating activities.
Net income € 43,100
- Change in accounts receivable –24,000
- Change in inventories –15,800
+ Change in accounts payable +11,400
Cash flow from operating activities € 14,700

M4-26. (15 minutes –INDIRECT METHOD)

Net income $ 45,000
Add back depreciation 8,000
Subtract gain on sale of investments (9,000)
Subtract change in operating assets:
Accounts receivable (9,000)
Inventory (6,000)
Prepaid rent 2,000
Add change in operating liabilities:
Income tax payable (2,000)


M4-27. (30 minutes)

a.
Trans- Accts.
Cash Prepaid Accum. Wages Contr. Earned
+ Receiv- + - = + + Revenue - Expenses = Net Income
action Asset Rent Deprec. Payable Capital Capital
able
= +769,200 +769,200 - +769,200
(1) + +769,200 + - + + =

(2) +46,200 + + - = + + +46,200 +46,200 - = +46,200

(3) + + - = +526,700 + + –526,700 - +526,700 = –526,700

(4) –149,100 + + +149,100 - = + + - =

(5) –521,600 + + - = –521,600 + + - =

(6) + + –117,900 - = + + –117,900 - +117,900 = –117,900

(7) +724,100 + –724,100 + - = + + - =

(8) –122,800 + + - = + + –122,800 - +122,800 = –122,800
(9) + + - +23,000 = + + -23,000 - +23,000 = -23,000
Total –23,200 + +45,100 + +31,200 - +23,000 = +5,100 + + +25,000 +815,400 - +790,400 = +25,000

b. Net income was $25,000 (from the net income column), and cash flow from
operating activities was –$23,200 (from the cash column).

c. 1. Accounts receivable increased by $45,100,
2. Prepaid rent increased by $31,200,
3. Accumulated depreciation (a contra-asset) increased by $23,000 due to
depreciation expense and
4. Wages payable increased by $5,100.

d. The accounting equation is kept with every entry, so it is kept for the totals over
the period.

Cash flow + change in accounts receivable + change in prepaid rent
– change in accumulated depreciation
= Change in wages payable + net income.

This relationship can be presented in the following indirect method cash flow
from operating activities.
Net income $ 25,000
+ Depreciation expense 23,000
– Change in accounts receivable –45,100
– Change in prepaid rent –31,200
+ Change in wages payable +5,100
Cash flow from (used in) operating activities ($ 23,200)




M4-28. (15 minutes—INDIRECT METHOD)

Net loss $(21,000)
Add (deduct) items to convert net loss to cash basis
Add back depreciation 8,600
Subtract change in operating assets:
Inventory 3,000
Prepaid expenses 3,000
Add change in operating liabilities:
Accrued liabilities (2,600)

Weber Company's 2016 operating activities provided $4,000 cash. The dividend paid
to shareholders affects cash flows from financing activities.

M4-29. (20 minutes)

A “+” indicates that the amount is added and a “-“ indicates that it is subtracted when
preparing the cash flow statement using the indirect method.

NORDSTROM, INC.
Consolidated Statement of Cash Flows – Selected Items
1 Increase in accounts receivable Operating -
2 Capital expenditures Investing -
3 Proceeds from long-term borrowings Financing +
4 Increase in deferred income tax net liability Operating +
5 Principal payments on long-term borrowings Financing -
6 Increase in merchandise inventories Operating -
7 Decrease in prepaid expenses and other assets Operating +
8 Proceeds from issuances under stock compensation plans Financing +
9 Increase in accounts payable Operating +
10 Net earnings Operating +
11 Payments for repurchase of common stock Financing -
12 Increase in accrued salaries, wages and related benefits Operating +
13 Cash dividends paid Financing -
14 Depreciation and amortization expenses Operating +


M4-30. (15 minutes—DIRECT METHOD)

a. Rent expense $ 60,000
– Prepaid rent decrease (2,000)
= Cash paid for rent $ 58,000

Noncash Contr. Earned Net
Transaction Cash + = Liabilities + + Revenue - Expenses =
Assets Capital Surplus Income
10,000
Begin
Balance
+ Prepaid = + + - =
Rent
+X
Make rent
-X + Prepaid = + + - =
payment
Rent
-60,000 -60,000 +60,000
Record rent
expense
+ Prepaid = + + Retained - Rent = -60,000
Rent Earnings Expense
End Balance + 8,000 = + + - =

X must equal $58,000 to make the FSET balance.

b. Interest income $ 16,000
– Interest receivable increase (700)
= Cash received as interest $ 15,300

3,000
Begin
Balance + Interest = + + - =
Receivable
Record +16,000 +16,000 +16,000
interest + Interest = + + Retained Interest - = +16,000
income Receivable Earnings income
Receive
interest +X + -X = + + - =
payment
End Balance + 3,700 = + + - =

X must equal $15,300 to make the FSET balance.


c.
Cost of goods sold $ 98,000
+ Inventory increase 3,000
+ Accounts payable decrease 4,000
= Cash paid for merchandise purchased $105,000

11,000
Begin 19,000
Balance
+
Inventory
= Accounts + + - =
Payable
Purchase
inventory
+ +X = +X + + - =
-Y
Pay
supplier
-Y + = Accounts + + - =
Payable
98,000
Recognize -98,000
-98,000 Cost of
Cost of +
Inventory
= + + Retained -
Goods
= -98,000
Goods Sold Earnings
Sold
End Balance + 22,000 = 7,000 + + - =

To make the inventory account work properly, X (purchases) must equal $101,000.
If purchases were $101,000, then Y (payments to suppliers) must equal $105,000.

M4-31. (15 minutes—DIRECT METHOD)

Operating cash flow + change in operating assets
= net income + change in operating liabilities

or

Net income - change in operating assets + change in operating liabilities
= operating cash flow

Effect of sales on net income $825,000
– Change in accounts receivable (11,000)
= Effect of customers on cash $814,000

Effect of cost of goods sold on net income ($550,000)
- Change in inventory (13,000)
+ Change in accounts payable (6,000)
= Effect of merchandise purchases on cash ($569,000)

Chakravarthy Company received $814,000 in cash from its customers and paid
$569,000 in cash to its suppliers.



EXERCISES

E4-32. (20 minutes)

(All dollar amounts in millions)

a. Merck: $11,564/$18,108 = 0.64
Pfizer: $17,765/$26,276 = 0.68
Abbott Labs: $3,324/$11,394 = 0.29
Johnson & Johnson: $17,414/$24,969 = 0.70

b. Merck: $11,564 – ($1,548 – $0) = $10,016
Pfizer: $17,765 – ($1,206 – $0) = $16,559
Abbott Labs: $3,324 – ($1,145 – $0) = $2,179
Johnson & Johnson: $17,414 – ($3,595 – 458) = $14,277

c. None of the firms has sufficient cash flow to cover their current liabilities
although none of the ratios is alarmingly low, with the possible exception of
Abbott Laboratories. The industry ratios shown in Chapter 5, page 233, show
that only Abbott is below median. Pfizer is the largest of these three companies
and has relatively more cash left over after capital expenditures to consider
using on other activities that could strengthen the firm’s operating or financial
position. But all four have significant free cash flow that could be invested or
returned to shareholders in the form of dividends or stock repurchases. Given
that these firms are of different sizes and have different research program
success, it is difficult to generalize further.

E4-33. (20 minutes)

(All dollar amounts in millions)

a. Wal-Mart: $23,257/$70,582 = 0.33
Coca-Cola: $10,542/$27,816 = 0.38
ExxonMobil: $44,914/$67,932 = 0.66

b. Wal-Mart: $23,257 – ($13,115 – $727) = $10,869
Coca-Cola: $10,542 – ($2,550 – $111) = $8,103
ExxonMobil: $44,914 – ($33,669 – $2,707) = $13,952

c. All three companies are producing much more cash than needed for capital
expenditures. All of them are returning substantial amounts of cash to
shareholders through dividends and share repurchases. ExxonMobil appears to
be in the best position with respect to OCFCL, but it is lower than the industry

average reported in Chapter 5 on page 233. Wal-Mart and Coca-Cola have lower
ratios, and are also below the average ratio for their industries.

E4-34. (30 minutes—INDIRECT METHOD)

MASON CORPORATION

Cash flows from operating activities
Cash received from customers $194,000
Cash received as interest 6,000
Cash paid to employees and suppliers (148,000)
Cash paid as income taxes (11,000)
Cash flows from investing activities
Sale of land 40,000
Purchase of equipment (89,000)
Net cash used by investing activities (49,000)
Cash flows from financing activities
Issuance of bonds payable 30,000
Acquisition of treasury stock (10,000)
Payment of dividends (16,000)
Net cash provided by financing activities 4,000
Net decrease in cash (4,000)
Cash at beginning of year 16,000
Cash at end of year $ 12,000

E4-35. (15 minutes—INDIRECT METHOD)

a. Net income $113,000
Accounts receivable increase (5,000)
Inventory decrease 6,000
Prepaid insurance increase (1,000)
Accounts payable increase 4,000
Wages payable decrease (2,000)
Net cash provided by operating activities $115,000

b. $115,000/[($31,000 + $29,000)/2] =3.83


E4-36. (15 minutes–INVESTING ACTIVITIES)

The basic approach here is to use the beginning and ending balances and the
additional information to reconstruct what must have happened during 2016. Begin
by setting up the T-accounts for property, plant and equipment with the beginning
and ending balances.

Property, plant and - - Accumulated
+ +
equipment at cost (A) depreciation (XA)
Beg. balance 1,000 350 Beg. balance

Ending balance 1,200 390 Ending balance

At this point in the book, we know four entries that can affect these two accounts –
(1) acquisitions using cash, (2) acquisitions without cash (other financing), (3)
disposals, and (4) depreciation expense. The journal entries for these entries are
given below, with amounts given in the problem filled in.

(1) Property, plant and equipment at cost (+A) 300
Cash (-A) 300
To record purchase of property, plant and equipment with cash.

Mortgage payable (+L) 100
To record purchase of property, plant and equipment with financing.

(3) Cash (+A) 100
Accumulated depreciation (-XA, +A) Y
Property, plant and equipment at cost (-A) X
Gain on equipment disposal (+R, +SE) 20
To record sale of used equipment.

(4) Depreciation expense (+E, -SE) Z
Accumulated depreciation (+XA, -A) Z
To record depreciation expense.

continued next page


The three unknowns in the journal entries correspond to the three questions in the
problem. We begin by putting the journal entry amounts into the T-accounts.

Property, plant and - - Accumulated
+ +
equipment at cost (A) depreciation (XA)
Beg. balance 1,000 350 Beg. balance
(1) 300
(2) 100
(3) X Y (3)
Z (4)
Ending balance 1,200 390 Ending balance

a. The PPE at cost account will only balance if the value X equals 200. So, the
original cost of the used equipment that was sold is €200. We can put that
amount in the T-account (so it balances) and also in Journal entry (3).

b. Now, looking at journal entry (3), we see that there is only one unknown left –
the depreciation that had accumulated on the used equipment. In order for the
entry to balance (with debits equal to credits), the accumulated depreciation
must have been 120 (= Y). Cost of 200 and accumulated depreciation of 120
would produce a net book value of 80, so when Meubles Fischer sold it for 100,
they recorded a gain of 20 on the disposal.

c. Back at the Accumulated depreciation T-account, we can fill in the entry for (3),
leaving only the depreciation expense to determine for entry (4). Knowing that
the disposal reduced the contra-asset by 120, and that the contra-asset
increased by 40 over the year, we can infer than the depreciation expense must
have been €160 (= Z).


E4-37. (15 minutes—INVESTING ACTIVITIES)

The basic approach here is to use the beginning and ending balances and the
additional information to reconstruct what must have happened during 2016. Begin
by setting up the T-accounts for property, plant and equipment with the beginning
and ending balances.

Property, plant and - -
Accumulated
+ equipment at cost +
depreciation (XA)
(A)
Beg. balance 175 78 Beg. balance

Ending balance 183 83 Ending balance

At this point in the course, we know four entries that can affect these two accounts –
(1) acquisitions using cash, (2) acquisitions without cash (other financing), (3)
disposals, and (4) depreciation expense. The journal entries for these entries are
given below, with amounts given in the problem filled in.

Cash (-A) 28
To record purchase of property, plant and equipment with cash.

Mortgage payable (+L) 0
To record purchase of property, plant and equipment with financing.

(3) Cash (+A) Z
Accumulated depreciation (-XA, +A) Y
Loss on equipment disposal (+E, -SE) 5
Property, plant and equipment at cost (-A) X
To record sale of used equipment.

(4) Depreciation expense (+E, -SE) 17
Accumulated depreciation (+XA, -A) 17
To record depreciation expense.

continued next page


The three unknowns in the journal entries correspond to the three questions in the
problem. We begin by putting the journal entry amounts into the T-accounts.

Property, plant and - -
Accumulated
+ equipment at cost +
depreciation (XA)
(A)
Beg. balance 175 78 Beg. balance
(1) 28
(2) 0
(3) X Y (3)
17 (4)
Ending balance 183 83 Ending balance

a. The PPE at cost account will only balance if the value X equals 20. So, the
original cost of the used equipment that was sold is £20. We can put that
amount in the T-account (so it balances) and also in Journal entry (3).

b. The accumulated depreciation account will only balance if the value Y equals 12.
So, the accumulated depreciation on the used equipment sold must be £12, and
that amount can be entered into transaction (3) above.

c. Now, looking at journal entry (3), we see that there is only one unknown left – the amount of cash
received from disposal of the used equipment. In order for the entry to balance (with debits equal to
credits), the cash amount must have been £3 million (= Z). Cost of 20 and accumulated depreciation of
12 would produce a net book value of 8, so when Kasznik Ltd. sold it for 3, they recorded a loss of 5
on the disposal.


E4-38. (30 minutes)

a. The analysis from the chapter shows that

Cash flow Change in Change in accounts Net income
+ = +
(payments) inventory payable (COGS expense)
-776 -320
X + = + -54,823
(=6,076-6,852) (=4,315-4,635)

The solution to this is that X = -$54,823 + 776 - 320 = -$54,367. So, the payments
to suppliers reduced cash by $54,367 million in fiscal year 2014.

b. The net property and equipment account increased by $119 million (=$12,257 –
$12,138). Depreciation expense would have decreased this balance by $1,316
million in fiscal year 2014, so the net investment must have been $1,435 million
(=$119 + $1,316) to result in the ending balance of $12,257 million.

c. With the beginning balance of $21,523 million in retained earnings, net earnings of
$2,031 would have increased retained earnings to $23,554 million. But the ending
balance in retained earnings is $22,229 million, so Walgreens must have paid
$1,325 million in dividends (=$23,554 - $22,229).

E4-39. (15 minutes)

a. Cash flows from investing activities will show:
Purchase of stock investments $ (80,000)
Sale of stock investments 59,000

b. Cash flows from financing activities will show:
Issuance of bonds $130,000
Retirement of bonds (131,000)


E4-40. (20 minutes)

a. The net increase in property and equipment was $2,151,755 (= $95,174,198 -
$93,022,443), and the expenditures should have increased this by $2,380,287.
Therefore, the original cost of the property and equipment sold must have been
$228,532 (= $2,380,287 - $2,151,755).

Depreciation expense should have increased the accumulated depreciation account
by $3,778,563, but the account increased by only $3,575,465. The accumulated
depreciation on the property and equipment sold must account for the difference,
making it $203,098 (=$3,778,563, - $3,575,465).

b. The book value of the property and equipment sold was $25,434 (=$228,532 –
$203,098), and the reported gain on sale of the property and equipment was
$22,693. Therefore, the cash proceeds must have been $48,127 (= $25,434 +
$22,693).

c.
Cash (+A) $ 48,127
Accumulated depreciation (-XA, +A) 203,098
Property and equipment, cost (-A) $ 228,532
Gain on sale of property and equipment (+R, +SE) 22,693

d. Retained earnings decreased by $544,752 (= $18,728,462 – 19,273,214), and net
income was $921,829, which would increase retained earnings. The overall
decrease would be accounted for by cash dividends paid to shareholders, and the
amount is $1,466,581 ($544,752 + $921,829). The dividends paid are
approximately equal to previous years and demonstrates that companies are
reluctant to cut dividends, even when earnings are lower.

E4-41. (20 minutes—DIRECT METHOD)

a. Advertising expense $ 62,000
+ Prepaid advertising increase 4,000
= Cash paid for advertising $ 66,000

b. Income tax expense $ 29,000
+ Income tax payable decrease 2,200
= Cash paid for income taxes $ 31,200

c. Cost of goods sold $180,000
– Inventory decrease (5,000)
– Accounts payable increase (2,000)
= Cash paid for merchandise purchased $173,000




E4-42.

HOSKINS CORPORATION
Year ended December 31, 2016
Cash Flows from Operations:
Net income $ 700
Adjustments:
Add back Depreciation 350
– Change in Accounts Receivable (900)
– Change in Inventory (100)
– Change in Prepaid Expenses 250
+ Change in Accounts Payable 400
+ Change in Income Taxes Payable (100)
Cash Flows from Operating Activities $ 600

Cash Flows from Investing:
Purchases of Equipment (1,200)
Proceeds from Disposal of Equipment 600
Cash Flows from Investing Activities (600)

Cash Flows from Financing:
Dividends Paid (250)
Increase in Short-term Debt 1,500
Decrease in Long-term Debt (1,000)
Cash Flows from Financing Activities 250

Net Change in Cash 250
Beginning Cash Balance 300
Ending Cash Balance $ 550

E4-43. (30 minutes—DIRECT METHOD)

a.
Sales $750,000
– Accounts Receivable Increase (5,000)
= Cash Received from Customers $745,000
Cost of Goods Sold $470,000

– Inventory Decrease (6,000)
– Accounts Payable Increase (4,000)
= Cash Paid for Merchandise Purchased $460,000

Wages Expense $110,000
+ Wages Payable Decrease 2,000
= Cash Paid to Employees $112,000

Insurance Expense $ 15,000
+ Prepaid Insurance Increase 1,000
= Cash Paid for Insurance $ 16,000

Cash Flows from Operating Activities
Cash Received from Customers $745,000
Cash Paid for Merchandise Purchased $460,000
Cash Paid to Employees 112,000
Cash Paid for Rent 42,000
Cash Paid for Insurance 16,000 630,000
Net Cash Provided by Operating Activities $115,000

b. $115,000/[($31,000 + $29,000)/2] =3.83

E4-44. (15 minutes)

1. True ---
2. False $25
3. False $10
4. False $0



PROBLEMS

P4-45. (20 minutes)

Net income ............................................................................................................................. $135,000
Adjustments to reconcile net income to operating cash flows
Add back depreciation expense ............................................................................. $25,000
Gain on sale of assets (5,000)
Subtract changes in:
Accounts receivable .................................................................................................... (10,000)
Prepaid expenses ......................................................................................................... 3,000
Add changes in:
Accounts payable ......................................................................................................... 6,000
Wages payable .............................................................................................................. (4,000) 15,000

Net cash provided from operating activities ........................................................... $150,000


P4-46. (45 minutes—INDIRECT METHOD)

a. Cash, December 31, 2016 .................................................................................. $11,000
Cash, December 31, 2015 .................................................................................. 5,000
Cash increase during 2016 ................................................................................ $ 6,000

b. STATEMENT OF CASH FLOWS (INDIRECT METHOD)

WOLFF COMPANY

Net Cash Flow from Operating Activities
Net Income $56,000
Add (Deduct) Items to Convert Net Income to Cash Basis
Depreciation 17,000
Accounts Receivable Increase (9,000)
Inventory Increase (30,000)
Prepaid Insurance Decrease 2,000
Accounts Payable Decrease (3,000)
Wages Payable Increase 3,000
Income Tax Payable Decrease (1,000)
Net Cash Provided by Operating Activities $35,000
Cash Flows from Investing Activities
Purchase of Plant Assets (55,000)
Cash Flows from Financing Activities
Issuance of Bonds Payable 55,000
Payment of Dividends (29,000)
Net Cash Provided by Financing Activities 26,000
Net Increase in Cash 6,000
Cash at Beginning of Year 5,000
Cash at End of Year $11,000

c. (1) $35,000/(($23,000 + $24,000)/2) = 1.49
(2) $35,000/$55,000 = 0.64
Wolff’s cash flow ratios indicate that, while the company has sufficient cash flow
to cover its current obligations, it must rely on external financing to pay for
capital expenditures.


P4-47. (30 minutes)

a.
Adjustments to Convert Income Statement Items to Operating Activity Cash Flows
Net Sales –Cost of –Wage –Insurance –Depreciation –Interest –Income tax
income = revenue goods sold expenses expense expense expense +Gains –Losses expense
$ 56,000 $635,000 –430,000 –86,000 –8,000 –17,000 –9,000 +0 –0 –29,000
Adjustments:
Add back +Depreciation

depreciation expense
expense +17,000
–Gains

Subtract (add) 0
non-operating
gains (losses) +Losses

0
Subtract the
change in –Change in – –Change in
operating accounts Change in prepaid
receivable inventory insurance
assets
(operating -9,000 -30,000 -(-2,000)
investments)
Add the
change in +Change in +Change in +Change in
operating accounts wages income tax
payable payable payable
liabilities
(operating +(-3,000) +3,000 +(-1,000)
financing)
Receipts –Payments –Payments –Payments (zero) –Payments (zero) (zero) –Payments

Cash from
from for for for for for
operations =
customers merchandise Wages insurance interest income tax
$ 35,000 0 +0 –0
$626,000 -463,000 -83,000 -6,000 -9,000 –30,000

b. Computing cash flows from operating activities using the direct method provides
additional detail about the specific cash flows that occurred during the period. For
example, the indirect method does not reveal that Wolff paid $463,000 for
merchandise during 2016, or $83,000 for wages. Because this detail is missing, the
FASB requires supplemental disclosure of two specific (and important) cash
payments – interest and taxes – if the indirect method is used.



a. Cash, December 31, 2016 $49,000
Cash, December 31, 2015 28,000
Cash increase during 2016 $21,000

b. Statement of Cash Flows (Indirect Method)
ARCTIC COMPANY

Net Loss $ (42,000)
Add (Deduct) Items to Convert Net Loss
to Cash Basis
Depreciation 22,000
Gain on Sale of Land (25,000)
Accounts Receivable Decrease 8,000
Inventory Decrease 6,000
Prepaid Advertising Decrease 3,000
Accounts Payable Decrease (14,000)
Interest Payable Increase 6,000
Net Cash Used by Operating Activities $ (36,000)
Cash Flows from Investing Activities
Sale of Land 70,000
Purchase of Equipment (183,000)*
Net Cash Used by Investing Activities (113,000)
Cash Flows from Financing Activities
Issuance of Bonds Payable 200,000
Purchase of Treasury Stock (30,000)
Net Cash Provided by Financing Activities 170,000
Net Increase in Cash 21,000
Cash at Beginning of Year 28,000
Cash at End of Year $ 49,000
* The sum of the increase in PPE assets account ($138,000) and the book value of the land sold ($45,000).

c. - $36,000/(($23,000 + $31,000)/2) = -1.33
- $36,000/$183,000 = -0.20
Arctic’s operating cash flows are negative, primarily because the firm reported a
net loss for the year. As a consequence, its cash flow ratios indicate insufficient
cash flows to fund operations and capital expenditures.


P4-49. (30 minutes)

a.
Adjustments to Convert Income Statement Items to Operating Activity Cash Flows
Net income Sales –Cost of –Wage –Advertising –Depreciation –Interest +Gains –Losses Income tax
(loss) = revenue goods sold expenses expense expense expense expense
–$ 42,000 $728,000 –534,000 –190,000 –31,000 –22,000 –18,000 +25,000 –0 –0
Adjustments:
Add back +Depreciation

depreciation expense
expense +22,000
–Gains

Subtract (add) –25,000
non-operating
gains (losses) +Losses

0
Subtract the
change in –Change in –Change in
operating accounts –Change in prepaid

assets receivable inventory advertising
(operating -(-8,000) -(-6,000) -(-3,000)
investments)
Add the
change in +Change in +change in +Change in +Change in
operating accounts wages interest income tax

liabilities payable payable payable payable
(operating +(-14,000) +0 +6,000 +0
financing)
Cash Receipts –Payments (zero) –Payments (zero) (zero) –Payments

–Payments for –Payments
from from for for for income
= merchandise for Wages
operations customers advertising interest tax
–542,000 –190,000
–$ 36,000 $736,000 –28,000 0 –12,000 +0 –0 –0

b. Computing cash flows from operating activities using the direct method provides
additional detail about the specific cash flows that occurred during the period. For
example, the indirect method does not reveal that Arctic paid $542,000 for
merchandise during 2016, or $28,000 for advertising. Because this detail is
missing, the FASB requires supplemental disclosure of two specific (and
important) cash payments – interest and taxes – if the indirect method is used.



a. Cash, December 31, 2016 ....................................................................... $27,000
Cash, December 31, 2015 ....................................................................... 18,000
Cash increase during 2016 ..................................................................... $ 9,000

b. STATEMENT OF CASH FLOWS (INDIRECT METHOD)

DAIR COMPANY

Net Income $ 85,000
Add (deduct) items to convert net income
to cash basis
Depreciation 22,000
Amortization of intangible assets 7,000
Loss on bond retirement 5,000
Inventory decrease 6,000
Prepaid expenses increase (2,000)
Interest payable decrease (3,000)
Income tax payable decrease (2,000)
Sale of equipment 17,000
Retirement of bonds payable (125,000)
Issuance of common stock 24,000
Net cash used by financing activities (127,000)
Net increase in cash 9,000
Cash at beginning of year 18,000
Cash at end of year $ 27,000


c. (1) Supplemental cash flow disclosures
Cash paid for interest ............................................................................................................. $ 13,000*
Cash paid for income taxes .................................................................................................. $ 38,000†

* Interest expense $10,000
+ Interest payable decrease 3,000
Cash paid for interest $13,000
† Income tax expense $36,000
Cash paid for income taxes $38,000

(2) Schedule of noncash investing and financing activities
Issuance of bonds payable to acquire equipment ................................................... $ 60,000

d. (1) $119,000/[($42,000 + $41,000)/2] = 2.87.
(2) The firm did not spend any cash on capital investments. The firm did issue
debt for equipment, but this is not a capital expenditure.
(3) $119,000 + $17,000 = $136,000

P4-51. (45 minutes)

a. CVS’ cash flow statement is prepared using the direct method. As required by
current accounting standards, CVS also reports a reconciliation of cash flow from
operations to net income.

b. Cash received from customers was $114,993. They report an increase in accounts
receivable, net of $2,210. So, total revenues must equal $114,993 + $2,210 =
$117,203.

c. Add net income and subtract dividends as follows: $24,998 + $4,592 - $1,097 =
$28,493.

d. Stock-based compensation is deducted as an expense when computing net income.
However, it is compensation paid in the form of common stock, not cash. Since it
doesn’t decrease cash, it is added back to net income when reconciling net income to
cash flow from operations.

e. Some of CVS’ operations occur in Canada and some of its cash transactions are
transacted in Canadian dollars. When the financial statements are prepared, the
Canadian dollars must be translated into U.S. dollars so that the statements are
presented in a common unit of currency. The amount listed in the cash flow
statement reflects the small effect that this conversion had on the cash flows and
cash balances of CVS.

f. CVS used its cash flow from operating activities as follows:
• It invested over $1.8 billion, mostly in new property, plant and equipment;

• It spent over 1.2 billion on financing transactions, mostly to repurchase stock and
pay dividends, net of amounts borrowed;
• It increased its cash balance by more than 2.7 billion.


a. Cash and cash equivalents, December 31, 2016 .............................................. $19,000
Cash and cash equivalents, December 31, 2015 .............................................. 25,000
Cash and cash equivalents decrease during 2016 ........................................... $ 6,000

b.
RAINBOW COMPANY

Cash flow from operating activities

Net income $ 90,000
Depreciation 39,000
Patent amortization 7,000
Loss on sale of equipment 5,000
Gain on sale of investments (3,000)
Inventory increase (26,000)
Interest payable increase 1,000
Net cash provided by operating activities ……… $101,000
Sale of investments 60,000
Purchase of land (90,000)
Improvements to building (95,000)
Sale of equipment 14,000
Net cash used by investing activities (111,000)
Issuance of bonds payable 30,000
Issuance of common stock 24,000
Net cash provided by financing activities ……… 4,000
Net decrease in cash and cash equivalents (6,000)
Cash and cash equivalents at beginning of year …. 25,000
Cash and cash equivalents at end of year $ 19,000


c. (1) Supplemental Cash Flow Disclosures
Cash paid for interest $ 12,000*
Cash paid for income taxes $ 46,000†

* Interest expense $13,000
- Interest payable increase (1,000)
Cash paid for interest $12,000

† Income tax expense $44,000
Cash paid for income taxes $46,000

Issuance of preferred stock to acquire patent $ 25,000

d. (1) $101,000/[($34,000 + $31,000)/2] = 3.11.
(2) $101,000/$185,000 = 0.55.
(3): $101,000 – ($90,000 + $95,000 - $14,000) = -$70,000

P4-53. (35 minutes)

a. Cash and cash equivalents, December 31, 2016 ……….. $19,000
Cash and cash equivalents, December 31, 2015 ……….. 25,000
Cash and cash equivalents decrease during 2016 …….. $ 6,000

b.
RAINBOW COMPANY
Statement of Cash Flows (Direct Method)

Cash received from customers ………………………… $740,000
Cash received as dividends …………………………….. 15,000 $755,000
Cash paid for merchandise purchased ……………….. 462,000
Cash paid for wages and other operating expenses … 134,000
Cash paid for interest …………………………………….. 12,000
Cash paid for income taxes ……………………………… 46,000 (654,000)
Net cash provided by operating activities …………….. 101,000

Sale of investments ……………………………………….. 60,000
Purchase of land …………………………………………… (90,000)
Improvements to building ………………………………… (95,000)
Sale of equipment ………………………………………….. 14,000
Net cash used by investing activities …………………... (111,000)


Table continued on next page


Table continued
RAINBOW COMPANY
Statement of Cash Flows (Direct Method)

Issuance of bonds payable ………………………………. 30,000
Issuance of common stock ………………………………. 24,000
Payment of dividends ……………………………………… (50,000)
Net cash provided by financing activities ……………… 4,000

Net decrease in cash and cash equivalents ……………….. (6,000)
Cash and cash equivalents at beginning of year …………. 25,000
Cash and cash equivalents at end of year …………………. $ 19,000

c. (1) Reconciliation of net income to net cash flow from operating activities

Net income $ 90,000
Depreciation 39,000
Patent amortization 7,000
Loss on sale of equipment 5,000
Gain on sale of investments (3,000)
Inventory increase (26,000)
Interest payable increase 1,000

Issuance of preferred stock to acquire patent $ 25,000


P4-54. (30 minutes)

Operating cash flow + change in operating assets
= net income + change in operating liabilities,
or
Net income - change in operating assets + change in operating liabilities
= operating cash flow

a. Apple’s adjustment for accounts receivable is ($4,232) million. This adjustment
represents minus the change in receivables, so Apple’s accounts receivable must
have gone up by $4,232 million.
($ millions)
Net sales ………………………………………………………………… $182,795
- Change in accounts receivable …………………………………… -4,232
+ Change in deferred revenue +1,460
Cash collected from customers …………………………………….. $180,023

b. ($ millions)
- Cost of goods sold ……………………………………………………. ($112,258)
- Change in inventories …………………………………………….. -76
+ Change in accounts payable ……………………………………… +5,938
- Cash paid for purchases of inventories …………………………… ($106,396)

c. ($ billions)
Property, plant and equipment, ending balance ………………… $20.6
- Purchases of property, plant and equipment ………………… (9.6)
+ Book value of PPE assets sold …………………………………... none
+ Depreciation of property, plant and equipment ……………… 6.9
Property, plant and equipment, beginning balance …………… $17.9

d. Stock-based compensation expense is deducted when calculating net income
similar to cash compensation. The only difference is that the compensation is paid
in shares of stock (or stock options) instead of cash. Because stock-based
compensation does not require the payment of cash, it is treated as a noncash
expense, much like depreciation, and added back to net income when the indirect
method is used in the cash flow statement. Generally speaking, compensation cost
is classified as part of operating activities whether or not the compensation is paid
in cash.


P4-55. (75 minutes)

a.
A B C D E F G H I J
No
1 Effect of change on cash flow effect Total
2 2014 2013 Change Operating Investing Financing on cash (F+G+H+I)
3
Assets
4 Cash and equivalents 1,160,630 757,111 403,519
5 Receivables, net
O 11,341,024 10,459,706 881,318 (881,318) (881,318)
6 Inventories O 5,659,639 4,955,813 703,826 (703,826) (703,826)
7 Prepaid expenses O 1,277,861 1,554,737 (276,876) 276,876 276,876
8 Deferred income taxes O 559,672 596,267 (36,595) 36,595 36,595
9 Property, plant & equipment, net 25,671,344 27,095,054 (1,423,710) 1,423,710
10 Depreciation expense
O 3,778,563
11 PP&E purchased I (2,380,285)
12 PP&E sold I (22,693) 48,125
13 Cash surrender value of life ins O 602,353 695,761 (93,408) 93,408 93,408
14 Other O 1,207,743 1,642,030 (434,287) 434,287 434,287
15
16
Liabilities
17 Accounts payable
O 3,719,102 4,809,066 (1,089,964) (1,089,964) (1,089,964)
18 Accrued income taxes O 378,659 53,475 325,184 325,184 325,184
19 Deferred income taxes O 2,969,389 3,304,451 (335,062) (335,062) (335,062)
20 Other accrued expenses O 5,953,171 5,427,017 526,154 526,154 526,154
21 Salary continuation plan (ST+LT) O 1,133,154 1,229,459 (96,305) (96,305) (96,305)
22 Checks outstanding in excess… F 1,971,076 1,442,915 528,161 528,161 528,161
23 Short-term and long-term debt F 7,842,723 7,432,352 410,371 410,371
24 Amount borrowed F 35,726,909
25 Amount repaid F (35,316,538)
26
27
Stockholders' equity
28 Common stock at par F 9,219,195 9,219,195 0 0 0
29 Additional paid-in capital F 6,497,954 6,497,954 0 0 0
30 Retained earnings 18,728,462 19,273,214 (544,752) (544,752)
31 Net income
O 921,829
32 Dividends paid F (1,466,581)
33 Treasury shares at cost F (10,932,619) (10,932,619) 0 0 0
34
35 3,263,728 (2,332,160) (528,049) 0 403,519


b. The following statement of cash flows from operations combines the effects of the
income tax asset and liability and combines the effects of the deferred tax asset and
liability. In addition, the effects of changes in current and noncurrent salary
continuation plan liabilities have been combined in the operating cash flow.

GOLDEN ENTERPRISES, INC.
Consolidated Statement of Cash Flows
Year ended May 30, 2014

CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 921,829
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation 3,778,563
Deferred income taxes (298,467)
Gain on sale of property and equipment (22,693)
- Change in receivables, net (881,318)
- Change in inventories (703,826)
- Change in prepaid expenses 276,876
- Change in cash surrender value of insurance 93,408
- Change in other assets 434,287
+ Change in accounts payable (1,089,964)
+ Change in accrued expenses 526,154
+ Change in salary continuation plan (96,305)
+ Change in accrued income taxes 325,184
Net cash provided by operating activities 3,263,728

CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property, plant and equipment (2,380,285)
Proceeds from sale of property, plant and equipment 48,125
Net cash used in investing activities (2,332,160)

CASH FLOWS FROM FINANCING ACTIVITIES:
Debt proceeds 35,726,909
Debt repayments (35,316,538)
Change in checks outstanding in excess of bank balances 528,161
Cash dividends paid (1,466,581)
Net cash used by financing activities (528,049)
NET INCREASE IN CASH AND CASH EQUIVALENTS 403,519
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 757,111
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 1,160,630

c. OCFCL = $3,263,728 ÷ [(14,047,261 + 15,133,468) ÷ 2] = 0.224

OCFCX = $3,363,728 ÷ 2,380,285 = 1.41


P4-56. (20 minutes)

a. The positive adjustment of $314,872 thousand (say, $315 million) is caused by
the change in the amount that Groupon owes its merchants. When a customer
purchases, Groupon gets the cash quickly and then waits to pay the merchants
(recognizing the accrued merchant payable liability). If we add the fact that
Groupon is growing very quickly, it means that the accrued merchant payable
grows over the period. The adjustment reflects the fact that the merchant share
of the amount collected from customers is $315 million more than the amount
that Groupon paid to the merchants.

Will this continue into the future? Only if Groupon continues to grow and if its
payment terms to merchants remain unchanged. If Groupon’s growth went to
zero, then the accrued merchant payable would level out and the change would
go to zero. Likewise, if competitors forced Groupon to speed up its payments to
merchants, the accrued merchant payable liability would decrease, and the
company’s ability to generate a positive cash flow from operations would be
impaired.

In the risk factors section of the SEC document, Groupon states “Our operating
cash flow and results of operations could be adversely impacted if we change our
merchant payment terms or our revenue does not continue to grow.”

b. While Groupon used $121 million in cash for investing activities, most of this
was for acquisitions of businesses and investments, rather than for capital
expenditures (only about $30 million). The OCFCX ratio was $129,511 ÷
$29,825 = 4.34. Groupon appears to be growing more by acquisition than by
“organic” growth.

c. Groupon used $353,550 thousand to repurchase its own common stock and
another $35,221 to redeem its own preferred stock, a total of about $389 million.
This might prompt a financial statement reader to look at the related party
transactions section of the company’s filing with the SEC prior to its initial public
offering. For example, in December 2010 and January 2011, Groupon issued
new preferred stock in exchange for $942.2 million in cash. Of this amount,
$132.4 million was retained in the company. The remaining $809.8 million was
used to redeem shares of common and preferred stock, mostly from current and
former board members and from entities that they control.

In the use of proceeds section of the SEC document, Groupon states “Based on
our current cash and cash equivalents, together with cash generated from
operations, we do not expect that we will utilize any of the net proceeds of this
offering to fund operations…during the next twelve months.”


CASES AND PROJECTS

C4-57. (30 minutes)

The required debt to equity ratio allows for total liabilities to be up to $477 million.
That is $477 / ($125+$148) =1.747 < 1.75. This implies total short-term borrowing of
$107 million and an ending cash balance of $70 million.

LAMBERT CO.
Statement of Cash Flows (projected)
Cash from operations
Net income
$ 18
……………………………………………………
Depreciation expense
120
………………………………………
Increase in accounts receivable
(40)
………………………….
Decrease in inventory
20
………………………………………
Increase accounts payable
30
………………………………..
Decrease in income taxes payable
(10)
……………………….
Cash provided by (used in) operations
$ 138
………………..
Cash from investing
Acquisitions of property, plant and equipment
(225)
…………
Disposal proceeds
75
…………………………………………..
Cash provided by (used in) investing
(150)
………………….
Cash from financing
Issue long-term debt
80
………………………………………..
Repay long-term debt
(100)
………………………………………..
Common stock issue
25
………………………………………..
Shareholder dividends (30)

………………………………………
Increase (decrease) in short-term borrowing
57
……………
Cash provided by (used in) financing
32
…………………..
Net change in cash
20
……………………………………………..
Beginning cash balance
50
……………………………………….
Ending cash balance
$ 70
…………………………………………..


C4-58. (45 minutes)

a. see following page

b.
1 Accounts receivable (+A) …………………………… 3,800
Sales revenue (+R,+SE)………………………… 3,800

2 Cash (+A) ……………………………………………… 3,500
Accounts receivable (-A) ……………………… 3,500

3 Cost of goods sold (+E,-SE) ………………………… 1,800
Inventory (-A) ……………………………………. 1,800

4 Inventory (+A) ………………………………………… 1,200
Accounts payable (+L) …………..…………….. 1,200

5 Accounts payable (-L) …..…………………………… 1,100
Cash (-A) …….………………………………….. 1,100

6 Salaries and wages expense (+E,-SE) ……………. 700
Salaries and wages payable (+L) ……………. 700

7 Salaries and wages payable (-L) …………………… 730
Cash (-A) ……..………………………………….. 730

8 Rent expense (+E,-SE)……………………….……… 200
Prepaid rent (-A) ……………………………….. 200

9 Prepaid rent (+A) ……………………..……………… 600
Cash (-A) …….………………………………….. 600

10 Depreciation expense (+E,-SE) ……………………. 150
Accumulated depreciation (+XA,-A) …………. 150

11 Cash (+A) ………………………………………………. 10
Accumulated depreciation (-XA,+A) ………………… 70
Fixtures and equipment (-A) …………………… 80

12 Fixtures and equipment (+A) ……………………….. 800
Cash (-A) ………………………………………….. 800

13 Interest expense (+E,-SE) …..……………………….. 16
Cash (-A) ………………………………………….. 16

continued next page

14 Bank loan payable (-L) ……….……………………….. 1,600
Cash (-A) ………………………………………….. 1,600

15 Cash (+A) ……………………………………………….. 2,000
Long-term loan payable (+L) …………………… 2,000

16 Income tax expense (+E,-SE) …………………………. 374
Taxes payable (+L) ……………………………….. 374

17 Retained earnings (-SE) ………………………………. 80
Cash (-A) …………………………………………… 80

18 Revenue (-R) ……………………………………………. 3,800
Cost of goods sold (-E) …………………………. 1,800
Salaries and wages expense (-E) ……………… 700
Rent expense (-E) ………………………………… 200
Depreciation expense (-E) ……………………… 150
Interest expense (-E) …………………………….. 16
Income tax expense (-E) ………………………… 374
Retained earnings (+SE) ………………………… 560

Entry 18 closes revenue and expense accounts to retained earnings.

a., c.
+ Cash (A) - - Accounts Payable (L) + - Common Stock (SE) +
600 3,000 4,600
2 3,500 5 1,100 1,200 4 4,600 Bal
1,100 5 3,100 Bal
730 7
600 9 - Retained Earnings (SE)+
11 10 - Salaries and Wages + 1,300
800 12 Payable (L) 17 80 560 18
16 13 100 1,780 Bal
1,600 14 7 730 700 6
15 2,000 70 Bal
80 17 - Revenue (R) +
Bal 1,184 3,800 1
- Taxes Payable (L) + 18 3,800
0 0 Bal
374 16
+ Accounts Rec. (A) - 374 Bal + Cost of Goods Sold (E) -
6,500 3 1,800
1 3,800 3,500 2 - Bank Loan Payable (L) + 1,800 18
Bal 6,800 1,600 Bal 0
14 1,600
0 Bal

continued next page


+ Inventory (A) - - Long-term Loan (L) + + Salaries & Wages (E) -
2,400 0 6 700
4 1,200 1,800 3 2,000 15 700 18
Bal 1,800 2,000 Bal Bal 0

+ Prepaid Rent (A) - + Rent Expense (E) -
0 8 200
9 600 200 8 200 18
Bal 400 Bal 0

+ Depreciation Exp. (E) -
10 150
150 18
+ Fixtures and - Bal 0
Equipment (A)
1,900 + Interest Expense (E) -
12 800 80 11 13 16
Bal 2,620 16 18
Bal 0

- Accum. Deprec. (XA) + + Income Tax Exp (E) -
800 16 374
11 70 150 10 374 18
880 Bal Bal 0


C4-59. (30 minutes)

a. Depreciation and amortization are noncash expenses that are deducted in the
computation of net income. The depreciation and amortization add-back effectively
zeros these expenses out of the income statement to focus on operating cash flow.
The positive amount for depreciation and amortization does not mean that the
company is generating cash from depreciation and amortization, a common
misconception. It is merely an adjustment to remove these expenses from net
income to convert profit to cash flow.

b. Losses on disposals of asset are the result of investing activity, not operating
activity, but these losses are recognized in net income. When we start with net
income in an indirect method cash from operations, adding the loss removes this
investing item from the determination of cash from operations.

Daimler reports cash proceeds from disposals of PPE and intangible assets of €180
million. If the recognized loss is €193 million, then the book value of the assets
disposed would be €373 million (= €180 million + €193 million).

c. It does not. The adjustments can only be interpreted relative to the amounts that
are included in net income. The negative €592 million inventory adjustment
means that Daimler’s cost to acquire inventory for the year exceeded its cost of
goods sold for the year by €592 million.

d. Free cash flow (€ millions): €3,285 – €(4,975 – 180) = -€1,510.

Daimler’s operating cash flow is positive, but its free cash flow is negative due to
the large investment in PPE assets. We did not include acquisition of intangible
assets in the calculation. Doing so would have reduced free cash flow by another
€1.9 billion. Daimler financed its investing activities by additions to long-term
financing.

e. The primary sources of difference between net income and cash from operating
activities are a net increase in operating assets (primarily inventories) and large
increases in financial receivables and vehicles on operating leases. These last two
items are related to their customer finance operation. In its analysis of cash flows,
Daimler reports that “The positive effect from the improvement in net profit
before income taxes was reduced in particular by increased new business in
leasing and sales financing as well as by significantly higher allocations to the
pension funds.”

f. Daimler is a global corporation and transacts business in many different
currencies. When the financial statements are prepared, these various
currencies must be translated into one common currency (Euros in this case) for
reporting purposes. Because exchange rates fluctuate, this translation process
results in some changes in the cash value of some transactions and cash

balances. The -€254 listed in the cash flow statement reflects the net impact on
Euros of the translation of foreign currencies.

Chapter 5
Analyzing and Interpreting
Financial Statements

Mini- Cases
Exercises Problems
15, 16,
LO1 – Prepare and analyze common 35
size financial statements. 19, 20
LO2 – Compute and interpret

measures of return on investment, 14, 17,
including return on equity (ROE), 25 - 31, 34 36, 38, 41 49
21, 22, 24
return on assets (ROA), and return
on financial leverage (ROFL).
LO3 – Disaggregate ROA into

25, 27 - 31, 36, 38,
profitability (profit margin) and 17, 21, 22, 24 47 - 49
efficiency (asset turnover) 34 41, 45, 46
components.
LO4 – Compute and interpret 18, 23 32, 33 37, 39, 42 49

measures of liquidity and solvency.
LO5 – Appendix 5A: Measure and

analyze the effect of operating 40, 43
activities on ROE.
LO6 – Appendix 5B: Prepare pro 35 44

forma financial statements.

QUESTIONS
Q5-1. Return on investment measures profitability in relation to the amount of

investment that has been made in the business. A company can always
increase dollar profit by increasing the amount of investment (assuming
it is a profitable investment). So, dollar profits are not necessarily a
meaningful way to look at financial performance. Using return on
investment in our analysis, whether as investors or business managers,
requires us to focus not only on the income statement, but also on the
balance sheet.
Q5-2. ROE is the sum of return on assets (ROA) and the return that results
from the effective use of financial leverage (ROFL). Increasing leverage
increases ROE as long as ROA exceeds the after-tax interest rate.
Financial leverage is also related to risk: the risk of potential bankruptcy
and the risk of increased variability of profits. Companies must,
therefore, balance the positive effects of financial leverage against their
potential negative consequences. It is for this reason that we do not
witness companies entirely financed with debt.
Q5-3. Gross profit margins can decline because 1) the industry has become
more competitive, and/or the firm’s products have lost their competitive
advantage so that the company has had to reduce prices or is selling
fewer units or 2) product costs have increased, or 3) the sales mix has
changed from higher-margin/slowly-turning products to lower-
margin/higher-turning products. Declining gross profit margins are
usually viewed negatively. On the other hand, cost increases that reflect
broader economic events or certain strategic product mix changes might
not be viewed negatively.
Q5-4. Reducing advertising or R&D expenditures can increase current
operating profit at the expense of the long-term competitive position of
the firm. Expenditures on advertising or R&D are more asset-like and
create long-term economic benefits.
Q5-5. Asset turnover measures the amount of revenue volume compared with
the investment in an asset. Generally speaking, we want turnover to be
higher rather than lower. Turnover measures productivity and an
important company objective is to make assets as productive as
possible. Since turnover is one of the components of ROE (via ROA),
increasing turnover increases shareholder value. Turnover is, therefore,
viewed as a value driver.
Q5-6. ROE>ROA implies a positive return on financial leverage. This results
from borrowed funds being invested in operating assets whose return
(ROA) exceeds the cost of borrowing. In this case, borrowing money
increases ROE.

Q5-7. Common-size financial statements express balance sheet and income
statement items in ratio form. Common-size balance sheets express
each asset, liability and equity item as a percentage of total assets and
common-size income statements express each line item as a
percentage of sales. The ratio form facilitates comparison among firms
of different sizes as well as across time for the same firm.
Q5-8. The asset turnover ratio (AT) is the ratio of sales revenue to average
total assets. The ratio is increased by increasing sales while holding
assets constant, or by reducing assets without reducing sales. The most
effective means of improving the ratio is to increase the efficient
utilization of operating assets. This is done by improving inventory
management practices, improving accounts receivable collection, and
improving the efficient use of PP&E.
Q5-9. The “net” in net operating assets, means operating assets “net” of
operating liabilities. This netting recognizes that a portion of the costs of
operating assets is paid for by parties other than the company. For
example, payables and accrued expenses help fund inventories, wages,
utilities, and other operating costs. Similarly, long-term operating
liabilities also help fund the cost of long-term operating assets. Thus,
these long-term operating liabilities are deducted from long-term
operating assets.
Q5-10. Companies must manage both the income statement and the balance
sheet in order to maximize ROA. This is important, as many managers
look only to the income statement and do not fully appreciate the value
added by effective balance sheet management. The disaggregation of
ROA into its profit margin and turnover components facilitates analysis of
these two areas of focus.
Q5-11. There are an infinite number of possible combinations of margin and
turnover that will yield a given level of ROA. The relative weighting of
profit margin and asset turnover is driven in large part by the company’s
business model. As a result, since companies in an industry tend to
adopt similar business models, industries will generally trend toward
points along the margin/turnover continuum.
Q5-12. Liquidity refers to how much cash a company has, how much cash is
coming in, and how much cash can be raised quickly. Companies must
generate cash in order to pay their debts, pay their employees and
provide their shareholders a return on investment. Cash is, therefore,
critical to a company’s survival.
Q5-13. Ratio analysis relies on the data presented in the financial statements
and is, therefore, dependent on the quality of those statements.
Differences in the application of GAAP across companies or within the
same company across time can affect the reliability of the analysis.
Limitations of GAAP itself and differences in the make-up of the

company (e.g., types of products or industries in which the company
competes) can also affect the usefulness of ratio analysis.

MINI EXERCISES
M5-14. (15 minutes)
a. ROE = $5,000/$500,000 = 1%
ROA = $20,000/$1,000,000 = 2%
ROFL = 1% - 2% = -1%
b. Net profit margin = $5,000/$1,000,000 = 0.5%

Asset turnover = $1,000,000/$1,000,000 = 1.0
Financial leverage = $1,000,000/$500,000 = 2.0
c. ROFL is negative for Sunder Company, indicating that financial leverage is

hurting this company. The return on assets is insufficient to cover the interest
cost of the debt. DuPont analysis masks this problem. The financial leverage
ratio of 2.0 suggests (incorrectly) that leverage doubled the return.
M5-15. (20 minutes)
TARGET CORPORATION
Common-size Balance Sheets
2015 2014
Cash and cash equivalents……………………………………. 5.3% 1.5%
Inventory…………………………………………………………. 21.2% 18.6%
Other current assets……………………………………………. 7.5% 5.9%
Total current assets…………………………………………….. 34.0% 26.0%
Property and equipment, net………………………………….. 62.7% 59.3%
Other noncurrent assets……………………………………….. 3.3% 14.7%
Total assets……………………………………………………… 100.0% 100.0%
Accounts payable………………………………………………. 18.7% 16.5%

Accrued and other current liabilities………………………….. 9.4% 9.6%
Current portion of long-term debt and notes payable............ 0.2% 2.6%
Total current liabilities…………………………………………. 28.3% 28.7%
Long-term debt………………………………………………….. 30.7% 25.7%
Deferred income taxes…………………………………………. 3.2% 3.0%
Other noncurrent liabilities……………………………………. 4.0% 6.2%
Total shareholders' investment………………………………. 33.8% 36.4%
Total liabilities and shareholders' investment……………….. 100.0% 100.0%

M5-16 (20 minutes)
TARGET CORPORATION
Common-size Income Statement
January 31,
Year ended: 2015
Sales
revenue………………..………………………………………………. 100.0%
Cost of
sales…………………………………………………………………. 70.6%
Selling, general and administrative
expenses……………………………. 20.2%
Depreciation and
amortization……………………………………………… 2.9%
Earnings from continuing operations before interest and income
taxes 6.2%
Net interest
expense………………………………………………………… 1.2%
Earnings from continuing operations before income
taxes……………… 5.0%
Provision for income
taxes…………………………………………………. 1.7%
Net earnings from continuing operations
………………………………… 3.4%
Discontinued operations, net of tax
……………………………………….. (5.6%)
Net earnings (loss)
………………………………………………………….. (2.3%)
M5-17. (15 minutes)
($ millions)
a. EWI = $(1,636) + $882 x (1-.35) = $(1,062.7)
= $2,449 + $882 x (1 - .35) = $3,022.3 (using net earnings from continuing
operations)
Average total assets = ($41,404 + $44,553)/2 = $42,978.5
ROA = $(1,062.7)/$42,978.5 = -2.47%
= $3,022.3/$42,978.5 = 7.03% (using net earnings from continuing operations)
b. PM = $(1,062.7)/$72,618 = -1.46%
AT = $72,618 /$42,978.5= 1.69
-1.46% X 1.69 = -2.474%
M5-18. (20 minutes)

a. 2015 Current ratio = $14,087 / $11,736 = 1.20
2014 Current ratio = $11,573 / $12,777 = 0.91
2015 Quick ratio = $2,210 / $11,736 = 0.19

2014 Quick ratio = $670 / $12,777 = 0.05
Both of these ratios improved over the year, as Target’s cash balance
increased by about $1.5 billion and its borrowings due within the year
decreased by more than $1 billion. Current ratio above 1 is good for a retailer
but Target’s quick ratio is low. It would be worthwhile to see whether these
changes represent a trend.

b. 2015 Times interest earned = $4,535 / $882 = 5.14
2015 Debt-to-equity = ($41,404 - $13,997) / $13,997= 1.96

2014 Debt-to-equity = ($44,553 - $16,231) / $16,231 = 1.74
Target’s debt-to-equity increased slightly but is not at a particularly high level.

The times-interest-earned ratio is calculated without including the loss from
discontinued operations.
c. Target is liquid and not excessively financially leveraged. Its times interest
earned ratio indicates that earnings before interest and taxes is just over 5
times interest expense. Because the company generates significant operating
profits and cash flow, we have no solvency concerns about Target.
M5-19. (20 minutes)
3M COMPANY
Common-size Balance Sheets
2014 2013
Cash and cash equivalent……………………………………... 8.1% 9.9%
Accounts receivable……………………………………………. 13.6% 12.7%
Total inventories………………………………………………… 11.9% 11.5%
Other current assets…………………………………………… 4.2% 3.8%
Total current assets…………………………………………… 37.6% 38.0%
Investments……………………………………………………… 3.0% 4.7%
Property, plant and equipment, net…………………………… 27.1% 25.8%
Goodwill………………………………………………………….. 22.5% 21.9%
Intangible assets, net…………………………………………… 4.6% 5.0%
Other assets…………………………………………………….. 5.1% 4.6%
Total assets……………………………………………………… 100.0% 100.0%
Short-term borrowings and current portion of long-term debt. 0.3% 5.0%

Accounts payable……………………………………………….. 5.8% 5.4%
Accrued payroll………………………………………………….. 2.3% 2.1%
Accrued income taxes………………………………………… 1.4% 1.2%
Other current liabilities………………………………………… 9.3% 8.6%
Total current liabilities………………………………………… 19.2% 22.3%
Long-term debt………………………………………………… 21.5% 12.9%
Other liabilities…………………………………………………… 17.3% 11.3%
Total liabilities…………………………………………………… 58.0% 46.5%
Stockholders' equity, net……………………………………… 42.0% 53.5%
Total liabilities and stockholders' equity……………………… 100.0% 100.0%

M5-20. (15 minutes)
3M COMPANY
Common-size Income Statements
2014 2013
Net sales…………………………………………………..... 100.0% 100.0%
Operating expenses:
Cost of sales……………………………………………... 51.7% 52.2%
Selling general and administrative expenses………… 20.3% 20.7%
Research, development and related expenses………. 5.6% 5.6%
Operating income………………………………………….. 22.4% 21.6%
Interest expense and income:
Interest expense…………………………………………. 0.4% 0.5%
Interest income…………………………………………… -0.1% -0.1%
Total………………………………………………………… 0.3% 0.3%
Income before income taxes and minority interest……… 22.1% 21.3%
Provision for income taxes………………………………… 6.4% 6.0%
Net income…………………………………………………… 15.7% 15.3%
M5-21. (20 minutes)
($ millions)
a. 2014 EWI = $4,998+ $142 x (1-.35) = $5,090.3
2014 Average total assets = ($31,269 + $33,550)/2 = $32,409.5
ROA = $5,090.3/$32,409.5 = 15.71%
b. PM = $5,090.3/$31,821 = 16.0%
AT = $31,821/$32,409.5 = 0.982
16.0% X 0.982 = 15.71%

M5-22. (15 minutes)
($ millions)
a. URBN: Average total assets = ($1,889 + $2,221)/2 = $2,055
ROA = $232.4 / $2,055 = 11.3%
TJX: Average total assets = ($11,128 + $10,201)/2 = $10,664.5

ROA = $2,241 / $10,664.5 = 21.0%
b. URBN: PM = $232.4 / $3,323 = 6.99%

AT = $3,323 / $2,055 = 1.62
6.99% X 1.62 = 11.3%
TJX: PM = $2,241 / $29,078 = 7.71%

AT = $29,078 / $10,664.5 = 2.73
7.71% X 2.73 = 21.0%
c. URBN’s ROA is quite a bit lower than TJX’s. TJX has a higher PM and AT. As
is typical of value-priced retailers, TJX’s asset turnover is high – its AT is 68%
higher than that of URBN. On balance, TJX’s business model appears to be
more successful in 2014 as it is able to maintain both a high AT and a high
PM, resulting in higher ROA.
M5-23. (20 minutes)
($ millions)
a. Verizon’s current ratio for the two years presented is as follows:
2014 current ratio: $29,623 / $28,064 = 1.06
2013 current ratio: $70,994 / $27,050 = 2.62
In 2014, Verizon’s current ratio was just above 1.0 which is slightly below the
industry median current ratio of 1.14. We might want to know, however,
whether Verizon’s current assets are concentrated in cash or relatively illiquid
inventories, as well as the maturity schedule of its current liabilities.
Its CR in 2013 is significantly higher than 2014 or prior years. This number
reflects a large increase in cash from a long-term borrowing in 2013. This
cash was used in 2014 to complete an acquisition, resulting in the current
ratio returning to a “normal” level.

b. Verizon’s times interest earned ratio for the two years is as follows:
2014 times interest earned = $20,185 / $4,915 = 4.11

2013 times interest earned = $31,944 / $2,667 = 11.98
Verizon’s times interest earned ratio has decreased, but remains higher than
the industry median (3.38).
2014 debt-to-equity = $219,032 / $13,676 = 16.0

2013 debt-to-equity = $178,682 / $95,416 = 1.87
Verizon’s 2013 debt-to-equity ratio is just slightly above the 1.79 median for
companies in the telecommunications industry. The ratio increased
dramatically in 2014 due to increased debt and a significant reduction in
stockholders’ equity.
Verizon’s operating cash flow to current liabilities ratio is as follows:

2014 OCFCL = $30,631 / [($28,064 + $27,050)/2] = 1.11
2013 OCFCL = $38,818 / [($27,050 + $26,956)/2] = 1.44
c. Verizon is carrying a significant amount of debt. Although its profitability and

operating cash flow are fairly strong, neither is particularly high in relation to
the company’s liabilities and interest costs. Verizon’s liquidity appears below
that of others in its industry, and its debt-to-equity is now very high. Given its
significant capital expenditure requirements and its current debt load, Verizon
may have to fund future capital expenditures with higher-cost equity. And, to
the extent that its competitors are not as highly leveraged, this may negatively
impact Verizon’s competitive position.

M5-24. (30 minutes)
a.
$ millions Asset Turnover
Procter & Gamble...............................$83,062/$141,765 = 0.59
CVS ....................................................$139,367/$72,889 = 1.91
Valero Energy ....................................$130,844/ $46,405 = 2.82
b.
$ millions ART
Procter & Gamble...............................$83,062/$6,447 = 12.88
CVS ....................................................$139,367/$9,208 = 15.14
Valero Energy ....................................$130,844/ $7,315 = 17.89
$ millions INVT
Procter & Gamble............................... $42,460/$6,834 = 6.21
CVS ....................................................$114,000/$11,488 = 9.92
Valero Energy ....................................$118,141/ $6,191 = 19.08
$ millions PPET
Procter & Gamble...............................$83,062/$21,985 = 3.78
CVS ....................................................$139,367/$8,729 = 15.97
Valero Energy ....................................$130,844/ $34,933 = 3.75
c. For all three companies, these ratios reflect differences in their businesses,
and the overall AT ratio is related to the three individual ratios as seen in
Exhibit 5.8 in the chapter. Valero has the highest AT: it collects from its
customers very quickly and carries small amounts of inventory relative to its
cost of goods sold. It also has the lowest level of property, plant and
equipment relative to its sales. Procter & Gamble’s ratios are influenced by
the relative strength of its largest customer (Wal-Mart), resulting in higher
inventory levels and slower collections. In addition, P&G has a large level of
intangible assets, as we will see in Chapter 8, so its PPET is relatively high,
but its AT is the lowest of the three. CVS’s inventory turnover is higher than
P&G and its receivable turnover is higher because most customers pay in
cash. CVS leases most of its store space, so PP&E is low relative to sales.

EXERCISES
E5-25. (30 minutes)
a.
($ millions)
McDonald’s [$4,758 + $571 x (1-.35)] / $35,454 = 14.47%
Yum! Brands [($1,021 + $130 x (1-.35)] / $8,520 = 12.98%
b.
($ millions) PM = EWI / Sales AT = Sales / Avg. Assets
McDonald’s [$4,758 + $571 x (1-.35)] / $27,441 = $27,441 / $35,454
18.69% = 0.774
Yum! Brands [($1,021 + $130 x (1-.35)] / $13,279 $13,279 / $8,520

= 8.33% = 1.559
c. McDonald’s ROA is greater than Yum! Brands’ in fiscal 2014. Yum! Brands’
value pricing strategy is clearly evident in its lower PM, but this is partially
offset by a higher asset turnover. For both firms, asset turnover is influenced
by franchising and leasing of retail stores.
E5-26. (20 minutes)

a.
Case A B C D E F
Assets 1,000 1,000 1,000 1,000 1,000 1,000
Non-interest-bearing
liabilities 0 0 0 0 200 200
Interest-bearing liabilities 0 250 500 500 0 300
Shareholders’ equity 1000 750 500 500 800 500
Earnings before interest

and taxes 120 120 120 80 100 80
Interest expense 0 25 50 50 0 30
Earnings before taxes 120 95 70 30 100 50
Tax expense (40%) 48 38 28 12 40 20
Net income 72 57 42 18 60 30
ROE 7.2% 7.6% 8.4% 3.6% 7.5% 6.0%

ROA 7.2% 7.2% 7.2% 4.8% 6.0% 4.8%
ROFL 0.0% 0.4% 1.2% -1.2% 1.5% 1.2%

b. These three cases differ only in the amount of interest-bearing liabilities used
to finance the firm. As leverage increases, the return to shareholders’ equity
(ROE) increases. However, the return on assets (ROA) does not change,
because the ROA is independent of the way that the business was financed.
c. However, financial leverage (the use of liabilities to finance the firm) does not
always work in favor of shareholders. The liability holders require a fixed
return (6% after-tax = 10% x (1 – 40%)), and in order for leverage to work in
favor of shareholders, the overall return on assets must exceed this fixed
return. In case C, the return on assets is 7.2% > 6%, so ROFL is positive. In
case D, the return on assets is 4.8% < 6%, so ROFL is negative.
In case E, the return on assets equals the after-tax return required on

interest-bearing liabilities, but the company has only non-interest-bearing
liabilities. The ROA is greater than zero, so ROFL is positive. In essence,
the rate required on liabilities is the “break-even” ROA in order for ROFL to be
positive.
d. In case F, there is a mixture of liability types. Even though ROA is less than
the amount needed for interest-bearing liabilities, ROFL is positive because
some of company F’s liabilities require no interest.
The general relationship among these variables is the following:
ROE = ROA + ROA*(NL/SE) + [ROA – (1 – t)*i]*(IL/SE)
where A = Assets,
NL = non-interest-bearing liabilities,
IL = interest-bearing liabilities,
SE = shareholders’ equity,
t = tax rate,
i = pre-tax interest rate on interest-bearing liabilities,
ROE = return on shareholders’ equity, and
ROA = return on assets.

E5-27. (20 minutes)
($ millions) CVS Walgreen

a. EWI $4,644 + $600 x (1-.35) = $5,034 $2,031 + $156 x (1-.35) = $2,132.4
Avg. Assets ($74,252 + $71,526)/2 = $72,889 ($37,182 + $35,481) /2 = $36,331.5
ROA $5,034/ $72,889 = 6.90% $2,132.4/ $36,331.5 = 5.87%
b. PM $5,034/$139,367 = 3.61% $2,132.4/$76,392 = 2.79%
AT $139,367/$72,889 = 1.91 $76,392/$36,331.5 = 2.10
c. Avg. Equity ($37,963 + $37,938)/2 = $37,950.5 ($20,561 + $19,454)/2 = $20,007.5
ROE $4,644 / $37,950.5 = 12.24% $2,031 / $20,007.5 = 10.15%
ROFL 12.24% - 6.90% = 5.34% 10.15% - 5.87% = 4.28%
d. Walgreen’s ROE and ROA are lower than CVS’s. CVS’s PM is slightly higher
than Walgreen’s, but its AT is lower. The low PMs for both companies reflect
the highly competitive retail pharmaceutical industry. CVS has a slight
advantage in 2014 due to its effective use of financial leverage. Asset
turnover and ROA differences would have to be examined further, because
both companies use operating leases that do not show up on its balance
sheet. Chapter 10 looks at this important topic.
E5-28. (30 minutes)

($ millions)
a. ROE 2014: $11,704 / [($55,865 + $58,256) / 2] = 20.5%

2013: $9,620 / [($58,256 + $51,203) / 2] = 17.6%
b. ROA 2014: [$11,704 + $192x(1-.35)] / [($91,956+$92,358) / 2] = 12.8%

2013: [$9,620 + $244x(1-.35)] / [($92,358+$84,351) / 2] = 11.1%
ROFL 2014: 20.5% - 12.8% = 7.7%

2013: 17.6% - 11.1% = 6.5%

c. Net Profit Margin 2014: $11,704 / $55,870 = 20.9%
2013: $9,620 / $52,708 = 18.3%
Asset Turnover 2014: $55,870 / [($91,956 + $92,358) / 2] = 0.61

2013: $52,708 / [($92,358 + $84,351) / 2] = 0.60
Financial 2014: [($91,956 + $92,358) / 2] / [($55,865 + $58,256) / 2] = 1.62

Leverage 2013: [($92,358 + $84,351) / 2] / [($58,256 + $51,203) / 2] = 1.61
Intel’s financial leverage increased slightly from 2013 to 2014. Both ROA and
ROE increased. Based on ROFL, leverage increased ROE by about 60%
over ROA each year, versus. These increases correspond to the DuPont
financial leverage measure in this case because Intel’s borrowing costs are
so low.
In general, there is a bias in DuPont analysis in that it tends to overstate the

benefits of financial leverage. Offsetting this bias, DuPont analysis calculates
the net profit margin, which is lower than PM because the numerator is net of
interest costs. For comparison purposes, Intel’s PM ratios are presented
below.
PM ratio 2014: [$11,704 + $192 x (1-.35)] / $55,870 = 21.2%

2013: [$9,620 + $244 x (1-.35)] / $52,708 = 18.6%
E5-29. (30 minutes)

($ millions)
a. ROE 2016: €850 / [(€138+€1,477) / 2] = 105.26%

2015: €805 / [(€1,477+€2,184) / 2] = 43.98%
2014: €448 / [(€2,184+$€1,875) / 2] = 22.07%
b. ROA 2016: [€850+€246x(1-.35)] / [(€6,108+€6,451) / 2] = 16.08%

2015: [€805+€208x(1-.35)] / [(€6,451+€7,173) / 2] = 13.80%
2014: [€448+€237x(1-.35)] / [(€7,173+€6,972) / 2] = 8.51%
ROFL 2016: 105.26% - 16.08% = 89.18%

2015: 43.98% - 13.80% = 30.18%
2014: 22.07% - 8.51% = 13.56%

c. Net Profit Margin 2016: €850 / €10,364 = 8.20%
2015: €805 / €9,613 = 8.37%
2014: €448 / €8,632 = 5.19%
Asset Turnover 2016: €10,364 / [(€6,108+€6,451) / 2] = 1.650

2015: €9,613 / [(€6,451+€7,173) / 2] = 1.411
2014: €8,632 / [(€7,173+€6,972) / 2] = 1.221
Financial Leverage 2016: [(€6,108+€6,451) / 2] / [(€138+€1,477) / 2] = 7.776

2015: [(€6,451+€7,173) / 2] / [(€1,477+€2,184) / 2] = 3.721
2014: [(€7,173+€6,972) / 2] / [(€2,184+€1,875) / 2] = 3.485
HD Rinker’s ROA increased slightly from 2015 to 2016 (mostly due to better
asset turnover), but its ROE skyrocketed! During both 2015 and 2016, Rinker
increased its liabilities, and significantly reduced its equity. Its debt-to-equity
ratio is 43.3 at the end of fiscal year 2016, so the ROE is greater than 100%.
This level of returns is exceptional for shareholders, but the company’s
condition could be precarious if its performance were to deteriorate.
The DuPont analysis shows that the net profit margin decreased from 2015 to
2016, but the asset turnover improved significantly. Based on ROFL,
leverage increased ROA by 2.6 times in 2014 (22.07%/8.51%) while in 2016,
leverage increased ROA by a factor of 6.5 (105.26%/16.08%). DuPont
analysis suggests that leverage had a slightly larger impact (3.485 in 2014
and 7.776 in 2016) but the trend is the same. This is consistent with the bias
in DuPont analysis in that it tends to overstate the effects of financial
leverage. Offsetting this bias, DuPont analysis calculates the net profit
margin, which is lower than PM because the numerator is net of interest
costs. For comparison purposes, HD Rinker’s PM ratios are presented
below:
PM ratio 2016: [€850+€246x (1-.35)] / €10,364 = 9.74%

2015: [€805+€208x (1-.35)] / €9,613 = 9.78%
2014: [€448+€237x(1-.35)] / €8,632 = 6.97%

E5-30. (20 minutes)
($ millions)
a. EWI $135 + $49 x (1-.35) = $166.85

Avg. Equity ($5,313 + $6,141)/2 = $5,727
Avg. Assets ($10,314 + $11,175)/2 = $10,744.5
ROE $135 / $5,727 = 2.36%
ROA $166.85 / $10,744.5 = 1.55%
ROFL 2.36% - 1.55% = 0.81%
b. PM $166.85 / $22,492 = 0.74%

AT $22,492 / $10,744.5 = 2.09
c. Staples has a very low profit margin and an asset turnover that is over 2.0.
This ratio combination is consistent with a low-price, high-volume business
model. However, compared to the retail industry, Staples is doing poorly. Its
AT is about at the median, but its PM is much lower. As a result its ROA and
ROE are well below the industry medians. ROFL is very low, suggesting that
Staples is close to being in a position where leverage is having a negative
effect on returns.
E5-31. (20 minutes)

($ millions)
a. EWI $907 + $31 x (1-.35) = $927.15

Avg. Equity ($3,078 + $3,531) / 2 = $3,304.5
Avg. Assets ($5,201 + $5,486) / 2 = $5,343.5
ROE $907 / $3,304.5 = 27.4%
ROA $927.15 / $5,343.5 = 17.4%
ROFL 27.4% - 17.4% = 10.0%
b. PM $927.15 / $4,506 = 20.6%

AT $4,506 / $5,343.5 = 0.84
c. Intuit has a relatively high PM ratio and a low AT ratio. These numbers are
consistent with the business model employed in the software industry.
Contrast these numbers with those of Staples (E5-30). Intuit uses financial

leverage effectively; leverage increased its ROA by a factor of 1.575
(27.4%/17.4%).

E5-32. (30 minutes)
a. ($ millions) Current Ratio

2012 $19,991 / $16,714 = 1.20
2013 $14,075 / $18,912 = 0.74
2014 $13,531 / $17,410 = 0.78
In 2013, Comcast’s current ratio dropped well below 1.0 and remained about
the same in 2014. Consequently, it does not appear to be very liquid. While
the current ratio provides a useful point estimate of liquidity, it would be
helpful to know when the cash flows from current assets will be realized and
when the current liabilities will need to be paid. Current assets dropped
almost 30% between 2012 and 2013, while current liabilities increased. The
change in current assets was due to a decrease in cash, which is troubling on
the surface. However, by examining the cash flow statement, we find that
operating cash flow was relatively stable and the big cash expenditure in
2013 was the $10 billion acquisition of outstanding noncontrolling interest in
NBC Universal (shares of NBC Universal held by minority shareholders—see
chapter 12).
b. ($ millions) Times interest earned Debt-to-equity

($164,971 - $49,796) / $49,796
$(11,609 + 2,521) / $2,521 = 5.6
2012 = 2.31
($158,813 - $51,058) / $51,058

$(11,115 + 2,574) / $2,574 = 5.3
2013 = 2.11
($159,339 - $53,068) / $53,068

$(12,465 + 2,617) / $2,617 = 5.8
2014 = 2.00
Both measures of solvency – the times interest earned ratio and the debt to
equity ratio – improved slightly in 2014. This is probably due to increasing
profits and the favorable interest rate environment in these years. Comcast is
able to cover its interest expense by a margin that is above the median for the
industry, but its debt-to-equity ratio is higher than the median.
c. Comcast’s current ratio is significantly lower than the industry median and
bears watching. At present, Comcast is able to cover its interest expense by
a margin that exceeds the median for the industry. Comcast’s debt-to-equity
ratio is relatively high and is above the industry median.
d. Comcast has a relatively high level of debt and appears to have a low level of
liquidity. However, its increasing profitability and interest coverage that is

above the industry median provide some reassurance that it will be able to
service its liabilities and continue to make further investments.

E5-33. (30 minutes)
a. ($ millions) Current Ratio OCFCL

2012 €52,128 / €42,627 = 1.22 €6,923 / [(€42,627 + €43,560) / 2] = 0.161
2013 €46,937 / €37,868 = 1.24 €7,186 / [(€37,868 + €42,627) / 2] = 0.179
2014 €48,076 / €36,598 = 1.31 €7,230 / [(€36,598 + €37,868) / 2] = 0.194
Siemens has a current ratio that is above 1.0 and has been increasing slightly
over these years. Moreover, its OCFCL ratio improved in each year. While
the current ratio provides a useful point estimate of liquidity, the OCFCL ratio
suggests that operations are not generating sufficient net cash flow to cover
short-term obligations, but it would be useful to also get a sense of the
volume of resource flows relative to the current liabilities.
b. ($ millions) Times interest earned Debt-to-equity

2012 €(6,636 + 760) / €760 = 9.73 €77,396 / €30,855 = 2.51
2013 €(5,813 + 784) / €784 = 8.41 €73,825 / €28,111 = 2.63
2014 €(7,427 + 764) / €764 = 10.72 €73,925 / €30,954 = 2.39
The times interest earned ratio decreased in 2013 but rebounded in 2014.
Siemens’ debt-to-equity ratio is quite high between 2.39 and 2.63.
c. It’s always a good idea to look into the numbers that make up the ratios
before coming to conclusions. For instance, Siemens’ current liabilities
include about €10.6 billion in unearned revenue, representing more than a
quarter of its current liabilities. In the normal course of business, deferred
performance liabilities like these aren’t paid off with cash – rather Siemens
must provide the agreed-upon services and products to the customers.
It’s not easy to place Siemens into one of the industry groups in Exhibit 5.13,
but its DE ratio appears to be higher than any industry median except tobacco
and utilities. However, its TIE appears to be in a satisfactory range. And, the
company’s size and diversified businesses give it a stability that can reassure
lenders.

E5-34. (30 minutes)
($ millions)
a. EWI $1,262 + $75 x (1-.35) = $1,310.75

Avg. Equity ($2,983 + $3,062) / 2 = $3,022.5
Avg. Assets ($7,690 + $7,849) / 2 = $7,769.5
ROE $1,262 / $3,022.5 = 41.8%
ROA $1,310.75 / $7,769.5 = 16.9%
ROFL 41.8% - 16.9% = 24.9%
b. PM $1,310.75 / $16,435 = 7.98%

AT $16,435 / $7,769.5 = 2.12
c. GPM $6,289 / $16,435 = 38.3%

INVT $10,146 / [($1,889 + $1,928) / 2] = 5.32
d. The Gap showed strong performance in the year ended January 31, 2015
(hereafter, 2014), though not quite as strong as 2013. Its ROA was 16.9%,
which is high for the retail industry. ROE was over 41% indicating the
effective use of financial leverage. Interest costs were low, suggesting that
most of The Gap’s debt is from operating liabilities (accounts payable and
accrued expenses). Its profit margin and asset turnover ratios place The Gap
in a strong position for this industry.
The GPM and INVT ratios are two important performance measures for retail
companies such as The Gap. GPM measures the ability of the firm to sell its
merchandise at reasonable margins while INVT provides evidence on
inventory management and the popularity of its product line. Both measures
are near the median for retailers in 2014.

E5-35. (20 minutes)
a. and b.
THE GAP, INC.
Common-size and Pro-forma Income Statements
2013 2014 2015 Pro forma
Net Sales 100.0% 100.0% $15,000 $16,000 $17,000
Cost of goods sold and
occupancy costs 61.0% 61.7% 9,600 10,240 10,880
Gross profit 39.0% 38.3% 5,400 5,760 6,120
Operating expenses 25.7% 25.6% 3,900 4,160 4,420
Operating income 13.3% 12.7% 1,500 1,600 1,700
Interest expense 0.4% 0.5% 75 75 75
Interest income. 0.0% 0.0% -5 -5 -5
Earnings from continuing
operations before income taxes 13.0% 12.2% 1,430 1,530 1,630
Income taxes 5.0% 4.6% 558 597 636
Net earnings 7.9% 7.7% $ 872 $ 933 $ 994
c. Note: 2013 and 2014 common size statements are reversed (2013 on the
left). Pro forma statements are presented for three different sales levels. The
Gap’s pro forma statements are based on (1) projected sales and (2) a set of
assumptions that determine the relationship between various expense items
and sales revenue. The accuracy of the projection depends on the reliability
of these estimates, which depends on management’s ability to maintain a
stable GPM ratio, maintain INVT ratio, and control operating expense ETS
ratios.

PROBLEMS
P5-36. (45 minutes)

($ millions)
Nike Adidas
a. EWI $2,693 + $53 x (1-.35) = $2,727.45 €496 + €67 x (1-.30) = €542.9
Avg. Equity ($10,824 + $11,081) / 2 = $10,952.5 (€5,618 + €5,481) / 2 = €5,549.5
Avg. Assets ($18,594 + $17,545) / 2 = $18,069.5 (€12,417 + €11,599) / 2 = €12,008
ROE $2,693 / $10,952.5 = 24.59% €496 / €5,549.5 = 8.94%
ROA $2,727.45 / $18,069.5 = 15.09% €542.9 / €12,008 = 4.52%
ROFL 24.59% - 15.09% = 9.5% 8.94% - 4.52% = 4.42%
Nike’s performance on both measures of profitability exceeded that of Adidas. We can

examine possible reasons for that difference by looking at the ratios below.
b. PM $2,727.45 / $27,799 = 9.81% €542.9 / €14,534 = 3.74%
AT $27,799 / $18,069.5 = 1.54 €14,534 / €12,008 = 1.21
Nike’s PM ratio is significantly higher than Adidas’s, as is its AT ratio. So, Nike’s higher
ROA appears to be driven by both superior margins and more efficient use of assets.
c. GPM $12,446 / $27,799 = 44.8% €6,924 / €14,534 = 47.6%
Operating ETS $8,766 / $27,799 = 31.5% €6,041 / €14,534 = 41.6%
Adidas reports a higher GPM ratio than Nike by about 3%. However, that is more than
offset by much higher operating expenses as a percentage of sales.
d. ART $27,799 / $[(3,434 + 3,117) / 2] = 8.49 €14,534 / €[(1,946 + 1,809) / 2] = 7.74
INVT $15,353 / $[(3,947 + 3,484) / 2] = 4.13 €7,610 / €[(2,526 + 2,634) / 2] = 2.95
PPET $27,799 / $[(2,834 + 2,452) / 2] = 10.52 €14,534 / €[(1,454 + 1,238) / 2] = 10.80
Nike’s INVT is significantly higher than Adidas’s, suggesting that Nike may be managing
inventory more efficiently. Both companies’ PPET ratios are high. These are consistent
with a business model that outsources most of the production.

e. The two companies’ fiscal years overlap by five months. Nike’s income
statement includes June through December 2013 while Adidas’ statements
cover June through December 2014. (Both cover January through May
2014.) Economic conditions were not materially different in 2014 than 2013,
so the comparisons involving income statement accounts shouldn’t be
affected too much.
However, companies that experience seasonality will have balance sheets
that look different at different points in time. For instance, a company might
have lower inventory levels just after a busy season, and choosing that point
for the end of its fiscal year would produce a higher value for INVT than a
fiscal year just prior to its busy season.
f. Normally, we would want to identify any major differences in the valuation of

assets and the measurement of income between these two companies. For
example, some assets are more likely to be valued at current value (rather
than historical cost) under IFRS reporting. Such a difference would affect
ratios such as ROA, AT, INVT and PPET.
P5-37. (20 minutes)
($ millions) Nike Adidas

a. Current Ratio 2014: $13,696 / $5,027 = 2.72 €7,347 / €4,378 = 1.68
2013: $13,630 / $3,962 = 3.44 €6,857 / €4,732 = 1.45
Quick Ratio 2014: $(2,220+2,922+3,434) / $5,027 = 1.71 €(1,683+403+1,946) / €4,378 = 0.92

2013: $(3,337+2,628+3,117) / $3,962 = 2.29 €(1,587+224+1,809) / €4,732 = 0.77
Nike is more liquid than Adidas. Its current ratio is around 3.0 and its quick ratio is near
2.0. In fact, Nike’s quick ratio is higher than Adidas’s current ratio.
b. TIE 2014: ($3,544 + $53) / $53 = 67.9 (€835 + €67) / €67 = 13.5
2013: ($3,256 + $20) / $20 = 163.8 (€1,113 + €94) / €94 = 12.8
Debt-to-Equity 2014: $7,770 / $10,824 = 0.72 €6,799 / €5,618 = 1.21

2013: $6,464 / $11,081 = 0.58 €6,118 / €5,481 = 1.12
Nike’s debt-to-equity ratio is very low but increased slightly in 2014. Adidas’s debt-to-
equity ratio is higher, and also went up in 2014. Nike’s TIE ratio decreased while
Adidas’ ratio increased slightly.
c. Adidas relies on greater amounts of debt financing than does Nike. This is evident by
the debt-to-equity ratio. In addition, the TIE ratio for Nike is much higher than for
Adidas. Although Adidas’s TIE ratio is not too low, Nike’s small amount of interest
expense produces a very high TIE. Neither company should have difficulty meeting its
debt obligations, but Adidas may not be able to borrow as much in the future (if

needed).

P5-38. (45 minutes)
($ millions) Home Depot Lowe’s

a. EWI $6,345 + $830 x (1-.35) = $6,884.5 $2,698 + $522 x (1-.35) = $3,037.3
Avg. Equity ($9,322 + $12,522) / 2 = $10,922 ($9,968 + $11,853) / 2 = $10,910.5
Avg. Assets ($39,946 + $40,518) / 2 = $40,232 ($31,827 + $32,732) / 2 = $32,279.5
ROE $6,345 / $10,922 = 58.1% $2,698 / $10,910.5 = 24.7%
ROA $6,884.5 / $40,232 = 17.1% $3,037.3 / $32,279.5 = 9.4%
ROFL 58.1% - 17.1% = 41.0% 24.7% - 9.4% = 15.3%
In 2014, Home Depot’s profitability exceeded that of Lowe’s, both in return to

shareholders and in return on assets. Home Depot also had a much larger
proportional effect from the use of leverage.
b. PM $6,884.5 / $83,176 = 8.27% $3,037.3 / $56,223 = 5.40%
AT $83,176 / $40,232 = 2.07 $56,223 / $32,279.5 = 1.74
Home Depot has a higher PM ratio, so it makes more money for every dollar of
sales, and it also generates more sales for every dollar of resources, suggesting that
it is managing assets more efficiently.
c. GPM $28,954 / $83,176 = 34.81% $19,558 / $56,223 = 34.79%
Operating ETS ($16,834 + $1,651) / $83,176 = 22.2% ($13,281 + $1,485) / $56,223 = 26.3%
These two companies have identical gross profit margins. The Home Depot’s GPM
ratio is slightly higher than that of Lowe’s, and its operating ETS ratio is lower.
Overall, Home Depot performed slightly better with respect to these two profitability
measures.
d. ART $83,176 / $[(1,484 + 1,398)/2] = 57.72 $56,223 / 0 = N/A
INVT $54,222 / $[(11,079 + 11,057)/2] = 4.90 $36,665 / $[(8,911 + 9,127)/2] = 4.07
PPET $83,176 / $[(22,720 + 23,348)/2] = 3.61 $56,223 / $[(20,034 + 20,834)/2] = 2.75
Lowe’s reports no accounts receivable and Home Depot reports very small amounts
of receivables. Neither company relies on customer credit to generate sales, so the
ART ratio is not very informative. More important is the INVT ratio. Home Depot’s
INVT is higher than Lowe’s ratio. The same is true for the PPET ratio. These
differences are consistent with the difference in the AT ratios noted earlier. Overall,
the numbers suggest that Home Depot is managing inventories and PPE assets
more efficiently.
e. Overall, It appears that Home Depot performed better than Lowe’s in 2014. Its ratio
values are either equal to or better than Lowe’s in almost every category.

P5-39. (30 minutes)
($ millions) Home Depot Lowe’s

a. Current Ratio 2014: $15,302 / $11,269 = 1.36 $10,080 / $9,348 = 1.08
2013: $15,279 / $10,749 = 1.42 $10,296 / $8,876 = 1.16
Quick Ratio 2014: ($1,723 + $1,484) / $11,269 = 0.285 ($466 + $125) / $9,348 = 0.063
2013: ($1,929 + $1,398) / $10,749 = 0.310 ($391 + $185) / $8,876 = 0.065
Both companies’ current ratios are above one, though Home Depot’s is a bit higher.
Quick ratios are very low due to the lack of receivables and low cash balances. Both
companies rely on operating cash flow to cover liquidity needs. Given the lack of
receivables, the INVT ratio becomes doubly important (see P5-38). Failure to turn
inventories quickly would result in lower operating cash flow and liquidity problems.
Hence, both companies emphasize inventory management.
b. TIE 2014: ($9,976 + $830)/$830 = 13.02 ($4,276 + $522)/$522 = 9.19

2013: ($8,467 + $711)/$711 = 12.91 ($3,673 + $480)/$480 = 8.65
Debt-to-Equity 2014: $30,624 / $9,322 = 3.29 $21,859 / $9,968 = 2.19

2013: $27,996 / $12,522 = 2.24 $20,879 / $11,853 = 1.76
For both companies, the debt-to-equity ratio increased from 2013 to 2014 indicating
more reliance on debt financing. Both are higher than the median for the retail industry.
Despite this trend, both companies’ TIE ratios increased.
c. The Home Depot utilizes more debt financing than does Lowe’s though both are higher
than the median retail firm. This results in a higher ROFL (see P5-38), as well as higher
debt-to-equity. Both firms have TIE ratios that are above the median for the retail
industry.

P5-40.A (30 minutes)
($millions) Home Depot Lowe’s

a. NOPAT $6,345 – [($337 - $830) x (1 - .35)] = $6,665.45 $2,698 – [($6 - $522) x (1 - .35)] = $3,033.4
NOA 2014: $39,946 - $(30,624 - 328 – 16,869) = $26,519 $(31,827 - 125 - 354) - $(21,859 - 552 – 10,815
= $20,856
NOA 2013: $40,518 - $(27,996 - 33 – 14,691) = $27,246 $(32,732 - 185 - 279) - $(20,879 - 435 – 10,086
= $21,910
Avg. NOA ($26,519 + $27,246) / 2 = $26,882.5 ($20,856 + $21,910) / 2 = $21,383
b. RNOA $6,665.45 / $26,882.5 = 24.8% $3,033.4 / $21,383 = 14.2%
c. NOPM $6,665.45 / $83,176 = 8.01% $3,033.4 / $56,223 = 5.40%
NOAT $83,176 / $26,882.5 = 3.09 $56,223 / $21,383 = 2.63
d. The Home Depot reports a higher RNOA than does Lowe’s, and the pattern in the operating
results parallels that in the total-firm results in P5-38. This is consistent with the ROA
numbers computed in P5-38 (ROA=17.1% for Home Depot and 9.4% for Lowe’s). Overall, we
would expect operating companies to have higher RNOA than ROA, because their core
business is the operations of the company, not investing in financial assets. And, if
management seeks to earn a favorable return for shareholders, they must expect a higher
return on their operations than they have to pay for borrowed funds.

P5-41. (30 minutes)
($ millions) 2014 2013
a. EWI $3,032 + $353 x (1-.35) = $3,261.45 $4,372 + $380 x (1-.35) = $4,619
Avg. Assets ($35,471 + $36,212) / 2 = $35,841.5 ($36,212 + $38,863) / 2 = $37,537.5
ROA $3,261.45 / $35,841.5 = 9.1% $4,619 / $37,537.5 = 12.3%
PM $3,261.45 / $58,232 = 5.60% $4,619 / $55,438 = 8.33%
AT $58,232 / $35,841.5 = 1.62 $55,438 / $37,537.5 = 1.48
UPS’ ROA appears healthy in both years. Although AT increased slightly in 2014, PM
decreased, which caused a corresponding decline in ROA.
b. Compensation ETS $32,045 / $58,232 = 55.0% $28,557 / $55,438 = 51.5%
The largest single expense on UPS’s income statement is compensation. The increase in
this ETS ratio from 51.5% to 55% of sales explains the drop in PM in 2014.
c. Avg. Equity ($2,158 + $6,488) / 2 = $4,323 ($6,488 + $4,733) / 2 = $5,610.5
ROE $3,032 / $4,323 = 70.1% $4,372 / $5,610.5 = 77.9%
d. ROFL 70.1% - 9.1% = 61.0% 77.9% - 12.3% = 65.6%
UPS relies very heavily on debt financing. In 2014 and 2013, when ROA was at an
acceptable level, ROFL produced an ROE between 6 and 8 times as large as ROA.

P5-42. (30 minutes)
($ millions) 2014 2013

a. Current Ratio $11,808 / $8,639 = 1.37 $13,387 / $7,131 = 1.88
Quick Ratio $(2,291 + 992 + 6,661) / $8,639 = 1.15 $(4,665 + 580 + 6,502) / $7,131 = 1.65
UPS current and quick ratios decreased in 2014. The quick ratio is only slightly lower
than the current ratio because UPS does not carry inventory balances.
b. TIE ($4,637 + $353) / $353 = 14.14 ($6,674 + $380) / $380 = 18.56
Debt-to-Equity $33,313 / $2,158 = 15.44 $29,724 / $6,488 = 4.58
The debt-to-equity ratio increased dramatically in 2014 due to the increase borrowing
and a drop in stockholders’ equity. A debt-to-equity ratio of 15.44 is extremely high. At
the same time, the TIE ratio decreased due to a drop in earnings. Together, these
indicate an increased dependence on debt financing.
c. UPS relies heavily on liability financing. The company’s current ratio and quick ratio are
in line with the medians of the Business Services industry but, being a capital-intensive
business, their debt-to-equity ratio is significantly higher than the median. Although the
company appears liquid, its ability to meet its obligations depends heavily on operating
cash flow. The high (and increasing) debt-to-equity ratio suggests that UPS may have
difficulty borrowing additional funds if needed.
($ millions) United Parcel Service (UPS)
a. NOPAT $3,032 + [($22 - $353) x (1-.35)] = $3,247.15
NOA 2014: $(35,471 – 992 - 489) - $(33,313 – 923 – 9,864) = $11,464

2013: $(36,212 – 580 - 444) - $(29,724 – 48 – 10,824) = $16,336
Avg. NOA ($11,464 + $16,336) / 2 = $13,900

b. RNOA $3,247.15 / $13,900 = 23.36%
c. NOPM $3,247.15 / $58,232 = 5.58%
NOAT $58,232 / $13,900 = 4.19
d. UPS invests only small amounts in non-operating assets (less than 5% of

total assets). So, when UPS invests borrowed funds in its operations, it earns
a return above 20%, at least in 2014. Because its borrowing costs are

significantly less than 20%, the financial leverage works in favor of the
shareholders.

P5-44.B (45 minutes)
a.
UNITED PARCEL SERVICE, INC.
Income Statements
2014 2015
($ millions)
Actual Pro forma
Revenue……………………………………………… $58,232 $60,000
Compensation and benefits……………………….. 32,045 33,018
Other………………………………………………….. 21,219 21,863
Operating profit……………………………………… 4,968 5,119
Investment income………………………………….. 22 22
Interest expense……………………………………… 353 353
Income before income taxes……………………….. 4,637 4,788
Income taxes………………………………………….. 1,605 1,676
Net income…………………………………………….. $ 3,032 $ 3,112
UNITED PARCEL SERVICE, INC.

Balance Sheets
2014 2015
($ millions)
Actual Pro forma
Cash and equivalents…………………………………. $ 2,291 $ 3,569
Marketable securities………………………………….. 992 992
Accounts receivable, net……………………………… 6,661 6,863
Deferred income taxes………………………………… 590 608
Other current assets………………………………….. 1,274 1,313
Total current assets…………………………………… 11,808 13,345
Property, plant and equipment………………………. 18,281 18,836
Goodwill and other intangible assets, net ………… 3,031 3,123
Non-current investments and restricted cash ……… 489 489
Other assets…………………………….……………… 1,862 1,919
Total assets……………………….……………………. $35,471 $37,712
Current maturities of long-term debt………………… $ 923 $ 923

Accounts payable………………………………………. 2,754 2,838
Accrued wages and withholdings……………………. 2,373 2,445
Self-insurance reserves, current portion…………….. 656 676
Other current liabilities………………………………… 1,933 1,992
Total current liabilities………………………………… 8,639 8,874
Long-term debt………………………….……………… 9,864 9,864
Pension and postretirement obligation……………… 11,452 11,800
Deferred taxes liabilities……………………………….. 83 86
Self-insurance reserves ………………………………. 1,916 1,974
Other noncurrent liabilities…………………………….. 1,359 1,400
Total liabilities…………………………………………... 33,313 33,998
Shareowners' equity…………………………………… 2,158 3,714
Total liabilities and shareowners' equity…………….. $35,471 $37,712
Students’ pro forma calculations may vary. An unrounded forecast factor was used in the
calculations presented in the solution.

P5-45. (45 minutes)
a. and b.
A summary of the ratios for these five companies appears in the following
table. Calculations are provided below for each company.
ABT BMY JNJ GSK PFE

PM 11.76% 18.53% 22.43% 14.30% 20.26%
GPM 54.47% 66.28% 69.40% 68.17% 80.69%
R&D ETS 6.64% 38.89% 11.43% 14.99% 16.92%
SG&A ETS 32.25% 41.36% 29.54% 37.54% 28.42%
c. What is perhaps most remarkable is how similar these five companies are.
For example, the SG&A ETS ratio ranges between 28% and 42%, with three
of the five between 28.4% and 32.25%. GPM ranges from a low of 54%
(ABT) to 81% (PFE), but the other three firms are between 66% and 69%.
This suggests that the business models employed by these companies are
very similar. The PM ratio shows a fairly wide variation, ranging from a low of
12% (ABT) to 22% (JNJ). Interestingly, ABT appears to be the least
profitable, with the lowest PM and GPM, yet it spends the least on R&D.
Calculations of ratios for each firm follow:
($ millions) Abbott Laboratories (ABT)
PM $1,233 + $150 x(1-.35) / $20,247 = 11.76%
GPM ($20,247 - $9,218) / $20,247 = 54.47%
R&D ETS $1,345 / $20,247 = 6.64%
SG&A ETS $6,530 / $20,247 = 32.25%
($ millions) Bristol-Myers Squibb (BMY)
PM $2,029 + $203 x(1-.35) / $11,660 = 18.53%
GPM ($11,660 - $3,932) / $11,660 = 66.28%
R&D ETS $4,534 / $11,660 = 38.89%
SG&A ETS $4,822 / $11,660 = 41.36%
continued next page

($ millions) Johnson & Johnson (JNJ)
PM $16,323 + $533 x(1-.35) / $74,331 = 22.43%
GPM ($74,331 - $22,746) / $74,331 = 69.40%
R&D ETS $8,494 / $74,331 = 11.43%
SG&A ETS $21,954 / $74,331 = 29.54%
($ millions) GlaxoSmithKline (GSK)
PM £4,297+ £1,134x(1-.265) / £35,872 = 14.30%
GPM (£35,872- £11,418) / £35,872 = 68.17%
R&D ETS £5,379/ £35,872 = 14.99%
SG&A ETS £13,466/ £35,872 = 37.54%
($ millions) Pfizer (PFE)
PM $9,168 + $1,360 x(1-.35) / $49,605 = 20.26%
GPM ($49,605 - $9,577) / $49,605 = 80.69%
R&D ETS $8,393 / $49,605 = 16.92%
SG&A ETS $14,097 / $49,605 = 28.42%

P5-46. (45 minutes)
Best Buy Kroger Nordstrom Staples Walgreens

ROA 8.8% 6.8% 9.1% 1.6% 5.6%
PM 3.2% 1.9% 6.0% 0.7% 2.7%
AT 2.76 3.63 1.52 2.09 2.10
ART 31.17 91.07 6.02 11.94 26.12
INVT 5.93 15.08 5.15 7.46 8.48
PPET 16.49 6.23 4.29 12.58 6.26
GPM 22.4% 21.2% 37.8% 25.8% 28.2%
Nordstrom has the highest PM (9.1%) and the highest GPM (37.8%). It also has the lowest AT
(1.52), ART (6.02), INVT (5.15) and PPET (4.29). Nordstrom clearly achieves its ROA by
emphasizing high profit margin. Kroger (KR) is at the opposite extreme from Nordstrom,
emphasizing efficient asset management. Kroger has the highest AT and INVT. Inventory
management is critical for a retail grocer. It also has very few receivables, so its ART is very high
(91.07 times). Fiscal year 2014 was not a successful one for Staples, with very low PM.
Retail companies lease much of their store space. As a result, the PPET ratio depends on how
these store leases are reported in the balance sheet. Lease accounting is discussed in Chapter
10.
Calculations follow for each firm ($ millions):
Best Buy (BBY)

EWI $2,284 + $90 x (1-.35) = $1,291.5
ROA $1,291.5 / $14,635 = 8.8%
PM $1,291.5 / $40,339 = 3.2%
AT $40,339 / $14,635 = 2.76
ART $40,339 / $1,294 = 31.17
INVT $31,292 / $5,275 = 5.93
PPET $40,339 / $2,447 = 16.49
GPM ($40,339 - $31,292) / $40,339 = 22.4%
continued next page

Kroger (KR)
EWI $1,728 + $488 x (1-.35) = $2,045.2
ROA $2,045.2 / $29,919 = 6.8%
PM $2,045.2 / $108,465 = 1.9%
AT $108,465 / $29,919 = 3.63
ART $108,465 / $1,191 = 91.07
INVT $85,512 / $5,670 = 15.08
PPET $108,465 / $17,403 = 6.23
GPM ($108,465 - $85,512) / $108,465 = 21.2%
Nordstrom (JWN)
EWI $720 + $138 x (1-.35) = $809.7
ROA $809.7 / $8,910 = 9.1%
PM $809.7 / $13,506 = 6.0%
AT $13,506 / $8,910 = 1.52
ART $13,506 / $2,242 = 6.02
INVT $8,406 / $1,632 = 5.15
PPET $13,506 / $3,145 = 4.29
GPM ($13,506 - $8,406) / $13,506 = 37.8%
Staples (SPLS)
EWI $135 + $49 x (1-.35) = $166.85
ROA $166.85 / $10,744 = 1.6%
PM $166.85 / $22,492 = 0.7%
AT $22,492 / $10,744 = 2.09
ART $22,492 / 1,883 = 11.94
INVT $16,691 / $2,236 = 7.46
PPET $22,492 / $1,788 = 12.58
GPM ($22,492 - $16,691) / $22,492 = 25.8%
Walgreen (WAG)
EWI $1,932 + $156 x (1-.35) = $2,033.4
ROA $2,033.4 / $36,332 = 5.6%
PM $2,033.4 / $76,392 = 2.7%
AT $76,392 / $36,332 = 2.10
ART $76,392 / $2,925 = 26.12
INVT $54,823 / $6,464 = 8.48
PPET $76,392 / $12,198 = 6.26
GPM ($76,392 - $54,823) / $76,392 = 28.2%

CASES and PROJECTS
C5-47. (30 minutes)
a. Raising prices and/or reducing manufacturing costs are not necessarily

independent solutions and are likely related to other factors. The effect of a
price increase on gross profit is a function of the demand curve for the
company’s product. If the demand curve is relatively elastic, a price increase
will likely significantly reduce demand, thereby decreasing, rather than
increasing, gross profit (an example is a 10% increase in price and a 20%
decrease in demand). A price increase will have a more desired effect if the
demand curve is relatively inelastic (a 10% price increase with a 3% decrease
in demand).
Cutting manufacturing costs will positively affect gross profit (via reduction of
COGS) if the more inexpensively made product is not perceived to be of
lesser quality, thereby reducing demand.
b. Raising prices is difficult in competitive markets. As the number of product

substitutes increases, companies are less able to raise prices. Rather, they
must be able to effectively differentiate their products in some manner in
order to reduce consumers’ substitution. This can be accomplished, for
example, by product design and/or advertising. These efforts, however, likely
entail additional cost, and, while gross profit might be increased as a result,
SG&A expense may also increase with little effect on the bottom line.
Manufacturing costs consist of raw materials, labor and overhead. Each can
be targeted for cost reduction. A reduction of raw materials costs generally
implies some reduction in product quality, but not necessarily. It might be the
case that the product contains features that are not in demand by consumers.
Eliminating those features will reduce product costs with little effect on selling
price.
Similarly, companies can utilize less expensive sources of labor (off-shore

production, for example), that can significantly reduce product costs and
increase gross profit provided that product quality is maintained.
Finally, manufacturing overhead can be reduced by more efficient production.

Wages and depreciation expense are two significant components of
manufacturing overhead. These are largely fixed costs, and the per-unit
product cost can often be reduced by increasing capacity utilization of
manufacturing facilities (provided, of course, that the increased inventory
produced can be sold).

The bottom line is that increasing gross profit is a difficult process than can
only be accomplished by effective management and innovation.

C5-48. (30 minutes)
a. Working capital management is an important component of the management

of a company. By reducing the level of working capital, companies reduce the
costs of carrying excess assets. This can have a significantly positive effect
on financial performance. Some common approaches to reducing working
capital via reductions in receivables and inventories, and increases in
payables, include the following:
• Reduce receivables
§ Constricting the payment terms on product sales
§ Better credit policies that limit credit to high-risk customers
§ Better reporting to identify delinquencies
§ Automated notices to delinquent accounts
§ Increased collection efforts
§ Prepayment of orders or billing as milestones are reached
§ Use of electronic (ACH) payment
§ Use of third-party guarantors, including bank letters of credit
• Reduce inventories
§ Reduce inventory costs via less costly components (of equal quality),
produce with lower wage rates, eliminate product features (costs) not
valued by customers
§ Outsource production to reduce product cost and/or inventories the
company must carry on its balance sheet
§ Reduce raw materials inventories via just-in-time deliveries
§ Eliminate bottlenecks in manufacturing to reduce work-in-process
inventories
§ Reduce finished goods inventories by producing to order rather than
producing to estimated demand
• Increase payables
§ Extend the time for payment of low or no-cost payables—so long as
the relationship with suppliers is not harmed)

b. The terms of payment that a company offers to its customers is a marketing
tool, similar to product price and advertising programs. Many companies
promote payment terms separately from other promotions (no payment for six
months or interest-free financing, for example). As companies restrict credit
terms, the level of receivables will likely decrease, thereby reducing working
capital. The restriction of credit terms may also have the undesirable effect of
reducing demand for the company’s products. The cost of credit terms must
be weighed against the benefits, and credit terms must be managed with care
so as to optimize costs rather than minimize them. Credit policy is as much
art as it is science.
Likewise, the depth and breadth of the inventories that companies carry
impact customer perception. At the extreme, inventory stock-outs result in not
only the loss of current sales, but also the potential loss of future sales as
customers are introduced to competitors and may develop an impression of
the company as “thinly stocked.” Inventories are costly to maintain, as they
must be financed, insured, stocked, moved, and so forth. Reduction in
inventory levels can reduce these costs. On the other hand, the amount and
type of inventories carried is a marketing decision and must be managed with
care so as to optimize the level inventories, not necessarily to minimize them.
One company’s account payable is another’s account receivable. So, just as

one company seeks to extend the time of payment, so as to reduce its
working capital, so does the other company seek to reduce the average
collection period so as to accomplish the same objective. Capable,
dependable suppliers are a valuable resource for the company, and the
supplier relation must be handled with care. All companies take as long to pay
their accounts payable as the supplier allows in its credit terms. Extending the
payment terms beyond that point begins to negatively impact the supplier
relation, ultimately resulting in the loss of the supplier. The supplier relation
must be managed with care so as to optimize the terms of payment, rather
than necessarily to minimize them.

C5-49. (30 minutes)
a. The list of parties that are affected by schemes to manage earnings is often
much broader than first thought. It includes the following affected parties:
1. employees above and below the level at which the scheme is

implemented
2. stockholders and elected members of the board of directors
3. creditors of the company (suppliers and lenders) and their employees,
stockholders, and boards of directors
4. competitors of the company
5. the company’s independent auditors
6. regulators and taxing authorities
b. Managers often believe that earnings management activities will be short-

lived, and will be curtailed once its operations “turn around.” Often, this does
not prove to be the case. Interviews with managers and employees who have
engaged in these activities often reveal that they started rather innocuously
(just managing earnings to “make the numbers” in one quarter), but, quickly,
earnings management became a slippery slope. Ultimately, the parties the
company was trying to protect (shareholders, for example) are hurt more than
they would have been had the company reported its results correctly,
exposing problems early so that corrective action could be taken (possibly by
removing managers) to protect the broader stakeholders in the company.
c. Company managers are just ordinary people. They desire to improve their
compensation, which is often linked to financial performance. Managers may
act to maximize their current compensation at the expense of long-term
growth in shareholder value. The reduction in the average employment period
at all levels of the company has exacerbated the problem.
d. Unfortunately, the separation of ownership and control often leads to less

informed shareholders who are unable to effectively monitor the actions of the
managers they have hired. To the extent that compensation programs are
linked to financial measures, managers can use the flexibility given to them
under GAAP to their benefit, even without violating GAAP per se. These
actions can only be uncovered by effective auditing and enforced by an
effective audit committee of the board. Corporate governance has grown
considerably in importance following the accounting scandals of the early
2000s. The Sarbanes-Oxley Act mandates new levels of corporate
governance. The stock market and the courts are helping to enforce this
mandate.


Revised 07.21.16
Chapter 6
Reporting and Analyzing Revenues,
Receivables, and Operating Income

Cases
Mini-
Exercises
Projects
LO1 – Describe and apply the 14, 15, 17 27, 28, 48, 49
criteria for determining when 33, 40
revenue is recognized.
LO2 – Illustrate revenue and 17, 24, 25 28, 31, 40, 47 48 - 50

expense recognition when the 41
transaction involves future
deliverables and/or multiple
elements.
LO3 – Illustrate revenue and 13, 16 29, 30 43

expense recognition for long-
term projects.
LO4 – Estimate and account for 18 - 21, 23 34 - 38 45, 46 50

uncollectible accounts
receivable.
LO5 – Calculate return on net 20, 22 32, 35, 39 42 50

operating assets, net operating
profit after taxes, net operating
profit margin, accounts
receivable turnover, and average
collection period.

LO6 –Discuss earnings 26 33 44 49
management and explain how it
affects analysis and
interpretation of financial
statements.
LO7 Appendix 6A – Describe

39 42 51
and illustrate the reporting for
nonrecurring items.

QUESTIONS
Q6-1. Revenue must be realized or realizable and earned before it can be

reported in the income statement. Realized or realizable means that the
company’s net assets have increased, that is, the company has received
an asset (for example, cash or accounts receivable) or satisfied a liability
as a result of the transaction. Earned means that the company has done
everything it must do under the terms of the sale.
For retailers, like Abercrombie & Fitch, revenue is generally earned
when title to the merchandise passes to the buyer (e.g., when the buyer
takes possession of the merchandise), because returns can be
estimated. For companies operating under long-term contracts, the
earning process is typically measured using the percentage-of-
completion method, that is, by the percentage of costs incurred relative
to total expected costs.
Q6-2. Financial statement analysis is usually conducted for purposes of
forecasting future financial performance of the company. Discontinued
operations are, by definition, not expected to continue to affect the
profits and cash flows of the company. Accordingly, the financial
statements separately report discontinued operations from continuing
operations to provide more useful measures of financial performance
and financial income. For example, yielding an income measure that is
more likely to persist into the future, and a net assets measure absent
discontinued items.
Q6-3. Restructuring costs typically consist of two general categories: asset
write-downs and accruals of liabilities. Asset write-downs reduce assets
and are recognized in the income statement as an expense that reduces
income and, thus, equity. Liability accruals create a liability, such as for
anticipated severance costs and exit costs, and yield a corresponding
expense that reduces income and equity.
Q6-4. Big bath refers to an event in which a company records a nonrecurring
loss in a period of already depressed income. By deliberately reducing
current period earnings, the company removes future costs from the
balance sheet or creates ‘reserves’ that can be used to increase future
period earnings.
Q6-5. Earnings management may be motivated by a desire to reach or exceed
previously stated earnings targets, to meet analysts’ expectations, or to
maintain steady growth in earnings from year to year. This desire to
achieve income goals may be motivated by the need to avoid violating
covenants in loan indentures or to maximize incentive-based
compensation.

The tactics used to manage income involve transaction timing
(recognizing a gain or loss) and estimations that increase (or decrease)
income to achieve a target.

Q6-6. Pro forma income adjusts GAAP income to eliminate (and sometimes
add) various items that the company believes do not (or do) reflect its
core operations. Such pro forma disclosures are only reported in
earnings and press releases and are not part of the published 10-Ks or
other annual reports provided for shareholders. The SEC requires that
GAAP income be reported together with pro forma income. Yet,
companies often report their GAAP income at the very end of the
earnings or press release, thus obfuscating their comparison and
focusing attention on the pro forma income.
It is because of this potential to confuse the reader about the true
financial performance of the company that the SEC has become
concerned. Also, pro forma numbers are not subject to accepted
standards (and, thus, we observe differing definitions across
companies), are not subject to usual audit tests, and are subject to
considerable management latitude in what is and is not included and
how items are measured.
Q6-7. Estimates are necessary in order to accurately measure and report

income on a timely basis. For example, in order to record periodic
depreciation of long-lived assets, one must estimate the useful life of the
asset. Estimates allow accountants to match revenues and expenses
incurred in different periods. For example, accountants estimate
warranty costs so that the warranty expense is matched against the
corresponding sales revenue. If the accounting process waited until no
estimates were necessary, there would be a significant delay in the
reporting of financial results.
Q6-8. When analysts publish earnings forecasts, these forecasts become a
benchmark against which some investors evaluate the company’s
performance. A company that fails to meet analysts’ forecasts may
suffer a stock price decline, even though earnings are higher than
previous years’ earnings and overall performance is good.
Consequently, management may feel pressure to meet or slightly
exceed analysts’ forecasts of earnings.
Q6-9. Bad debts expense is recorded in the income statement when the
allowance for uncollectible accounts is increased. If a company
overestimates the allowance account, net income will be understated on
the income statement and accounts receivable (net of the allowance
account) will be underestimated on the balance sheet. In future periods,
such a company will not need to add as much to its allowance account
since it is already overestimated from that prior period (or, it can reverse
the existing excess allowance balance). As a result, future net income
will be higher.
On the other hand, if a company underestimates its allowance account,
then current net income will be overstated. In future periods, however,

net income will be understated as the company must add to the
allowance account and report higher bad debts expense.

Q6-10. There are several possible explanations for a decrease in the allowance
account. First, after an aging of accounts receivable, Wallace Company
may have determined that a smaller percentage of its receivables are
past due. Wallace Company may have changed its credit policy such
that it is attracting lower-risk customers than in the past. Second,
experience may have indicated that the percentages used to estimate
uncollectibles was too high in previous years. By correcting the
estimated percentage of defaults, the estimated uncollectibles would end
up lower than in past years. Third, Wallace Company may be managing
earnings. By lowering estimated uncollectibles, the company can
increase current earnings, but may end up reporting a loss in a future
year when write-offs exceed the balance in the allowance account.
Q6-11. Minimizing uncollectible accounts is not necessarily the best objective
for managing accounts receivable. That objective could be
accomplished by not offering to sell to customers on credit. The purpose
of offering credit to customers is to increase sales and profits. Losses
from uncollectible accounts are a cost of doing business. As long as the
benefit (greater contribution to profits due to increased sales) exceeds
the cost (increased losses due to uncollectibles) then a higher-risk credit
policy which increases the amount of uncollectible accounts would be a
more profitable policy.
Q6-12. The number of defaults tends to rise and fall with the economy. For
example, in a recession, customers are more likely to default and
companies take longer, on average, to pay their bills than during a
healthy economy. This would result in higher estimated uncollectibles if
the estimates are based on an aging of accounts receivable.
For many companies, sales revenue also tends to decline during a
recession. If estimated uncollectibles are estimated as a percentage of
sales, then the estimate would tend to fall in a recession. This is
contrary to the increase in the number of defaults that occurs during a
recession. Therefore, the percentage of sales approach is not as
sensitive to changing economic conditions as is accounts receivable
aging.

MINI EXERCISES
M6-13. (15 minutes)

Note: The completed contract method is not required but is presented for the
purpose of comparison.
Percentage-of-Completion Method Completed Contract
Revenue
Percent recognized
of total (percentage of Income
expected costs incurred × (revenue
Costs costs total contract – costs Revenue
Year incurred (rounded) amount) incurred) recognized Income
2016 $ 400,000 21%a $ 525,000 $125,000 0 0
2017 1,000,000 53%b 1,325,000 325,000 0 0
2018 500,000 26%c 650,000 150,000 $2,500,000 $600,000
Total $1,900,000 $2,500,000 $600,000 $2,500,000 $600,000

a
$400,000 / $1,900,000
b
$1,000,000/ $1,900,000
c
$500,000 / $1,900,000
M6-14. (20 minutes)
Company Revenue recognition

GAP When merchandise is given to the customer and returns can be
estimated (or the right of return period has expired).
Merck When merchandise is given to the customer and returns can be
estimated (or the right of return period has expired). The company
will also establish a reserve and recognize expense relating to
uncollectible accounts receivable at the time the sale is recorded.
Deere When merchandise is given to the customer and the right of return
period, if any, has expired. The company will also establish a reserve
and recognize expense for uncollectible accounts receivable and
anticipated warranty costs at the time the sale is recorded.
Table continued on next page

Table continued
Company Revenue recognition
Bank of America Interest is earned by the passage of time. Each period, Bank of
America accrues income on each of its loans and establishes a
receivable on its balance sheet.
Johnson Controls Revenue is recognized under long-term contracts under the
percentage-of-completion method.
Syngenta AG Revenue is recognized when product is delivered to the customer or
distributer. Estimated returns are netted against revenues and if an
estimate of expected returns cannot be made, no revenue is
recognized.
M6-15. (15 minutes)
The Unlimited can only recognize revenues once they have been earned and the
amount of returns can be estimated with sufficient accuracy. Assuming that
happens at the time of sale, it must estimate the proportion of product that is
likely to be returned and deduct that amount from gross sales for the period. In
this case, it would report $4.9 million in net revenue (98% of $5 million) for the
period. If The Unlimited does not have sufficient experience to estimate returns,
then it should wait to recognize revenue until the right of return period has
elapsed.
M6-16. (20 minutes)
a. Percentage-of-completion method:
Year 2016 2017 2018 Total

Percent completed 30% 50% 20%
Revenue $12,000,000 $20,000,000 $8,000,000 $40,000,000
Expense:
Construction costs 9,000,000 15,000,000 6,000,000 30,000,000
Gross profit $3,000,000 $5,000,000 $2,000,000 $10,000,000
b. Completed contract method:
Year 2016 2017 2018 Total

Revenue $40,000,000 $40,000,000
Expense:
Construction costs 30,000,000 30,000,000

Gross profit $10,000,000 $10,000,000

M6-17. (20 minutes)
a. A.J. Smith should recognize the warranty revenue as it is earned. Since the
warranties provide coverage for three years beginning in 2017, one-third of
the revenue should be recognized in 2017, one-third in 2018, and the
remaining third in 2019.
b.
Year 2017 2018 2019 Total
Revenue $566,666 $566,667 $566,667 $1,700,000
Warranty expenses 166,666 166,667 166,667 500,000
Gross profit $400,000 $400,000 $400,000 $1,200,000
c. Total revenue from sales of the camera packages is $79,800 ($399 x 200).
The revenue is allocated among the three elements of the sale (camera,
printer and warranty) as follows:
Element Retail Price Proportion of Total

Camera $300 60% ($300/$500)
Printer 125 25% ($125/$500)
Warranty 75 15% ($75/$500)
Total $500 100%
Using these proportions, the revenue is allocated among the three elements
and recognized for each element as it is earned. In this case, the portion of
the revenue allocated to the camera and printer are recognized immediately,
while the revenue allocated to the warranty is deferred and recognized over
the three-year warranty coverage period.
Year Revenue
2017 $67,830 ($79,800 x 0.6) + ($79,800 x 0.25)
2018 3,990 ($79,800 x 0.15) / 3
2019 3,990
2020 3,990
Total $79,800

M6-18. (15 minutes)
a. To bring the allowance to the desired balance of $2,100, the company will
need to increase the allowance account by $1,600, resulting in bad debts
expense of that same amount.
b. The net amount of Accounts Receivable is calculated as follows: $98,000 −

$2,100 = $95,900.
c.
- Allowance for Doubtful Accounts + Bad Debts Expense (E) -
(XA) +
500 Balance (a) 1,600
1,600 (a)
2,100 Balance Balance 1,600
M6-19. (15 minutes)
a. Credit losses are incurred in the process of generating sales revenue.

Specific losses may not be known until many months after the sale. A
company sets up an allowance for uncollectible accounts to place the
expense of uncollectible accounts in the same accounting period as the sale
and to report accounts receivable at its estimated realizable value at the end
of the accounting period.
b. The balance sheet presentation shows the gross amount of accounts

receivable, the allowance amount, and the difference between the two, the
estimated net realizable value. The balance sheet, thus, reports the net
amount that we expect to collect. That is the amount that is the most relevant
to financial statement users.
c. The rule for expense recognition is that expenses are recognized when
assets are diminished (or liabilities increased) as a result of earning revenue
or supporting operations, even if there is no immediate decrease in cash. This
dictates the use of the allowance method. Recognition of expense only upon
the write-off of the account would delay the reporting of our knowledge that
losses are likely and, thereby, reduce the informativeness of the income
statement. Accountants believe that providing more timely information justifies
the use of estimates that may not be as precise as we would like.

M6-20. (20 minutes)
a.
($ millions) 2014 2013
Accounts receivable (net)............................................. $588 $458
Allowance for uncollectible accounts ........................... 270 245
Gross accounts receivable ........................................... $858 $703
Percentage of uncollectible accounts to gross 31.5% 34.9%
accounts receivable...................................................
($270/$858 ) ($245/$703)
b. In general, a decrease in the allowance for uncollectible accounts as a

percentage of gross accounts receivable may indicate that the quality of the
accounts receivable has improved, perhaps because the economy has
improved, the company is selling to a more creditworthy class of customers,
or the company’s management of accounts receivable is more effective. It
may also indicate, however, that the receivables were over-reserved (e.g.,
allowance account was too high in 2013). This would result in higher reported
profits in 2014 because past profits were too low. It is also possible that credit
quality has not changed and that the amount recorded in prior years is
correct, but that management has incentives to record additional income in
2014. Thus, perhaps management has reduced the amount reserved for
uncollectible accounts to meet some target income level.
c. $7,284/[($588+$458)/2] = 13.93 times

365/13.93 = 26.20 days
M6-21. (10 minutes)
Bad debts expense of $2,400 ($120,000 × 0.02) would cause the allowance for
uncollectibles to increase by the same amount. If the allowance increased by
only $2,100 for the period, Sloan Company must have written off accounts
totaling $300. In computing accounts receivable, sales revenue increased the
account by $120,000, and the write-offs would decrease it by $300. If there was
a net increase of $15,000 for the period, Sloan Company must have collected
$104,700 in cash. ($104,700 = $120,000 - $300 - $15,000.)

M6-22. (20 minutes)
a.
Accounts Receivable Turnover Average Collection Period
Procter & $83,062/ [($6,386 +$6,508)/2] 365 / 12.9 = 28.3 days
Gamble = 12.9 times
Colgate- $17,420 / [($1,636+$1,668)/2] 365 / 10.5 = 34.8 days

Palmolive = 10.5 times
b. P&G turns its accounts receivable faster than Colgate-Palmolive. Receivable

turns typically evolve to an equilibrium level for each industry that arises from
the general business models used by industry competitors. Differences can
arise due to variations in the product mix of competitors, the types of
customers they sell to, their willingness to offer discounts for early payment,
and their relative strength vis-à-vis the companies or individuals owing them
money.
Also, the size of the firm may affect the ability of a company to exert
bargaining power over major suppliers or customers. For instance, both of
these companies sell a significant amount of their product to Wal-Mart. P&G
is a sizable company, and may have greater bargaining power over Wal-Mart
than does the smaller Colgate-Palmolive.
One other possibility is that the difference is due to the companies’ differing
fiscal year-ends. If the receivable balance is not constant during the year due
to some seasonality, then the receivable turnover ratio will depend on the
choice of fiscal year.

M6-23. (20 minutes)
a.
i. Accounts receivable (+A) ……………………………………… 3,200,000
Sales revenue (+R, +SE) …………………………..…… 3,200,000
ii. Bad debts expense (+E, -SE) ………………………………… 42,000

Allowance for uncollectible accounts (+XA, -A)……. 42,000
iii. Allowance for uncollectible accounts (-XA, +A) ………. 39,000

Accounts receivable (-A) ………………………………….. 39,000
iv. Accounts receivable (+A) ……………………………………… 12,000

Allowance for uncollectible accounts (+XA, -A) 12,000
vi. Cash (+A) …..……………………………………………………… 12,000

Accounts receivable (-A) ………………………………… 12,000
The recovered receivable is reinstated, so that its payment may be properly

recorded.
b. Besides the $12,000 in recovery, the collections from customers can be

summarized in the following entry:
v. Cash (+A) 2,926,000
Accounts receivable (-A) 2,926,000
(This amount includes payment of the recovered receivable for $12,000. The
allowance increases by $15,000 over the period, so the fact that net
receivables increased by $220,000 means that gross receivables must have
increased by $235,000. That fact allows us to “back out” the cash received.)
c.
+ Cash (A) - - Sales Revenue (R) +
(v) 12,000 3,200,00 (i)
0
(vi) 2,926,00
0
2,938,00
0
+ Accounts Receivable (A) - + Bad Debts Expense (E) -
(i) 3,200,00 (ii) 42,000
0
(iv) 12,000 39,000 (iii)
12,000 (v)
2,926,00 (vi)

0
235,000
- Allowance for Uncollectibles (XA)
+
42,000 (ii)
(iii) 39,000
12,000 (iv)
15,000
continued next page

d.
i. Sales on +3,200,000 - = +3,200,000 +3,200,000 - = +3,200,000
account. Accounts Retained Sales
ii. Bad debts - +42,000 = -42,000 - +42,000 = -42,000
expense. Allowance for Retained Bad Debts
Uncollectible Earnings Expense
Accounts
iii. Write-off of -39,000 - -39,000 = - =
uncollectibl Accounts Allowance for
e accounts. Receivable Uncollectible
Accounts
iv. Reinstate +12,000 - +12,000 - =
account Accounts Allowance for
previously Receivable Uncollectible
written off. Accounts
v. Collect +12,000 -12,000 - - =
reinstated Cash Accounts
account. Receivable
vi. Collect +2,926,000 -2,926,000 - = - =
cash on Cash Accounts
sales. Receivable
M6-24. (20 minutes)
a.
Fiscal Year Revenue Revenue Growth
2015 $48,000
2016 55,000 14.6%
2017 62,000 12.7%
2018 62,000 0.0%
b.
Unearned Customer Purchases = Growth in
Fiscal Revenue Liability Revenue + Change in Customer
Year Revenue (end of year) Unearned Revenue Liability Purchases
2015 $48,000 $20,000
2016 55,000 24,000 55,000 + 4,000 = 59,000
2017 62,000 26,000 62,000 + 2,000 = 64,000 8.5%
2018 62,000 25,000 62,000 - 1,000 = 61,000 -4.7%

c. In both fiscal year 2017 and 2018, the growth in customer purchases is lower
than the growth in reported revenues. The practice of deferring revenue
recognition implies that reported revenues in a given period are the result of
customer purchases over many periods, resulting in a smoothing of revenues.
In the case of Finn Publishing, revenues in any given year are the result of
newsstand and bookstore purchases during that year, plus part of the
subscriptions from that year, plus part of the subscriptions from the previous
year. That means that growth in annual revenues is a composite of growth in
customer purchases over an even longer period of time.
For 2017 and 2018, Finn’s growth in revenues exceeds the growth in
customer purchases because the revenues are still reflecting growth from
prior periods. Purchases are a “leading indicator” of revenues, and thus,
calculating customer purchase behavior can be useful in forecasting future
revenue and identifying changes in customers’ attitudes about a company’s
current offerings.
M6-25. (15 minutes)
This question is based on an actual situation, in which the accounting rules were
influencing the product decisions. The rules for revenue deferral when there are
multiple deliverables deterred the company from providing enhancements and
upgrades that were available. If Commtech’s customers (the wireless
companies) had been willing to pay for the upgrades to its customer’s phones,
that would have been allowed. (It’s not clear what the wireless companies’
incentives would be, because they may want to encourage users to purchase
new phones – with a new service contract – rather than improving their existing
phones.)
The question can generate a discussion about whether accounting should drive
decisions. Whether it should or not, it does, so the question should evolve into
what top management should do about this type of situation. Does the situation
described in the problem require some managerial action, or not. Is the company
foregoing sales because of its accounting? Within Commtech, the finance staff
was skeptical of marketing’s predictions that the upgrades and enhancements
would increase the sales of existing phone models. If the upgrades and
enhancements are delivered, Commtech will have to change its accounting for
revenue, with a resulting decrease in near-term profitability. How might the
company communicate that change in a way that the investing public will
understand as a net benefit to the company?

M6-26 (20 minutes)
a. Verdi Co. would report stable sales because extending sales to lower
credit quality customers broadens the customer pool and thus Verdi Co.
can sell the same number of computers year over year.
b. Verdi Co. should have disclosed that is was selling to higher credit risk
customers. At a minimum, Verdi Co. should have estimated a larger
expected bad debts expense related to these customers. (If the credit
quality was so poor, Verdi Co. may even consider not reporting the
revenue (i.e., if not realizable)).
c. In future periods when it is revealed that customers cannot pay for the
computers, Verdi Co. will have to write off the related accounts receivable.
If these bad debts were not reserved for early via the bad debts expense
and allowance for doubtful accounts, then Verdi Co. will have to record
bad debts expense when the debt goes bad. This will result in an expense
in a year different than the reported revenue and will supress future
earnings, potentially significantly.

EXERCISES
E6-27. (20 minutes)
Company Revenue Recognition

The Limited When merchandise is given to the customer and returns can be
estimated (or the right of return period has expired).
Boeing Revenue is recognized under long-term contracts under the
Corporation percentage-of-completion method.
SUPERVALU When merchandise is given to the customer and cash is received.
MTV When the content is aired by the TV stations.
Real estate When title to the houses is transferred to the buyers.
developer
Wells Fargo Interest is earned by the passage of time. Each period, Wells Fargo
accrues income on each of its loans and establishes an account
receivable on its balance sheet.
Harley-Davidson When title to the motorcycles is transferred to the buyer. Harley will
also set up a reserve for anticipated warranty costs and recognize
the expected warranty cost expense when it recognizes the sales
revenue.
Time-Warner When the magazines are sent to subscribers.
E6-28. (20 minutes)

Company Revenue Recognition
Real Money Recognize revenue ratably over the period of time that customers
can access its website, not when the cash is received. The
recognition of revenue is dependent upon Real Money providing
updates.
Oracle The fee to purchase the right to use the software can be recorded
as revenue when the software is installed, unless that fee includes
future deliverables like upgrades and support. (If such post-sale
services are included in the fee, some portion must be deferred and
recognized over the appropriate period.) Service revenue can only
be recognized ratably over the period of time covered by the service
contract.
Intuit Recognize revenue when the software is sent to customers. The
company must estimate potential warranty claims and establish a
reserve for them when revenue is recorded.
Computer game Record revenue after the 10-day right of return period has elapsed.

developer

E6-29. (20 minutes)
($ millions) a. Percentage-of-Completion Method b. Completed

Contract
Percent Income
Revenue recognized
Costs of total (percentage of costs (revenue
incurre expected incurred × total – costs Revenue
Year d costs contract amount) incurred) recognized Income
2016 $100 25% $125 $ 25 $ 0 $ 0
2017 300 75% 375 75 500 100
$400 $500 $100 $500 $100
c. The percentage-of-completion method normally provides a reasonable

estimate of the revenues, expenses, and income earned for each period
based on the amount of work completed. A key assumption underlying the
use of this method is that the contract price is fixed and it is possible to obtain
reliable estimates of expected costs and costs to date. When such estimates
are not available, the completed contract method should be used.
The percentage-of-completion method is acceptable under GAAP for a variety

of contracts spanning more than one accounting period, such as in the
consulting and transportation industries.
E6-30. (20 minutes)

a.
($ millions) Percentage-of-Completion Method Completed Contract
Percent
of total Income
Revenue recognized
Costs expected (percentage of costs (revenue
incurre costs incurred × total – costs Revenue
Year d (rounded) contract amount) incurred) recognized Income
2017 $15 18% $ 21.6 $ 6.6 $ 0 $ 0
($15/$85)
2018 40 47% 56.4 16.4 0 0
($40/$85)
2019 30 35% 42.0 12.0 120 35
($30/$85)
$85 $120.0 $35.0 $120 $ 35
b. The percentage-of-completion method provides a good estimate of the

revenue and income earned in each period. This method is also acceptable

under GAAP for contracts spanning more than one accounting period.
Recognition of revenue and income is not affected by the cash received, but
the percentage-of-completion method more closely approximates cash flows
than the completed contract method.

E6-31. (15 minutes)
a. Multiple element arrangements are sales transactions in which two or more

deliverables are “bundled” together and sold for one price. The revenue
should be recognized on each deliverable element when it is earned. This
involves first assigning a portion of the sales revenue to each element and
then recognizing each portion of the revenue only when that element has
been delivered to the customer.
b. The total revenue for the “bundle” is $190. However the Kindle, if sold alone
sells for $170 and the wireless and upgrades sell for $30, which brings the
total “value” to $200. Thus, the Kindle device represents 85% of the total
value of the bundle ($170/$200). Amazon should recognize $161.50 at the
time of the sale (85% of the $190 sale price) and defer the remaining $28.50.
c.
Cash Noncas Liabilitie Contrib Earned Revenue Expense Net
Transaction Asse + h = + . + - = Incom
s Capital s s
t Assets Capital e
To record bundled sale +190 + = +28.50 + + +161.50 +161.50 - = +161.50
transaction Unearned
revenue Retained Sales
Earnings revenue
Cash (+A) 190.00

Sales revenue (+R, +SE) 161.50
Unearned revenue (+L) 28.50
E6-32. (15 minutes)
a. 2013: $60,578 + $7,374 x (1-.35) = $65,371

2014: $128,088 + $6,060 x (1-.35) = $132,027
b. 2013: $65,371/$985,737 = .0663 or 6.63%

2014: $132,027/$1,394,205= .0947 or 9.47%
c. $132,027/ [($815,364 - $276,487 + $439,671 - $254,227) / 2] = .3646 or

36.46%

E6-33. (15 minutes)
In none of these cases should Simpyl Technologies recognize revenue. Each of

the four settings touches on one of the four conditions for revenue recognition
listed by the SEC. In part a, “persuasive evidence of an exchange agreement”
does not yet exist, because the company’s policies have defined a contract with
authorized signatures to constitute persuasive evidence. In part b, delivery has
not occurred. The product has been shipped, but not to the customer and not
with the specified customizations that are required by the customer. In part c, the
price is not yet fixed or determinable, because the negotiations over volume
discounts have not been concluded. Finally, the distributor in part d does not
have the means to pay for the items delivered, so collectibility cannot be
reasonably assured (until the distributor sells the product to an end customer).
The delivery should be viewed as a consignment arrangement, in which Simpyl
recognizes revenue when the distributor sells the items to a third party.
E6-34. (20 minutes)
a. Prior to the aging of accounts, the balance in the Allowance for Uncollectible
Accounts would be a credit of $520 (the opening balance of $4,350 less the
amounts written off of $3,830).
2016 bad debts expense computation

$250,000 × 0.5% = $1,250
$ 90,000 × 1% = 900
20,000 × 2% = 400
11,000 × 5% = 550
6,000 × 10% = 600
4,000 × 25% = 1,000
4,700
Less: Unused balance before adjustment 520

Bad debts expense for 2016 $4,180
b. Accounts receivable, net = $381,000 - $4,700 = $376,300
Reported in the balance sheet as follows:

Accounts receivable, net of $4,700 in allowances .................................... $376,300
c.
+ Bad Debts Expense (E) - - Allowance for Uncollectible
Accounts (XA) +
(a) 4,180 4,350 Balanc
e
Write- 3,830
offs

4,180 (a)
4,700 Balanc
e

E6-35. (25 minutes)
a. Allowance for doubtful accounts (-XA) 4.3

Accounts receivable (-A) 4.3
Provision for doubtful accounts (+E,-SE) 2.8

Allowance for doubtful accounts (+XA) 2.8
The provision for doubtful accounts (bad debts expense) has a credit entry
that has the effect of decreasing Steelcase’s reported income by $2.8 million
for the year. The write-off of $4.3 million of uncollectible accounts has no
effect on income.
b.
2014 2013
Accounts receivable, net 306.8 287.3
Allowance for doubtful accounts 13.0 14.5
Gross receivables (net plus allowance) $319.8 $301.8
Allowance as a % of gross receivables 4.1% 4.8%
c. $2,989 / [($306.8 + $287.3) / 2] = 10.1 times.
d. $2,989 + ($16.0 - $13.5) – ($306.8 - $287.3) – $2.8 = $2,969.2.
E6-36. (15 minutes)
Accounts receivable $138,100

Less Allowance for uncollectible accounts 10,384
$127,716
Computations
Accounts Allowance for
Receivable Uncollectible
Accounts
Beginning balance $ 122,000 $ 7,900
Sales 1,173,000
Collections (1,150,000)
Write-offs ($3,600 + $2,400 +$900) (6,900) (6,900)
Provision for uncollectibles ($1,173,000 × 0.8%) _________ 9,384
$ 138,100 $ 10,384

E6-37. (20 minutes)
a. Aging schedule at December 31, 2016

Current $304,000 × 1% = $ 3,040
0–60 days past due 44,000 × 5% = 2,200
61–180 days past due 18,000 × 15% = 2,700
Over 180 days past due 9,000 × 40% = 3,600
Amount required 11,540
Balance of allowance 4,200
Provision $ 7,340 = 2016 bad debts
expense
b. Current Assets
Accounts receivable $375,000
Less: Allowance for uncollectible accounts 11,540 $363,460
c.
+ Bad Debts Expense (E) - - Allowance for Uncollectible
Accounts (XA) +
(a) 7,340 Balanc
4,200
e
7,340 (a)
11,540 Balanc
e
E6-38. (30 minutes)

a.
Year Sales Collections Accounts Written
Off
2015 $ 751,000 $ 733,000 $ 5,300
2016 876,000 864,000 5,800
2017 972,000 938,000 6,500
Total $2,599,000 $2,535,000 $17,600
Accounts Receivable at the end of 2017 is $46,400, computed as:

($2,599,000 - $2,535,000 - $17,600).
Bad Debts Expense is:

2015 $ 7,510 computed as 1% × $751,000
2016 8,760 computed as 1% × $876,000
2017 9,720 computed as 1% × $972,000
2015-2017 $25,990 computed as 1% × $2,599,000

Allowance for Uncollectible Accounts is $8,390 computed as:
$25,990 total bad debts expense less $17,600 in total write-offs.

b.
Accounts Receivable (A) Allowance for Uncollectibles (XA)
Beg 0 0 Beg Bal
Bal
Sales 751,00 5,300 Write offs Write 5,30 7,510 Bad debts
0 offs 0 exp.
733,00 Collections
0
2015 12,700 2,210 2015 Bal
Bal
0 offs 0 exp.
864,00 Collections
0
2016 18,900 5,170 2016 Bal
Bal
0 offs 0 exp.
938,00 Collections
0
2017 46,400 8,390 2017 Bal
Bal
There isn’t any indication that the 1% rate is incorrect. If the rate is too high,
we would expect the allowance to grow at a faster rate than receivables. If
the rate is too low, the opposite would occur. In this case, the allowance
percentage of receivables is 17%, 27% and 18% at the end of 2015, 2016
and 2017, respectively. So, there is no clear direction that would indicate an
inappropriate estimate.
E6-39. (20 minutes)

a.
Earnings Return on
from End. Beg. Avg. Capital
Operations Assets Assets Assets Employed
Personal Systems $ 1,270 $ 12,104 $ 11,690 $11,897 10.7%
Printing 4,185 10,063 11,088 10,575.5 39.6%
Enterprise Group 4,008 27,236 29,759 28,497.5 14.1%
Enterprise Services 803 13,472 16,217 14,844.5 5.4%
Software 872 11,575 11,940 11,757.5 7.4%
HP Financial Services 389 13,529 12,746 13,137.5 3.0%

Corporate Investments (199) 34 105 69.5 (286.3)%
b. The most profitable group seems to be Printing , which represents HP’s

traditional strength. However, it is not growing (based on a sales percentage
decrease in 2014). The Enterprise Group and Personal Systems (commercial
and personal PCs, workstations, calculators, etc.) also have good return on
capital employed. Corporate Investments is described by the company as
including HP Labs and cloud-related business incubation projects. The
negative return makes sense as this sounds like new businesses within HP.
As an aside, HP announced late in 2014 that they will split the company into
two in 2015 – HP Inc., which will include Personal Systems and Printing, and
Hewlett-Packard Enterprises, which will include Enterprise Group, Enterprise
Services, Software, and HP Financial Services.

c. Restructuring charges are reported “above the line,” as part of income from
continuing operations before income taxes. They are listed as a charge
against operating income in the income statement, and thus would reduce our
calculation of return on capital employed. Restructuring charges are
nonrecurring, however, and should be considered separately when evaluating
profitability of a business segment.
E6-40. (20 minutes)
a. Just like for-profit organizations, not-for-profit organizations cannot recognize

revenue until it has been earned. In the case of The Lyric Opera, it cannot
recognize the ticket revenue until the performances occur. (The Lyric does
not issue quarterly reports, so we cannot observe how much of the revenue
has been earned part way through its fiscal year.)
b. This entry is simplified by the fact the fiscal year-end is after the end of the
current season and by assuming that all of The Lyric’s deferred revenue
relates to the following season (and none to any years after the following
season).
To record revenue for the fiscal year 2014 season:
Deferred ticket and other revenue (-L) 14,525

Cash or Accounts receivable (+A) 14,353
Ticket sales (+R, +NA) 28,878
(As a not-for-profit, The Lyric Opera does not have shareholders’ equity, but
rather “net assets.” Therefore, the recognition of revenue increases net
assets (NA) on the balance sheet.)
To record advance purchases for the fiscal year 2014 season:

Cash or Accounts receivable (+A) 13,750
Deferred ticket and other revenue (+L) 13,750
c. The Lyric Opera usually operates close to seating capacity. And, in a typical
year, approximately more than one-half of its seats are sold before the
season. The quantity of unsold seats will affect The Lyric’s marketing efforts
for subscribers who have not yet renewed, outreach to new potential
subscribers and promotions for individual tickets which go on sale shortly
before the season. Those efforts can be scaled up or down depending on the
experience with advance sales.

E6-41. (20 minutes)
a. Membership fees are initially recorded as a liability (deferred membership fee

revenue) and recognized over a period of one year. Member rewards are
similarly deferred, but the offsetting debit is recorded as a reduction to sales
revenue.
b.
Cash (+A) 2,515
Deferred membership fees (+L) 2,515
Deferred membership fees (-L) 2,428

Membership fee revenue (+R, +SE) 2,428
c.
Sales revenue (-R, -SE) 1,051
Accrued member rewards (+L) 1,051
Accrued member rewards (-L) 988

Merchandise inventory (-A)* 988
*The Costco note does not say how the membership rewards are redeemed.
The entry above assumes that the rewards are redeemed for merchandise,
as is the case in many such situations. If, instead, the rewards are redeemed
for cash, the credit entry would be to cash and not merchandise inventory.

PROBLEMS
a. The following items might be considered to be operating:

1. Net Sales, cost of sales, R&D expenses, and SG&A expenses are
typically designated as operating.
2. Amortization of intangible assets and restructuring charges would usually
be considered to be operating under the assumptions that the acquisition
that gave rise to the intangible assets is included as part of operations,
and that the restructuring did not involve discontinuation of distinct parts of
the business.
3. The asbestos-related charge, restructuring charges and goodwill
impairment losses would be considered to be operating since they are
related to Dow Chemical’s operating activities. (These items are both
operating and nonrecurring – see b.)
4. Equity in earnings of nonconsolidated affiliates would be considered
operating under the assumption that the affiliates are related to Dow’s
core operations, which is typically the case.
5. Sundry income would generally be considered nonoperating in the
absence of a footnote clearly indicating its connection to the operating
activities of the company.
6. Interest income is considered nonoperating
7. Interest expense and amortization of debt discount is nonoperating.
b. The following items might be identified as nonrecurring items:

1. Asbestos-related charges – this is an accrual of an expense due to
increased asbestos-related liability related to Union Carbide Corporation,
a wholly-owned subsidiary of the company. More specifically, it is primarily
due to higher mesothelioma claim activity relative to forecasts of such
activity. GAAP requires such an accrual if the loss is probable and can be
reasonably estimated. Since it is a one-time occurrence, it can be
considered to be a transitory item.
2. Goodwill and other asset impairment losses – this loss results from
changes in expectations of the performance of past acquisitions. It would
be considered operating, but transitory.
3. Restructuring charges (credits) – the company had two significant
restructuring plans in 2012. The $3 million credit in 2014 represents an
adjustment to contract cancellation fees included as part of the 2012

restructuring plans. Restructuring costs are considered “special items,”
meaning that individually they are transitory, but as a category, they
happen frequently.

c. 2014 NOPAT: $3,839 – [($51 - $27 - $983) x (1-0.35)] = $4,462.35
NOPM: $4,462.35 / $58,167 = 7.67%
2013 NOPAT: $4,816 – [($2,554 + $41 - $1,101) x (1-0.35)] = $3,844.9
NOPM: $3,844.9 / $57,080 = 6.74%
P6-43. (20 minutes)
a. 1. Percentage-of-completion based on number of employees trained

Year 2016 2017 2018 Total
Number of employees
trained 125 200 75 400
Revenues (# trained x
$1,200) $150,000.00 $240,000.00 $90,000.00 $480,000.00
Expenses (# trained x
$437.50)* 54,687.50 87,500.00 32,812.50 175,000.00
Gross Profit $95,312.50 $152,500.00 $57,187.50 $305,000.00
* $437.50 = $175,000 / 400
2. Percentage-of-completion based on costs incurred

Year 2016 2017 2018 Total
Costs incurred $60,000 $75,000 $40,000 $175,000
Percentage
completed 34.29% 42.86% 22.86% 100.00%
Revenues (% x
$480,000) $164,571.43 $205,714.29 $109,714.29 $480,000.00
Expenses 60,000.00 75,000.00 40,000.00 175,000.00
Gross Profit* $104,571.43 $130,714.29 $69,714.29 $305,000.00
*Answers may vary due to rounding of percentage completed.
3. Completed contract method

Year 2016 2017 2018 Total
Revenues $0 $0 $480,000 $480,000
Expenses 0 0 175,000 175,000
Gross Profit $0 $0 $305,000 $305,000
b. Assuming that (1) Philbrick has a noncancelable contract that specifies the
price at $1,200 per employee, (2) the number of employees and the costs of
training can be estimated with a reasonable degree of accuracy, and (3) Elliot
Company is a reasonable credit risk, the best method would be to recognize
revenues using the percentage-of-completion method based on the number
of employees trained. The completed contract method should only be used if
either of the first two conditions is not met.

P6-44. (15 minutes)
a. Management would have an incentive to shift $1 million of income from the

current period into next. This might be accomplished by delaying revenue
recognition or accelerating expenses. This would increase their bonus by
$100,000 next year without decreasing the current bonus.
b. Management would have an incentive to shift $3 million of income from next

year into income reported this year. This would increase the current year
bonus by $300,000 without reducing next year’s bonus.
c. Management would have an incentive to shift income from the current year
into next year. Even though this would reduce earnings this year, earnings
are already so low that management does not expect to receive a bonus.
Shifting earnings into a future period increases the bonus in that period.
d. These incentives for earnings management would be mitigated if the “kinks”

in the bonus formula were removed. Alternatively, some companies pay
bonuses based on a three-year moving average of earnings to minimize the
impact of earnings management.
This problem can provide an opportunity to discuss the “slippery slope” of

earnings management. For example, management’s optimism about next year in
part b may not turn out to be warranted. Suppose next year’s “natural” earnings
turns out to be $20 million instead of $24 million. Management’s action in the
first year will have reduced next year’s $20 million to $17 million, and earnings
management would again be required to meet the target. And, if meeting the
target in one year causes the next year’s target to increase, things can get out of
control very quickly.

P6-45. (40 minutes)
($ millions)
a. Net receivables as of February 1, 2014 were $2,177.
b.
Bad debts expense (+E, -SE) 52
Allowance for credit losses (+XA) 52
Allowance for credit losses (-XA) 80

Accounts receivable (-A) 80
Cash (+A) 23
Allowance for credit losses (+XA) 23
+ Bad Debts Expense (E) - - Allowance for Credit Losses (XA) +

52 Balanc
85
e
80 52
23
80 Balanc
e

23 Balanc 2,184
e
80
Balanc 2,104
e
c. Estimated credit losses to gross credit card receivables are:
3.7% ($80/$2,184) in fiscal 2013

4.0% ($85/$2,142) in fiscal 2012
There is a slight decrease in the allowance for credit losses as a percent of

credit card receivables is reflected in the aging of Nordstrom’s receivables.
This could be caused by (1) a general improvement in economic conditions
(fewer customers are late or defaulting on their obligations), (2) tighter credit
policies (credit is denied to risky customers) and/or (3) more rigorous
collection practices. Another possible hypothesis in some cases might be that
managers are accruing less bad debts expense in order to increase earnings.

This does not seem to be the case here because their aging analysis of the
allowance does not reveal an increase in long-outstanding receivables.
d. The receivables turnover rate is $12,166 / [($2,177 + $2,129)/2] = 5.65

Days sales in accounts receivable is 365/5.65 = 64.6 days

P6-46. (25 minutes)
For the instructor:

This problem covers the accounting for product returns, which is not covered in
depth the chapter. The description of The Gap’s practices should allow students
to answer parts a and b. Part c is a bit of a stretch, because it requires that the
allowance for returns, which is in gross profit terms, be “grossed-up” to revenue
terms.
a. Beginning balance + $896 million - $897 million = $26 million, so Beginning

balance = $27 million.
b. Sale and expected returns:

(1) Record revenue. Cash (+A) 5,000
Revenue (+R,+SE) 5,000
(2) Record COGS. Cost of goods sold (+E,-SE) 3,000
Inventory (-A) 3,000
(3) Recognize Revenue contra, returns (+XR, -SE) 500
expected returns. COGS contra, returns (+XE, +SE) 300
Sales returns allowance (+L) 200
The sales returns allowance is equal to Gross sales ($5,000) times the
probability of return (10%) times the gross profit margin (40%), or $200. For
these ten units, the cost of goods was $300.
Returns:
(4) Process return Inventory (+A) 300
transactions. Sales returns allowance (-L) 200
Cash (-A) 500
At the conclusion of this transaction, the customers have their cash, the
inventory costs have been adjusted to include the returned items, and the
sales returns allowance liability has a balance of zero because the actual
returns coincided with the expected returns.

c. The Gap’s reported gross profit is 39.0% of its net sales ($6,293
million/$16,148 million). So, if The Gap expects returns of items with gross
profit of $896 million, those items must have had sales prices of $2,297
million ($896 million/0.390) and cost of goods sold of $1,401 million ($2,297
million - $896 million). The entry that would have reflected The Gap’s
accounting for these expected returns is the following:
Recognize expected Revenue contra, returns (+XR, -SE) 2,297

returns. COGS contra, returns (+XE, +SE) 1,401
Sales returns allowance (+L) 896
The Gap’s gross sales revenue would have been $18,445 million ($16,148
million + $2,297 million), and its expected returns as a percentage of sales
would be 12.5% ($2,297 million/$18,445 million).
The size of the allowance for 2013 ($896 million) relative to the end-of-year
return liability ($26 million) means that the vast majority of these product
returns occurred during the 2013 fiscal year, so it is more a reflection of actual
experience than of management’s estimates of future events.
d. Under these circumstances, The Gap doesn’t have to worry about accounting
for expected returns, because it has not satisfied the requirements for
revenue recognition. If the amount to be received (or in this case, the amount
to be kept) is not yet “fixed or determinable,” the revenue should not be
recognized until it is.
P6-47. (25 minutes)
a.
Fiscal Year Net Growth
Ending March 31 Revenue Rate
2005 3,129 –
2006 2,951 -5.7%
2007 3,091 4.7%
2008 3,665 18.6%
2009 4,212 14.9%
2010 3,654 -13.2%
2011 3,589 -1.8%
2012 4,143 15.4%
2013 3,797 -8.4%
2014 3,575 -5.8%

b.
Fiscal Year Deferred Purchases = Net
Ending Net Net Revenue Revenue + Change in Growth
March 31 Revenue (Liability) Deferred Net Revenue Rate
2005 3,129 0 3,129 –
2006 2,951 9 2,960 -5.4%
2007 3,091 32 3,114 5.2%
2008 3,665 387 4,020 29.1%
2009 4,212 261 4,086 1.6%
2010 3,654 766 4,159 1.8%
2011 3,589 1,005 3,828 -8.0%
2012 4,143 1,048 4,186 9.4%
2013 3,797 1,044 3,793 -9.4%
2014 3,575 1,490 4,021 6.0%
When companies defer revenue, there is a lag between customers’

purchases and the recognition of revenue on the income statement. When
customer purchases grow significantly (as they did in 2008) revenues grow in
subsequent years. When purchases fall off, we might expect revenues to fall
off in subsequent years (see 2009 and 2010). Purchases declined in 2011
but revenue grew significantly in 2012. One possible explanation here is that
in this case revenues are deferred for only six months, so if purchases picked
up in early 2012, these purchases would be recognized as sales revenue by
the end of the year. Some evidence consistent with this possibility is that
purchases grew in 2012 but the ending deferred revenue did not increase as
much, meaning more of that increase in purchases was recognized in 2012
than remained as deferred at the end of the year.
c. If customer purchases in 2014 are a leading indicator of revenue in 2015, we

would predict revenue growth for 2015.

CASES and PROJECTS
C6-48. (40 minutes)
a.
Cash (+A) 120,000
Sales revenue (+R, +SE) 60,000
Payable to merchant partners (+L) 60,000
b. Revenues were previously recorded at the full amount of the Groupon sale
($120,000 in a above) and the amount payable to the merchant partner was
recorded as an expense. This was changed in 2011 to record the sale of the
Groupon, net of the amount due to the merchant partner as revenue. The
effect of this change was that revenues and expenses were reduced by the
amount paid to the merchant partner. This did not alter the bottom line as net
income does not change. The NOPM ratio would increase due to the
decrease in revenue without a corresponding decrease in operating income.
c.
Sales revenue contra (-R, -SE) 6,000
Allowance for returns (+L) 6,000
Allowance for returns (-L) 6,000

Payable to merchant partners (-L) 6,000
Cash (-A) 12,000
d.
Cost of revenue (+E, -SE) 6,000
Allowance for returns (+L) 6,000
Allowance for returns (-L) 6,000

Cash (-A) 6,000
e. Groupon could wait to recognize revenue until the 60-day period to pay the
merchant partner has expired. By doing so, there would be no need to
estimate refunds that would involve reducing the payable or recovering a
refund from the merchant partner. Groupon would still need to estimate
refunds for any cancelation that might occur after the end of the 60-day period
when the merchant partner has been paid. This is when Groupon’s risk is
greatest, since it cannot recover any part of the refund from the merchant.
However, by waiting 60 days before recognizing the revenue (and estimating
the refunds) Groupon would likely have a better idea about the amount of
refunds that will likely occur.

C6-49. (30 minutes)
a. When Dell sells other companies’ software products, it is often as part of a

multiple-element sales agreement. For example, the customer may purchase
hardware, software, and customer support for one price. This is an example
of a bundled sale. Dell must allocate the sales price based on the relative fair
market value of each element. Revenue is recognized for each specific
element when it is clear that the element has been delivered and the revenue
is earned.
There are at least two possibilities for earnings management here. First, Dell
could misallocate the sales price. By allocating more of the price to hardware
and less to software, Dell may be able to manage when earnings are
reported. Second, Dell may be aggressive in applying the “earned and
realizable” criteria to each element, thereby prematurely recognizing revenue.
From the information provided, it appears that Dell was recognizing revenue
on software “resales” at the time of sale. However, most software is not truly
sold. Instead, the customer purchases a license to use the software. As a
result, Dell should have deferred part of the revenue and recognized it ratably
over the license period.
b. Extended warranties are typically sold separately from other products.

Therefore, the revenue should be deferred and recognized ratably over the
warranty contract period. Dell employees were apparently recording revenue
at the time of sale, or were recognizing the revenue over a shorter time period
than the contract period. As a result, revenues and income were overstated.
c. It is common for managers to have performance targets based on revenues

and earnings. This provides an incentive for these employees to take actions
to accelerate revenue recognition when it appears that targets may not be
met. On the other hand, in periods when revenues and earnings exceed the
targets, managers may delay revenue recognition until a future period. In this
way, they can “store up” revenues and earnings to meet future targets.
The key to preventing this type of abuse is the periodic audit of divisional
revenues and earnings. In addition, businesses spend a large amount of
resources trying to design incentive compensation plans that do not
encourage this type of abuse.
Note: Dell Inc. was publicly traded under the ticker symbol DELL until it was
taken private in October of 2013 by Michael Dell, the company’s founder, and
Silver Lake Partners.

C6-50. (45 minutes)
a. 2011:
i. Bad debts expense (+E, -SE) 13,989
Allowance for doubtful accounts (+XA, -A) 13,989
ii. Allowance for doubtful accounts (-XA, +A) 1,206

2012:
iii. Bad debts expense (+E, -SE) 2,111
Allowance for doubtful accounts (+XA, -A) 2,111
iv. Allowance for doubtful accounts (-XA, +A) 14,903

- Allowance for Doubtful Accounts (XA) ($000) +

Balanc 6,859 2010 Balance
e
Sales 13,989 (i)
(ii) 1,206
Balanc 19,642 2011 Balance
e
2,111 (iii)
(iv) 14,903
6,850 2012 Balance
b. 2011: $19,642 / ($168,310 + $19,642 + $65,664) = 7.7%

2012: $6,850 / ($171,561 + $6,850 + $48,612) = 3.0%
The extra provision for the Borders account significantly increased Wiley’s
allowance account for 2011.
c. If sales returns are material in amount and can be estimated with a

reasonable degree of accuracy, they should be estimated just as bad debts
are estimated. Sales revenue is debited for the estimated returns while an
allowance for returns is credited. One important difference is that with sales
returns (unlike bad debts) the customer returns the product to the company
and it is often returned to inventory. Hence, the amount of allowance for
returns is a net amount equal to the estimated gross profit on expected
returns.

d. To record estimated returns:
Sales revenue (est. sales returns) (-R, -SE) 112,948

Allowance for returns – A/R (+XA) 112,948
Allowance for returns – Inventory (+A) 17,761

Cost of sales (-E, +SE) 17,761
Allowance for returns – royalties payable (+XL) 12,286

Royalty expense (-E, +SE) 12,286
To record actual returns:

Allowance for returns – A/R (-XA, +A) 130,000
Inventory (+A) 20,000

Allowance for returns – Inventory (-A) 20,000
Royalties payable (-L) 13,963

Allowance for returns – Royalties payable (-XL) 13,963
The net amount reported in the allowance for returns consists of three
separate amounts – one offsetting accounts receivable (a contra asset) an
amount added to inventory (an adjunct asset) and a third amount offsetting
royalties payable (a contra liability):
Allowance for returns – A/R: $65,664 + $112,948 - $130,000 = $48,612

Allowance for returns – Inventory: $9,485 + $17,761 - $20,000 = $7,246
Allowance for returns – Royalties: $7,270 + $12,286 - $13,963 = $5,593
Note that $130,000 - $20,000 - $13,963 = $96,037, and $112,948 - $17,761 -

$12,286 = $82,901.
When these three accounts are combined, we get the net amount reported in
the allowance for returns each year.
e. Accounts receivable turnover : $1,782,742 / [($171,561 + $168,310)/2] = 10.5

times.
Average collection period: 365 / 10.5 = 34.8 days.

C6-51 (20 minutes)
a. Restructuring charges are reported as part of operating income. A liability
is recorded on the balance sheet.
b. A financial analyst generally should treat these costs as nonrecurring in

nature. Thus, when forecasting future earnings the analyst would
generally not expect another restructuring.
c. Management may have incentives to overstate restructuring charges in

some cases. If the charges are overstated, the manager will expense
more as restructuring costs (and record a larger liability) than they really
expect. If the company does not actually have cash outlays in future
periods equivalent to the accrued liability related to the restructuring
charge, the liability that was recorded will need to be reversed. In the
period in which that occurs, recorded income will be higher than it
otherwise would be, perhaps helping managers meet an earnings target.
On the other hand, management may have incentives to understate
restructuring charges in some cases. If they do not want the current period
earnings to be too low (relative to some target, or if the managers are
nearing the end of their working horizon) then they may record too low of
costs for restructuring. However, this will make it harder to reach future
targets because if the actual cash outlays turn out to be higher than the
costs they accrue, additional expenses will need to be recorded in future
years.
Revised 07.21.16
Chapter 7
Reporting and Analyzing Inventory

Cases
Mini-
Exercises
Projects
13 - 15, 17

LO1 – Interpret disclosures of
information concerning
operating expenses, including
manufacturing and retail
inventory costs.

LO2 – Account for inventory 26, 27,

and cost of goods sold using 18 - 21, 23 33, 34, 36 37, 38
29 - 31
different costing methods.
LO3 – Apply the lower of cost

or market rule to value 24 28
inventory.
LO4 – Evaluate how inventory

costing affects management
decisions and outsiders’ 18 26, 29 - 31 33, 34, 36 37, 38
interpretations of financial
statements.
LO5 – Define and interpret

gross profit margin and
inventory turnover ratios. Use 16, 22 25, 31, 32 33 - 35 37
inventory footnote information
to make appropriate
adjustments to ratios.
LO6 – Appendix 7A: Analyze

LIFO liquidations and the 36 37
impact they have on the
financial statements.

QUESTIONS
Q7-1. When company A purchases inventory from company B, the buyer and
seller must agree on which firm is responsible for the transportation
costs. The terminology “freight on board shipping point” or FOB is used
to indicate the buyer assumes responsibility for the transportation cost
once notice of delivery to the shipper is received. In addition, the buyer
assumes responsibility for any delay or damage during transit.
When goods are shipped FOB, the seller normally can recognize
revenue unless the seller has not fulfilled all requirements of the
purchase agreement. An example is when an equipment installation
and/or up-and-running properly is part of that agreement.
Q7-2. If stable purchase prices prevail, the dollar amount of inventories
(beginning or ending) tends to be approximately the same under different
inventory costing methods and the choice of method does not materially
affect net income. To see this, remember that FIFO profits include holding
gains on inventories. If the inflation rate is low (or inventories turn quickly),
there will be less holding (inflationary) profit in inventory.
Q7-3. FIFO holding gains occur when the costs of earlier inventory acquisitions
are matched against current selling prices. Holding gains on inventories
increase with an increase in the inflation rate and a decrease in the
inventory turnover rate. Conversely, if the inflation rate is low or inventories
turn quickly, there will be less holding (inflationary) profit in inventory.
Q7-4. (a) Last-in, first-out, (b) Last-in, first-out, (c) First-in, first-out, (d) First-in,
first-out, (e) Last-in, first-out.
Q7-5. A significant tax benefit results from using LIFO when costs are
consistently rising. LIFO results in lower pretax income and, therefore,
lower taxes payable, than other inventory costing methods.
Q7-6. Kaiser Aluminum Corporation is using the lower of cost or market (LCM)
rule. When the replacement cost for inventory falls below its (FIFO or
LIFO) historical cost, the inventory must be written down to the lower
replacement costs (market value).
Q7-7. The various inventory costing methods would produce the same results
(inventory values and cost of goods sold) if prices were stable. The
inventory costing methods produce differing results when prices are
changing.
Q7-8. Inventory “shrink” refers to the loss of inventory due to theft, spoilage,
damage, etc. Shrink costs are part of cost of goods sold but do not
represent goods that were actually sold.

Q7-9. The “LIFO reserve” is the difference between the cost of inventory
determined using the last-in, first-out (LIFO) method and the cost
determined using another method (either FIFO or average cost).
Companies that report inventory cost using the LIFO method must also
report the LIFO reserve. This allows the financial statement reader to
convert from LIFO to another method for comparison purposes.
The LIFO reserve represents the difference between the historical, LIFO
cost of inventory and its current cost. This disparity between the book
value and the current value represents a gain from holding the inventory
that has not yet been recognized in income or in equity ̶ an unrealized
holding gain.
Q7-10. Because LIFO assigns the last units purchased during the year to cost of
goods sold (COGS), changing prices can make it difficult to forecast
earnings. Companies have discretion as to when and how much inventory
they purchase during an accounting period. LIFO is always applied on a
periodic, annual basis, so a purchase made during the final days of the
year will end up in COGS and affect current earnings. However, if that
purchase is delayed until the first week of the next year, it could be several
years before those units are transferred to COGS. Unlike other inventory
methods, LIFO requires that the quantity and price of inventory purchases
be predicted to make accurate earnings forecasts.
Q7-11A. LIFO liquidation is involuntary when it is caused by events that are beyond
management’s control. Examples of such events include labor strikes,
natural disasters, or wars which could interrupt the delivery of inventory by
suppliers or shut down production facilities.
Q7-12A. In periods of rising prices, LIFO liquidation results in older, lower-cost
goods being expensed as cost of goods sold, yielding higher profits. This
may be the result of a management decision to reduce inventory levels for
efficiency purposes. However, it may also be an earnings management
tactic. Management may be trying to avoid violating bond covenants, or it
may be trying to manipulate management compensation. In any case, this
practice is costly, in that the additional profits lead to higher income taxes.

MINI EXERCISES
M7-13. (15 minutes)
The cost to be assigned to the inventory is $535 ($500 + $30 + $5).
+ Inventory (A) - - Accounts Payable (L) +

(a) 500 30 (b)
(b) 30 10 (c)
(d) 5 5 (d)
- Notes Payable (L) + + Interest Expense, Discounts Lost (E)

-
500 (a) (c) 10
M7-14. (15 minutes)
The only cost that should be included in inventory is the cost of merchandise to
be sold.
M7-15. (20 minutes)
RAW MATERIALS INVENTORY

Beginning inventory $ 0
Purchases + 84,000
Materials used - 63,000
Ending inventory $ 21,000
WORK IN PROCESS INVENTORY

Materials used + 63,000
Labor costs + 58,000
Overhead costs + 28,000
Cost of goods produced - 130,000
FINISHED GOODS INVENTORY

Cost of goods produced + 130,000
Cost of goods sold - 95,000


M7-16. (10 minutes)
$74,331 -22,746
2014: = 0.694
$74,331
$71,312 -22,342
2013: = 0.687
$71,312
$67,224 -21,658
2012: = 0.678
$67,224
M7-17. (15 minutes)
a. Purchases are understated. If ending inventory is correctly valued, cost of

goods sold will also be understated and current income will be overstated.
There would be no effect in the following year.
If, however, ending inventory is understated (due to the mistakenly recorded

purchase) then there is no effect on income in either period.
b. Purchases are overstated. The effect on income, assuming normal inventory

levels, depends on the inventory costing system being used by the company.
Assuming rising prices, income would be reduced in the current year under
LIFO or average costing but unaffected under FIFO costing. Income in the
following year would not be affected. (The solution assumes the error is not
discovered and corrected in the current year.)
c. Shrink (part of cost of goods sold) is overstated and ending inventory is

understated. Consequently, current period income is understated. If the
inventory is counted correctly the following year, the error will reverse itself
and income will be overstated. This is an example of a “self-correcting”
inventory error.

M7-18. (20 minutes)
a. Balance Sheet , December 2016

Assets
Cash $12,000
Inventory 50,000
Shareholders’ equity
Contributed capital $62,000
b. All monetary amounts in $ thousands.
Year 2017 2018 2019

Income statement:
Revenue 75 85 95
COGS-FIFO 50 60 70
Earnings before tax 25 25 25
Tax expense 10 10 10
Net income 15 15 15
Cash flows:
Receipts 75 85 95
Inventory purchases -60 -70 -80
Tax payments -10 -10 -10
Cash from 5 5 5
operations
Dividends -9 -9 -9
Cash from financing -9 -9 -9
Net change in cash -4 -4 -4
Balance sheet:
Assets
Cash 8 4 0
Inventory 60 70 80
Total 68 74 80
Contributed capital 62 62 62
Retained earnings 6 12 18
Total 68 74 80
Clearly there is a problem with this business model. The company is showing
profits, and assets and retained earnings are increasing. However, there is a
cash flow problem. The net change in cash every year is -$4 thousand and,
by the end of 2019, the company would have a cash balance of zero. In

2020, it would not be possible to replenish the inventory and to pay the
dividend.

c. All monetary amounts in $ thousands.
Year 2017 2018 2019

Income statement:
Revenue 75 85 95
COGS-LIFO 60 70 80
Earnings before tax 15 15 15
Tax expense 6 6 6
Net income 9 9 9
Cash flows:
Receipts 75 85 95
Inventory purchases -60 -70 -80
Tax payments -6 -6 -6
Cash from operations 9 9 9
Dividends -9 -9 -9
Cash from financing -9 -9 -9
Net change in cash 0 0 0
Balance sheet:
Assets
Cash 12 12 12
Inventory 50 50 50
Total 62 62 62
Contributed capital 62 62 62
Retained earnings 0 0 0
Total 62 62 62
Interestingly, the use of LIFO reduces profits, and the company’s reported
assets (and net assets) are not growing like the FIFO case above. However,
the cash flow situation is improved. The company can pay the desired
dividends and continue to replace its inventory at the end of every year. The
difference between LIFO and FIFO is that FIFO profits include a gain from
holding inventory while prices are rising. When the company is taxed on that
gain, it has less cash available to maintain its physical assets (inventory). In
essence, paying taxes based on FIFO (when inventory costs are increasing)
can cause a firm’s ability to stay in business to be taxed away. LIFO profits
exclude holding gains, so the company could continue to stay in business.
(The tax authorities will “catch up” when the business decides to stop
investing in inventory, and the LIFO liquidation profits get taxed.)

M7-19. (20 minutes)
a. FIFO cost of goods sold = 1,000 @ $100 + 700 @ $150 = $205,000

FIFO ending inventories = $400,000 - $205,000 = $195,000
b. LIFO cost of goods sold = 1,700 @ $150 = $255,000

LIFO ending inventories = $400,000 - $255,000 = $145,000
c. AC cost of goods sold = 1,700 @ $400,000/3,000 = $226,667

AC ending inventories = $400,000 – $226,667 = $173,333
M7-20. (15 minutes)
a. $1,320,000 + purchases - $6,980,000 = $1,460,000; purchases = $7,120,000.
b.
1. Inventory (+A) 7,120,000
Cash or Accounts payable (-A or +L) 7,120,000
2. Cost of goods sold (+E, -SE) 6,980,000

Inventory (-A) 6,980,000
c.
+ Cash (A) - + Cost of Goods Sold (E) -
7,120,00 (1) (2) 6,980,00
0 0
+ Inventory (A) -
Balance 1,320,00
0
(1) 7,120,00
0
6,980,00 (2)
0
Balance 1,460,00
0
d.
Transaction Cash + Noncash = Liabi- + Contrib+ Earned Revenue - Expense = Net

Asset Assets lities . Capital s s Income
Capital
a. Purchase inventory. -7,120,000 +7,120,000
= - =
Cash Inventory
c. Cost of inventory sold. -6,980,000 -6,980,000 +6,980,000 -6,980,000
Inventory = Retained - Cost of =
Earnings Goods Sold

M7-21. (10 minutes)
a. FIFO cost of goods sold = 400 @ $10 + 200 @ $12 = $6,400

FIFO ending inventories = $12,400 - $6,400 = $6,000
b. LIFO cost of goods sold = 600 @ $12 = $7,200

LIFO ending inventories = $12,400 - $7,200 = $5,200
c. AC cost of goods sold = 600 @ $12,400/1,100 = $6,764

AC ending inventories = $12,400 – $6,764 = $5,636
M7-22. (20 minutes)
a.
Inventory Turnover-2014 Inventory Turnover-2013
Wal-Mart 358/[(44.9+43.8)/2] = 8.07 352/[(43.8+40.7)/2] = 8.33
Target 51.3/[(8.79+8.28)/2] = 6.01 50.0/[(8.28+7.90)/2] = 6.18
b. Wal-Mart’s inventory turnover rate is higher than Target’s. There can be

several reasons for this. Wal-Mart’s product lines may be oriented toward
lower-margin/higher-turnover goods (Wal-Mart does report a lower gross
profit margin than Target). Both companies had slight decreases in turnover
rates from 2013 to 2014. At the end of 2014, both companies hold roughly the
same, or slightly more, inventory than in the prior year, possibly in anticipation
of increased sales in 2015 (or the addition of new products).
c. Inventory turns improve as the dollar volume of goods sold increases relative
to the dollar volume of goods on hand. Inventory reductions can be realized
by reducing the depth and breadth of product lines carried (e.g., not every
style, size and color), eliminating slow-moving product lines, working with
suppliers to arrange for delivery when needed rather than inventorying for a
longer holding period, and marking down goods for sale at the end of product
seasons.
Retailers must balance the cost savings from inventory reductions against the
marketing implications of lower inventory levels on hand. It would be possible
to stock only those items that turn over very quickly, but those items may
have low margins. Or, there may be items that turn over slowly, but have
sufficient margins to make offering them attractive, even though it reduces
inventory turnover. Whenever ratios are used as incentive measures, it is
important to recognize that they may cause “cherry-picking” of only those
activities that provide the highest ratio outcome.

M7-23. (15 minutes)
a. Cost of goods sold (+E, -SE) 142,790,000

Inventory (-A) 142,790,000
b.
+ Inventory - + Cost of Goods Sold -
Balance 25,790,00 (a) 142,790,0
0 00
142,790,00 (a)
0
(c) 140,560,0
00
Balance 23,560,00
0
c. Inventory (+A) 140,560,000

Cash or Accounts payable (-A or +L) 140,560,000
d. ($000)
Noncas Contrib
Transacti Cash Liabil- Earned Revenue Expense Net
+ h = + . + - =
on Asset ities Capital s s Income
Assets Capital
c. Purchase -140,560 +140,560
inventory Cash Inventory = - =
a. Cost of -142,790 -142,790 +142,790 -142,790

inventory sold Inventory = Retained - Cost of =
Earnings Goods Sold
M7-24. (10 minutes)
a. (60 x $45) + (210 x $34) + (300 x $20) + (100 x $27) = $18,540
b. Cost: (60 x $45) + (210 x $38) + (300 x $22) + (100 x $27) = $19,980
Market: (60 x $48) + (210 x $34) + (300 x $20) + (100 x $32) = $19,220
Therefore, the ending inventory balance should be $19,220.

EXERCISES
E7-25. (45 minutes)
a. Fiscal year 2013:

Gross profit margin = ($663 – $472) ÷ $663 = 28.8%
Inventory turnover ratio = $472 ÷ [($189 + $203) ÷ 2] = 2.41 times
Fiscal year 2014:

Gross profit margin = ($676 – $483) ÷ $676 = 28.6%
Inventory turnover ratio = $483 ÷ [($203 + $214) ÷ 2] = 2.32 times
b.
Gross
Fiscal Year Quarter Gross Profit Profit Margin
1 $ 25 21.9%
2 88 37.1%
2013
3 57 29.5%
4 21 17.6%
1 25 22.1%
2 82 34.7%
2014
3 59 29.9%
4 27 20.8%
The gross profit and gross profit margin numbers show that West Marine is
significantly more profitable in the second and third quarters. The revenues
from these quarters are 50% - 100% higher than the other quarters and the
gross profit from quarters two and three is sometimes more than three times
that of quarters one and four. Unlike many retailers, who make most of their
sales and profits in the fourth calendar quarter, West Marine must discount its
prices and run promotions in order to generate sales in the first and fourth
quarters.
c. Inventory is lowest at the end of the fiscal year. At the end of the first quarter
(end of March), inventory has increased in anticipation of the busy second
quarter, and inventory stays high through the second quarter (end of June).
By the end of September (third quarter), inventory has declined, and it
continues to decline through the fourth quarter.
It is common for seasonal businesses to choose fiscal year-ends when

inventories (and other balances like receivables) are lower. But it can mean
that annual ratios (like those calculated in part a) do not reflect the inventory
investment that was necessary to generate the sales reported for the year.
Understanding these seasonal effects can be important for cash management
over the year.

d. One approach to calculating an inventory turnover ratio is to use an “average
of averages” approach. For the first quarter of 2013, the average inventory
was ($189 + $238) / 2 = $213.5. Follow the same process to determine the
average inventory for quarters two, three and four. Then average the
averages. The effect of this process is the following:
2013: Weighted average inventory = [189 + 2x(238 + 237 + 217) + 203)] / 8 =

$222
2014: Weighted average inventory = [203 + 2x(245 + 244 + 215) + 214)] / 8 =

$228
The weighted average inventory levels are greater than the simple annual
averages for both years because the fiscal year-end is set when inventory is
predictably low. When these inventory values are divided into annual cost of
goods sold, the inventory turnover ratios are lower than those calculated in
part a.
Weighted average inventory turnover ratio:
2013: $472 / $222 = 2.1 times
2014: $483 / $228 = 2.1 times
E7-26. (30 minutes)
Units Cost
Beginning Inventory 1,000 $ 20,000
Purchases: #1 1,800 39,600
#2 800 20,800
#3 1,200 34,800
Goods available for sale 4,800 $115,200
Units in ending inventory = 4,800 – 2,800 = 2,000
a. First-in, first-out
Units Cost Total
1,200 @ $29 = $34,800
800 @ $26 = 20,800
Ending Inventory 2,000 $55,600
Cost of goods available for sale $115,200

Less: Ending inventory 55,600

b. Last-in, first-out
Units Cost Total
1,000 @ $20 = $20,000
1,000 @ $22 = 22,000
Ending inventory 2,000 $42,000

c. Average cost
$115,200/4,800 = $24 average unit cost
2,000 x $24 = $48,000 ending inventory
$115,200 - $48,000 = $67,200 cost of goods sold (or 2,800x$24)
d. 1. The first-in, first-out method in most circumstances represents physical flow.

This inventory system applies to perishables or to situations in which the
earliest items acquired are moved out first because of risk of deterioration or
obsolescence.
2. Last-in, first-out results in the lowest inventory amount during periods of

rising unit costs, which in turn results in the lowest net income and the
lowest income tax.
3. The first-in, first-out results in the lowest cost of goods sold in periods of
rising prices. This is the inventory method Chen should use to report the
largest amount of income. Of course, this assumes that prices will continue
to rise. Companies cannot change inventory costing methods without
justification, and the change may be prohibited by tax laws as well.

E7-27. (25 minutes)
Units Cost Total

Beginning inventory 100 @ $46 = $ 4,600
Purchases: Purchase #1 650 @ 42 = 27,300
Purchase #2 550 @ 38 = 20,900
Purchase #3 200 @ 36 = 7,200
Cost of goods available for sale 1,500 $60,000
a. First-in, first-out
Units Cost Total
200 @ $36 = $ 7,200
150 @ 38 = 5,700
Ending inventory .................................. 350 $12,900
Cost of goods available for sale .......... $60,000

Less: Ending inventory ........................ 12,900
Cost of goods sold ............................... $47,100
b. Average cost
Cost of Goods Available for Sale/Total Units Available for Sale
= $60,000/1,500 = $40 Average Unit Cost
Ending Inventory = 350 units x $40 = $14,000

Cost of goods sold $46,000
c. Last-in, first-out
Units Cost Total
100 @ $46 = $
4,600
250 @ 42 =
10,500
Ending inventory 350
$15,100
Cost of goods available for sale
$60,000
Less: Ending inventory
15,100
Cost of goods sold
$44,900

E7-28. (20 minutes)
a. 1. (70 x $190) + (45 x $268) + (20 x $350) + (120 x $60) + (80 x $88) + (50 x
$126)
= $52,900.
2. Desks: (70 x $190) + (45 x $280) + (20 x $350) = $32,900

(70 x $210) + (45 x $268) + (20 x $360) = $33,960
Chairs: (120 x $60) + (80 x $95) + (50 x $130) = $21,300

(120 x $64) + (80 x $88) + (50 x $126) = $21,020
Therefore, inventory would be reported at $32,900 + $21,020 = $53,920.
3. (70 x $190) + (45 x $280) + (20 x $350) + (120 x $60) + (80 x $95) + (50 x
$130)
= $54,200
(70 x $210) + (45 x $268) + (20 x $360) + (120 x $64) + (80 x $88) + (50 x
$126)
= $54,980
Therefore, inventory would be reported at $54,200.
b. Applying the lower of cost or market rule to individual items in inventory

results in the lowest inventory amount, the highest cost of goods sold and the
lowest net income. Under either of the other two methods, the inventory may
be valued at the higher of cost or market for some items in inventory.
E7-29. (20 minutes)
a. $13,042 million
b. $14,275 million
c. Pretax income has been reduced by $1,233 million cumulatively since GM

adopted LIFO inventory costing. This is because it has matched current
inventory costs against current selling prices, thus avoiding the recognition of
holding gains that would have resulted had FIFO inventory costing been
used. If LIFO has put $1,233 million less into ending inventory than FIFO, it
must have put $1,233 more into cost of goods sold than FIFO.
d. Pretax income has been reduced by $1,233 million (see part c). Assuming a
35% tax rate, taxes have been reduced by $1,233 x 0.35 = $431.6 million.
Cumulative taxes were decreased by the use of LIFO inventory costing.

e. During this period GM was experiencing declining earnings while inventory
costs were not keeping pace. Under these conditions, FIFO reporting
mitigates the effect on income.

E7-30. (25 minutes)
a. $4,935 million
b. $6,464 million. The FIFO inventory carrying amount is greater than the LIFO
carrying amount, which is common. It implies Deere’s current inventory costs
are rising. We cannot blindly assume that inventory costs always rise,
however. When costs decline as is true in the computer chip industry
(generally not on LIFO) or in the past year in the oil and gas industry
(generally on LIFO), a lower FIFO carrying amount can occur. However, if
prices fall for so long and to such an extent that the FIFO carrying amount is
lower than the LIFO carrying amount the company would have to consider
switching off of LIFO onto FIFO.
c. Pretax income has been decreased by $1,529 million cumulatively since

Deere adopted LIFO inventory costing. This result occurs because higher
current inventory costs are matched against current selling prices, thus
avoiding the recognition of holding gains that would have resulted had FIFO
inventory costing been used.
d. Pretax income has been decreased by $1,529 million (see part c). Assuming
a 35% tax rate, taxes have been decreased by $1,529 x 0.35 = $535.2
million.
e. Cumulative taxes have been decreased by use of LIFO inventory costing.
f. For 2013, the change in the LIFO reserve is an increase of $108 million.
Pretax income has been decreased by this amount, thus decreasing taxes by
$108 million x 0.35 = $37.8 million.
g. Observation: If Deere’s inventory were at some future date to be more highly

valued under LIFO than under FIFO, the company could reduce its tax
expense by switching to FIFO costing. This is, however, unlikely for Deere or
other industries facing continued price increases or even essentially constant
prices.
h. In 2014, Deere liquidated some LIFO layers, meaning that it sold more
inventory than it bought (of a certain type) and thus older costs assigned
previously assigned to inventory are now assigned to cost of goods sold as
that inventory is sold. In periods of rising costs that means old, lower costs
are assigned to cost of goods sold and matched with revenues from the
current period. As a result, higher profits are recorded than would have been
recorded if new inventory (purchased at higher prices) would have been
bought and assumed to have been sold. Companies are required to disclose
this when it happens because it shows a higher profit merely for depleting
inventory layers. Deere states that they recorded $13 million in pretax profit
attributable to such LIFO liquidations in 2014.

E7-31. (20 minutes)
a. ($ millions)
$414 + Purchases - $9,150 = $441. Purchases = $9,177.
b.
($ millions) As reported (LIFO) Pro forma (FIFO)
Sales revenue $14,194 $14,194
Cost of goods sold 9,150 9,134
Gross profit $ 5,044 $ 5,060
$9,150 - ($48 - $32) = $9,134
c. As reported (LIFO): $5,044 / $14,194 = 35.5%

Pro forma (FIFO): $5,060 / $14,194 = 35.6%
The small differences between LIFO and FIFO reflect both the rate of price
change for Whole Foods’ inventories and the fact that its inventory moves
through very quickly (about 21 times per year).
E7-32. (30 minutes)
a.
Tiffany Zale Blue Nile
2013 2012 2013 2012 2013 2012
Revenue $4,031 $3,794 $1,888 $1,867 $450 $400
COGS 1,691 1,631 904 906 366 325
Gross profit 2,340 2,163 984 961 84 75
Gross profit margin 58.1% 57.0% 52.1% 51.5% 18.7% 18.8%
(GPM)
b.
Tiffany Zale Blue Nile
2013 2013 2013
COGS 1,691 904 366
Average inventory 2,280.5 755 34
Inventory turnover 0.74 1.20 10.76
Average inventory 2,280.5 755 34

Average daily COGS 4.63 2.48 1.00
AIDO 492 304 34

c. The financial crisis led to declining sales in the jewelry industry. These three
companies have seen slightly increasing sales since 2011. The companies
have experienced pretty stable or slightly increasing GPMs in 2013.
A turnover value of 0.74 means that Tiffany holds an item in inventory for 492
days (on average) before sale. Zale’s inventory turnover ratio is quicker.
Inventory turnover ratios are also affected by the cost flow assumption.
Tiffany uses average cost, Zale’s uses LIFO and Blue Nile uses specific
identification, probably close to average cost. Zale’s LIFO reserves were $63
million in 2013 and $58.3 million in 2012.
As an Internet retailer, Blue Nile earns a significantly lower gross profit on
every dollar of sales, but its volume of sales is very high relative to its
inventory. Compared to Tiffany’s 492 days’ inventory, Blue Nile has 34 days’
inventory. One of the ways that Blue Nile keeps its turnover high can be seen
in the following from their 2013 10-K. “The Company also lists loose
diamonds on its websites that are typically not included in inventory until the
Company receives a customer order for those diamonds. Upon receipt of a
customer order, the Company purchases a specific diamond and records it in
inventory until it is delivered to the customer, at which time the revenue from
the sale is recognized and inventory is relieved.” Blue Nile does not disclose
the amount of such “consignment” or “agency” diamonds. Zale discloses
consignment inventories of $149.1 million and $118.4 million at the end of
2013 and 2012, respectively. Tiffany’s financial reports make no mention of
consignment inventories.
d. Zale has saved 0.35 x $63 = $22.1 million in taxes to date by using LIFO. Of
this amount, 0.35 x ($63 - $58.3) = $1.65 million for the year ending July 31,
2013.

PROBLEMS
P7-33. (25 Minutes)
a. Caterpillar: $40,727/[($15,547 + $12,625)/2] = 2.89

Komatsu: ¥1,393,048/[(¥633,647 + ¥625,077)/2] = 2.21
As calculated, Caterpillar’s turnover is about 0.68 times faster than
Komatsu’s, and there is a 39-day difference in the companies’ average
inventory days outstanding. This difference could be attributed to differential
production efficiencies or to differential component sourcing strategies.
Perhaps, Caterpillar purchased more components from outside suppliers.
b. When there are no LIFO liquidation effects, changes in the LIFO reserve can
be attributed to changes in the company’s costs. Caterpillar’s LIFO reserve
decreased in 2013, implying that its costs probably decreased. Note that
between the end of 2011 to the end of 2012 the LIFO reserve increased
suggesting that prices probably increased during 2012.
c. Pretax income has been reduced by $2,504 million cumulatively since CAT
adopted LIFO inventory costing. This is because it has matched current
inventory costs against current selling prices, thus avoiding the recognition of
holding gains that would have resulted had FIFO inventory costing been
used. Each year, the difference between FIFO cost of goods sold and LIFO
cost of goods sold is added to the LIFO reserve.
Assuming a 35% tax rate, cumulative taxes have been reduced by $2,504 x
0.35 = $876.4 million by the use of LIFO inventory costing.
d. For 2013, the change in the LIFO reserve is a decrease of $246 million
($2,504 million - $2,750 million). Pretax income has been increased by this
amount (relative to FIFO), thus increasing taxes by $246 million x 0.35 =
$86.1 million.
e. Komatsu’s use of specific identification probably approximates a FIFO

inventory costing method. As a result, the comparison in part a above is not
valid because Caterpillar’s use of LIFO produces distortions. We should use
the LIFO reserve information to construct Caterpillar’s inventory turnover
based on FIFO.
FIFO 2013 cost of goods sold = $40,727 – ($2,504 – $2,750) = $40,973
FIFO 2013 average inventory = [($12,625 + $2,504)+($15,547+$2,750)]÷2 =
$16,713
FIFO 2013 inventory turnover = $40,973 ÷ $16,713 = 2.45 times

So, Caterpillar’s inventory turnover is only 0.24 times faster than Komatsu’s
once we take into account the differences in their inventory cost flow
assumptions.

P7-34. (20 minutes)
a. $6,933 million - $1,245 million = $5,688 million
b. $1,245 million
c. $1,245 million x 0.35 = $ 435.8 million
d. $1,728 million + [($1,245 million - $1,150 million) x (1 - 0.35)] = $1,789.8

million
e. $85,512 / [($5,688 + $5,651) / 2] = 15.08
f. [$85,512 - ($1,245 - $1,150)] / [($6,933 + $6,801) / 2] = 12.44
P7-35. (30 minutes)
a.
Samsung Hewlett-Packard Apple
2014 2013 2012 2014 2013 2012 2014 2013 2012
Revenue 206,205,987 228,692,667 201,103,613 $73,726 $72,398 $77,887 $182,795 $170,910 $156,508
COGS 128,278,800 137,696,309 126,651,931 56,469 55,632 59,468 112,258 106,606 87,846
Gross
77,927,187 90,996,358 74,451,682 17,257 16,766 18,419 70,537 64,304 68,662
profit
Gross
profit
37.8% 39.8% 37.0% 23.4% 23.2% 23.6% 38.6% 37.6% 43.9%
margin
(GPM)
b.
2014 2013 2014 2013 2014 2013
COGS 128,278,800 137,696,309 56,469 55,632 112,258 106,606
Average ending 18,226,186 18,441,140.5 6,230.5 6,181.5 1,937.5 1,277.5
inventory
Inventory turnover 7.0 7.5 9.1 9.0 57.9 83.4

2014 2013 2014 2013 2014 2013
Average ending 18,226,186 18,441,140.5 6,230.5 6,181.5 1,937.5 1,277.5
inventory
Average daily 351,449 377,250 155 152 307 292
COGS

AIDO 52 49 40 41 6 4

c. Gross profit margins reflect the companies’ cost control and their relative
ability to create differentiated products. Samsung is a heavy spender on
research and development (R&D), in 2014 the company spent a little over 6%
of its sales revenues on research and development costs. Hewlett-Packard
spends about 3% of total revenue (4.7% of product revenue). Apple’s R&D is
currently 3.3% of revenues..
Inventory turnover is much higher at Apple. This may be tied to Apple’s

practice of outsourcing a great deal of its production to third party
manufacturers in Asia. In fact, Apple reports “The Company’s inventories
consist primarily of finished goods for all periods presented.” In addition,
Apple seems willing to be out of stock following new product releases
meaning they do not hold as much inventory at any particular time.

($ thousands)
a. Inventories as a percent of current assets follow:

77% ($451,250/$584,059) of current assets in 2014
79% ($479,730/$606,773) of current assets in 2013
As long as Seneca has sufficient product to meet demand, the reduction of
inventories reflects a positive development as it likely represents more
efficient manufacturing processes. The reduction of inventories might be of
concern, however, if Seneca is facing price declines, crop yield decreases
due to weather, a demand slowdown forcing the company to dispose of
perishable product, or financial difficulty in securing sufficient harvesting labor
or to purchase the raw materials necessary for production.
b. The inventory turnover rate follows:

$1,249,245 $1,134,985
2014: = 2.68 2013: = 2.49
$451,250 + $479,730 $479,730 +$432,433
2 2
The inventory turnover rate has increased slightly from 2013 to 2014. This
increase is positive because it represents increased manufacturing/retailing
efficiency.

c. Seneca uses the LIFO inventory costing method. The effect of LIFO was to
reduce net earnings by $13.2 million relative to if the firm had used FIFO in
2014. This is because LIFO records newer (higher) costs in cost of goods
sold which makes income lower.
The company states that during 2014, the company liquidated some LIFO
inventory. As a result, the company showed an increase in earnings in the
amount of $4.8 million. In other words, the company sold inventory that it has
assigned costs from a prior period -- lower costs – thus making cost of goods
sold lower and income higher.
d. Seneca’s use of LIFO has led to a reduction of its taxes as indicated by the
$153 million amount in the LIFO reserve. Seneca’s cash savings due to the
use of assuming a constant tax rate of 35% amount to $53.6 million = $153M
X (0.35).

CASES and PROJECTS
C7-37.A (30 minutes)
a. In the year 2014, Exxon’s pretax earnings would be lower by the change in
the LIFO reserve because the reserve decreased. In 2014, the LIFO reserve
decreased from $21.2 billion to $10.6 billion, for a decrease of $10.6 billion.
The 2014 pretax income that would have been reported if FIFO had been
used would thus be $51.63 billion - $10.6 billion = $41.03 billion. Note: The
decline in the LIFO reserve is likely due to falling oil (and oil product) prices in
the last year. As a result, the LIFO cost (replacement cost or current cost) in
cost of goods sold is much lower than the year before, for example. In
addition, the amount of the difference between inventory valued using LIFO
and inventory valued using FIFO becomes much smaller (because the FIFO
costs in inventory (recent purchases) are now closer to the very old LIFO
costs in inventory).
b. The inventory turnover would be as follows:

$225,972
[($12,384+$4,294)+($12,117+$4,018)]/2 = 13.77
c. BP’s inventory turnover is calculated as follows:
$281,907
= 11.84
($18,373+$29,231)÷2
d. Based on calculations from their financial statements, it appears that Exxon

Mobil’s inventory turns over more quickly than BP’s. However, Exxon Mobil’s
use of LIFO makes such a comparison invalid, because BP is not allowed to
use LIFO under IFRS. To make a better comparison, we adjust Exxon
Mobil’s inventory turnover ratio to FIFO. In 2014 there was a decline in the
LIFO reserve, so we need to increase the cost of goods sold by the decrease
in the LIFO reserve and increase the value of the inventories by the balance
in the LIFO reserve each year:
$225,972 + $10,600
[($12,384 + $4,294 + $10,600 )+ ($12,117 + $4,018 + = 7.32
$21,200)]/2
This ratio shows that Exxon Mobil’s inventory is turning over more slowly
than the original calculation implied. And, rather than turning over its

inventory more quickly than BP, it appears that Exxon Mobil’s inventory is
turning over significantly less quickly than BP.
e. The statement refers to the impact of LIFO liquidation on Exxon-Mobil’s

profits.


C7-38. (40 minutes)
a. GAAP requires that LIFO abandonment decisions be presented using the

retrospective method. That is, all of the financial statements that are
presented must be restated using the new accounting method (FIFO). As a
result, all of Virco’s statements – income statement and balance sheets - that
are presented in the January 31, 2011 10-K are restated to reflect the switch
to FIFO.
Virco’s 10-K reveals that inventories increased by $7.6 million for the year
ended January 31, 2011. This represents the LIFO reserve that is added to
LIFO inventory value to get to the inventory valued at FIFO. The company
states that $4.7 is added to equity. This adjustment reflects that LIFO reduces
reported earnings by allocating higher cost goods (most recently purchased)
in cost of goods sold and lower cost goods (earlier purchases). These lower
earnings over time cause retained earnings to be lower. Thus, to adjust to
FIFO retained earnings needs to be increased to get to what retained
earnings would have been had the company been on the FIFO method of
accounting for inventory all along. Finally, the increase to inventory and the
increase to equity are not the same because of taxes. If the company would
have been on FIFO they would have paid extra taxes over time. Upon the
switch to FIFO the company has to pay tax on the LIFO reserve amount (but
can spread the payments over time). Thus, the effect on equity will be net of
tax on the earnings but the effect on inventory is not net of tax.
b. Virco argues (correctly) that the FIFO method is better because all inventory
will be on the same method of accounting for inventory, it results in a balance
sheet that reflects current acquisition costs, and it increases comparability
with companies on IFRS because IFRS does not allow LIFO.
c. Note that Virco justified the use of LIFO in prior annual reports by saying it
provided a better matching of current costs to current revenues in the income
statement. This is a correct statement but in some contrast to the statements
made in the year the company decided to switch to FIFO? Do they not care
about matching anymore? One explanation is that the arguments in favor of
FIFO outweighed the matching benefit of LIFO. The IFRS is potentially an
explanation (although financial statement users should be able to adjust the
inferences from the statements to use “as if FIFO” numbers). The company’s
statement about the line of credit is interesting. It potentially suggests that the
covenants in their debt agreement are affected adversely if the company uses
LIFO (e.g., income is lower so the covenant more easily violated). Other
potential explanations are that 1) the company may not expect prices to rise
in the future which would negate the tax savings of LIFO, or 2) perhaps
corporate performance is declining and management is switching off LIFO so
stated results look better.


Chapter 8
Reporting and Analyzing
Long-Term Operating Assets

Cases
Mini-
Exercises
Projects
LO1 – Describe and distinguish

between tangible and intangible 17 31
assets.
LO2 – Determine which costs to

capitalize and report as assets 11,17 22
and which costs to expense.
LO3 – Apply different

12, 13,
depreciation methods to 22 - 28, 32
allocate the cost of assets over 16, 18, 19
time.
LO4 – Determine the effects of 22, 24, 40, 42, 43,

asset sales and impairments on 14, 15 36, 38, 39
26, 35 44
financial statements.
LO5 – Describe the accounting

and reporting for intangible 17, 21 31, 34 37 42, 44
assets.

LO6 – Analyze the effects of
tangible and intangible assets on 20, 21 29, 30, 33 40 – 42, 46
key performance measures.

QUESTIONS
Q8-1. Routine maintenance costs that are necessary to realize the full benefits
of ownership of the asset should be expensed. However, betterment or
improvement costs should be capitalized if the outlay enhances the
usefulness of the asset or extends the asset’s useful life beyond original
expectations. As would be the case with any cost, an immaterial amount
should be expensed as incurred.
Q8-2. Capitalizing interest costs as part of the cost of constructing an asset
reduces interest expense, and increases net income during the
construction period. In subsequent periods, the interest costs that were
capitalized as part of the cost of the asset will increase the periodic
depreciation expense and reduce net income.
Q8-3. As any asset is used up, its cost is removed from the balance sheet and
transferred into the income statement as an expense. Capitalization of
costs onto the balance sheet and subsequent removal as expense is the
essence of accrual accounting. If the cost of a depreciable asset is
recognized in full upon purchase, profit would be inaccurately measured:
it would be too low in the year of purchase when the asset is expensed
and too high in later years as revenues earned by the asset are not
matched with a corresponding cost. In other words, expenses would not
be recognized as assets are used up or as a result of earning revenue.
Q8-4. The primary benefit of accelerated depreciation for tax reporting is that
the higher depreciation deductions in early periods reduce taxable
income and income taxes. Cash flow is, therefore, increased, and this
additional cash can be invested to yield additional cash inflows (e.g., an
"interest-free loan" that can be used to generate additional income). We
would generally prefer to receive cash inflows sooner rather than later in
order to maximize this investment potential.
Q8-5. When a change occurs in the estimate of an asset's useful life or its
salvage value, the revision of depreciation expense is handled by
depreciating the current undepreciated cost of the asset (original cost –
accumulated depreciation) using the revised assumptions of remaining
useful life and salvage value.
Present and future periods are affected by such revisions. Depreciation
expense calculated and reported in past periods is not revised.
Q8-6. The gain or loss on the sale of a PPE asset is determined by the
difference between the asset's book value and the sale proceeds. Sales
proceeds in excess of book values create gains; sales proceeds less
than book values cause losses. The relevant factors, then, are the
depreciation rate and salvage values used to compute depreciation

expense, accumulated depreciation and the net book value of the asset,
as well as the selling price of the asset.

Q8-7. A PPE asset is considered to be impaired when the sum of the
undiscounted expected cash flows to be derived from the asset is less
than its current book value.
An impairment loss is calculated as the difference between the asset's
book value and its current fair market value.
Q8-8. Research and development costs must be expensed under GAAP
unless they have alternative future uses. Equipment relating to a specific
research project with no alternative use would, therefore, be expensed
rather than capitalized and subsequently depreciated.
Accounting standard-setters have justified this ‘expense as incurred’
treatment for R&D costs since the outputs from research and
development activities are uncertain and thus there is not a way to know
when the asset is used up or whether revenue will be earned from the
R&D spending.
Q8-9. The difficulty with amortizing intangible assets is estimating the useful
life. For some intangibles, the useful life is limited and can be easily
estimated. However, some intangibles have an indefinite life. This
means that the useful life of the intangible is long and cannot be
determined with any reasonable degree of accuracy. Under these
circumstances, it is not appropriate to amortize the asset until the useful
life can be determined.
Q8-10. Goodwill arises whenever a company acquires another company and the
purchase price is greater than the fair value of the identifiable assets
acquired. The amount of goodwill is the difference between the
purchase price and the value assigned to the net assets of the acquired
company. It is recorded as a long-term asset in the balance sheet.
Since goodwill is assumed to have an indefinite life, it is not amortized.
The only time that goodwill will affect the income statement is if it is
determined that its value is impaired. In that case, an impairment loss is
recorded in the income statement and the value of the goodwill asset on
the balance sheet is reduced.

MINI EXERCISES
M8-11. (10 minutes)
a. Expense
b. Capitalize
c. Capitalize (the new equipment enhances the assembly line)
d. Expense – this is routine maintenance of the building, unless it extends the
building’s useful life
e. Capitalize – the useful life is extended
f. Capitalize – this is a purchased intangible asset
M8-12. (15 minutes)
a. Straight-line: ($18,000 - $1,500)/ 5 years = $3,300 for both 2016 and 2017.
b. Double-declining-balance: Twice straight-line rate = 2 x 1/5 = 40%

2016: $18,000 x 0.40 = $7,200
2017: ($18,000 - $7,200) x 0.40 = $4,320
Notice that, over the first two years, the company reports $6,600 of depreciation
expense under the straight-line method and $11,520 of depreciation expense
under the double-declining-balance method.
M8-13. (15 minutes)
a. Straight-line: ($130,000 - $10,000)/ 6 years = $20,000 for both 2016 and 2017.
b. Double-declining-balance: Twice straight-line rate = 2 x 1/6 = 1/3

2016: $130,000 x 1/3 = $43,333
2017: ($130,000 - $43,333) x 1/3 = $28,889
c. Units of production: ($130,000 - $10,000) / 1,000,000 = $0.12 per unit

2016: 180,000 units x $0.12 = $21,600
2017: 140,000 units x $0.12 = $16,800

M8-14. (15 minutes)
Straight-line depreciation: $40,000/10 = $4,000; 8 years x $4,000 = $32,000.
a. Cash (+A) ............................................................................................

3,500
Accumulated depreciation (-XA, +A) .................................................. 32,000
Loss on sale of furniture and fixtures (+E, -SE) ................................ 4,500
Furniture and fixtures (-A) ................................................................ 40,000
b.

Cash Noncash Contra Liabi- Contrib. Earned Net
Transaction - = + + Revenues - Expenses =
Asset + Assets Assets lities Capital Capital Income
Sold furniture +3,500 -40,000 -32,000 -4,500 +4,500 -4,500

and fixtures Cash Furniture Accum. Retained Loss on
for cash. and - Deprec. Earnings - Sale of =
Fixtures Furniture
and
Fixtures
M8-15. (15 minutes)
Twice the straight-line rate = 1/5 x 2 = 40%

Year 1: $75,000 x .4 = $30,000
Year 2: ($75,000 - $30,000) x .4 = 18,000
Year 3: ($75,000 - $30,000 - $18,000) x .4 = 10,800
Total accumulated depreciation $58,800
a. Cash (+A) ...........................................................................................

25,000
Accumulated depreciation (-XA, +A) .................................................. 58,800
Machinery (-A) ................................................................ 75,000
Gain on sale of machinery (+R, +SE) ................................ 8,800
b.

Transaction - = + + Revenues - Expenses =
Asset + Assets Assets lities Capital Capital Income
Sold +25,000 -75,000 -58,800 +8,800 +8,800 +8,800

machinery Cash Machinery - Accum. Retained Gain on - =
for cash. Deprec. Earnings Sale of
Machinery

M8-16. (15 minutes)
a. Straight-line depreciation
2016: ($145,800 - $5,400)/3 = $46,800; (8/12) x $46,800 = $31,200
(Note: 8/12 is the fraction of the year, May through December)
2017: $46,800
b. Double-declining-balance depreciation
Preliminary computation: Twice straight-line rate = 2 x 1/3 = 66⅔%

($145,800 x 66⅔%) = $97,200
2016: (8/12) x $97,200 = $64,800
2017: ($145,800 - $64,800) x 66⅔% = $54,000
M8-17. (20 minutes)
a. Under U.S. GAAP, capitalization of development costs is not allowed and all
R&D costs must be expensed. Under IFRS, development costs are capitalized
if there is the intention, feasibility and resources to bring the asset to completion,
there exists the ability to use or sell the asset to generate an economic benefit.
Otherwise the costs must be expensed.
b. Yes, impairment should be tested for annually (or sooner if there is an indication
that goodwill is impaired).
M8-18. (20 minutes)
a.
Year Book Value Depreciation Rate Depreciation Expense
1 $50,000 2 x ¼ = 0.5 $25,000
2 25,000 2 x ¼ = 0.5 12,500
3 12,500 4,500
4 8,000 0*
*No depreciation is recorded in Year 4 because the asset is depreciated to its residual value of $8,000.
b.
1 $50,000 2 x 1/5 = 0.4 $20,000
2 30,000 2 x 1/5 = 0.4 12,000
3 18,000 2 x 1/5 = 0.4 7,200
4 10,800 2 x 1/5 = 0.4 4,320
5 6,480 3,480*
*$3,480 of depreciation is required in Year 5 to depreciate the asset to its residual value of $3,000.

c.
1 $50,000 2 x 1/10 = 0.2 $10,000
2 40,000 2 x 1/10 = 0.2 8,000
3 32,000 2 x 1/10 = 0.2 6,400
4 25,600 2 x 1/10 = 0.2 5,120
5 20,480 2 x 1/10 = 0.2 4,096
6 16,384 2 x 1/10 = 0.2 3,277
7 13,107 2 x 1/10 = 0.2 2,621
8 10,486 2 x 1/10 = 0.2 2,097
9 8,389 2 x 1/10 = 0.2 1,678
10 6,711 5,711*
* $5,711 of depreciation is required in Year 10 to depreciate the remaining value of the asset. Alternatively,
DeFond could switch to straight-line depreciation in Year 7, recording $3,027 of depreciation in Years 7
through 10.
M8-19. (15 minutes)
a.
Year Barrels Depletion per Barrel Depletion
Extracted
$32,000,000 / 4,000,000 =
2016 300,000 $8 $2,400,000
$32,000,000 / 4,000,000 =
2017 500,000 $8 $4,000,000
$32,000,000 / 4,000,000 =
2018 600,000 $8 $4,800,000
b.
i. Oil reserve (+A) .......................................................... 32,000,000
Cash (-A) ............................................................. 32,000,000
ii. Oil inventory (+A) ...................................................... 2,400,000

Oil reserve (-A) ...................................................... 2,400,000
c.
+ Oil Reserve (A) - + Oil Inventory (A) -
i. 32,000,00 ii. 2,400,00
0 0
2,400,00 ii.
0
Balanc 29,600,00 Balanc 2,400,00
e 0 e 0
+ Cash (A) -

32,000,0 i.
00
Balanc 32,000,0
e 00

M8-20. (15 minutes)
a.
PPE Turnover Rates for 2014
Texas Instruments $13,045 / [($2,840 + $3,399) / 2] = 4.18
Intel Corp. $55,870 / [($33,238 + $31,428) / 2] = 1.73
Texas Instruments turns its PPE more quickly than does Intel.
b. PPE turnover rates increase with increases in sales volume relative to the dollar
amount of PPE on the balance sheet. The PPE turnover rate is often a very
difficult turnover rate to change, and typically requires creative thinking. Many
companies are outsourcing the manufacturing process in whole or in part to
others in the supply chain. This is beneficial so long as the savings realized by
the reduction of manufacturing assets more than offset the higher cost of the
goods as these are now purchased rather than manufactured. Another
approach is to utilize long-term operating assets in partnership with another firm,
say in a joint venture.
M8-21. (15 minutes)
a. $1,345 / $20,247 = 6.64%.

Abbott’s R&D expenditure level could be compared to the R&D expenditure
level for its competitors to gain a sense of the appropriateness of its R&D
expenditures. Roche Holding AG has a research and development intensity
ratio of 19.8% while Teva Pharmaceutical Industries Limited has a research and
development intensity ratio of 7.3% (note both of these companies are listed as
primary competitors on Yahoo Finance). Abbott Laboratories spun off part of its
pharmaceutical business (known now as AbbVie) in 2013 which may account
for their lower relative ratio.
b. R&D costs must be expensed when incurred unless they are expenditures for
depreciable assets that have alternative future uses (in which case the
depreciation is expensed as recognized). As a result, the balance sheet does
not reflect the costs incurred for long-term R&D assets. In addition, operating
expenses are increased, thus reducing retained earnings.
($ millions) Balance Sheet Income Statement

Cash Noncash Liabi- Contrib. Earned Net
Transaction Asset + Assets = lities + Capital + Capital Revenues - Expenses = Income
R&D -1,345 -1,345 +1,345 -1,345

= - =
expenditures Cash Retained R&D
Earnings Expense

EXERCISES
E8-22. (15 minutes)
a. Machine (+A) ......................................................................................

89,500
Cash (-A) ($85,000 + $2,000 + $2,500) ................................ 89,500
b. ($89,500 - $7,000) / 5 = $16,500 per year.
Depreciation expense (+E, -SE) .........................................................

16,500
Accumulated depreciation (+XA, -A) ................................ 16,500
c. Cash (+A) ...........................................................................................

12,000
Accumulated depreciation (-XA, +A) ($16,500 x 4) ............................ 66,000
Loss on sale of machine (+E, -SE) ..................................................... 11,500
Machine (-A) ................................................................ 89,500
E8-23. (20 minutes)
a. Straight line:
($80,000 - $5,000)/5 years = $15,000 per year
b. Double declining balance: Twice straight-line rate = 2 x 1/5 = 40%

Year Book Value x Rate Depreciation Expense
1 $80,000 x 0.40 = $32,000
2 ($80,000 - $32,000) x 0.40 = 19,200
3 ($80,000 - $51,200) x 0.40 = 11,520
4 ($80,000 - $62,720) x 0.40 = 6,912
5 5,368 (plug)
Total $75,000

E8-24. (25 minutes)
a. 1. Accumulated depreciation on the date of sale:

[($800,000-$80,000)/10 years] x 6 years = $432,000
2. Net book value of the plane at date of sale:
$800,000 - $432,000 = $368,000
b. 1.
Cash (+A) ........................................................................................
368,000
Accumulated depreciation (-XA, +A) ............................................... 432,000
Plane (-A) ..................................................................................... 800,000
2. Loss on sale of: $195,000 - $368,000 = $173,000

Cash (+A) ........................................................................................
195,000
Loss on sale of plane (+E, -SE) ...................................................... 173,000
Plane (-A) ..................................................................................... 800,000
3. Gain on sale of: $600,000 - $368,000 = $232,000
Cash (+A) ........................................................................................

600,000
Gain on sale of plane (+R, +SE) .................................................. 232,000
Plane (-A) ..................................................................................... 800,000
E8-25. (15 minutes)
a. Straight-line: 2016 and 2017 ($218,700 - $23,400)/6 years = $32,550
b. Double-declining-balance: twice straight-line rate = 2 x 1/6 = 33⅓%

2016 $218,700 x 33⅓% = $72,900
2017 ($218,700 - $ 72,900) x 33⅓% = $48,600
E8-26. (15 minutes)
a. Depreciation expense to date of sale is [($27,200 - $2,000)/6] x 3 = $12,600.

The net book value of the van is, therefore, $27,200 - $12,600 = $14,600.
b. 1. $0
2. $400 gain ($15,000 - $14,600)
3. $2,600 loss ($12,000 - $14,600)

E8-27. (20 minutes)
a. Straight line: ($110,000 - $15,000) / 6 = $15,833 each year.
b. Double-declining-balance: rate = 2 x 1/6 = 1/3
2016: $110,000 x 1/3 = $36,667

2017: ($110,000 – $36,667) x 1/3 = $24,444
2018: ($110,000 – $36,667 – $24,444) x 1/3 = $16,296
c. Straight line: [$110,000 – ($15,833 x 2) – $10,000] / 5 = $13,667 in 2018 and

each subsequent year.
Double-declining balance: rate = 2 x 1/5 = 40%.

($110,000 – $36,667 – $24,444) x 40% = $19,556 in 2018
E8-28. (20 minutes)
a. Straight-line: $6,000,000 / 30 = $200,000 per year each year.
b. Double-declining balance: rate = 2 x 1/30 = 1/15.
2016: $6,000,000 x 1/15 = $400,000

2017: ($6,000,000 – $400,000) x 1/15 = $373,333
c. The revised depreciation rate = 2 x 1/23 = 8.7%
2018: ($6,000,000 – $400,000 – $373,333) x 8.7% = $454,720*

*$454,493 (using unrounded depreciation rate)
E8-29. (10 minutes)
Percent depreciated = Accumulated depreciation / Asset cost

= $5,751 million / ($11,329 - $124 - $530) million = 54%
Note: We eliminate land and construction in progress from the computation

because these assets are not depreciated.
Assuming that assets are replaced evenly as they are used up, we would expect
assets to be 50% depreciated, on average. Deere’s 54% is just slightly higher
than this level. If the percentage depreciation were high, one possible concern is
that it often requires higher capital expenditures in the near future to replace
aging assets.

E8-30. (25 minute)
a. Receivable Turnover Rate Inventory Turnover Rate PPE Turnover Rate

$30,871 $16,106 $30,871
2013 = 7.43 = 4.18 = 3.63
$4,253+$4,061 $3,864+$3,837 $8,652+$8,378
2 2 2
$31,821 $16,447 $31,821

2014 =7.50 = 4.35 = 3.71
$4,238+$4,253 $3,706+$3,864 $8,489+$8,652
2 2 2
b. 3M’s Receivable, PPE, and Inventory turnover ratios have improved from
2013 to 2014. 3M’s revenues increased in 2014, and that increase is likely to
account for the increase in the PPET. PPE turns can also be improved by off-
loading manufacturing to other companies in the supply chain and acquiring
long-term operating assets in partnership with other companies, for example,
in a joint venture. Receivable turnover improvement could be due to
monitoring more closely the quality of customers to which credit is granted,
implementing better collection procedures, and offering discounts as an
incentive for early payment. Inventory turnover rates can be improved by
weeding out slowly moving product lines, by reducing the depth and breadth
of products carried, and by implementing just-in-time deliveries.
E8-31. (10 minutes)
a. b.
Fair Value Useful Amortization
(Capitalized) Life Expense for 2016
Patent $200,000 3 years $66,667
Trademark $500,000 Indefinite
Noncompetition agreement $300,000 5 years $60,000
$126,667
E8-32. (15 minutes)
a. Cost of resource property: $7,200,000 + $420,000 + $50,000 + $800,000

= $8,470,000
Residual value: $1,200,000
Depletion base: $8,470,000 – $1,200,000 = $7,270,000
Depletion rate: $7,270,000 / 500,000 tons = $14.54 per ton
2016: 60,000 x $14.54 = $872,400

2017: 85,000 x $14.54 = $1,235,900

b. 2016: Inventory (+A) ................................................................ 872,400
Resource property (-A) ................................................................ 872,400
2017: Inventory (+A) ................................................................1,235,900

Resource property (-A) ................................................................1,235,900
E8-33. (15 minutes)
a. Percent depreciated – 2011: $11,320 / $12,266 = 92.3%

2010: $10,925 / $11,804 = 92.6%
b. PPET: $96,504 / [(946 + 879)/2] = 105.8 times
c. Adams’ assets are almost completely depreciated at the end of 2011. This
results in an extremely high percent depreciated ratio and also a very high
PPE turnover ratio (PPET). Adding inventories and receivables to get all the
firm’s net operating asset turnover (NOAT) is more reasonable devisor.
Adams outsources most of its manufacturing and, recognizing concerns that
these numbers might produce, reports in its 10-K that its current facilities
(PPE assets) are adequate for the foreseeable future. Thus, although the
ratios might suggest otherwise, the company does not anticipate large capital
expenditures in the near future. Indeed this has been the case for the last
several years as well. (We note that Adams was acquired in 2012 by
TaylorMade.)
E8-34. (15 minutes)
a. The list illustrates the wide range in expenditures for R&D (as a percent of
sales) across firms. Note the large amount spent by Intel (20.65%) and
pharmaceutical companies Pfizer (16.9%) and Merck (17.0%), compared to
the amount spent by Apple (3.30%). The companies in the list are to some
extent paired by industry. It is interesting to see how similar some firms in the
same industry are. For example, Apple and Samsung spend almost the
same percentage of sales on R&D.
b. Beside industry affiliation, the differences in R&D expenditures as a percent
of sales is due to differences in markets, product mix, and other strategic
considerations. As suppliers of technology (hardware and software), Intel and
Microsoft depend very heavily on their intellectual property. As a result, their
expenditures on research and development are among the highest of
established firms. Apple has established itself as an innovator in technology
and design and has spent billions of dollars developing unique products such
as the iPad®. Apple’s research intensity looks relatively low but the company
has tremendous sales revenue (the denominator in the R&D intensity ratio).

In addition, the company has increased their spending on R&D -- from 2012
to 2014, Apple’s R&D expense increased by 78%.

E8-35. (20 minutes)
a. Yes, the equipment is impaired at July 1, 2016 because its book value is not
recoverable through future cash flows. Specifically, on July 1, 2016, its book
value is $145,000 ($225,000 initial cost less $80,000 accumulated
depreciation*) and the estimated future (undiscounted) cash flows are only
$125,000.
*4 years of [($225,000-$25,000)/10 years].
b. The impairment loss in a is computed as the equipment's book value minus its
current fair value: $145,000 − $90,000 = $55,000
Impairment loss (+E, -SE) ................................................................

55,000
Equipment* (-A) ................................................................ 55,000
*Accumulated depreciation is sometimes credited for the loss.
c. Assuming that the salvage value remains the same after the impairment (this is
not likely given the decline in market value of the asset), the annual depreciation
expense would be ($90,000 - $25,000) / 6 = $10,833 per year.
Depreciation expense (+E, -SE) ........................................................

10,833
Accumulated depreciation (+XA, -A) ................................ 10,833
d.
($000) Balance Sheet Income Statement
Transaction Asset + Assets - Assets = lities + Capital + Capital Revenues - Expenses = Income
b. Impairment -55,000 -55,000 +55,000 -55,000

charge. Equip- - Retained - Impairment =
ment Earnings Loss
c. Depreciation +10,833 -10,833 +10,833 -10,833

- - =
expense. Accum. Retained Deprec.
Deprec. Earnings Expense

PROBLEMS
P8-36. (20 minutes)
In order to determine the entries for the sale of property, plant and equipment, we
need to “fill in the blanks” for the PPE and accumulated depreciation accounts.
Once we record the purchases and the depreciation expense, we can determine
the cost and accumulated depreciation for the assets sold.
(i) Property, plant and equipment (+A) .................................................. 2,380,287
Cash (-A) ...................................................................................... 2,380,287
(ii) Depreciation expense (+E, -SE) .......................................................

3,778,563
Accumulated depreciation (+XA, -A) ................................ 3,778,563
(iii) Cash (+A) ..........................................................................................

48,125
Accumulated depreciation (-XA, +A) ................................................. 203,098
Gain on sale of property and equipment (+R, +SE) ...................... 22,691
Property, plant and equipment (-A) ................................ 228,532
+
Property, Plant and Equipment - Accumulated Depreciation (XA) +
(A) -
Balance 93,022,4 65,927,38 Balance
43 9
(i) 2,380,28 3,778,563 (ii)
7
228,53 (iii) (iii) 203,098
2
Balance 95,174,1 69,502,85 Balance
98 4
P8-37. (20 minutes)
a. $719 million / $6,981 million = 10.3%
b. R&D costs are expensed in the income statement except for the portion
relating to depreciable assets that have alternate uses. Expensing (rather
than capitalizing and depreciating) reduces assets, and the additional
expense reduces profit and equity (via the reduction in retained earnings). In
addition, expensing R&D as incurred means that potentially valuable
intangible assets are omitted from the balance sheet.

c. Agilent has reduced its R&D spending as a percent of revenues in recent
years and, as a result, increased its earnings. (Agilent had a loss from
operations in 2003.) This has turned operating losses into an operating profit
for the company. However, Agilent is dependent upon technology in order to
maintain its market position, and R&D is critical to its very existence. Agilent
divested itself of some high-intensity R&D businesses between 2003 and
2011, and its spending on R&D has constant or
has increased slightly in recent years (e.g., 2011 R&D expense was $649M,
2012 was $668M, and 2013 was $ 704M). Changes in R&D spending, as a
percent of revenues, is affected by R&D spending and also by revenues.
Agilent’s revenues have increased from 2011 to 2014 by 5%.A company can
maintain its investment in intellectual capital and reduce expenses by
outsourcing the activity to other countries where the intellectual resources are
less expensive.
P8-38. (20 minutes)
($ millions)
a.
i. Depreciation expense (+E, -SE) .......................................................2,108
Accumulated depreciation (+XA, -A) ................................................. 2,108
ii. Property and equipment (+A) ...........................................................1,786

Cash (-A) ........................................................................................... 1,786
iii. Cash (+A) ......................................................................................... 95

Accumulated depreciation (-XA, +A) (see T-account) ......................1,068
Property and equipment (-A) (see T-account) ................................ 1,163
iv. Repair and maintenance expense (+E, -SE) .................................... 715

Cash (-A) ........................................................................................... 715
v. Impairment and writedown charges (+E, -SE) 124

Property and equipment (-A) 124
+ Property and Equipment (A) - - Accumulated Depreciation (XA)

+
Balance 40,478 14,066 Balance
(ii) 1,786 2,108 (i)
1,16 (iii) (iii) 1,068
3
124 (v)
(b) 87
Balance 41,064 15,106 Balance

b. The problem provides information directly to make entries (i), (ii), (iv) and (v)
in part a. For part (iii), we can infer the accumulated depreciation on
disposed property and equipment as being the amount ($1,068) that makes
that account balance. Since no gain or loss was reported on these disposals,
the credit to property and equipment in part (iii) is the amount that balances
the disposal transaction ($1,163).
However, this leaves the property and equipment T-account unbalanced. A

likely reason is that Target acquires some property and equipment without an
expenditure of cash. (Chapter 10 will cover capital lease transactions, which
play a role in Target’s operations.) Based on the information in the problem,
we would estimate that $87 million of property and equipment was acquired
through such transactions, because that amount balances the property and
equipment T-account.
P8-39. (20 minutes)
The process used in this question is to fill in the entries for property and
equipment and for accumulated depreciation in parts a, b and c, and then to use
the “plug” figures in the T-accounts to determine the values in part d.
($ thousands)
a. Depreciation expense (+E, -SE) ........................................................
144,630
Accumulated depreciation (+XA, -A) ................................................. 144,630
b. Property and equipment (+A) ............................................................ 61,906

Cash (-A) ........................................................................................... 61,906
c. Loss on impairment of property and equipment (+E) ........................5,453

Property and equipment (-A) ............................................................. 5,453
d. Cash (+A) ..........................................................................................

11,433
Accumulated depreciation (-XA, +A) (see T-account) ....................... 90,694
Property and equipment (-A) (see T-account) ................................ 100,988
Gain on sale of property and equipment (+R,+SE) 1,139
+ Property and Equipment (A) - - Accumulated Depreciation (XA)

+
Balanc 1,902,58 1,073,5 Balanc
e 4 57 e
(b) 61,906 144,630 (a)
5,453 (c)
100,98 (d) (d) 90,694
8
Balanc 1,858,04 1,127,4 Balanc

e 9 93 e

CASES and PROJECTS
C8-40. (90 min)
a. PPE Turnover: $17,909.6/[($3,941.9 + $3,878.1)/2] = 4.6
The firm does not appear to be as capital intensive as others in the industry
based on a higher than average PPE turnover ratio than its closest
competitors. However, if the assets are older (more depreciation) the
denominator will be smaller and could cause the PPE turnover to be higher.
Thus, the age of the assets can affect the ratio as well.
b. Accumulated depreciation / Depreciable asset cost
$5,451.2/ ($9,393.1 - $106.9*- $600.8*) =0.63 or 63%

*Note: We eliminate land from the computation because land is never
depreciated. We eliminate construction in progress because these represent
assets that the company is building. These assets are not yet in service and are
consequently not yet depreciable. This elimination is also used in part c.
If plant assets are replaced at a constant rate, we would expect those assets
to be about 50% “used up,” on average. A substantially higher percentage
“used up” indicates that the assets are closer to the end of their useful lives
and will require replacement (and usually higher maintenance costs near the
end of their useful lives). Such a situation would negatively impact future cash
flows.
c. Average depreciable assets = [($9,393.1 – 106.9 – 600.8) + ($8,932.9 –

101.2 – 495.1)] / 2 = $8,511
Average depreciable assets/ Depreciation expense = $8,511 / $585 per year

= 14.5 years.
d. Depreciation expense (+E, -SE) ........................................................

585
PPE accumulated depreciation (+XA, -A) ................................ 585
PPE (+A) ...........................................................................................

664
Cash (-A) ........................................................................................... 664

C8-41. (40 minutes)
Reducing operating assets is an important means of increasing performance

measures including the return on net operating assets. Most companies focus
first on reducing receivables and inventories. This is the so-called low-hanging
fruit that can lead to quick results. Some possible actions include those listed.
Students will think of additional possibilities.
a. Reducing receivables through:
1. Better underwriting of credit quality

2. Better controls to identify delinquencies, automated over-due notices, and
better collection procedures
3. Increased attention to accuracy in invoicing
4. Offering early payment incentives
b. Reducing inventories and inventory costs through essentially eliminating

nonproductive activities including inspection, moving activities, waiting setup
time:
1. Use of less costly components (of equal quality) and production with lower
wage rates
2. Elimination of product features not valued by customers
3. Outsourcing to reduce product cost
4. Just-in-time deliveries of raw materials
5. Elimination of manufacturing bottlenecks to reduce work-in-process
inventories
6. Producing to order rather than to estimated demand to reduce finished
goods inventories
7. Eliminating defects
c. Reducing PPE assets is much more difficult. The benefits, however, can be
substantial. Some suggestions are the following:
1. Sale of unused and unnecessary assets

2. Acquisition of production and administrative assets in partnership with
other companies for greater throughput
3. Acquisition of finished or semi-finished goods (sub-components) from
suppliers to reduce manufacturing assets
d. Reducing unnecessary intangible assets that are reported on the balance

sheet is the most difficult.
1. Sale of assets no longer relevant to company plans

2. License intangibles to other companies

C8-42. (30 minutes)
a. Take-Two (TTWO) spent $208,965 in 2013 and $197,046 in 2014 on software

development. TTWO’s amortization and write-downs were $230,748 in 2013
and $265,533 in 2014. Using EA’s method, the money spent on additions
would be expensed, and the amortization and write-downs would disappear.
The result is that if TTWO used EA’s approach, 2013 expenses would
decrease by $21,783 ($230,748 – 208,965). Net income would increase by
$14,159 [$21,783 X (1-0.35)] in 2013. In 2014, TTWO’s expenses would
decrease by $68,487 ($265,533 - $197,046) if TTWO used the same method
as EA. Net income would increase by $44,517 [$68,487 X (1-0.35)].
b. A variety of answers are possible here. Amortization (including write-downs)

as a percentage of “amortizable cost” (average of beginning and ending
balances before amortization) increased from 55% in 2013 to 68% in 2014.
The increase indicates a possible increase in the rate of amortization.
However, it could also mean that the company is adding assets more slowly
in recent years such that amortization of prior costs becomes greater as a
percent of cost.
C8-43. (20 minutes)
a. DreamWorks would have recorded a pretax profit of $10.6 million for 2014.
b. DreamWorks capitalizes film production costs and amortizes them over the
life of the film, meaning over the time period of the expected revenue stream.
The unamortized asset (that is, the unamortized capitalized costs) have to be
tested for impairment each reporting period.
c. Loss due to impairment (+E, -RE) 96.8 million

Mr. Peabody and Sherman (-A) 66.5
million
The Penguins of Madagascar (-A) 30.3
million

C8-44. (40 minutes)
a. Vodafone states that they test goodwill annually and, if impaired, they write
the value of goodwill down. Thus, in a big picture sense goodwill impairment
operates similarly between GAAP and IFRS. However, the details differ. For
example, GAAP requires testing at the reporting unit level and under IFRS
testing is at the cash-generating level. Under GAAP the impairment loss is the
amount by which the carrying value of goodwill exceeds the implied fair value
of goodwill within the reporting unit. Under IFRS, the impairment loss is the
amount by which the carrying value of the cash- generating unit exceeds its
recoverable amount (and the loss can be allocated to goodwill and to other
assets). The recoverable amount under IFRS seeks to determine whether a
third-party fair value is higher or lower than the value-in-use to the current
entity. When the value-in-use is greater, then that will be the relevant
benchmark under IFRS. GAAP does not explicitly consider value-in-use.
b. An analyst would treat an impairment loss as operating but nonrecurring. The

charge for Vodafone was 6.6 billion pounds and would reduce pretax income
Revised 11.04.16
by that amount.
c. Impairment charges are noncash charges.

Chapter 9
Reporting and Analyzing Liabilities

Cases
Mini-
Exercises
Projects
18, 19, 21,
LO1 – Identify and account for 38 - 40, 43 51
current operating liabilities. 25, 33
LO2 – Describe and account for

current nonoperating (financial) 20, 21 49
liabilities.

LO3 – Explain and illustrate the 22, 31, 32, 41, 42,
pricing of long-term 52 - 58 60, 61
34 - 37 45 - 48, 50
nonoperating liabilities.
LO4 – Analyze and account for 20, 23, 24,

41,
financial statement effects of 26 - 29, 51 - 58 60, 61
long-term nonoperating 44 - 50
liabilities. 34 - 36
LO5 – Explain how solvency

ratios and debt ratings are 22, 30 60, 61
determined and how they impact
the cost of debt.

QUESTIONS
Q9-1. Current liabilities are obligations that require payment within the coming
year or operating cycle, whichever is longer.
Generally, current liabilities are normally settled with use of existing
current assets or operating cash flows.
Q9-2. If a company fails to take a cash discount that is offered by a supplier, it
is effectively paying a penalty for taking additional time to pay the
account payable. Depending on the size of the discount, this penalty (an
implicit interest rate) can be quite high.
The net-of-discount method records the inventory at the purchase cost
less the discount. If the discount is lost, the extra cost is treated as part
of interest expense for the period. This has two benefits: (1) the lost
discount is not capitalized as part of the cost of inventory, and (2) the
lost discount is highlighted, which is useful information that may be
helpful in managing accounts payable.
Q9-3. An accrual is the recognition of an event in the financial statements even
though no actual transaction has occurred. Accruals can involve both
liabilities (and expenses) and assets (and revenues).
Accruals are vital to the fair presentation of the financial condition of a
company as they impact both the recognition of revenue and the
matching of expense.
Q9-4. The coupon rate is the rate specified on the face of the bond. It is used
to compute the amount of cash interest paid to the bond holder. The
market rate is the rate of return expected by investors that purchase the
bonds. The market rate determines the market price of the bond. It
incorporates expectations about the relative riskiness of the borrower
and the rate of inflation. In general, there is an inverse relation between
the bond’s market rate and the bond’s market price.
Q9-5. Bonds sold at face (par) value earn an effective interest rate equal to the
bonds’ coupon rate. Bonds are sold at a discount when the effective
interest rate is higher than the coupon rate. Bonds are sold at a premium
when the effective interest rate is lower than the coupon rate.

Q9-6. Bonds are reported at historical cost, that is, the face amount plus
(minus) unamortized premium (discount). The market price of the bonds
varies inversely with the level of interest rates and fluctuates
continuously. Differences between the market price of a bond and its
carrying amount represent unrealized gains and losses. These
unrealized gains (losses) are not reflected in the financial statements
(although they are disclosed in the footnotes). They must be recognized
upon repurchase of the bonds, the point at which they become
“realized.”
If the bonds are refunded (that is, replaced with new bonds reflecting
current market values and interest rates), the gain (or loss) that is
recognized in the current period will be offset by correspondingly higher
(lower) interest payments in the future. The present value of the future
interest payments, along with the present value of the difference
between the face amount of the new bond and the former face amount,
exactly offset the reported gain (loss).
Q9-7. Debt ratings reflect the relative riskiness of the borrowing company. This
riskiness relates to the probability of default (e.g., not repaying the
principal and interest when due). Higher (greater quality) debt ratings
result in higher market prices for the bonds and a correspondingly lower
effective interest rate for the issuer. Lower (lesser quality) debt ratings
result in lower market prices for the bonds and a correspondingly higher
effective interest rate for the issuer.
Q9-8. Reported gains or losses on bond redemption result from changes in the
market price of the bonds and the use of historical cost accounting.
Because bonds are typically reported at historical cost, fluctuations in
bond prices are not recognized until they are realized when the bonds
are redeemed or refunded. If the bonds are refunded (new bonds are
issued), the gain or loss is offset by the present value of lower (higher)
future interest payments on the new bond issue.
Q9-9. (a) Bonds payable – the liability account used to record the face value
of bonds issued by a company
(b) Call provision – the right for the bond issuer to repurchase the debt,
before it matures, at a predetermined price.
(c) Face value – the predetermined amount (typically $1,000) that must
be repaid when a bond matures
(d) Coupon rate – the rate specified on the face of the bond that
determines the periodic interest (coupon) payment
(e) Bond discount – the difference between the face value of the bond
and the market price when the price is lower than the face value;
recorded as a contra-liability

(f) Bond premium – the difference between the market price of a bond
and the face value when the market price is higher than the face
value; recorded as an adjunct-liability
continued next page

(g) Amortization of premium or discount – the periodic reduction of the
balance in the premium or discount account recorded each time
interest expense is accrued; equal to the difference between the
accrued interest and the coupon payment (or payable)
Q9-10. The advantages of issuing bonds are (1) the interest payments are
limited to the predetermined amount specified on the bond; (2) the
interest is tax deductible; (3) bondholders do not have a vote when it
comes to electing directors and managing the company; (4) the
additional financial leverage created when bonds are issued increases
profits in good years. The disadvantages of bonds include (1) bonds
must be repaid while common stock is issued with an indefinite life; (2)
bondholders can impose restrictive covenants in the loan indenture; (3)
the additional financial leverage created when bonds are issued
decreases profits in lean years.
Q9-11. $3,000,000 x [.98 + (.09 x 3/12)] = $3,007,500
Q9-12. The contract rate (or stated rate or coupon rate) determines the periodic
coupon payment. If this rate is not equal to the rate required by the
market, the bond price is adjusted to the present value of the cash
payments from the bond discounted at the applicable market rate of
interest. If the market rate is higher than the coupon rate, then the
periodic coupon payments are insufficient and the bond will be priced
lower than the face value (a discount). If the market rate is lower than
the coupon rate, then the periodic coupon payments will be higher than
required by the market, and the bond will sell for a premium.
Q9-13. When the bonds mature, the book value of the bonds will be equal to the
face value. Over the life of the bonds, the change in the book value of
the bonds will be equal to face value less the market value at the time
that the bonds are issued.
Q9-14. When the effective interest method is used to amortize a bond discount
or premium, the effective rate is multiplied by the net balance in bonds
payable (bonds payable plus/minus the premium or discount). If the
bond is issued at a discount, the balance increases over the life of the
bond; the interest expense will increase as the balance increases. If the
bond is issued at a premium, the balance decreases over the life of the
bond; the interest expense will decrease as the balance decreases.
Q9-15. Bonds payable is presented in the balance sheet net of any discount or
plus any premium.
Q9-16. The loss is the difference between the retirement value and the book
value of the bond: (101% x $200,000) – $197,600 = $4,400.
Q9-17. Each payment includes both interest on the outstanding balance and
repayment of the principal. As each payment is made, the principal
balance is reduced. As a consequence, the interest component of the
payment is smaller each period.

MINI EXERCISES
M9-18. (15 minutes)
a.
11/15 Inventory (+A) 6,076
11/23 Accounts payable (-L) 6,076

Cash (-A) 6,076
$6,076 = $6,200 x 0.98
b.
11/15 6,076 6,076 11/15
11/23 6,076
+ Cash (A) -
6,076 11/23
c. [($6,200 - $6,076)/$6,076] x [365/(30-10)] = 37.24%. (With interest

compounding, the annual rate of interest r can be solved from
(1+r)(20/365)=1.02. The value that solves this relationship is r = 43.5%.)
M9-19. (15 minutes)
a.
1/20 Inventory (+A) 12,250
2/15 Accounts payable (-L) 12,250

Interest expense, discounts lost (+E, -SE) 250
Cash (-A) 12,500
$12,250 = $12,500 x 0.98

b.
1/20 12,250 12,250 1/20
2/15 12,250
+ Cash (A) - + Interest Expense, Discounts

Lost (E) -
12,500 2/15 2/15 250
c. [($12,500- $12,250)/$12,250] x [365/(60-15)] = 16.55%. (With interest

compounding, the annual rate of interest r can be solved from
(1+r)(45/365)=1.02. The value that solves this relationship is r = 17.4%.)
M9-20. (10 minutes)
a. Interest expense (+E,-SE)…………………… 24

Interest payable (+L)……………………. 24
$7,200 × 8% × (1/24) = $24

b.
- Interest Payable (L) + + Interest Expense (E)
-
24 a. a. 24
c.
Transaction Asset + Assets = Liabil-ities + Capital + capital Revenues - Expenses = Income
Accrued $24 +24 -24 +24 -24
interest on = Interest Retained - Interest =
note payable Payable Earnings Expense
M9-21. (15 minutes)
a. Accounts Payable, $110,000 (current liability).
b. Not recorded as a liability; an accountable transaction has not yet occurred.
c. Estimated liability for product warranty, $2,200 (current liability).

d. Bonuses Payable, $30,000 (current liability)—computed as $600,000 × 5%.
This liability must be reported since its payment is “probable” and can be
“estimated.”

M9-22. (10 minutes)
a. Microsoft is offering bonds with a coupon (stated) rate of 2.7% when the
market rate (yield) is higher (2.772%). In order to obtain this expected rate of
return, the bonds sell at a discount price of 99.37 (99.37% of par).
b. The first bond matures in 2025 while the second matures in 2055. There is,
generally, a higher rate (yield) expected for a longer maturity.
M9-23. (10 minutes)
Amount paid to retire bonds ($400,000 x 102%) .............................................. $408,000

Book value of retired bonds, net of $3,000 unamortized discount ................... 397,000
Loss on bond retirement ................................................................................... $ 11,000
M9-24. (10 minutes)
a. The $3,011 million of debt that is due in 2015 is already listed as the current
portion of long-term debt in Pfizer’s current liabilities.
b. Pfizer will need to pay off the bonds when they mature. This will result in a
cash outflow that must come from operating activities if the bonds cannot be
refinanced prior to maturity. However, most of Pfizer’s long-term debt
matures more than 5 years after the financial statement date (December 31,
2014). Thus, Pfizer’s near-term cash needs for covering long-term debt
should not place a significant burden on the company’s operations.
M9-25 (10 minutes)
a. Gain on Bond Retirement: In the other (nonoperating) income and expenses

section of the income statement.
b. Discount on Bonds Payable: Deduction from Bonds Payable; thus, a (contra)

long-term liability in the balance sheet (e.g., it is netted in the presentation of
long-term liabilities).
c. Mortgage Notes Payable: Long-term liability in the balance sheet.
d. Bonds Payable: Long-term liability in the balance sheet.
e. Bond Interest Expense: In other (nonoperating) income and expenses section of

the income statement.

f. Bond Interest Payable: Current liability in the balance sheet.

g. Premium on Bonds Payable: Addition to Bonds Payable; thus, part of a
long-term liability in the balance sheet (e.g., it is included in the presentation of
long-term liabilities).
h. Loss on Bond Retirement: In the other (nonoperating) income and expenses

section of the income statement.
M9-26. (10 minutes)
a. Restrictive loan covenants are typically designed to protect the bond holders
against actions by management that they feel would be detrimental to their
interests. These covenants might include restrictions against the impairment
of liquidity, restrictions on the amount of financial leverage the company can
employ, and restrictions on the payment of dividends. In addition, bond
holders usually impose various covenants prohibiting the acquisition of other
companies or the divestiture of business segments without their consent. All
of these covenants, by design, restrict management in its actions.
b. Management, facing imminent violation of one or more of its bond covenants,

may be pressured into taking actions in order to avoid default. These may
include, for example, foregoing profitable investments, reduction of
discretionary spending such as R&D or advertising in order to improve
profitability, missing opportunities to take cash discounts and other methods
of “leaning on the trade,” or reduction of receivables (via early payment
incentives) and inventories (by marketing promotions or delaying restocking)
in order to boost cash balances. Actions may also include questionable
accounting measures, such as improper recognition of revenues or delayed
recognition of expenses.
c. When evaluating solvency, analysts should compare a company’s position

relative to its restrictive covenants. A company may appear solvent, but in
fact may be in close proximity to a restrictive covenant. Also, analysts should
be aware of the potential effect that restrictive covenants can have on
management decisions (see the answer to requirement b). Restricted assets,
such as cash or securities, should not be considered as general assets in an
analysis of the firm’s liquidity or solvency because they are not available to
management for general corporate uses.

M9-27. (15 minutes)
a.
1/1/2010 Cash (+A) ……………………………………..... 432,000
Bonds payable (+L) ………………..…… 400,000
Bond premium (+L) ………………..…… 32,000
1/1/2016 Bonds payable (-L) ………………………..….. 400,000

Bond premium (-L) ……………………..…….. 27,809
Cash (-A) ………………………………..... 412,000
Gain on retirement of bonds (+R, +SE) 15,809
b.
+ Cash (A) - - Bonds Payable (L) +
1/1/1 432,000 400,000 1/1/10
0
412,000 1/1/16 1/1/16 400,000
- Gain on Retirement of Bonds (R) - Bond Premium (L) +

+
15,809 1/1/16 32,000 1/1/10
1/1/16 27,809
c.
1/1/10 432,000 = +400,000 - =
Issue bonds Cash Bonds
at a premium. Payable
+32,000
Bond
Premium
1/1/16 -412,000 = -400,000 +15,809 +15,809 - = +15,809
Retired bonds Cash Bonds Retained Gain on
issued on Payable Earnings Retirement
1/1/10. of Bonds
-27,809
Bond
Premium

M9-28. (15 minutes)
a.
7/1/2009 Cash (+A) ……………………………………. 240,000
Bond discount (+XL, -L) …………….….…. 10,000
Bonds payable (+L) ………………….. 250,000
7/1/2016 Bonds payable (-L) ………………………… 250,000

Loss on retirement of bonds (+E, -SE) … 9,314
Bond discount (-XL, +L) ……….…… 6,814
Cash (-A) ………………………………. 252,500
b.
7/1/09 240,000 250,000 7/1/09
252,500 7/1/16 7/1/16 250,000
+ Loss on Retirement of Bonds (E) - + Bond Discount (XL) -

7/1/16 9,314 7/1/09 10,000
6,814 7/1/16
c.
Transaction Asset + Assets = Liabilities - Liability + Capital + Capital Revenues - Expenses = Income
7/1/09 +240,000 = +250,000 +10,000 - =
Issue bonds
Cash Bonds Bond
at a discount
Payable Discount
7/1/16 Retired -252,500 = -250,000 -6,814 -9,314 - +9,314 = -9,314

bonds issued
Cash Bonds Bond Retained Loss on
on 7/1/09
Payable Discount Earnings retirement
of Bonds
M9-29. (10 minutes)
Nissim: $18,000 × 0.10 × 40/365 = $197.26

Klein: $14,000 × 0.09 × 18/365 = 62.14
Bildersee: $16,000 × 0.12 × 12/365 = 63.12
$322.52

M9-30. (10 minutes)
a. Unless there has been a decline in the General Mills’ operating liabilities, the
Debt-to-Equity ratio (D/E) will increase. The net effects of financing cash flows
are to increase financial liabilities and decrease shareholders’ equity. Times
interest earned will decrease as additional interest cost on new borrowing is
added to the denominator. How much of an effect this will have depends on
the size of the change in net income.
b. Generally, the higher (lower) the firm's solvency measures, the higher (lower)
the firm's debt rating. In financial leverage terms, the higher (lower) the firm's
leverage the lower (higher) the firm's debt rating. Increasing the amount of
debt while decreasing equity may harm General Mills’ debt ratings, though
increases in operating results (reflected in Times Interest Earned), could
support additional financial liabilities.
M9-31. (15 minutes)
a. Selling price of 9% bonds discounted at 8%

Present value of principal repayment ($500,000 × 0.45639) $228,195
Present value of interest payments ($22,500 × 13.59033) 305,782
Selling price of bonds $533,977
b. Selling price of 9% bonds discounted at 10%

M9-32. (15 minutes)
a. Selling price of zero-coupon bonds discounted at 8%:

b. Selling price of zero coupon bonds discounted at 10%:

c. Based on the debt-to-equity ratio, financial leverage would increase from 2.0
[=($3 - $1)/$1] to 2.19 [=($3 - $1 + $0.188)/$1)

M9-33. (15 minutes)
a.
Month 1 2 3 4
Income statement:
Revenue $420 $420 $420 $420
Cost of goods sold 300 300 300 300
Operating expenses 110 110 110 110
Income $10 $10 $10 $10
Operating cash flows

Receipts $420 $420 $420 $420
Payments to suppliers 300 300 300 300
Payments for operating
110 110 110 110
expenses
Net cash flow from operations $10 $10 $10 $10
b.
Month 1 2 3 4
Income statement:
Revenue $420 $420 $420 $420
Cost of goods sold 300 300 300 300
Operating expenses 110 110 110 110
Income $10 $10 $10 $10
Operating cash flows

Receipts $420 $420 $420 $420
Payments to suppliers 0 300 300 300
Payments for operating
110 110 110 110
expenses
Net cash flow from operations $310 $10 $10 $10
The CFO’s proposal would increase the cash generated by operations, but
only for one month. Then the cash flows would revert to their original pattern.
Therefore, “leaning on the trade,” (deferring payables) is not likely to produce
a steady source of cash for expansion of the business.

M9-34. (30 minutes)

M9-35. (15 minutes)
a. Gain on bond retirement Reported in the income statement under other

(nonoperating) income
b. Discount on bonds payable Contra-liability netted against bonds payable
under long-term liabilities in the balance sheet
c. Mortgage notes payable Long-term liability in the balance sheet; the
amount due within one year would be reported as
a current liability
d. Bonds payable Long-term liability in the balance sheet; the
amount due within one year would be reported as
a current liability
e. Bond interest expense Nonoperating expense reported in the income
statement
f. Bond interest payable A current liability in the balance sheet
g. Premium on bonds payable Adjunct-liability added to bonds payable under
long-term liabilities in the balance sheet
M9-36. (15 minutes)
a.
12/31/15 Cash (+A) …………………………………….. 700,000
Mortgage note payable (+L) ………….. 700,000
6/30/16 Interest expense (+E, -SE) ……………………. 42,000

Mortgage note payable (-L) …………………… 8,854
Cash (-A) ………………………………….. 50,854
12/31/16 Interest expense (+E, -SE) …………………… 41,469

Mortgage note payable (-L) ………………….. 9,385
Cash (-A) …………………………………. 50,854
* $41,469 = ($700,000 – $8,854) x 12%/2.

b.
+ Cash (A) - - Mortgage Note Payable (L)
+
12/31/ 700,000 700,000 12/31/
15 15
50,854 6/30/16 6/30/16 8,854
50,854 12/31/1 12/31/16 9,385
6

6/30/1 42,000
6
12/31/ 41,469
16
c.

12/31/15 +700,000 = +700,000 - =
Borrow $700,000
Cash Mortgage
on a 15-year
Note
mortgage note
Payable
payable.
6/30/16 -50,854 = -8,854 -42,000 - +42,000 = -42,000
Interest payment
Cash Mortgage Retained Interest
on note.
Note Earnings Expense
Payable
12/31/16 -50,854 = -9,385 -41,469 - +41,469 = -41,469
Interest payment
on note.
Payable
M9-37. (5 minutes)
$900,000 x 0.55839 + [(900,000 x 10%/2) x 7.36009] = $833,755.

$833,755 / $900,000 = 92.6% of par value.

EXERCISES
E9-38. (15 minutes)
a.
Total expected failures from units sold in the current period ............. 1,380*
Average cost per failure ....................................................................... × $50
Total expected warranty costs for current period sales ...................... $ 69,000
Plus beginning warranty liability .......................................................... $ 30,000
Minus warranty services provided ....................................................... $ 27,000
Ending warranty liability ....................................................................... $ 72,000
*(69,000 x 0.02)
The product warranty liability must be increased by $69,000 to cover the

expected repair costs of products sold during the period, and that amount would
be recognized as expense. With the opening liability balance of $30,000 and
warranty services provided of $27,000, the ending liability balance would be
$72.000.
b. The warranty liability should be equal, at all times, to the expected dollar cost
of future repairs. Waymire Company should conduct an analysis similar to an
aging of accounts to determine which products are still under warranty and
what the expected cost will be. That estimate will provide the correct value
for the warranty liability and determines any required adjustments in the
period’s warranty expense.
Analysis issues relate to whether the warranty liability exists and, if so,
whether it is at the correct amount. Understating (overstating) the accrual
overstates (understates) current period income at the expense (benefit) of
future income.
c. The debt-to-equity ratio will increase and the operating cash flow to liabilities
will decrease. The times-interest earned ratio will decrease, because the
increase in liability causes an increase in warranty expense, which decreases
earnings before interest and taxes.

E9-39. (10 minutes)
Item Accounting Treatment

a. Neither record nor disclose (neither probable nor reasonably possible)
b. Record a current liability for the note, no liability for interest until incurred
as time passes.
c. Disclose in a footnote (at least reasonably possible)
d. Record warranty liability on balance sheet and recognize expense in
income statement (costs are probable and reasonably estimable).
E9-40. (15 minutes)
The company must accrue the $25,000 of wages that have been earned by
employees even though these wages will not be paid until the first of next month.
The required accounting accrual will:
• Increase wages payable by $25,000 on the balance sheet
• Increase wages expense by $25,000 in the income statement
Failure to make this accounting accrual (called an adjusting entry) would understate
liabilities, understate expenses, overstate income, and overstate stockholders’
equity.
E9-41. (15 minutes)
a. Selling price of bonds:

Present value of principal repayment ($300,000 × 0.30832) $ 92,496
b.
1/1/16 Cash (+A) …………………………………….. 377,814
Bond premium (+L) …………………… 77,814
Bonds payable (+L) ……………...…… 300,000
6/30/16 Interest expense (+E, -SE) ………………… 15,113

Bond premium (-L) ……………...………….. 1,387
Cash (-A) ……………………………….. 16,500

Bond premium (-L) …………………………. 1,443

Cash (-A) ……………………………….. 16,500
$15,057 = ($377,814 – $1,387) x 8%/2.

c.
1/1/16 377,814 300,000 1/1/16
16,500 6/30/16
16,500 12/31/16
+ Interest Expense (E) - - Bond Premium (L) +

77,814 1/1/16
6/30/1 15,113 6/30/16 1,387
6
12/31/ 15,057 12/31/16 1,443
16
d.

1/1/16 +377,814 = +300,000 - =
Issue bonds at
Cash Bonds
a premium.
Payable
+77,814
Bond
Premium
6/30/16 -16,500 = -1,387 -15,113 - +15,113 = -15,113

Interest
Cash Bond Retained Interest
payment on
Premium Earnings Expense
bonds.
12/31/16 -16,500 = -1,443 -15,057 - +15,057 = -15,057

Interest
payment on
bonds.
E9-42. (10 minutes)
Selling price of bonds


E9-43. (15minutes)
a. Additions to the Warranty provision would be reflected in Warranty expense.
Warranty expense (+E, -SE) ………………………. 1,776

Warranty provision (+L)…………………… 1,776
b. Usage of the warranty provision would reflect Siemens providing warranty

services to its customers. The provision liability would be reduced, as would
balances in cash and perhaps inventory reflecting the resources needed for
the warranty work.
Warranty provision (-L) 771

……………………………..
Cash or inventory (- 771
A)…………………….
c. It can be useful to report the additions and reversals separately for a couple
of reasons. First, the reversals would reflect past periods’ errors in estimates,
while the additions could reflect the expected cost of providing warranty
service for sales made in the current period. In addition, it may provide
insights into whether Siemens tends to be systematically optimistic or
pessimistic in its estimates. The numbers reported indicate that Siemens
tends to overestimate its warranty expenses.
d. 2014: €1,776/ €71,920 = 2.5%

2013: €1,544/ €73,445= 2.1%.
Warranty expense appears to have increased in 2014 as a percentage of

sales revenue.
E9-44. (15 minutes)
a.
5/1/15 Cash (+A) ………………………………………... 500,000
Bonds payable (+L) ………………………. 500,000
10/31/15 Interest expense (+E, -SE) ……………………. 22,5001

Cash (-A) …………………………………... 22,500
11/1/16 Bonds payable (-L) ……………………………... 300,000

Loss on retirement of bonds (+E, -SE) ………. 3,000
Cash (-A) …………………………………… 303,0002

1
$500,000 x 0.09 x 1/2 = $22,500 interest expense. Because the bonds were
sold at par, there is no discount or premium amortization.
2
Cash required to retire $300,000 of bonds at 101 = $300,000 x 1.01 =
$303,000. The difference between the cash paid and the carrying amount of
the bonds is the gain or loss on the redemption. In this case, the loss is
$3,000. This calculation assumes that the interest was paid on 10/31/16, so
accrued interest is not recorded.

b.
5/1/15 500,000 500,000 5/1/15
22,500 10/31/1
5
303,000 11/1/16 11/1/16 300,000
+ Interest Expense (E) - + Loss on Retirement of Bonds (E)

-
10/31/ 22,500 11/1/16 3,000
15
c.

5/1/15 +500,000 = +500,000 - =
Issue bonds.
Cash Bonds
Payable
10/31/15 -22,500 = -22,500 - +22,500 = -22,500

Interest payment
on bonds.
Earnings Expense
11/1/16 -303,000 = -300,000 -3,000 - +3,000 = -3,000

Early retirement
Cash Bonds Retained Loss on
of bonds.
Payable Earnings Retirement of
Bonds
E9-45. (25 minutes)
a. Selling price of bonds

b.
1/1/16 Cash (+A) ………………………………………. 220,776
Bond discount (+XL, -L) ……………………… 29,224
Bonds payable (+L) …………………….. 250,000
6/30/16 Interest expense (+E, -SE) …………………… 11,039

Bond Discount (-XL, +L) ………….……. 1,039
Cash (-A) ………………………………….. 10,000
$11,039 = $220,776 × 0.05


12/31/16 Interest expense (+E, -SE) …………………. 11,091
Bond Discount (-XL, +L) …………….…. 1,091
Cash (-A) ………………………………….. 10,000
$11,091 = [$220,776 + $1,039] × 0.05

c.
1/1/16 220,776 250,000 1/1/16
10,000 6/30/16
10,000 12/31/16
+ Interest Expense (E) - + Bond Discount (XL) -

1/1/16 29,224
6/30/1 11,039 1,039 6/30/1
6 6
12/31/ 11,091 1,091 12/31/
16 16
d.
1/1/16 +220,776 = +250,000 +29,224 - =
Issue bonds
Cash Bonds Bond
at a
Payable Discount
discount.
6/30/16 -10,000 -1,039 -11,039 +11,039 -11,039
Interest
payment on
Discount Earnings Expense
bonds.
12/31/16 -10,000 = -1,091 -11,091 - +11,091 = -11,091

Interest
payment on
bonds.
E9-46. (25 minutes)
a. Selling price of bonds:

b.
1/1/16 Cash (+A) ………………………………………... 879,172
Bond premium (+L) ……………………… 79,172
Bonds payable (+L) ……………………… 800,000
6/30/16 Interest expense (+E,-SE) ……………………. 35,167

Bond premium (-L) …………….……………… 833
Cash (-A) ………………………………….. 36,000
$35,167 = $879,172 x 0.04

12/31/16 Interest expense (+E,-SE) ……………………. 35,134
Bond premium (-L) …………….……………… 866
Cash (-A) ………………………………….. 36,000
$35,134 = ($879,172 - $833) x 0.04

c.
1/1/16 879,172 800,000 1/1/16
36,000 6/30/16
36,000 12/31/1
6
+ Interest Expense (E) - - Bond Premium (L) +

79,172 1/1/16
6/30/1 35,167 6/30/16 833
6
12/31/ 35,134 12/31/16 866
16
d.
1/1/16 +879,172 = +800,000 - =
Issue bonds at
Cash Bonds
a premium.
Payable
+79,172
Bond
Premium
6/30/16 -36,000 = -833 -35,167 - +35,167 = -35,167

Interest
payment on
bonds.
12/31/16 -36,000 = -866 -35,134 - +35,134 = -35,134
Interest
payment on
bonds.
E9-47. (20 minutes)
a. There is an inverse relation between interest rates and bond prices (examine
the increasing discount rates as the yield increases in present value tables).
Since the bonds now trade at a premium and assuming that Deere’s credit
ratings have not changed, we can conclude that interest rates have fallen
since the bonds were issued.
b. No, once the bond is initially recorded, neither the coupon rate nor the yield
used to compute interest expense is changed. Bonds are recorded at
historical cost (like most other balance sheet assets and liabilities). As a
result, changes in the general level of interest rates have no effect on interest
expense (or the interest payment) that is reflected in the financial statements.

c. Because the bonds trade at a premium in the market, Deere would be paying
more to retire the bonds than the amount at which they are carried on its
balance sheet. This would result in a loss on the repurchase that would lower
current profitability.
d. The face amount of the bonds will be paid at maturity. As a result, the market
price of the bonds must also equal their face amount ($200 million) at that
time.
E9-48. (25 minutes)
a. Selling price of bonds

Present value of principal repayment ($600,000 × 0.09722) $ 58,332
b.
1/1/16 Cash (+A) …………………………………….. 554,860
Bond discount (+XL, -L) ………………..…… 45,140
Bonds payable (+L) …………………… 600,000
6/30/16 Interest expense (+E, -SE) …………………. 33,292

Bond discount (-XL, +L) ………………. 292
Cash (-A) ………………………………… 33,000
$33,292 = $554,860 × .06.

Bond discount (-XL, +L) …………….…. 309
Cash (-A) ………….……………………. 33,000
$33,309 = ($554,860 + $292) × 0.06.
c.
1/1/16 554,860 600,000 1/1/16
33,000 6/30/16
33,000 12/31/1
6

1/1/16 45,140
6/30/1 33,292 292 6/30/1
6 6
12/31/ 33,309 309 12/31/
16 16

d. At December 31, 2016 (after the coupon payment recorded in b), the book
value of the bonds would be $554,860 + $292 + $309 = $555,461. The
market value would be $600,000 X 1.01 = $606,000. Thus, a fair value
adjustment of $50,539 (=$606,000-$555,461) would be recorded as follows:
12/31/16 Loss due to adjustment of bonds to fair value +E,-SE) 50,539

Fair value adjustment (+L) 50,539
The loss would be reported in net income for the period.
e. Coupon payments ($33,000 X 2) $ 66,000

Discount amortization ($292 + $309) 601
Total interest expense 66,601
Fair value adjustment (loss) 50,539
Total effect on income (deduction) $117,140
E9-49. (10 minutes)
Current liabilities:
Bond interest payable $ 25,000
Current maturities of long-term debt:
10% bonds payable due 2016 500,000
Total current liabilities $525,000
Long-term debt:
9% bonds payable due 2017, net of $19,000 discount $581,000
Zero coupon bonds payable due 2018 170,500
8% bonds payable due 2020, including $2,000 premium 102,000
Total long-term debt $853,500

E9-50. (20 minutes)
a.
12/31/15 Cash (+A) …………………………………………… 500,000
Mortgage note payable (+L) ………………. 500,000
3/31/16 Interest expense (+E, -SE) ………………………. 10,000

Mortgage note payable (-L) ……………………... 8,278
Cash (-A) ……………………………………… 18,278
6/30/16 Interest expense (+E, -SE) ………………………. 9,834

Mortgage note payable (-L) ……………………... 8,444
Cash (-A) ……………………………………… 18,278
$9,834 = ($500,000 – $8,278) x 8%/4.
b.
+ Cash (A) - - Mortgage Note Payable (L) +
12/31/ 500,000 500,000 12/31/
15 15
18,278 3/31/16 3/31/16 8,278
18,278 6/30/16 6/30/16 8,444

3/31/1 10,000
6
6/30/1 9,834
6
c.
12/31/15 Borrow +500,000 = +500,000 - =
$500,000 on a
Cash Mortgage
10-year mortgage
Note
note payable.
Payable
3/31/16 Payment -18,278 = -8,278 -10,000 - +10,000 = -10,000
on note.
Payable
6/30/16 Payment -18,278 = -8,444 -9,834 - +9,834 = -9,834
on note.
Payable

PROBLEMS
P9-51. (20 minutes)
a.
Hewlett-Packard Cisco Systems
- Accrued Warranty Liability (L) - Accrued Warranty Liability (L)
+ +
2,031 13 bal. 402 13bal.
1,840 14 exp. 704 14 exp.
1,915 660
1,956 14 bal. 446 14 bal.
Hewlett-Packard incurred $1,915 million in warranty repair costs and

settlements in 2014 while Cisco Systems, Inc. incurred costs of $660 million.
b. HP’s ratio of warranty expense to sales was 2.50% in 2014 ($1,840/$73,726)

down slightly from 2.72% in 2013 ($2,007/$72,398). Cisco’s ratio was 1.95%
in 2014 ($704/$36,172) and 1.71% ($649/$38,029) in 2013. Cisco’s warranty
expense is lower relative to sales revenue than that of HP. Possible reasons
for this include the following: (1) perhaps Cisco products require fewer repairs
than HP products or (2) HP may have a more generous warranty policy than
Cisco, resulting in more warranty repairs, even if the quality is the same. The
decrease in HP’s warranty expense as a percent of sales indicates that either
(1) warranty costs have gone down, (2) the company overestimated warranty
costs in the past and needed to record smaller than normal accruals in 2014
to correct the overestimation; or (3) HP was building up a “cookie-jar reserve”
by increasing its warranty liability in past years.
P9-52. (20 minutes)
a. Cash (+A) ………………………………………….. 518,750

Accrued interest payable (+L) …………… 18,750
Bonds payable (+L) ……………………….. 500,000
$18,750 = $500,000 x .09 x 5/12
b. Interest expense (+E, -SE)………………………. 3,750

Accrued interest payable (-L) ………………….. 18,750
Cash (-A) …………………………………….. 22,500
$22,500 = $500,000 x 9%/2

c. Interest expense (+E, -SE) ……………………… 7,500
Accrued interest payable (+L) …………… 7,500
$7,500 = $500,000 x 9% x 2/12

d. Fair value adjustment (+XL, -L) ……………….. 5,000
Gain from adjustment of bonds to fair value 5,000
(+R, +SE) ……………………………..
e. Interest expense (+E, -SE) ……………………… 15,000

Accrued interest payable (-L) ………………….. 7,500
Cash (-A) …………………………………….. 22,500
f. Bonds payable (-L) ………………………………. 300,000

Loss on retirement of bonds (+E, -SE) ………. 18,000
Cash (-A) …………………………………….. 303,000
Fair value adjustment (-XL, +L) … 15,000
g. If gains/losses on bond revaluations were reported in other

comprehensive income rather than net income, Eskew, Inc.’s December
31, 2015 income statement would be lower because it would not include
the $5,000 gain from part d above. The $5,000 gain (after accounting for
expected taxes) would increase the balance in an account entitled
accumulated other comprehensive income in Eskew, Inc.’s shareholders’
equity, so shareholders’ equity would be unchanged. (Such gains/losses
would go through the income statement when Eskew, Inc. redeems the
bonds.)
P9-53. (15 minutes)
a. CVS reports interest expense of $615 million, plus $19 million in capitalized
interest, giving a total interest cost of $634 million on average debt of
$13,178.5 million ([$12,995 million + $13,402 million]/2) for an average rate of
4.8%. Using interest paid ($647 million) instead of interest expense yields
4.9%. See the answer to c below.
b. CVS reports coupon rates of 1.2% to 6.6%. In addition, no rates are reported
for capital leases, mortgage notes, commercial paper, or the floating rate
notes. So, the average rate seems reasonable given the information
disclosed in the long-term debt footnote.
c. Interest paid can differ from interest expense if bonds are sold at a premium
or a discount. It can also differ because of capitalized interest. CVS reported
capitalized interest of $19 million in 2014. Thus, CVS apparently amortized
$13 million in net bond discounts ($647m -$615m -$19m).

P9-54. (25 minutes)
a. 7/1/16 Cash (+A) ……………………………………. 824,000

Accrued interest payable (+L) ……. 24,000
Bonds payable (+L) ………………… 800,000
$24,000 = $800,000 x .09 x 4/12
b. 9/1/16 Interest expense (+E, -SE) ……………..… 12,000

Accrued interest payable (-L) ……………. 24,000
Cash (-A) ……………………………… 36,000
$36,000 = $800,000 x 9%/2
c. 12/31/16 Interest expense (+E, -SE) ………………… 24,000

Accrued interest payable (+L) ……. 24,000
d. 3/1/17 Interest expense (+E) ……………………… 12,000

Accrued interest payable (-L) ……………. 24,000
Cash (-A) ……………………………… 36,000
e. 3/1/17 Bonds payable (-L) ………………………… 200,000

Loss on retirement of bonds (+E, -SE) … 2,000
Cash (-A) …………………………….. 202,000

a. 824,000 36,000 b. 800,000 a.
36,000 d.
202,000 e. e. 200,000
+ Interest Expense (E) - - Accrued Interest Payable (L) +

b. 12,000 b. 24,000 24,000 a.
c. 24,000 d. 24,000 24,000 c.
d. 12,000
+ Loss on Retirement of Bonds (E) -
e. 2,000
continued next page

a. 7/1/16 +824,000 = +800,000 - =
Issue
Cash Bonds
bonds.
Payable
+24,000
Interest
Payable
b. 9/1/16 -36,000 = -24,000 -12,000 - +12,000 = -12,000

Interest
Cash Interest Retained Interest
payment
on bonds.
c. 12/31/16 = +24,000 -24,000 - +24,000 = -24,000

Accrued
Interest Retained Interest
interest
on bonds.
d. 3/1/17 -36,000 = -24,000 -12,000 - +12,000 = -12,000

Interest
Cash Interest Retained Interest
payment
on bonds.
e. 3/1/17 -202,000 = -200,000 -2,000 - +2,000 = -2,000

Early
Cash Bonds Retained Loss on
retirement
Payable Earnings Retirement of
of bonds.
bonds
P9-55. (20 minutes)
a.
Interest Cash Discount Discount Bond
Period Expense Interest Paid Amortization Balance Payable Net
0 $41,292 $678,708
1 $40,722 $39,600 $1,122 $40,170 $679,830
2 $40,790 $39,600 $1,190 $38,980 $681,020
$40,722 = $678,708 x 12%/2
$40,790 = $679,830 x 12%/2
b.
12/31/15 Cash (+A) ………………………………….. 678,708
Bond discount (+XL) ……………………. 41,292
Bonds payable (+L) ……………….. 720,000
6/30/16 Interest expense (+E,-SE) ………………. 40,722
Bond discount (-XL) ……………….. 1,122
Cash (-A) …………………………….. 39,600
12/31/16 Interest expense (+E,-SE) ………………. 40,790
Bond discount (-XL) ……………….. 1,190
Cash (-A) …………………………….. 39,600

c.
12/31/ 678,708 720,00 12/31/
15 0 15
39,600 6/30/16
39,600 12/31/1
6

12/31/15 41,292
6/30/1 40,722 1,122 6/30/1
6 6
12/31/ 40,790 1,190 12/31/
16 16
d.
Cash Noncash Contra Contrib. Retained Net

Transaction Asset + Assets = Liabilities - Liability + Capital + Earnings Revenues - Expenses = Income
12/31/15 +678,708 = +720,000 +41,292 - =
Issue bonds
Cash Bonds Bond
at a discount.
Payable Discount
6/30/16 -39,600 = -1,122 -40,722 - +40,722 = -40,722
Interest
payment on
bonds.
12/31/16 -39,600 = -1,190 -40,790 - +40,790 = -40,790

Interest
Cash Bonds Retained Interest
payment on
bonds.
P9-56. (20 minutes)
a.
Interest Cash Discount Discount Bond
Period Expense Interest Paid Amortization Balance Payable Net
0 $43,230 $206,770
1 $8,271 $7,500 $771 $42,459 $207,541
2 $8,302 $7,500 $802 $41,657 $208,343
$8,271= $206,770 x 8%/2
$8,302 = $207,541 x 8%/2
b.
4/30/16 Cash (+A) …………………….……….………..…… 206,770
Bond discount (+XL, -L) …………………………. 43,230
Bonds payable (+L) …….…………………… 250,000

10/31/16 Interest expense (+E, -SE) ………………..….….. 8,271
Bond discount (-XL, +L) ……………………. 771
Cash(-A) ……………………………………….. 7,500
continued next page

12/31/16 Interest expense (+E, -SE) ………………..….….. 2,767*
Accrued interest payable (+L) …………….. 2,500
4/30/17 Interest expense (+E, -SE) …………………...….. 5,535*

Accrued interest payable (-L) ………..….………. 2,500
Cash(-A) ……………………………………….. 7,500
* Within each six-month period, interest is apportioned to individual months

on a straight-line basis.
c.
4/30/1 206,770 250,00 4/30/1
6 0 6
7,500 10/31/1
6
7,500 4/30/17

4/30/16 43,230
10/31/ 8,271 771 10/31/
16 16
12/31/ 2,767 267 12/31/
16 16
4/30/1 5,535 535 4/30/1
7 7
- Accrued Interest Payable (L) +

2,500 12/31/1
6
4/30/1 2,500
7
d.

4/30/16 +206,770 = +250,000 +43,230 - =
Issue bonds
Cash Bonds Bond
at a discount.
Payable Discount
10/31/16 -7,500 = -771 -8,271 - +8,271 = -8,271

Interest
payment on
bonds.

12/31/16 = +2,500 -267 -2,767 - +2,767 = -2,767
Accrued
Accrued Bond Retained Interest
interest on
Interest Discount Earnings Expense
bonds.
Payable
4/30/17 -7,500 = -2,500 -535 -5,535 - +5,535 = -5,535

Interest
Cash Accrued Bond Retained Interest
payment on
Interest Discount Earnings Expense
bonds.
Payable

P9-57. (20 minutes)
a. Payment x 12.46221 = $500,000; Payment = $500,000/12.46221 = $40,121.
b.
12/31/15 Cash (+A) ………………………………………..…… 500,000
Mortgage note payable (+L) ………………… 500,000
6/30/16 Interest expense (+E, -SE) ………………………… 25,000

Mortgage note payable (-L) ………………………. 15,121
Cash (-A) …………………………………..…… 40,121
$25,000 = $500,000 x 10%/2
12/31/16 Interest expense (+E, -SE) ……………………….… 24,244

Mortgage note payable (-L) ……………………….. 15,877
Cash (-A) …………………………………..…… 40,121
$24,244 = ($500,000 – $15,121) x 10%/2
c.
12/31/ 500,000 500,00 12/31/
15 0 15
40,121 6/30/16 6/30/16 15,121
40,121 12/31/16 12/31/16 15,877
6/30/1 25,000
6
12/31/ 24,244
16
d.
Transaction Asset + Assets = Liabil-ities + Capital + Capital Revenues - Expenses = Income
12/31/15 +500,000 = +500,000 - =
Borrow $500,000
Cash Mortgage
on a 10-year
Note
mortgage note
Payable
payable.
6/30/16 Interest -40,121 = -15,121 -25,000 - +25,000 = -25,000

payment on note.
Payable

12/31/16 Interest -40,121 = -15,877 -24,244 - +24,244 = -24,244
payment on note.
Payable

P9-58. (20 minutes)
a. Payment x 16.35143 = $950,000; Payment = $950,000/16.35143 = $58,099.
b.
12/31/15 Cash (+A) ………………………………………..…… 950,000
Mortgage note payable (+L) ………………… 950,000
3/31/16 Interest expense (+E, -SE) ………………………… 19,000*

Cash (-A) …………………………………..…… 58,099
* $19,000 = $950,000 x 8%/4
6/30/16 Interest expense (+E, -SE) ………………………… 18,218*

Cash (-A) …………………………………..…… 58,099
* $18,218 = ($950,000 – $39,099) x 8%/4.
c.
12/31/ 950,000 950,00 12/31/1
15 0 5
58,099 3/31/16 3/31/16 39,09
9
58,099 6/30/16 6/30/16 39,88
1
3/31/1 19,000
6
6/30/1 18,218
6
d.
12/31/15 +950,000 = +950,000 - =
Borrow $950,000
Cash Mortgage
on a 5-year
Note
mortgage note
Payable
payable.

3/31/16 -58,099 = -39,099 -19,000 - +19,000 = -19,000
Payment on note.
Payable
6/30/16 -58,099 = -39,881 -18,218 - +18,218 = -18,218

Payment on note.
Payable

P9-59. (10 minutes)
a. BP recorded the $9.2 billion estimate as an expense on its 2010 income

statement. This increased the company’s liabilities.
b. If BP had prepared its financial statements in accordance with U.S.
GAAP, the accrual would most likely have been at the low end of the
range -- $6 million, instead of the expected amount (best reliable
estimate), or mid-point in the range.

CASES and PROJECTS
C9-60. (30 minutes)
a. The difference between interest expense and interest paid can be caused by
three factors: (1) interest capitalized as part of self-constructed assets is paid
but not part of interest expense; (2) coupon payments differ from interest
expense charged on bonds due to amortization of discounts or premiums; (3)
interest payments may not coincide with the fiscal period, thus requiring the
company to record accrued interest payable.
b. In 2014, Comcast’s debt had a fair value of $55.3 billion while its historical
cost was $48.2 billion. Thus, Comcast would report a fair value adjustment
as a credit in its balance sheet of $7.1 billion ($55.3 - $48.2). In 2013, the fair
value was $51.8 billion and the historical cost was $47.8 billion yielding a
credit balance in the fair value adjustment account of $4.0 billion ($51.8 -
$47.8). The change in the fair value adjustment from 2013 to 2014 ($3.1 =
$7.1 – $4.0) would be recorded as follows:
12/31/14 Loss due to adjustment of bonds to fair value (+E, -SE) 3.1
Fair value adjustment (+L) 3.1
c. Debt-to-equity: $106,271 million/$53,068 million = 2.00
Times interest earned: ($12,465 million + $2,617 million)/$2,617 million = 5.76
Creditors are naturally concerned about the risk of default. The debt-to-equity
ratio measures the extent to which a company is relying on debt financing and
the higher the ratio, the greater chance of default. In addition, the times
interest earned ratio measures the company’s ability to pay the interest on the
debt.
d. Management may bypass profitable investment projects or cut discretionary

expenditures such as R&D or advertising. It may also engage in questionable
accounting practices in an attempt to manage the ratios.

C9-61. (20 minutes)
a. The gain results from the difference between the book value of the debt
($3,000,000) and the current redemption (market) value ($2,200,000). The
gain would be reported in the income statement under other (nonoperating)
income. The source of the gain should be adequately disclosed in the notes.
b. Currently, Foster is paying 4% interest on the $3,000,000 of long-term debt,

or $120,000 per year. Under the proposed refinancing, Foster would pay 8%,
or $240,000. The refinancing would generate an additional $800,000 in cash.
However, because interest costs are increasing by $120,000 per year
($240,000 - $120,000), Foster is effectively borrowing the additional $800,000
at a rate of almost 15% ($120,000 / $800,000). As such, Foster would be
paying in the future (in the form of higher interest costs) for a one-time boost
in current earnings.
c. The potential ethical conflict exists because Foster’s president is concerned

that his job might be dependent on producing short-term earnings. Because
of this, he might be tempted to accept this proposal and boost current
earnings at the cost of lower earnings in future years. This thinking is
misguided because, given adequate disclosure, analysts and investors would
be able to identify and discount the source of the earnings boost. The most
serious unethical act would be to try to hide (or obfuscate) the bond
refinancing with inadequate disclosure.
Chapter 10
Leases, Pensions, and Income Taxes

Cases
Mini-
Exercises
Projects
LO1 – Define off-balance-sheet 21 45

financing and explain its effects

on financial analysis.
LO2 – Account for leases using

the operating lease method or 12 - 15 23, 25 - 28 35 - 37 45
the capital lease method.
LO3 – Convert off-balance-

sheet operating leases to the 14, 16 23, 25 - 28 35 - 37 45
capital lease method.
LO4 – Explain and interpret the 17 - 20 24, 29, 30 38, 39 44

reporting for pension plans.
LO5 – Analyze and interpret 18 - 20 24, 29, 30 38, 39 44

pension footnote disclosures.
LO6 – Describe and interpret 22 31 - 34 40 - 43 46, 47

accounting for income taxes.

QUESTIONS
Q10-1. In accounting for an operating lease, the lessee doesn’t record either the
leased asset or the lease liability on the balance sheet, and normally
charges each lease payment to rent expense. In contrast, the lessee
accounts for a capital lease by recording the leased property as an asset
and establishing a liability for the lease obligation. The leased asset is
subsequently depreciated, and interest expense is accrued on the lease
liability.
Q10-2. The leasing footnote is reasonably complete to allow for capitalization of
operating leases for analysis purposes. Despite the quality of the leasing
disclosures, on-balance-sheet treatment is, arguably, a more direct form
of communication from the company and, as a result, is more easily
interpreted by users of its financial statements.
Q10-3. Yes, over the term of the lease the rent expense on an operating lease
will be equal to the sum of the interest and depreciation on a capital
lease. Only the timing of the expense recognition changes. Expense is
ultimately related to the cash flows required to discharge the obligation.
Those cash flows are the same whether or not the lease is capitalized.
Q10-4. Under defined contribution plans, companies and employees make
contributions to the plans which, together with earnings on the amounts
invested, provide the sole source of funding for payments to retirees.
Under defined benefit plans, the obligations are defined with payment to
be made in the future from general corporate funds. These plans may or
may not be fully funded. Since the company’s obligation is extinguished
upon contribution for a defined contribution plan, the accounting is
relatively simple: record an expense when paid or accrued. Defined
benefit plans present a number of complications in that the liability is
very difficult to estimate and involves a number of critical assumptions.
In addition, companies lobbied for (and the FASB agreed to) various
mechanisms to smooth the impact of pension costs on reported
earnings. These smoothing mechanisms further complicate the
accounting for defined benefit plans vis-à-vis defined contribution plans.
Q10-5. Although the accounting can get complicated, a net pension asset will be
reported if the fair market value of the plan assets exceeds the plan
obligation. Otherwise, a net liability will be reported on the balance sheet
to represent the underfunding of the pension obligation.
Q10-6. Service cost, interest cost and the expected return on plan investments
(a reduction of the pension cost) are the basic components of pension
expense. Companies might also report amortization of deferred gains
and losses.

Q10-7. The use of expected returns and the deferral of unexpected gains and
losses act to smooth corporate earnings by removing the effects of
swings in the market values of investments and variation in pension
liabilities resulting from changes in actuarial assumptions or plan
amendments.
Q10-8. For a capital lease, the initial value of the lease asset and the lease
obligation are determined by calculating the present value of the
minimum lease payments. The minimum lease payments include those
payments that are not subject to options or contingencies, including any
guaranteed residual value.
Q10-9. Retirement benefits are normally expensed in the period in which they
are earned by the employee, not when they are paid. Some benefits are
calculated for periods of employment prior to the inception of a pension
plan or prior to a plan amendment. The cost of these benefits (called
prior service costs) is expensed by amortizing the cost over the average
expected future period of employee service.
Q10-10. Income tax expense is a financial accounting expense measured using
accrual accounting. Thus, the expense includes the cash taxes paid but
also includes accruals for future tax payments and future tax benefits
that result from transactions in the current period.
Q10-11. A tax payment would be recorded as a deferred tax asset or liability
under two situations. First, if the company is required to make a tax
payment based on a temporary difference that makes taxable income
reported on the tax return higher than the income reported for financial
accounting. In this case, the tax on the temporary difference would not
be recorded as tax expense. Recall that tax expense is the expense
related to the accounting income. For example, consider a company that
receives a cash payment in advance of delivering a service. For financial
accounting this is recorded as unearned revenue and not recognized as
revenue until earned and thus is not in accounting earnings. However,
generally for tax purposes such a payment would be included in taxable
income. Thus, a cash tax payment would be required to be made on this
amount. For financial accounting, this would increase current tax
expense but a deferred tax asset and corresponding deferred tax benefit
(negative tax expense) would need to be recorded yielding a zero effect
on total income tax for the year. The second situation arises when a
deferred tax liability reverses. In this situation, tax expense has been
recognized in excess of tax payments in prior years. When the tax
return “catches up with” the income statement, the tax deferral reverses
and the deferred tax liability is reduced (debited). Consider the example
of depreciation discussed in the text. In the later years of the asset’s life,
taxable income will be higher than book income. The cash tax payments
related to that temporary difference will be recorded as current tax
expense. In addition, the deferred tax liability will also be reversed along

with a reduction to deferred tax expense, thus, again, the net effect on
the total tax expense will be zero.

MINI EXERCISES
M10-12. (15 minutes)
a. i.
1/3 No entry
12/31 Rent expense (+E, -SE) …………………………. 12,000
Cash (-A) …………………………………… 12,000
ii.
1/3 Leased asset (+A) ……………………………….. 57,198
Lease liability (+L) ………………………… 57,198
$57,198 = $12,000 x 4.76654
12/31 Depreciation expense (+E, -SE) ……………...… 9,533

Accumulated depreciation (+XA) ………… 9,533
$9,533 = $57,198 / 6
12/31 Lease liability (-L) ………………………………… 7,996

Interest expense (+E, -SE) ……………………… 4,004
Cash (-A) ………………………………… 12,000
$4,004 = $57,198 x 0.07; $7,996 = $12,000 - $4,004
b.
+ Cash (A) - -Lease Liability (L) +
12,00 12/31 57,19 1/3
0 8
12/31 7,996
+ Leased Asset (A) - + Interest Expense (E) -

1/3 57,198 12/31 4,004
- Accumulated Depreciation (XA) + Depreciation Expense (E) -

+
9,533 12/31 12/31 9,533
c.
Signed a +57,198 - = +57,198 - =
capital lease. Leased Lease
Asset Liability

Depreciation on - +9,533 = -9,533 - +9,533 = -9,533
leased asset. Accum. Retained Deprec.
Made annual -12,000 - = -7,996 -4,004 - +4,004 = -4,004
lease payment. Cash Lease Retained Interest
Liability Earnings Expense

a.
7/1 Leased asset (+A) ……………………………….. 123,100
Lease liability (+L) ………………………. 123,100
$123,100 = $4,500 x 27.35548
b.
9/30 Depreciation expense (+E, -SE) ……………….. 3,078
Accumulated depreciation (+XA, -A) …. 3,078
$3,078 = $123,100 / (10 x 4)
9/30 Lease liability (-L) ……………………………….. 2,038

Cash (-A) …………………………………… 4,500
$2,462 = $123,100 x (0.08/4); $2,038 = $4,500 - $2,462
12/31 Depreciation expense (+E, -SE) ……………….. 3,078

Accumulated depreciation (+XA, -A) …. 3,078
12/31 Lease liability (-L) ……………………………….. 2,079

Cash (-A) …………………………………… 4,500
$2,421 = ($123,100 - $2,038) x (0.08/4); $2,079 = $4,500 - $2,421
c.
+ Cash (A) - - Lease Liability (L) +
4,500 9/30 123,100 7/1
4,500 12/31 9/30 2,038
12/31 2,079

7/1 123,100 9/30 2,462
12/31 2,421

+
3,078 9/30 9/30 3,078
3,078 12/31 12/31 3,078

d.
7/1/17 +123,100 - = +123,100 - =
Signed a
Leased Lease
capital lease.
Asset Liability
9/30/17 - +3,078 = -3,078 - +3,078 = -3,078

Depreciation
Accum. Retained Deprec.
on leased
asset.
9/30/17 -4,500 - = -2,038 -2,462 - +2,462 = -2,462

Made quarterly
Cash Lease Retained Interest
lease
payment.
12/31/17 - +3,078 = -3,078 - +3,078 = -3,078
Depreciation
Accum. Retained Deprec.
on leased
asset.
12/31/17 -4,500 - = -2,079 -2,421 - +2,421 = -2,421

Made quarterly
lease
payment.
e.
7/1 No entry
9/30 Rent expense (+E, -SE) ………………………… 4,500

Cash (-A) …………………………………… 4,500
12/31 Rent expense (+E, -SE) ………………………… 4,500

Cash (-A) …………………………………… 4,500
The amount of rent expense recognized if the lease is treated as an operating

lease is $9,000 ($4,500 + $4,500). However, if the lease is treated as a
capital lease, interest and depreciation are recognized. The total expense for
2017 is $11,039 ($2,462 + $2,421 + $3,078 + $3,078). The capital lease
method tends to report higher expense in the early periods of the lease.
M10-14 (10 minutes)
a. Leased asset (+A) ……………………………………… 74,520

Lease liability (+L)…………………………………. 74,520
b. Prepaid rent (+A) ……………………………………….. 1,000

Cash (-A) …………………………………………… 1,000

a. Capital leases require a company to record both the leased asset and the
lease liability on the face of the balance sheet. Operating leases, by contrast,
do not require a company to record either the leased asset or the lease
liability. They are, as a result, a common technique to achieve off-balance-
sheet financing. Concerning the income statement, capital leases result in
depreciation of the leased asset and interest expense on the lease liability.
Operating leases record only rent expense.
b. Analysts frequently add the present value of the operating lease payments to
both assets and liabilities, thus capitalizing the operating lease. This
adjustment improves the interpretation of measures of financial leverage and
operating performance. If Yum!’s operating lease commitments in total are
substantial, they could have a significant impact on the assessment of
financial leverage. Yum! indicates no individual lease is material. However,
the total commitment could be substantial.
a. The implied interest rate in the capital leases is 7%. Computed as follows:
YEAR 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028
AMOUNT -175 20 21 20 20 20 20 20 20 20 20 20 20 20 21
IRR 7% *
b. Present value of expected operating lease payments for Yum! Brands using
the Table A2 in Appendix A, I/YR=7:
Year Operating Present Present

($ millions) Lease Payment Value Factor Value
2015 ........................ $ 709 0.93458 $ 662.6
2016 ........................ 661 0.87344 577.3
2017 ........................ 609 0.81630 497.1
2018 ........................ 555 0.76290 423.4
2019 ........................ 501 0.71299 357.2
2020 ........................ 501 0.66634 333.8
2021 ........................ 501 0.62275 312.0
2022 ........................ 501 0.58201 291.6
2023 ........................ 501 0.54393 272.5
2024 ........................ 440 0.50835 223.7
$3,951.3

c. The capitalization of these operating leases increases Yum!’s total liabilities
by 59% to $10,683 million ($6,732 million + $3,951 million).

M10-17 (10 minutes)
a. Pension expense (+E, -SE) …………………………… 16,000

Cash (-A) …………………………………….…….. 16,000
$16,000 = $400,000 x 0.04
b. Bartov would report a net liability of $450,000 ($625,000 - $175,000) in its 2016
balance sheet. Because Bartov is effectively self-insured, it must report the
estimated death benefit obligation net of any assets set aside to meet that
obligation.
a. Exxon Mobil is reporting $1,378 million in pension expense for 2014.
b. Expected returns are an offset to service and interest costs and serve to reduce
reported pension expense.
c. “Expected” refers to the use of long-term average returns for the investment
portfolio. Expected returns are used in the computation of pension expense,
rather than actual returns, in order to smooth reported income.
a. Yum! Brands is reporting $33 million of pension expense for 2014.
b. Expected returns are an offset to service and interest costs and serve to reduce
reported pension expense.
c. “Expected” refers to the use of long-term average returns for the investment
portfolio. Expected returns are used in the computation of pension expense,
rather than actual returns, in order to smooth reported income.
a. A&F maintains a defined contribution plan for the benefit of its employees.
b. Contributions are expensed when made. The entry to record expenses for
2014 was ($ millions):
Pension expense (+E, -SE) …………………… 13.8

Cash (-A) ………………………………… 13.8

c. Only the unpaid contribution, if any, appears on the A&F balance sheet.

a. The use of contract manufacturers removes the manufacturing assets and

related liabilities from Nike’s balance sheet.
Because sales are unaffected, PPE turnover is increased by the removal of

assets. The effect on net operating profit after taxes (NOPAT) is uncertain;
depreciation is removed (interest on the liabilities incurred to purchase the
manufacturing assets is also removed, but this is a nonoperating expense
and, therefore, does not affect NOPAT), but Nike will pay a higher price for its
manufactured goods in order to provide the manufacturer with a return on its
investment. If the contract manufacturer is more efficient than Nike, however,
the price increase is mitigated. Profitability will increase if the turnover effect
more than offsets the negative effect on NOPAT and profit margin, which is
likely.
b. Executory contracts are not recognized under GAAP. As a result, the use of
contract manufacturers achieves off-balance-sheet financing. This is one
motivating factor for their use.
a, b, and c.
Temporar
y Tax Deferred
Book Tax Basis (after depreciation Differenc Rat Tax
Year Value deduction) e e Liability
201 $127,00
6 $300,000 $173,000 0 40% $50,800
201 $173,000 - ($100,000 - $31,000) =
7 $200,000 $104,000 $96,000 40% $38,400
201 $104,000 - ($100,000 - $31,000) =
8 $100,000 $35,000 $65,000 40% $26,000
d. Because the deferred tax liability is reversing in years 2017, 2018 and 2019,
part of the deferred tax liability should be classified as a current liability each
year. The amounts are presented in the following table.
Long-Term Amount – Current Portion –

Deferred Reversing Beyond One Reversing Within One
Year Tax Liability Year Year
2016 $50,800 $38,400 $12,400
2017 $38,400 $26,000 $12,400
2018 $26,000 $0 $26,000

EXERCISES
a. Present value of operating leases = $2,214 million, computed using the NPV
function in Excel:
b.
($millions) Balance Sheet Income Statement
To capitalize +2,214 = +2,214 - =
operating
Leased Lease
leases
Asset Liability
c. Recognition of the operating leases would reduce the current ratio.

Recording the leased asset would increase noncurrent assets by $2,214
million, but recording the lease liability would increase current liabilities by
$75 million [$186 million – ($2,214 million x 0.05)], and noncurrent liabilities
by $2,139 million ($2,214 - $75).
d. (in $ millions)
Leased asset (+A) ……………………………….. 2,214
Lease liability (+L) ………………………. 2,214
+ Leased Asset (A) - - Lease Liability (L) +

2,214 2,214
e. No. The fixed commitment for 2015 ($186 million) represents less than 5% of
Targets operating cash flow.

a. Target maintains only a defined contribution plan for the benefit of its
employees.
b. Contributions are expensed when made.
c. Only the unpaid contribution, if any, appears on Target’s balance sheet.
d. First, employees who do not meet the unspecified eligibility requirements will
not be covered. Second, matching contributions can be reduced or eliminated
in bad times. Third, employees covered by defined contribution plans must
choose how those funds are invested and, consequently, they bear all of the
risks of price volatility.

a. The Home depot reports $684 million as capital lease obligations in its 2014
balance sheet. This amount is reported as $648 million in non-current liabilities
and $36 million as a current liability. At the inception of these leases, the leased
assets and lease obligations were equal to the present value of the minimum
lease payments. Since that point in time, however, the leased assets are
depreciated on a straight-line basis and the lease obligations are amortized
using the effective interest method. The result is that the net asset value
declines faster than the liability. At the end of fiscal 2014, assets totaled $557
million and obligations totaled $684 million.
b. Present value = $6,123 million using the NPV function in Excel:
c. Home Depot’s D/E ratio was 3.29 ([$39,946 million - $9,322 million]/$9,322
million). Adding capitalized operating leases would increase the ratio to 3.94
([$39,946 million + $6,123 million - $9,322 million]/$9,322 million).

a. According to Verizon’s lease footnote, it has both capital and operating leases.
Only the capital leases are reported on-balance sheet in the amount of $516
million ($158 million in current liabilities and $358 million as long-term liabilities).
This is not the total obligation to its lessors. Verizon also has a significant
amount of leases that it has classified as operating. In fact, the minimum lease
payments under operating leases are 24 times that for capital leases! These
operating leases are not reported on-balance-sheet.
b. Although capital leases are reported as an asset and liability on the balance
sheet, neither the leased asset nor the lease obligation is reported on the
balance sheet for Verizon’s operating leases. As a result, total assets and total
liabilities are lower than they otherwise would be if these leases were reported
as capital leases. Over the life of the lease, total rent expense under operating
leases will be equal to the interest and depreciation expense that would have
been recorded under capital leases. Profit is unaffected by this classification.
During any given year during the life of the lease, however, the two will not be
equal. Even if depreciation is computed on a straight-line basis, interest is
accrued based on the balance of the lease obligation which is higher in the
earlier years of the lease. As a result, depreciation plus interest will exceed rent
expense during the early years of the lease life and will be less toward the end
of the lease.
c. Interest expense will be $23 million. The entry for 2015 is as follows:
Lease liability (-L) ……………………………. 158

Interest expense (+E, -SE) ……………………… 23
Cash (-A) …………………………………... 181
d. The present value of Verizon’s operating leases totals $11,832 million. This
amount would be added to Verizon’s noncurrent assets and to its lease
obligations if these operating leases were reported as capital leases.

a. To treat the operating leases as capital leases we would need to capitalize (add
to both assets and liabilities) the present value of the expected operating lease
payments. The present value is $24,185 million, computed as follows:
b. In 2015, Walgreen Co. would report interest expense of $1,209 million ($24,185
million x 0.05) and depreciation expense of approximately $1,612 million
($24,185/15 years), instead of rent expense of $2,569 million.
a. The present value of Nike’s operating lease payments is computed as follows:
.
The present value of Nike’s operating leases is computed to be $2,357 million.
We might consider adjusting its balance sheet by adding this amount to both
assets and liabilities.
b.
To capitalize +2,357 = +2,357 - =
operating
Leased Lease
leases.
Asset Liability

c.
1. Leased asset (+A) ……………………………. 2,357
Lease Liability (+L) ……………………. 2,357
2. Depreciation expense (+E, -SE) ………….… 236

Accumulated depreciation (+XA, -A)... 236
3. Lease liability (-L) …………………………… 333

Interest expense (+E, -SE) ……………….… 94
Cash (-A) …………………..……………. 427
d.
1 2,357 2,357 1
3 333

+
236 2 2 236
+ Cash (A) - + Interest Expense (E) -

427 3 3 94
a. Service cost is the increase in the pension obligation resulting from employees
working another year for the company. Interest cost is the accrual of interest on
the (discounted) pension obligation.
b. Payments to retirees are made from the pension investment account. There is a
corresponding reduction in the pension obligation.
c. The funded status is the pension obligation less the fair value of the plan assets.
In this case $1,301 million (pension obligation) – $991 million (plan assets) =
$(310) million funded status (when pension obligations are greater than the plan
assets it is an underfunded amount).
d. A $310 million net pension liability is reported in the balance sheet.

a. Service cost is the increase in the pension obligation resulting from

employees working another year for the company. Interest cost is the accrual
of interest on the (discounted) pension obligation.
b. Payments to retirees are made from the pension investment account. There is
a corresponding reduction in the pension obligation.
c. The funded status is the pension benefit obligation less the fair value of the
plan assets. In this case $25,320 million – $18,548 million = $(6,772) million
funded status (underfunded amount).
d. A $6,772 million net pension liability is reported on the balance sheet.
a. In 2016, the temporary difference is $8,000. $8,000 x 40% = $3,200.

In 2017, the temporary difference reverses and no liability would be reported.
b. Income tax expense (+E, -SE) ………………….. 91,200

Income taxes payable* (+L) ………………. 88,000
Deferred income tax liability (+L) ……….. 3,200
*($236,000 – $16,000) x 40% = $88,000
Income tax expense (+E, -SE) …………………. 94,800

Deferred income tax liability (-L) ……………… 3,200
Income taxes payable* (+L) ……………… 98,000
*($245,000 – $0) x 40% = $98,000
The solution to part c depends on what the company knew, in 2016, about the tax
rate in 2017. In the journal entries below, the assumption is that the tax rate is 35%
in 2016, but the company knows in 2016 that the rate will change to 40% in 2017.
c. Income tax expense (+E, -SE) …………………. 80,200

Income taxes payable (+L)* ……………… 77,000
Deferred income tax liability (+L) ………. 3,200
*($236,000 – $16,000) x 35% = $77,000
Income tax expense (+E, -SE) …………………. 94,800

Income taxes payable (+L)* ……………….. 98,000
*($245,000 – $0) x 40% = $98,000
continued next page

However, if the change in the tax rate was not known in 2016, the following entries
would be required:
c. Income tax expense (+E, -SE) …………………. 79,800

Deferred income tax liability (+L) ** ……. 2,800
*($236,000 – $16,000) x 35% = $77,000
**$8,000 x 0.35 = $2,800
Income tax expense (+E, -SE) ................................................................

95,200
Deferred income tax liability (-L) ................................................................
2,800
Income taxes payable* (+L) ................................................................ 98,000
*($245,000 – $0) x 40% = $98,000
Either way, the amount of income tax expense is determined as a plug amount.
(Note that if you assume the taxes due are paid in cash in the reporting period,
the account Income taxes payable used above would be replaced with Cash—
Cash would be reduced. Either is correct.)
a. $12,000 x 40% = $4,800.
b. Current Deferred Tax Liability is $1,600.

Long-term Deferred Tax Liability is $3,200.
c. $8,000 x 40% = $3,200.

a.
To record = +862 -851 - +851 = -851
income tax Taxes Retained Income
expense Payable Earnings Tax
Expense
-11
Deferred
Tax
Liability

b.
Deferred income tax liability (-L) ……………….….….… 11
Income tax expense (+E, -SE) ……………..…..… 851
Income taxes payable (+L) …………………. 862
Cash would be reduced. Either is correct. Also, in this problem if you increased
a Deferred income tax asset for 11 rather than decrease the Deferred tax
liability that is acceptable as well because the disclosures are not presented that
show whether the company has a net deferred tax asset or liability.)
c. An expense of $851 million is recorded in the income statement, thereby

reducing both net income and retained earnings. Liabilities are increased by
$851 million, $862 million in income taxes payable (assuming the amount due
this year has not been paid yet) less the decrease of $11 million in deferred
income tax liability.
d. 2012: 25.0% ($754/$3,011)
2013: 24.7% ($805/$3,256)
2014: 24.0% ($851/$3,544)
a.
a. To record = +836 -1,691 - +1,691 = -1,691
income tax Taxes Retained Income
expense. Payable Earnings Tax
Expense
+855
Deferred
Tax
Liability
b.
Income tax expense (+E, -SE) …..………………………… 1,691
Deferred income tax liability (+L) …………………. 855
Income tax payable (+L)……………………………... 836

c. An expense of $1,691 million is recorded in the income statement, thereby
reducing both net income and retained earnings. This total tax expense is
composed of two parts – current tax expense and deferred tax expense. The
current portion ($836 million) approximates income taxes on the tax return for
the current year (ignoring some more complicated factors like unrecognized
tax benefits that are beyond the scope of this text). Boeing also records an
increase in deferred tax liabilities of $855 million and a deferred tax expense
of $855.

PROBLEMS
a. The present value of Staples operating lease payments is computed as follows:
The present value of Staples’ operating leases is computed to be $2.509 billion.

We might consider adjusting its balance sheet by adding this amount to both
assets and liabilities. Staples’ liabilities are 50% higher following this adjustment
(adjusted liabilities are $5 billion + $2.509 billion = $7.509 billion).
b.
($ 000s) Balance Sheet Income Statement
To capitalize +2,509,171 = +2,509,171 - =
operating Leased Lease
leases. Asset Liability
c. (in thousands)
2014 Leased asset (+A) ……………………………... 2,509,171
Lease liability (+L) ……………………… 2,509,171
2015 Depreciation expense (+E, -SE) ……….……. 278,797

Accumulated depreciation (+XA, -A) ..… 278,797
Interest expense (+E, -SE) ……..………..…… 125,459 *

Lease liability (-L) ……………………..………. 578,446
Cash (-A) ………………………………….. 703,905
* $125,459 = $2,509,171 x 0.05

d.
+ Leased Asset (A) - - Lease liability (L) +
201 2,509,171 2,509,1 2014
4 71
2015 578,446

+
278,7 2015 2015 278,797
97
+ Cash (A) - + Interest Expense (E) -

703,9 2015 2015 125,459
05
a. Rent expense (+E, -SE) ………………………… 2,320,000,000

Cash (-A) …………………………………… 2,320,000,000
b. CVS would report a lease liability of $20,773 million at December 31, 2014 if
the operating leases were capitalized.
c. In 2015, CVS would report interest expense of $831 million ($20,773 x 0.04)
and depreciation expense of $2,077 million ($20,773/10) instead of rent
expense of $2,279 million. In 2014, it would also report interest and
depreciation instead of rent expense. The $2,320 million in rent expense
reported for 2014 most likely includes some contingent rentals (rent based on
some measure of usage, such as sales revenue). These contingent rentals
are reported as rent expense even if the leases are capitalized. Therefore, it
is impossible to say exactly how much of the 2014 rent expense would be
replaced by the interest and depreciation.
In the early years of a lease the higher interest expense causes the
capitalization of leases to increase expenses compared to the rent expense.
This situation reverses in the later years of the lease.

d. Capitalizing leases is reflected in the financial statement effects template
below (in millions).
($000s) Balance Sheet Income Statement

Capitalize +20,773 - = +20,773 - =
operating Leased Lease
leases Assets Liability
e. In the statement of cash flows, the rent expense on operating leases is

classified as an operating cash flow. Although the total cash flow is the same,
if the lease is treated as a capital lease, then part of the lease payment (the
interest) is classified as operating and the remainder (the principal) is
classified as a financing cash flow. Depreciation on the lease is subtracted in
the computation of income but added back in the operating section of the
cash flow statement (indirect method) because it is not a cash flow.
f. The company sells properties but then leases them back using operating
leases. This results in the asset not being on the company’s financial
statements. This often improves ratios like return on assets (because the
recorded assets are smaller). If the company had debt associated with the
property, they can use the sales proceeds to pay down the debt and reduce
the liabilities on the balance sheet as well. The operating leases result in
recorded rent expense but do not require and asset and liability to be
recorded (under current rules).
a. Best Buy reports $121 million of capital leases as assets and in its liabilities.
The operating leases are not reported in the balance sheet nor are the related
leased assets.
b. Total assets and total liabilities are lower than the balance that would have been
reported had the leases been capitalized. Over the life of the lease, total rent
expense under operating leases will be equal to the interest and depreciation
expense that would have been recorded under capital leases. In any given year
of the lease, however, the two will not be equal. If depreciation is computed on a
straight-line basis, interest is accrued based on the balance of the lease
obligation, which is higher in the earlier years of the lease. As a result,
depreciation plus interest will exceed rent expense during the early years of the
lease life and will be less toward the end of the lease. Over the life of the lease,
profit is unaffected by this classification.

c. Using a 7% discount rate, the present value of Best Buy’s operating leases
payments is $3,122 million, computed as follows:
d.
(in millions) Balance Sheet Income Statement

To capitalize +3,122 - = +3,122 - =
operating
Leased Lease
leases at Jan.
Asset Liability
31, 2015.
To record +312.2 -312.2 +312.2 -312.2

depreciation
expense in
Deprec.— Earnings Expense
year ended
Leased Asset
Jan. 2016
To record -873 -654.5 -218.5 +218.5 -218.5

lease
payments in
year ended
Jan. 2016
e. January 31, 2015

1. Leased asset (+A) ………………………………. 3,122
Lease liability (+L) ……………………….. 3,122
Year ended January, 2016

2. Depreciation expense (+E, -SE) ………………. 312.2

Accumulated depreciation (+XA, -A) ….. 312.2
$312.2 = $3,122 / 10
3. Lease liability (-L) ……………………………….. 654.5

Interest expense (+E, -SE) …………………….. 218.5
Cash (-A) …………………………………… 873
$218.5 = $3,122 x 0.07

f.
+ Cash (A) - - Lease Liability (L) +
3,122 1.
873 3. 3. 654.5

1. 3,122 3. 218.5

+
312.2 2. 2. 312.2
g. The effect of a failure to report the leased assets and related lease obligation
on-balance-sheet understates assets and liabilities. Gross margin and net
income are largely unaffected if we assume that the leases are approximately at
the midpoint of their lives, on average. Capitalization of the leases would
increase the asset base, which would, in turn, lower asset turnover. Hence
turnover rates are overstated by the failure to capitalize the leases. The debt to
equity ratio would be increased. Overall these two factors offset each other
leaving ROE only marginally affected. Our conclusion of how Best Buy is
achieving its ROE is likely to be altered because Best Buy would have lower
turnover and higher financial leverage than was apparent based on the
published (unadjusted) financial statements.
a. Hoopes Corporation recognized $543 million as pension expense in 2015.
b. The expected return is computed as the beginning fair market value of the
pension plan assets multiplied by the long-term expected return on these
investments. For 2015, this is computed as $13,295 × 8% = $1063.6, slightly
more than the reported amount of $1,062 million. The plan assets reported an
actual return of $2,425 million. U.S. GAAP permits the use of the expected
long-term rate of return in order to smooth earnings. If actual returns were to
be used, corporate profits would fluctuate greatly with swings in investment
returns. The logic behind using the long-term rate is that investment returns
are expected to fluctuate around this average and its use more accurately
captures the average cost of the pension plan. (It is similar to the logic of
reporting held-to-maturity bond investments at historical cost rather than
current market value.)

c. The pension liability is increased by the service and interest costs and
decreased by any payments made to plan participants. The actuarial loss (gain)
relates to the effects on the pension obligation of changes in assumptions used
to compute it, such as the discount rate or the rate of expected wage inflation.
The pension plan assets are increased (decreased) by investment gains
(losses), are increased by company contributions and are decreased by benefits
paid to plan participants.
d. The “funded status” is the excess (deficiency) of the pension obligation over
plan assets. If plan assets exceed pension obligation, the funded status is
positive or overfunded. If pension obligations exceed the fair value of plan
assets, the funded status is negative or underfunded. The funded status of the
Hoopes Corporation pension plan is $(1,531) million at the end of 2015.
Pension obligations are $17,372 million and plan assets are $15,841 million.
Hoopes should report its net funded status as a net pension liability of $1,531
million on its balance sheet.
e. Because the pension obligation is the present value of expected pension

payments, a decrease in the discount rate increases the present value reported
on the balance sheet. The effect on the income statement is more difficult to
predict. The interest cost component of pension expense is the product of the
beginning of the year pension obligation and the discount rate. In 2015, the
effect of a decrease in the discount rate is to apply a lower discount rate to a
higher pension obligation. These two effects are offsetting, but usually result in
lower interest cost.
f. The estimated wage inflation rate is used to project future benefit payments.
Decreasing the estimated inflation rate decreases the pension obligation
because a lower amount of payments to plan participants is projected.
Decreasing the expected wage inflation rate reduces service cost and
decreases the pension obligation reported on the balance sheet and,
consequently, the interest component of pension expense. It is an income-
increasing action.
a. Service cost is the increase in the pension obligation resulting from employees
working another year for the company. Interest cost is the accrual of interest on
the (discounted) pension obligation.
b. The “actual” return on plan assets is $2,078 million in 2014.
c. Actuarial losses (gains) generally arise as a result of decreases (increases) in

the discount rate used to compute the pension obligation (PBO). Because the
PBO is the present value of expected future payouts to retirees, a decrease in

the discount rate results in an increase in the PBO. This decrease is recorded
as an actuarial loss.
d. Payments to retirees are made from the plan assets account. There is a
corresponding reduction in the pension obligation.

e. Johnson and Johnson contributed $1,176 million to its pension plans in 2014.
f. Johnson and Johnson paid $813 million in benefits to its retirees in 2014.
g. The funded status is the pension obligation less the fair value of the plan assets.
In this case $26,889 million – $22,575 million = $(4,314) million underfunded
amount.
h. A $4,314 million net pension liability is reported on the balance sheet.
a. Tax expense – 2014: $1,772 million; 2013: $676 million; 2012: $2,534
million.
Current tax expense – 2014: $2,958 mil.; 2013: $3,971 mil.; 2012: $3,686
mil.
Deferred tax expense – 2014: $(1,186) mil.; 2013: $(3,295) mil.; 2012:
$(1,152) mil.
b. 2014: $1,772 / $17,229 = 10.3%

2013: $676 / $16,151 = 4.2%
2012: $2,534 / $17,381 = 14.6%
c. Deferred tax liabilities are created when a company reports greater revenues
and/or lower expenses in the income statement than are reported on the tax
return. The most common cause is the use of accelerated depreciation for
taxes and straight-line depreciation for financial reporting. When these
deferred taxes reverse (late in the asset’s life) the deferred tax liability is
reduced.
d. Deferred tax assets arise when income is recognized for tax purposes before
it is recognized in the financial statements, such as can be the case with
advance payments from customers. Receipt of the cash creates a deferred
tax asset as revenue is recognized on the tax return but deferred in the
financial statements. Alternatively, deferred tax assets may arise when the
tax return defers expenses that are recognized in the financial statements.
Examples include bad debt expense and warranty expense. A restructuring
charge is another example of the latter. Restructuring charges are not
recognized in the tax return until they are realized (cash paid or assets sold at
a loss).

a. Temporary differences
2016: $32,000 - $24,000 = $8,000;
2017: ($32,000 + $37,000) – ($24,000 + $26,000) = $19,000.
b. Deferred tax liability

2016: $8,000 x 40% = $3,200; 2017: $19,000 x 40% = $7,600
c. $19,200 + ($7,600 – $3,200) = $23,600
d. Income tax expense (+E, -SE)…………………… 23,600

Income taxes payable (+L) ...……………… 19,200
Deferred tax liability (+L) …………..……… 4,400
+ Income Tax Expense - Income Taxes Payable - Deferred Tax Liability

(E) - (L) + (L) +
(d) 23,60 19,200 (d) 4,400 (d)
0
(Note that if you assume the taxes due are paid in cash in the reporting period, the
account Income taxes payable used above would be replaced with Cash—Cash
would be reduced. Either is correct.)
a. Temporary differences
2016: $140,000 - $130,000 = $10,000;
2017: ($140,000 + $122,000) – ($130,000 + $128,000) = $4,000.
b. Deferred tax liability
2016: $10,000 x 35% = $3,500; 2017: $4,000 x 35% = $1,400
c. $45,150 + ($1,400 – $3,500) = $43,050
d. Income tax expense (+E, -SE)…………………… 43,050
Deferred tax liability (-L) ………………………… 2,100
Income taxes payable (+L) ……………….. 45,150
+ Income Tax Expense - Income Taxes Payable - Deferred Tax Liability

(E) - (L) + (L) +
(d) 43,05 45,150 (d) (d) 2,100
0

the account Income taxes payable used above would be replaced with Cash
(Cash would be reduced). Either is correct.)

a, b, and c.
Assume that the tax rate increase in 2018 was not known until 2017.
a. b. c.
Book Tax Temporary
Value Basis Difference Deferred Tax Liability
2016 $12,000 $0 $12,000 $4,200 ($12,000 x 0.35)
2017 $6,000 $0 $6,000 $2,400 ($6,000 x 0.40)
2018 $0 $0 $0 $0
d. 12/31/16
Income tax expense (+E, -SE) ..………………… 112,000
Deferred income tax liability (+L)………… 4,200
Income taxes payable (+L)* ……………..… 107,800
*$312,000 x 0.35 = 107,800
12/31/17
Income tax expense (+E, -SE) …….…………… 138,200
Deferred income tax liability (-L) ….…………… 1,800
Income taxes payable (+L)* ……..………. 140,000
*$400,000 x 0.35 = $140,000.
12/31/18
Income tax expense (+E, -SE) ………………….. 165,600
*$420,000 x 0.40 = $168,000.
The expense is determined as a plug amount.


CASES and PROJECTS
C10-44. (30 minutes)
a. Dow Chemical reported net pension expense of $705 million for 2014.
b. The expected rate of return is computed as the beginning fair value of the
pension plan assets multiplied by the long-term expected return on these
investments. For 2014, expected return was $1,322 on assets of $18,827
million. This implies an expected rate of return of 7.02% ($1,322 / $18,827).
c. The pension liability is increased by the service and interest costs and
decreased by any payments made to plan participants. The actuarial loss (gain)
relates to the effects of changes in assumptions used to compute the pension
obligation, such as the discount rate or the rate of expected wage inflation. The
pension plan assets are increased (decreased) by investment gains (losses),
are increased by company contributions, and are decreased by benefits paid to
plan participants.
d. The “funded status” is the excess (deficiency) of the pension obligation over
plan assets. If plan assets exceed pension obligation, the funded status is
positive. If pension obligations exceed the fair value of plan assets, the funded
status is negative. The funded status of the Dow Chemical pension plan is
$(8,350) million at the end of 2014. Thus, the pension is underfunded and the
balance sheet should show a net pension liability of $8,350 million.
e. Since the pension obligation is the present value of expected pension

payments, a decrease in the discount rate increases the present value reported
on the balance sheet. The effect on the income statement is more difficult to
predict. The interest cost component of pension expense is the product of the
beginning-of-the-year pension obligation and the discount rate. The effect of a
decrease in the discount rate is to apply a lower interest rate to a larger pension
obligation. Interest expense on the pension liability will usually decrease in this
circumstance. However, the actuarial “gain” resulting from the lower liability
amount may offset the higher interest cost.
f. An increase in expected return unambiguously increases profitability as pension

cost is reduced. This result occurs because the long-term expected rate of
return is used to compute the expected return that is subtracted in the
computation of pension expense.
g. Inflation rates differ from country to country. For 2014, those rates are generally
higher outside the U.S. where Dow operates. Inflation is expected to increase in
the U.S. and could exceed the rates in other countries implying relatively higher

compensation levels. Discount rates vary across countries as well, due in part
to differences in inflation.

a.
2014 Rent expense (+E, -SE) …………………………. 298
Cash (-A) …………………………………... 298
2015 Rent expense (+E, -SE) …………………………. 235
Cash (-A) …………………………………... 235
Note: the rent expense in 2014 most likely includes contingent rentals, such as
charges based on the number of hours a plane is flown. These contingent
rentals are not included in the minimum rental obligation for 2015.
b. The total liability reported on the 2014 balance sheet is $170 million. Of this
amount, $15 million would be classified as a current liability leaving a noncurrent
liability of $155 million.
This amount only reflects those leases that JetBlue classified as capital leases.
Operating leases represent many times that amount and are not recorded on its
balance sheet.
c.
i. Leased assets (+A) ……………………………… 101
Lease liability (+L) ……………………….. 101
(change in historical cost of capital leases per the note…$253-$152)
ii. Depreciation expense (+E, -SE) ………………. 7

Accumulated depreciation (+XA, -A) ….. 7

i. 101 101 i.
- Accumulated Depreciation (XA) + + Depreciation Expense (E) -

7 ii. ii. 7

d.
To record -23 - = -15 -8 - +8 = -8
lease Cash Lease Retained Interest
payments on Liability Earnings Expense
capital leases
for 2015.
Lease liability (-L) ……………………………….. 15

Interest expense (+E, -SE) …………………….. 8
Cash (-A) …………………………………… 23
+ Cash (A) - - Lease Liability (L) + + Interest expense (E) -

23 15 8
e. Using a 4% discount rate, the present value of JetBlue’s operating lease

payments is computed as follows:
If operating leases were capitalized, JetBlue would report additional assets of

$1,219 million and additional liabilities of $1,219 million as well. The liabilities
would be split between current liabilities of $186 million [$235 million – ($1,219
million x 0.04)] and noncurrent liabilities of $1,033 million ($1,219 - $186). Its
long-term debt would increase by 52% from $1,968 million to $3,001 million
($1,968 + $1,033).
f. Not including the entry to record payments on existing capital leases, which are
recorded in d above, the entry to record lease payments would be:
Lease liability (-L) ……………………………….. 186

Interest expense (+E, -SE) …………………….. 49
Cash (-A) …………………………………… 235
+ Cash (A) - - Lease Liability (L) + + Interest expense (E)

-
235 186 49

a. $193,349 thousand
b. 2015: $193,349 / $502,203 = 38.50%.
c. 2014: $173,780 / $452,682 = 38.39%.

2013: $153,226/409,956 = 37.38%
Current US: $157,227/ $482,739 = 32.57%

Deferred US: $2,719 / $482,739 = 0.56%;
Total US rate: $159,946/$482,739 = 33.13%.
d. $49,365 - $32,488 + $193,597 = $210,474 thousand
e. Income tax expense (+E, -SE) ………………………… 193,349

Deferred tax asset (+A) …..………………….………… 248*
Income taxes payable …………………………………… 16,877
Cash (-A) 210,474
…..…………………………………………
* Plug to balance. Note that in the 2014, some of the amount would have potentially been recorded to current and some
to noncurrent deferred tax assets (or liabilities). The FASB issued Proposed Accounting Standard Update 2015-210
proposing to change disclosure on the balance sheet to only be in noncurrent assets and liabilities, thus we present it
that way here for simplicity. As an external financial statement user (i.e., not someone with access to internal detailed
records), we cannot often tie out the change in assets and liabilities on a company’s financial statements to the amount
recorded as deferred tax expense due to mergers and acquisitions during the year (that will change the amount of
assets and liabilities on the books in the year of the acquisition but will not affect tax expense).
e. $883,012 – ($9,888/0.35) = $854,761 thousand.
f. Prepaid catalog expenses are capitalized and amortized for financial reporting
purposes. However, for tax reporting purposes, the costs are expensed when
paid. Consequently, the tax deduction is recognized before the expense is
recognized in the income statement. The prepaid catalog expense of $33,942
thousand represents a temporary difference between financial and tax reporting.
The resulting deferred tax liability shown of $12,753 thousand offsets the current
deferred tax assets in the balance sheet.
g. $43,300 thousand. Accounting earnings would be reduced because income tax

expense would be higher.
h. A valuation allowance is a contra-asset account related to deferred tax assets.

Management establishes a valuation allowance if it thinks the deferred tax
assets will not be realized in the future. That is, management does not think the
company will generate enough future taxable income to be able to offset the
future deductions represented by the deferred tax assets. Recognizing a

valuation allowance lowers the amount of deferred tax assets recognized and
reduces income (increases tax expense).

a. Domestic:
2014: ($2,424 + $140 + $29 + $7) / $7,936 = 32.8%
2013: ($2,217 + $117 - $421 + $0) / $7,044 = 27.2 %
2012: ($2,484 + $169 - $109 + $5) / $6,447 = 39.5%
Foreign:
2014: ($774 - $43) / $9,323 = 7.8%
2013: ($711 - $72) / $8,855 = 7.2%
2012: ($312 - $55) / $8,021 = 4.6%
Total:
2014: $3,331 / ($7,936 + $9,323) = 19.3%
2013: $2,552 / ($7,044 + $8,855) = 16.1%
2012: $2,916 / ($6,447 + $8,021) = 20.2%
b. Google states that they have $47.4 billion of unremitted foreign earnings on
which they have not accrued any U.S. income taxes. The company does not
have to accrue the deferred taxes related to these earnings because the
company has stated that the earnings are permanently reinvested, meaning that
Google does not plan to bring the earnings back to the US. There is an
exception to the normal deferred tax accounting rules in such a case and the
deferred tax liability and expense are not required to be recorded.

c. Using 2014 tax rates, Google might owe $16.6 billion x (35% x 47.4 billion).
This is a very rough guess, however. Google would likely be able to offset at
least some of these taxes with foreign tax credits. Another reason why our
amount is an estimate is because as long as Google doesn’t move its assets
from foreign subsidiaries into the U.S., it may never have to pay these taxes at
all. Furthermore, the US is considering changing the tax rate on these earnings.
Google states it is not practicable to estimate the US taxes that would be due if
they repatriated the earnings. It is difficult to estimate the taxes due to the
reasons we state above, the complexities of the foreign tax rate computation,
and the timing of when the amounts would be repatriated.
As an aside, Google states that it has $64.4 billion in cash and cash equivalents
on its 2014 balance sheet. Google holds this large amount of cash likely in part
due to the tax expensethe company would have to record if they would
repatriate the cash and pay the U.S. tax. For companies that are not financially
constrained, like Google, they can often borrow in the U.S. to fund U.S. Revised 07.21.1
operations and/or pay dividends and repurchase shares if they do not have
enough cash from U.S. operations.


Chapter 11
Stockholders’ Equity

Cases
Mini-
Exercises
Projects
LO1 – Describe business

financing through stock 19, 37 41, 45 59 62, 63
issuances.
LO2 – Explain and account for 20 - 22, 24, 39 - 41,

the issuance and repurchase of 55 - 59 62 - 64
25, 36, 37 45, 52, 54
stock.
LO3 – Describe how operations

increase the equity of a 30, 37 48, 49, 51 55 - 57 63, 64
business.
23, 26 - 31, 42, 44,

LO4 – Explain and account for 56, 58
dividends and stock splits. 36 46 - 51, 54
LO5 – Define and illustrate 56, 59, 60

comprehensive income.
24, 25,
LO6 – Describe and illustrate 41, 43, 44,
basic and diluted earnings per 32 - 34, 55 - 57 64
50
share computations. 36 - 38
35 53 59, 60 61
LO7 – Appendix 11A: Analyze

the accounting for convertible
securities, stock rights, and
stock options.

QUESTIONS
Q11-1. Par value stock is stock that has a face value printed (identified) on the
stock certificate.
From an accounting standpoint, the par value of the common stock is the
amount added to the common stock portion of paid-in-capital upon the
issuance of stock. The remainder of the issue price is added to the
additional paid-in-capital portion of paid-in-capital. There are no analysis
implications of the par value of stock.
Q11-2. Preferred stock usually takes priority over common stock in the receipt of
a specified amount of dividends and in the distribution of assets if the
corporation is ever liquidated. Also, preferred stock does not usually
have voting rights.
Typically, preferred stock has the following features: 1) Preferential claim
to dividends and to assets in liquidation, 2) Cumulative dividend rights,
and 3) No voting rights.
Q11-3. Preferred stock is similar to debt when
1. Dividends are cumulative.
2. Dividends are nonparticipating.
3. It has a preference to assets in liquidation.
Preferred stock is similar to common stock when

1. Dividends are not cumulative.
2. Dividends are fully participating.
3. It is convertible into common stock.
4. It does not have a preference to assets in liquidation.
Q11-4. Dividend arrearage on preferred stock is the aggregate amount of
dividends on cumulative preferred stock that has not been declared to
date. The amount of dividends in arrears and a current dividend must be
paid to preferred stockholders before common stockholders can receive
any dividends. In the example, preferred stockholders must receive
$90,000 in dividends ($500,000 × 0.06 × 3 years = $90,000) before
common stockholders receive any dividends.

Q11-5. A corporation's authorized stock is the maximum number of shares of
stock it may issue. The authorized amounts and classes of stock are
enumerated in the company's charter when the corporation is formed. A
corporation can later amend its charter to change the amount of
authorized capital, but such action must have the approval of the
company’s shareholders. Shares that have been sold and issued to
stockholders are the company's issued stock. Shares that have been
sold and issued can be subsequently reacquired by the corporation—
called treasury stock. When treasury stock is held, the issued shares
exceed the outstanding shares.
Q11-6. Contributed capital represents the total investment that has been paid in
to the company by its shareholders as a result of the purchase of stock.
Earned capital represents the cumulative net income that has been
earned, less the portion of that income that has been paid out to
shareholders in the form of dividends.
When profit is earned, shareholders have the option of paying out that
profit as a dividend or reinvesting the earnings in order to grow the
company. In fact, many companies title the Retained Earnings account
as Reinvested Earnings. Earned capital, thus, represents an implicit
investment by the shareholders in the form of forgone dividends.
Q11-7. Paid-in capital is divided into two accounts: the common or preferred
stock account and additional paid-in capital. The common stock or
preferred stock accounts are increased by the par value of the shares
issued and the additional paid-in capital account is increased for the
balance of the proceeds received from the sale of the shares. The
balance of the paid-in capital account is affected by the par value of the
stock; the higher (lower) the par value, the lower (higher) the additional
paid-in capital. Although paid-in capital will, in general, be higher if the
stock price is higher, the breakdown of paid-in capital between the
common or preferred stock accounts and additional paid-in capital does
not yield any inferences regarding the financial condition of the
company.
Q11-8. A stock split refers to the issuance of additional shares of a class of
stock to the current stockholders in proportion to their ownership
interests, normally accompanied by a proportionate reduction in the par
or stated value of the stock. For example, a 2-for-1 stock split doubles
the number of shares outstanding and halves the par or stated value of
the shares. Consequently, there is no change in the amount of
contributed capital associated with that class of stock. The major reason
for a stock split is to reduce the per-share market price of the stock.
Another possible reason is to influence shareholders’ in believing there
has been some distribution of value.

Q11-9. Treasury stock is a corporation's issued stock that has been reacquired
by the issuing corporation through purchases of its stock from its
shareholders. A corporation often purchases treasury stock for
distribution to employees under stock option plans or to offset dilution
resulting from such sales. It is also used by management to prop up
stock price when management believes its stock is inappropriately
underpriced.
On the balance sheet, treasury stock should be carried at its cost and is
shown as a deduction in deriving the total stockholders' equity—known
as a contra equity account.
Q11-10. The $2,400 increase should not be shown on the income statement as
any form of income or gain. The $2,400 is properly treated as additional
paid-in capital and is shown as such in the stockholders' equity section
of the balance sheet. The latter treatment is justified because treasury
stock transactions are considered capital rather than operating
transactions.
Q11-11. The book value per share of common stock is the total stockholders'
equity divided by the number of shares outstanding, or
$4,628,000/260,000 = $17.80.
Q11-12. A stock dividend is the distribution of additional shares of a corporation's
stock to its stockholders. A stock dividend does not change a
stockholder's relative ownership interest, because each stockholder
owns the same fractional share of the corporation before and after the
stock dividend. There is empirical evidence, however, suggesting that
the stock price does not decline fully for the additional shares issued—
various hypotheses, such as signaling theory, have been asserted as
explanations of this phenomenon.
Q11-13. The stock dividend transfers capital from retained earnings to
contributed capital. For a small stock dividend, this transfer is recorded
at the market price of the shares at the time of the dividend. For a large
stock dividend, the transfer is made at the par value of the stock.
Q11-14. Many companies repurchase shares (as Treasury Stock) in order to
offset the dilutive effects of exercised stock options which increase the
number of outstanding shares. This repurchase results in a cash outflow,
and has been used by those arguing for the expensing of employee
stock options as evidence of the cash effect of these options and linkage
to the payment of wages.
Q11-15. The statement of stockholders' equity analyzes and reconciles changes
in all major components of stockholders' equity for an accounting period.
The statement begins with the beginning balances of those key
stockholders' equity components, reports the items causing changes in
these components, and ends with the period-end balances.

Q11-16. Other Comprehensive Income (OCI) represents changes in
stockholders’ equity that are caused by factors other than profit (loss)
and the sale (repurchase) of equity securities. Some examples include
unrealized gains (losses) on available-for-sale securities, foreign
currency translation adjustments (current-rate method only), unrealized
gains (losses) on derivatives, and minimum pension liability adjustments.
Q11-17. A stock option vesting period is a period of time after the grant date that
an employee must wait before exercising stock options. For example, a
company may grant five-year options that vest in three years. An
employee would then be able to exercise the options in Years 4 or 5, but
not before. Typically, the vesting period requires that the employee
remains employed at the company until the options vest; otherwise
he/she forfeits the options. GAAP requires that the fair value of the
option be recorded as a compensation expense ratably over the vesting
period.
Q11-18. When a convertible bond is converted, both the face amount and any
associated unamortized premium or discount are removed from the
balance sheet. The stock is, then, issued considering the “purchase
price” to be the book value (face amount ± an unamortized premium or
discount) of the bond. This purchase price is, then, allocated to common
stock and additional paid-in capital. No gain or loss is reported upon the
conversion.

MINI EXERCISES
a. These transactions increase Beatty Corp.’s contributed capital. Earned

capital is affected by net income, other comprehensive income and
dividends.
b. Transactions between a company and its shareholders do not affect the

income statement.
c. Preferred stock has priority over common stock in the payment of dividends
and in liquidation. That is, a company cannot pay common dividends until
after it has fulfilled its preferred dividend obligation. And, if a company
liquidates, the claims of the preferred shareholders are met before those of
the common shareholders.
a.
Issue 18,000 +864,000 = +180,000 - =
shares of $10 Cash Preferred
par value Stock
preferred
stock at $48
per share. +684,000
Additional
Paid-in Capital
Issue 120,000 +4,440,000 = +240,000 - =

shares of $2 Cash Common
par value Stock
common at
$37 per
share. +4,200,000
Additional
Paid-in Capital
b.
9/1 Cash (+A) ..........................................................................................
864,000
Preferred stock (+SE) ................................................................ 180,000
Additional paid-in capital (+SE) ........................................................ 684,000
9/1 Cash (+A) .........................................................................................

4,440,000
Common stock (+SE) ................................................................ 240,000
Additional paid-in capital (+SE) ......................................................... 4,200,000

c.
+ Cash (A) - - Preferred Stock (SE) +
9/1 864,000 180,000 9/1
9/1 4,440,000
- Common Stock (SE) + - Additional Paid-in Capital (SE)
+
240,000 9/1 684,000 9/1
4,200,0 9/1
00

(in millions)
Common stock ........................................ $ 5.107a

Additional paid in capital ......................... 41,878.893
Total ........................................................ $41,884.000
a
5,107 million shares issued × $0.001 par value.
a.
Cash Noncash Liabil- Contrib. Earned Contra Net

Transaction Asset + Assets = ities + Capital + Capital - Equity Revenues - Expenses = Income
Issue 5,000 +1,250,000 = - - =
shares of $100 Cash +500,000
par value
Preferred
preferred stock Stock
at $250 per
share.
+750,000
Add’l
Paid-in
Capital
Repurchase -415,000 = - +415,000 - =

5,000 shares Cash Treasury
of $1 par value
Stock
common stock
at $83 per
share.
b.
1/1 Cash (+A) ...................................................................................
1,250,000
Additional paid-in capital (+SE) .................................................... 750,000
3/1 Treasury stock (+XSE, -SE) .........................................................

415,000

Cash (-A) ................................................................................... 415,000

c.
1/1 1,250,000 500,000 1/1
415,000 3/1
+ Treasury Stock (XSE) - - Additional Paid-in Capital (SE)

+
3/1 415,000 750,000 1/1
A stock split that is affected as a large stock dividend requires an entry into the
accounting records. The number of outstanding shares must be changed in the
parenthetical note to the common and preferred stock accounts in the
stockholders’ equity section of the balance sheet. The par value of the new
shares must be taken out of retained earnings and put into the common stock at
par account. In the two-for-one stock split effected by Starbucks, each
shareholder receives one additional share for each share owned, thus doubling
the outstanding shares, and – because the split was effected as a large stock
dividend – the par value of the shares is unchanged. The dollar amount of total
paid-in capital increases, but the total dollar amount of stockholders’ equity is
unchanged. Earnings per share is recomputed for all years presented in the
income statement to reflect the additional shares outstanding.
a. Basic EPS: [$501,000 – (16,000 x $2)] / 134,000 = $3.50
Calculation of weighted average shares outstanding:
120,000 x 2/12 = 20,000

130,000 x 5/12 = 54,167
146,000 x 3/12 = 36,500
140,000 x 2/12 = 23,333
134,000
b. Diluted EPS: $501,000 / (134,000 + 16,000) = $3.34
c. Given a simple capital structure, only basic EPS need be reported.

a. Treasury shares are deducted from issued shares to yield outstanding

shares. The outstanding shares are, therefore:
Shares outstanding = 3,417,997,492 – 271,183,861 = 3,146,813,631
b. If the stock repurchase took place on July 1, 2014, three months after the end
of the previous fiscal year, the denominator of the basic EPS calculation
would decrease by 271,183,861 x 9/12. That is, the weighted average shares
outstanding would be 3,417,997,492 – [271,183,861 x (9/12)] =
3,214,609,596 shares.
a.
Declared and -18,000 = -18,000 - =
paid cash Cash Retained
dividend on Earnings
preferred
stock.
Declared and -88,000 = -88,000 - =
dividend on Earnings
common stock.
b. Preferred dividend:
12/31 Retained earnings (-SE) ......................................................... 18,000

Cash (-A) .......................................................................................... 18,000
Common dividend:
12/31 Retained earnings (-SE) ................................................................

88,000
Cash (-A) ...........................................................................................88,000
c.
+ Cash (A) - - Retained Earnings (SE) +
18,000 12/31 12/31 18,000
88,000 12/31 12/31 88,000

Because this is a small stock dividend (4%), retained earnings is debited for the
market value of the 2,800 additional shares of stock (70,000 x 4% x $21).
a.
Declaration = +14,000 -58,800 - =
and Common Retained
distribution of Stock Earnings
stock
dividend.
+44,800
Additional
Paid-in Capital
b.
12/31 Retained earnings (-SE) ..............................................................
58,800
Common stock (+SE) ................................................................
14,000
Additional paid-in capital (+SE) ................................ 44,800
c.
- Retained Earnings (SE) + - Common Stock (SE) +
12/31 58,800 14,000 12/31
- Additional Paid-in Capital (SE)

+
44,800 12/31
a. Immediately after the 3-for-2 stock split, the company has 375,000 shares of
$10 par value common stock [250,000 shares × (3/2) = 375,000 shares] issued
and outstanding.
b. The dollar balance in the Common Stock account is unchanged by the stock
split; the balance remains at $3,750,000 (375,000 shares at the new $10 par
value per share).
c. The usual reason for a corporation to split its stock is to reduce the per share
market price of the stock and, therefore, improve the stock's marketability. The
market price of the common stock prior to the split is $165 per share, which is
somewhat high. Splitting the stock would reduce the per-share price (though
not the total market value).

Distribution to
Preferred Common
a. $1,000,000 × 6%............................................................. $60,000
Balance to common ........................................................ $100,000
Per share
$60,000/20,000 shares ....................................... $3.00
$100,000/80,000 shares ..................................... $1.25
b. $1,000,000 × 6% × 2 years............................................. $120,000

Balance to common ........................................................ $40,000
Per share
$120,000/20,000 shares ..................................... $6.00
$40,000/80,000 shares ....................................... $0.50
BAMBER COMPANY
Retained earnings, December 31, 2014 .................................................. $347,000
Add: Net income ....................................................................................... 94,000
441,000
Less: Cash dividends declared.................................................. $35,000
Stock dividends declared ................................................. 28,000 63,000
Retained earnings, December 31, 2015 .................................................. $378,000
a. No entry is made when the dividend is declared; an entry is required only

when the additional stock is issued. Because this is a large stock dividend,
the dividend is recorded at par value:
Retained earnings (-SE) ..............................................................

400,000
Common stock (+SE) ................................................................ 400,000
b. The stock split would reduce the par value, but no journal entry would be
recorded. As a consequence, neither the common stock nor the retained
earnings accounts are affected. Neither method changes total shareholders’
equity.

a. Basic EPS: [$440,000 – (10,000 x $50 x 8%)] / 50,000 = $8.00 per share
b. Diluted EPS: $440,000 / [50,000 + (10,000 x 3)] = $5.50 per share
a. Basic EPS: $234,000 / 45,000 = $5.20
38,000 x 4/12 = 12,667

48,000 x 4/12 = 16,000
49,000 x 4/12 = 16,333
45,000
b. Basic EPS: [$234,000 – (6,000 x $50 x 6%)] / 45,000 = $4.80
a. Basic earnings per share is computed as net income less any preferred
dividends divided by the weighted average number of common shares
outstanding for the period. Diluted earnings per share adjusts for dilutive
securities (such as convertible securities or employee stock options) by
including the securities in the denominator and also adjusting for any effect on
the numerator. Consequently, diluted earnings per share is always less than
or equal to basic earnings per share.
b. In the case of Siemens, it has 843,449 thousand weighted average common

shares outstanding, and an additional 8,485 thousand weighted average
common shares that could potentially be issued (dilutive). These dilutive
shares relate to employee stock options and convertible securities, like
convertible debt and convertible preferred stock, that potentially could be
converted into common shares. (Note: with 843,449 thousand shares and a
basic EPS of €6.24, the implied earnings number is €5,263,122 thousand,
computed as 843,449 thousand × €6.24. For diluted EPS, 851,934 thousand
times €6.18 implies earnings of €5,264,952 thousand, a difference of €1,830
thousand. This difference is likely due to the interest/dividends on convertible
securities and rounding of EPS.)
c. While diluted EPS is favored over basic EPS by analysts, the data reflect
events that have not and may never occur. In addition, the dilution is
assumed to be made at the year’s start.

a. No entry is required when the options are granted. The compensation

expense is recognized ratably over the vesting period. As the options vest,
the following entry is required (assume one-third vested in 2014):
Compensation expense (+E, -SE) ................................................

11,026,960
Additional paid in capital (+SE) ............................................... 11,026,960
b. Granted stock options (whether vested or not) are included in the

denominator of diluted EPS whenever the stock price is greater than the
exercise price. These options would reduce diluted EPS but have no effect
on basic EPS.
c. Cash (+A) ..................................................................................

1,560,000
Contributed capital (+SE) ........................................................... 1,560,000
The details of the credit to contributed capital would depend on where the
shares came from. If they had been held as treasury shares, the credit would
have been to the treasury shares contra asset, with either a debit or credit in
additional paid-in capital. If the shares were newly issued, the credit would
have been to the par value and additional paid-in capital for Merck’s common
stock.
d. When options are exercised, the number of outstanding shares increases.

This would reduce basic EPS. It might also lower diluted EPS, though most
likely to a lesser degree. This is because the dilutive effect may already be
reflected in diluted EPS prior to exercise.
Total Total Total Operating

Year Assets Liabilities Stockholders’ Equity EPS Income
1 ….. Increase No effect Increase Decrease No effect
2 ….. Decrease No effect Decrease Increase No effect
3 ….. No effect Increase Decrease No effect No effect

a. $30 = $18,000,000 / 600,000 shares

b. $10 = $6,000,000 / 600,000 shares
c. $12,000,000 = $18,000,000 - $6,000,000
d. $4,000,000 = $5,000,000 – $1,000,000
e. 50,000 shares = 600,000 – 550,000
f. $8.70 = $5,000,000 ÷ (600,000 + 550,000)/2. 600,000 shares were
outstanding for the first half year but only 550,000 during the second half of
the year.
a. The diluted EPS calculation is made to reflect a worst-case scenario

(conservative) EPS figure.
b. $401/294.7 = $1.36 per share
c. $408/343.3 = $1.19 per share
d. Options that are “under water” (the stock price is below the exercise price) are
not included in the calculation of diluted EPS. This is because diluted EPS is
supposed to be a conservative possible outcome, but not so conservative that
it assumes “under water” options would be exercised.

EXERCISES
a.
Issue 10,000 +250,000 = +10,000 - - =

par value Stock
common
stock at $25 +240,000
per share. Add’l
Paid-in
Capital
Issued 15,000 +4,125,000 = +1,500,000 - - =

shares of Cash Preferred
$100 par Stock
preferred
stock at $275 +2,625,000
per share. Add’l
Paid-in
Capital
Purchased -30,000 = - +30,000 - =

of treasury Stock
stock at $15
per share.
Sold 1,000 +21,000 = +6,000 - -15,000 - =

shares of Cash Add’l Treasury
treasury stock Paid-in Stock
at $21 per Capital
share.
b.
2/20 Cash (+A) ..........................................................................................
250,000
Common stock (+SE) ................................................................ 10,000
2/21 Cash (+A) ..........................................................................................

4,125,000
Preferred stock (+SE) ................................................................ 1,500,000
Additional paid-in capital (+SE) ................................ 2,625,000
6/30 Treasury stock (+XSE, -SE) .............................................................

30,000
Cash (-A) ............................................................................................ 30,000
9/25 Cash (+A) ..........................................................................................

21,000
Treasury stock (-XSE, +SE) ................................ 15,000

c.
2/20 250,000 1,500,0 2/21
00
2/21 4,125,000
30,000 6/30 - Common Stock (SE) +
9/25 21,000 10,000 2/20

+
6/30 30,000 240,000 2/20
15,000 9/25 2,625,0 2/21
00
6,000 9/25
a.

Issue 25,000 +425,000 = +125,000 - - =
par common Stock
stock at $17
+300,000
per share.
Add’l
Paid-in
Capital
Issued 6,000 +468,000 = +300,000 - - =

shares of $50 Cash Preferred
par preferred Stock
stock at $78
+168,000
per share.
Add’l
Paid-in
Capital
Repurchased -60,000 = - +60,000 - =

of treasury Stock
stock at $20
per share.
Sold 2,000 +52,000 = +12,000 - -40,000 - =

at $26 per Capital
share.
Sold 1,000 +19,000 = -1,000 - -20,000 - =

at $19 per Capital
share.

b.
1/15 Cash (+A) ..........................................................................................
425,000
Common stock (+SE) ................................................................ 125,000
1/20 Cash (+A) .........................................................................................

468,000
3/31 Treasury stock (+XSE, -SE) .............................................................

60,000
Cash (-A) ..........................................................................................60,000
6/25 Cash (+A) ..........................................................................................

52,000
Treasury stock (-XSE, +SE) ............................................................. 40,000
7/15 Cash (+A) ..........................................................................................

19,000
Additional paid-in capital (-SE) ..........................................................
1,000
Treasury stock (-XSE, +SE) ............................................................. 20,000
c.
1/15 425,000 300,000 1/20
1/20 468,000
60,000 3/31 - Common Stock (SE) +
6/25 52,000 125,000 1/15
7/15 19,000
+ Treasury Stock (XSE) - - Additional Paid-in Capital (SE) +

3/31 60,000 300,000 1/15
40,000 6/25 168,000 1/20
20,000 7/15 12,000 6/25
7/15 1,000
a. 7,040 million - 2,674 million = 4,366 million shares outstanding.
b. ($1,760 million + $13,154 million) / 7,040 million shares = $2.12 per share.
c. $42,225 million / 2,674 million shares = $15.79 per share.
d. EPS is computed based on the number of shares outstanding. The number

of shares in treasury stock is subtracted from shares issued to get the number

of shares outstanding. Thus, the number of treasury shares is subtracted
from the denominator in computing EPS.

a. Dividend Distribution
Preferred Common
Preferred Common per Share per Share
2015 Preferred $0 $0.00
Common $0 $0.00
2016 Arrearage on preferred
[7% × (20,000 × $60)] $84,000
Current year on preferred
[7% × (20,000 × $60)] 84,000
Remainder to common $15,000
Total distribution $168,000 $15,000
Per share
Preferred ($168,000/20,000) $8.40
Common ($15,000/100,000) $0.15
2017 Current year on preferred
[7% × (20,000 × $60)] $84,000
Per share
Preferred ($84,000/ 20,000) $4.20
Common ($116,000/100,000) $1.16
b.
2015 Preferred $0 $0.00
Common $0 $0.00
[7% × (20,000 × $60)] $84,000
Per share
Preferred ($84,000/20,000) $4.20
Common $0.00

[7% × (20,000 × $60)] $ 84,000
Partial current year on preferred 66,000
Total distribution $150,000
Per share
Preferred ($150,000/20,000) $7.50
Common $0.00

a. Basic EPS: [$230,000 – (5,000 x $4)] / 30,000 = $7.00

25,000 x 4/12 = 8,333
34,000 x 2/12 = 5,667
28,000 x 2/12 = 4,667
34,000 x 4/12 = 11,333
30,000
b. Diluted EPS: $230,000 / [(30,000 + (5,000 x 2)] = $5.75
c. If Nichols Corporation had a simple capital structure, only basic EPS ($7.00)
would be reported.
Distribution to
Preferred Common
a. Year 1 $ 0 $ 0
Year 2: Arrearage from Year 1
($750,000 × 8%) $ 60,000
Current year dividend
($750,000 × 8%) 60,000
Balance to common _______ $160,000
Total for Year 2 $120,000 $160,000
Year 3: Current year dividend
($750,000 × 8%) $ 60,000 $ 0
b. Year 1 $ 0 $ 0
($750,000 × 8%) $ 60,000
Balance to common $220,000
($750,000 × 8%) $ 60,000 $ 0
c. Because the preferred stock is not convertible, Potter Company has a simple
capital structure and would only report basic EPS. Basic EPS would be
reduced in Years 2 and 3 when the preferred dividends are subtracted from
net income in the numerator.

a. 35,394 thousand × $0.01 = $353.94 thousand rounded to $354 thousand.

b. ($354 thousand + $1,038,932 thousand) / 35,394 thousand shares = $29.36
per share
c. 35,394 thousand shares issued – 4,367 thousand shares in treasury = 31,027
thousand shares outstanding
d. $748,759 thousand / 4,367 thousand shares = $171.46 per share
e. Companies repurchase stock for a variety of reasons:
1. To offset the dilutive effects of shares issued to employees under stock
option plans.
2. To mitigate a takeover threat by concentrating the remaining shares in
“friendly hands.”
3. To send a signal to the market that the company feels its shares are
undervalued.
a. Dividend Distribution
Preferred Common
2015
[6% × (18,000 × $50)] $54,000
Per share
Preferred ($54,000/18,000) $3.00
Common ($9,000/90,000) $0.10
2016
Preferred $0 $0.00
Common $0 $0.00
2017
Arrearage on preferred
[6% × (18,000 × $50)] $54,000
[6% × (18,000 × $50)] 54,000
Total distribution $108,000 $270,000
Per share
Preferred ($108,000/18,000) $6.00
Common ($270,000/90,000) $3.00

continued next page
b. Dividend Distribution
Preferred Common
2015
Preferred $0 $0.00
Common $0 $0.00
2016
Arrearage on preferred
[6% × (18,000 × $50)] $ 54,000
[6% × (18,000 × $50)] 54,000
Common $0
Total distribution $108,000 $0
Per share
Preferred ($108,000/18,000) $6.00
Common $0.00
2017
[6% × (18,000 × $50)] $54,000
Per share
Preferred ($54,000/18,000) $3.00
Common ($135,000/90,000) $1.50
a.
1
Declared and -47,500 = -47,500 - =
dividend. Earnings
2
Declared and = +10,000 -35,000 - =
issued stock Common Retained
dividend. Stock Earnings
+25,000
Additional
Paid-in Capital
1
$1.90 × 25,000 = $47,500.
2
Retained Earnings is reduced by the market price of the shares distributed (25,000 shares × 4% × $35 market value =
$35,000). Common Stock is increased by the par value with the balance of the market price reflected in an increase in
Additional Paid-in Capital.

b.
1) Retained earnings (-SE) ................................................................
47,500
Cash (-A) ................................................................ 47,500
2) Retained earnings (-SE) ................................................................
35,000
Common stock (+SE) ................................................................ 10,000
c.
47,500 1) 10,000 2)
- Retained Earnings (SE) - Additional Paid-in Capital (SE)

+ +
1) 47,500 25,000 2)
2) 35,000
a.
1
Declared and = +56,000 -100,800 - =
paid stock Common Retained
+44,800
Add’l
Paid-in
Capital
2
Declared and -64,200 = -64,200 - =
issued cash Cash Retained
dividend. Earnings
1
The 7% dividend is a small stock dividend and, accordingly, Retained Earnings is reduced by the market value of the shares
distributed (7% × 80,000 shares × $18 = $100,800). Common Stock is increased by the par value of the shares ($56,000) and
Additional Paid-in Capital in increased by the remainder ($44,800).
2
Retained Earnings is reduced by $0.75 per share on 85,600 shares outstanding and Cash is decreased by the payment.
b.
100,800
Common stock (+SE) ................................................................56,000
64,200
Cash (-A) ................................................................ 64,200

c.
64,200 12/31 56,000 5/12
- Retained Earnings (SE) + - Additional Paid-in Capital (SE)

+
5/12 100,800 44,800 5/12
12/31 64,200
d.
PALEPU COMPANY
Retained earnings, December 31, 2015 $305,000
Add: Net income 283,000
588,000
Less: Cash dividends declared $ 64,200
Stock dividends declared 100,800 165,000
a.
1
Declared and = +250,000 -250,000 - =
paid 100% Common Retained
stock dividend. Stock Earnings
2
Declared and +15,000 -42,000
paid 3% stock Common Retained
+27,000
Additional
Paid-in
Captal
3
Declared and -102,400 = -102,400 - =
issued cash Cash Retained
dividend. Earnings
1
The large stock dividend is reflected as a reduction of Retained Earnings at the par value of the shares distributed (50,000
shares × 100% × $5 par value per share = $250,000). Common Stock is increased by the same amount.
2
This is a small stock dividend. As a result, Retained Earnings is decreased by the market value of the shares to be
distributed (3% × 100,000 shares × $14 per share = $42,000). Common Stock is increased by the par value of the shares
distributed (3% × 100,000 × $5 = $15,000) and Additional Paid-in Capital is increased by the balance ($27,000).

3
Total dividends are 4,000 × $5 = $20,000 for the preferred shares and 103,000 × $0.80 = $82,400 for the common shares.
Retained Earnings and Cash are reduced to reflect the payment.

b.
250,000
Common stock (+SE) ................................................................250,000
42,000
Common stock (+SE) ................................................................ 15,000
102,400
Cash (-A) ................................................................ 102,400
c.
102,400 12/20 250,000 4/1
15,000 12/7
- Retained Earnings (SE) + - Additional Paid-in Capital (SE)

+
4/1 250,000 27,000 12/7
12/7 42,000
12/20 102,400
d.
KINNEY COMPANY
Add: Net income 253,000
909,000
Less: Cash dividends declared $102,400
Stock dividends declared 292,000 394,400
a. Immediately after the stock split, 800,000 shares (2 x 400,000 shares) of $10
par value common stock are issued and outstanding.
b. The stock split does not change the Common Stock account balance. The
account balance is $8,000,000 just before and immediately after the stock split.
c. The stock split does not change the Paid-in Capital in Excess of Par Value
account. The account balance is $3,400,000 just before and immediately after
the stock split.

d. The 2-for-1 split will reduce EPS by half. The EPS numbers currently reported
in previous years’ income statements would also be reduced by half for
comparison purposes.

a. Beginning retained earnings + Net income – Dividends = Ending retained

earnings, so $5,262 million + $907 million – Dividends = $5,949 million.
Dividends = $220 million.
b. The change in shares outstanding was 284,950 thousand – 299,503

thousand = a decrease of 14,553 thousand shares. Therefore, Intuit must
have issued 7,914 thousand shares for the exercise of stock options.
c. When a company reissues treasury shares, the difference between the value
received and the treasury share cost is either put in or taken from Additional
paid-in capital (APIC). In this case, the option exercises increased APIC,
implying that the average exercise price exceeded the average cost of the
treasury shares.
a. Shares issued × Par value = Common Stock amount

3,577 million shares × $0.50 = $1,788.5 million
b. (Common Stock + Other Paid-In Capital)/Shares issued = Average Issue price

($1,788 million + $40,423 million) / 3,577 million = $11.80 per share
c. Treasury Stock / Treasury shares = Treasury cost per share

$35,262 million / 739.0 million = $47.72 per treasury share
d. Shares issued – Treasury shares = Shares outstanding

3,577,103,522 – 738,963,326 = 2,838,140,196 shares outstanding
a. Using diluted EPS and average shares outstanding, ($1.27) per share × 235
million shares = a loss of $ 298.45 million. This amount is after tax.
b. $7.54 x 235 million = $1,771.9 million based on diluted EPS. $7.66 x 232
million = $1,771.1 million based on basic EPS. The actual amount (from
McKesson’s 10-K) was $1,842 million. Because of rounding, the numbers
based on basic EPS and diluted EPS reflect approximations and can be
interpreted as high and low values of an estimated range. All such losses
(and/or income) are reported net of tax.

c. The dilution would be due to potentially dilutive securities. In McKesson’s
case these dilutive securities were primarily in-the-money stock options and
restricted stock units.

a. Yes, the number of shares outstanding increased by 18 million from “equity

compensation activity” and a decrease in treasury stock.
b. Net income + other comprehensive income = total comprehensive income.

$7,501 million + $(781) million = $6,720 million.
c.

-6,527 = - +6,527 - =
Cash Treasury
Stock
Treasury stock (+XSE, -SE) .......................................................... 6,527

Cash (-A) .................................................................................... 6,527
+ Cash (A) - + Treasury Stock (XSE) -

6,527 6,527
d. The $17 million difference between $1,525 million and $1,508 million went
into the Common Stock account. Perhaps Disney paid some portion of its
dividends into a dividend reinvestment account that effectively provides a
stock dividend.

PROBLEMS
a.

Cash Noncash Liabil- Contrib. Earned Contra Reve- Expen Net
Transaction + = + + - - =
Asset Assets ities Capital Capital Equity nues -ses Income
1/10: +476,000 = +280,000 - - =

Issued Cash Common
common Stock
1
stock.
+196,000
Additonal
Paid-in
Capital
1/23: -152,000 = - +152,000 - =

Purchased Cash Treasury
treasury Stock
2
stock.
3/14: +84,000 = +8,000 - -76,000 - =

Sold Cash Additional Treasury
treasury Paid-in Stock
3
stock. Capital
7/15: +128,000 = +80,000 - - =

Issued Cash Preferred
preferred Stock
4
stock.
+48,000
Additional
Paid-in
Capital
11/15: +24,000 = +5,000 - -19,000 - =

Sold Additonal Treasury
5
stock. Capital
1
Total proceeds of 28,000 × $17 = $476,000 are reflected as an increase in Cash. Common Stock is increased by the par value of
the shares issued (28,000 × $10 = $280,000) and Additional Paid-in Capital is increased for the balance ($196,000).
2
Cash is decreased and Treasury Stock is increased by the purchase price of 8,000 shares × $19 = $152,000. The increase in
Treasury Stock reduces contributed capital.
3
Cash received is 4,000 shares × $21 = $84,000. Treasury Stock is reduced by the original cost of $19 per share and the
remainder of $8,000 is reflected as an increase in Additional Paid-in Capital.
4
Cash received is $128,000. The Preferred Stock account is increased by the par value of the preferred shares issued (3,200 ×
$25 = $80,000) and Additional Paid-in Capital is increased for the balance.
5
Cash received is 1,000 shares × $24 = $24,000. Treasury Stock is reduced by its original cost of 1,000 shares × $19 = $19,000,
thus increasing contributed capital, and Additional Paid-in Capital is increased for the balance ($5,000).

b.
1/10 Cash (+A) ...................................................................................
476,000
Common stock (+SE) ................................................................ 280,000
1/23 Treasury stock (+XSE, -SE) .........................................................

152,000
Cash (-A) ................................................................................... 152,000
3/14 Cash (+A) ..................................................................................

84,000
Treasury stock (-XSE, +SE) ........................................................ 76,000
7/15 Cash (+A) ..................................................................................

128,000
11/15 Cash (+A) ..................................................................................

24,000
c.
1/10 476,000 152,000 1/23 280,000 1/10
3/14 84,000
7/15 128,000 - Preferred Stock (SE) +
11/15 24,000 80,000 7/15

+
1/23 152,000 76,000 3/14 196,000 1/10
19,000 11/15 8,000 3/14
48,000 7/15
5,000 11/15
d. 1/10: Decrease basic EPS

1/23: Increase basic EPS
3/14: Decrease basic EPS
7/15: Decrease basic EPS
11/15 Decrease basic EPS
Note: These answers ignore the effect of cash balances on earnings. Each
transaction changed the cash balance. If cash is invested in operations or in
securities to earn a return, net earnings would be affected by each transaction.

e.
Paid-in capital
8% Preferred stock, $25 par value,50,000 shares
authorized; 10,000 shares issued and outstanding $ 250,000
Common stock, $10 par value, 200,000shares
authorized; 78,000 shares issued,of which 3,000
shares are in treasury 780,000 $1,030,000
Additional paid-in capital
Paid-in capital in excess of par value—Preferred stock 116,000
Paid-in capital in excess of par value—Common stock 396,000
Paid-in capital from Treasury stock 13,000 525,000
Total paid-in capital 1,555,000
1,884,000
Less: Treasury stock (3,000 common shares) at cost 57,000
Total stockholders’ equity $1,827,000
a.
1
Purchased -100,000 = - +100,000 - =
of treasury Stock
stock for cash.
2
Sold 1,500 +18,000 = +3,000 - -15,000 - =
treasury stock. Paid-in Stock
Capital
3
Issued 5,000 +55,000 = +25,000 - - =
shares of Cash Common
common Stock
stock. +30,000
Add’l
Paid-in
Capital
4
Sold 1,200 +10,800 = -1,200 - -12,000 - =
treasury stock. Paid-in Stock
Capital
Notes:
1
The stock is acquired for 10,000 shares × $10 = $100,000. This is reflected as a reduction in Cash and a corresponding increase in
the Treasury Stock account, a contra-equity account which reduces contributed capital.
2
Cash received is 1,500 shares × $12 per shares = $18,000. Treasury Stock is reduced by its original cost of $10 per share and the
balance ($3,000) is reflected as an increase in Additional Paid-in Capital.
3
Cash received is 5,000 shares × $11 per share. Common Stock is increased by the par value of the shares issued (5,000 × $5 =
$25,000) and Additional Paid-in Capital is increased by the balance ($30,000).

4
Cash received is 1,200 shares × $9 = $10,800. Treasury Stock is reduced by the original cost of the shares (1,200 shares ×
$10 = $12,000) and Additional Paid-in Capital is reduced by the balance ($10,800 - $12,000 = -$1,200).

b.
1/12 No entry is required for the 3-for-1 stock split.
9/1 Treasury stock (+XSE, -SE) ......................................................... 100,000

Cash (-A) ................................................................................... 100,000
10/12 Cash (+A) ..................................................................................

18,000
11/21 Cash (+A) ..................................................................................

55,000
Common stock (+SE) ................................................................ 25,000
12/28 Cash (+A) ..................................................................................

10,800
Additional paid-in capital (-SE) .....................................................1,200
c.
10/12 18,000 100,000 9/1 25,000 11/21
11/21 55,000
12/28 10,800
+
9/1 100,000 15,000 10/12 12/28 1,200 3,000 10/12
12,000 12/28 30,000 11/21
d. 1/12: stock split – decrease basic EPS

9/1: purchase treasury stock – increase basic EPS
10/12: sold treasury stock – decrease basic EPS
11/21: issued common stock – decrease basic EPS
12/28: sold treasury stock – decrease basic EPS
e.
Paid-in capital
7% Preferred stock, $100 par value, 20,000 shares authorized;
5,000 shares issued and outstanding $500,000
Common stock, $5 par value, 300,000 shares authorized;
125,000 shares issued, of which 7,300 shares are in
the treasury 625,000 $1,125,000
Paid-in capital from treasury stock 1,800 415,800

1,948,800
Less: Treasury stock (7,300 common Shares) at cost 73,000
Total stockholders' equity $1,875,800

f. Because Sougiannis did not pay the 7% dividend on its preferred stock,
ROCE is computed as follows:
$83,000 / [($1,875,800+$1,809,000)/2 -$500,000] = 0.062 or 6.2%
a.
Issued +120,000 = +50,000 - - =
10,000 shares Cash Common
of common Stock
1
stock.
+70,000
Add’l
Paid-in
Capital
Purchased -56,000 = - +56,000 - =

of treasury Stock
2
stock.
Sold +17,000 = +3,000 - -14,000 - =

1,000 shares Cash Add’l Treasury
of treasury Paid-in Stock
3
stock. Capital
Sold 500 +6,500 = -500 - -7,000 - =

4
stock. Capital
Issued +175,000 = +125,000 - - =

5,000 shares Cash Preferred
of preferred Stock
5
stock.
+50,000
Add’l
Paid-in
Capital
1
Cash is increased by the proceeds from the stock sale (10,000 shares × $12 = $120,000). Common Stock is increased by
the par value (10,000 shares × $5) and Additional Paid-in Capital for the balance ($70,000).
2
Cash is reduced by the cost of the Treasury Stock (4,000 shares × $14 = $56,000). The Treasury Stock account is
increased accordingly. Since this account has a negative balance in stockholders’ equity, contributed capital is reduced.
3
Cash is increased by the proceeds from the sale of the Treasury Stock (1,000 shares × $17 = $17,000). The Treasury
Stock account is reduced by the original cost of the shares (1,000 × $14 = $14,000) and Additional Paid-in Capital is
increased for the balance.
4
Cash is increased by the proceeds from the sale of the Treasury Stock (500 shares × $13 = $6,500). Treasury Stock is
reduced by its original cost (500 shares × $14 = $7,000) and Additional Paid-in Capital is reduced for the balance.
5
Cash is increased by the proceeds from the sale of the Preferred Stock (5,000 shares × $35 per share = $175,000).
Preferred Stock is increased by its par value (5,000 shares × $25 = $125,000) and Additional Paid-in Capital is increased
for the balance ($50,000).

b.
1/5 Cash (+A) ..................................................................................
120,000
Common stock (+SE) ................................................................ 50,000
1/18 Treasury stock (+XSE, -SE) .........................................................56,000

Cash (-A) ................................................................................... 56,000
3/12 Cash (+A) ..................................................................................

17,000
Treasury stock (-XSE, +SE) ......................................................... 14,000
7/17 Cash (+A) ..................................................................................

6,500
Additional paid-in capital (-SE) ..................................................... 500
10/1 Cash (+A) ...................................................................................

175,000
c.
1/5 120,000 56,000 1/1 50,000 1/5
8
3/12 17,000
7/17 6,500 - Preferred Stock (SE) +
10/1 175,000 125,000 10/1

+
1/18 56,000 14,000 3/1 70,000 1/5
2
7,000 7/1 7/17 500 3,000 3/12
7
50,000 10/1
d.
Paid-in capital
8% Preferred stock, $25 par value, 50,000 shares authorized,
5,000 Shares issued and outstanding $125,000
Common stock, $5 par value, 350,000 shares authorized;
160,000 shares issued; 2,500 shares in treasury 800,000 $ 925,000

Paid-in capital from Treasury stock 2,500 722,500
2,066,000
Less: Treasury stock (2,500 shares) at cost 35,000
Total stockholders' equity $2,031,000

e. The transactions on January 5 (stock issue), March 12 and July 17 (both
treasury stock sales), and the transaction on October 1 (issued preferred
stock) would decrease basic EPS. The transaction on January 18 (treasury
stock purchase) would increase basic EPS.
a. See explanations in part b below.

Issued +62,000 = +50,000 - - =
1,000 shares Preferred
of preferred Stock
stock.
+12,000
Additional
Paid-in
Capital
Issued +144,000 = +80,000 - - =

4,000 shares Common
Cash
of common Stock
stock.
+64,000
Additional
Paid-in
Capital
Issued +60,000 = +20,000 - - =

2,000 shares Common
Cash
of common Stock
stock.
+40,000
Additional
Paid-in
Capital
Purchased -45,000 = - +45,000 - =

of treasury Stock
stock.
Sold 900 +18,900 = +2,700 - -16,200 - =

shares of Cash Additional Treasury
stock. Capital
Issued 500 +29,500 = +25,000 - - =

shares of Cash Preferred
preferred Stock
stock.
+4,500
Additional
Paid-in
Capital

b.
1/15 Cash (+A) ..................................................................................
62,000
Cash is increased by the proceeds from the sale of the Preferred Stock
(1,000 shares × $62 per share = $62,000). The Preferred Stock account is
increased for its par value (1,000 shares × $50 par = $50,000) and Additional
Paid-in Capital is increased for the balance ($12,000).
1/20 Cash (+A) ..................................................................................

144,000
Common stock (+SE) ................................................................ 80,000
Cash is increased by the proceeds from the sale of the Common Stock (4,000
shares × $36 = $144,000). Common Stock is increased by its par value
(4,000 × $20 = $80,000) and Additional Paid-in Capital is increased for the
remainder ($64,000).
5/18 No entry is required for the 2-for-1 stock split
6/1 Cash (+A) ..................................................................................

60,000
Common stock (+SE) ................................................................ 20,000
Common Stock is increased by its par value (2,000 × $10 = $20,000) and
Additional Paid-in Capital is increased for the balance ($40,000).
9/1 Treasury stock (+XSE, -SE) ......................................................... 45,000

Cash (-A) .................................................................................... 45,000
Cash is reduced by the cost of the Treasury Stock (2,500 shares × $18 per
share = $45,000). The Treasury Stock account is increased by its cost,
thereby reducing contributed capital.
10/12 Cash (+A) ..................................................................................

18,900
Cash is increased by the proceeds from the sale of the Treasury Stock (900 ×
$21 = $18,900). The Treasury Stock account is reduced by its cost (900 × $18
= $16,200), thereby increasing contributed capital, and Additional Paid-in
Capital is increased by the balance ($2,700).
12/22 Cash (+A) ..................................................................................

29,500
Cash is increased by the proceeds from the sale of the preferred shares (500
× $59 = $29,500). The Preferred Stock account is increased for its par value
(500 shares × $50 = $25,000) and Additional Paid-in Capital is increased for
the balance ($4,500).

c.
1/15 62,000 80,000 1/20
1/20 144,000 20,000 6/1
6/1 60,000
45,000 9/1 - Preferred Stock (SE) +
10/12 18,900 50,000 1/15
12/22 29,500 25,000 12/22

+
9/1 45,000 12,000 1/15
16,200 10/12 64,000 1/20
40,000 6/1
2,700 10/12
4,500 12/22
a. 2014: 4,009 – 1,298.4 = 2,710.6 million 2013: 4,009 – 1,266.9 = 2,742.1

million
Estimated average shares outstanding: ($11,643 - $253)/$4.19 = 2,718.4
million.
Average shares outstanding is slightly greater than the number of shares
outstanding at year-end because P&G has more shares in treasury stock at
the end of 2014 that at the end of 2013.
b. 2014: $75,805/1,298.4 = $58.38

2013: $71,966/1,266.9 = $56.80
c.
Preferred stock (-SE) ……………………………………… 26
Additional paid-in capital (+SE) ............................................ 4
Treasury stock (-XSE, +SE) ........................................................ 22
The reported value for preferred stock includes additional paid-in capital. This
fact can be discerned by noting that 600 million of class A preferred shares
are authorized and if all 600 million shares were issued, the stated value of $1
per share would yield $600 million of preferred stock. But if the $1,111 million
is assumed to be the stated value, the number of issued shares exceeds the
number authorized. Therefore, the $1,111 million figure must include
additional paid-in capital and the additional paid-in capital account refers only
to common stock.

d. P&G’s diluted EPS reflects the effects of convertible preferred stock and,
most likely, outstanding stock options.
e. 2014 ($millions): ($11,643 - $253) / [($69,214-$1,111+$68,064-$1,137)/2] =

0.17 or 17%

a. Class A and B common shares are identical except for voting rights. Class A
shares have 1 vote per share while class B shares have 10 votes per share.
This means that class B shareholders have greater control in the governance
of the corporation. Presumably, class B shares were retained by the original
management team of the firm when the class A shares were offered.
Class C capital shares have no voting rights at all, though they participate in
any dividends declared for common shares. Class C shares allow Google
executives to continue using shares to make acquisitions and motivate
employees, while ensuring that the Class B shares retain more than 50% of
the voting power.
b. 1,571 x $214.39 per share = $336,807
c. Options vest over 4 years; $336,807/4 = $84,201.8
Compensation expense (+E, -SE) ……………… 84,201.8

Additional paid-in capital (+SE) …………… 84,201.8
This entry would reduce Google’s 2013 income before tax by $84,201.8.
d. Intrinsic value refers to the difference between the current stock price and the
exercise price of the options. The aggregate intrinsic value of the options
granted in 2013 is:
($1,120.71 - $723.25) x 1,571 = $624,409.7
The option’s intrinsic value is always less than the option’s fair value (when
both are measured at the same time).
e. $12,920 million / $38.82 = 332.8 million shares.
Google had 330.0 million shares outstanding at the end of 2012 and 335.8
million shares outstanding at the end of 2013.
f. If all outstanding stock options were exercised, basic EPS would decrease.
Google had 5.0 million options outstanding at the end of 2013. If all of these
options had been exercised and added to shares outstanding, basic EPS
would have been $12,920 / (332.8 + 5.0) = $38.25 per share (compared to
$38.82).
g. The diluted EPS figure includes an adjustment only for outstanding options
that are not “under water,” i.e., are anti-dilutive. But this would cause the
diluted EPS to be higher than the amount calculated in part f. The difference

is due to the fact that Google has stock-based compensation besides stock
options, like restricted stock units.

CASES and PROJECTS
a. Mandatorily redeemable means that the issuing company can decide to

repurchase all of the remaining shares that have not been converted before
the redemption date specified in the preferred issue contract. Prior to that
date, holders of the preferred shares can convert their shares to common
stock. Northrop Grumman preferred holders converted most of their shares
and the rest were redeemed by the company. “Convertible” means that the
preferred stock can be exchanged for common stock. Usually this option rests
with the holder of the preferred stock. Sometimes, companies retain an option
to force the conversion. Northrop Grumman did so. This option is spelled out
in the preferred stock contract. The issue may also include a “liquidation
preference”, which would indicate the amount that will be paid to the preferred
shareholders in the event that the company fails. This amount must be paid in
full before the common shareholders can be paid anything in the event of the
liquidation of the company.
b. $350 million/$3.5 million = $100
c. The conversion option has increased substantially in value since issue. This
increase is likely due to an expected new government contract most likely for
an aircraft.
d. The answer depends on whether the remaining preferred shares are

redeemed for cash or converted into common shares. If Northrop Grumman
pays for the conversion in cash, cash is reduced, as is preferred stock. If
converted into common, the preferred stock is removed from the balance
sheet and the common stock is “sold” for the book value of the preferred; that
is, the par value and additional paid-in capital accounts increase as if the
common were sold for the book value of the preferred.
e. Outstanding convertible preferred shares need to be considered in our

analysis of the company, as the potential shares to be issued represent a
contingent claim to the future cash flows of the company. Convertible
preferred shares are considered in the computation of diluted EPS, which
assumes conversion at the earliest possible opportunity. The forgone
preferred dividends are removed from (added back to) the numerator, and the
additional shares issued are added to the denominator. The net effect is a
reduction in the diluted EPS over basic EPS.

King’s responsibility is to the shareholders of Image, Inc. Hatcher’s offer is

beneficial to the shareholders, so, in theory, King should support Hatcher’s
efforts. However, since it is likely that King and other managers will lose their
jobs if Hatcher’s takeover attempt is successful, King’s inclination may be to
resist Hatcher’s move.
It would be unethical to pay Hatcher 50% above current market price to

repurchase his stock. This would harm the remaining shareholders in two ways.
First, blocking the takeover would deprive shareholders of the opportunity to sell
their shares at a price that is substantially higher than current market price.
Second, King would be using company funds to purchase Hatcher’s stock, so the
other shareholders are essentially paying for King’s job security.
A tactic that would be ethical and beneficial to shareholders is for King, along
with other managers and directors, to make a competing offer to shareholders for
the outstanding stock. In that way, shareholders benefit by receiving the higher
stock price (whether from King or Hatcher) and if King acquires the company, he
keeps his job.
a. There are no cash proceeds from the stock dividend.
b. 2013: $9,450,000 / 250,000 = $37.80 per share

2014: $10,285,000 / 275,000 = $37.40 per share
c. Because of the stock dividend, the number of shares you own increased by
10% to 8,250 in 2015. Your percentage ownership in Pillar has remained the
same. The market value of your shares at the end of 2015 is $214,500
(8,250 x $26). At December 14, just prior to the stock dividend, your shares
were worth $210,000 (7,500 x $28).
d. Stock dividends, like stock splits, do not increase the book value of
stockholders’ equity. Stock dividends are paid to indicate a continued
expectation of earnings and earnings growth in periods when cash must be
maintained for investment needs. Stock dividends also serve to keep the per
share price of the stock at manageable levels during growth periods.
e. Retained earnings are restricted as to the amount of cash dividends that Pillar
can pay. Except for this restriction, paying a cash dividend then allowing
shareholders to purchase additional shares would have accomplished the
same thing as a stock dividend. However, some of the shareholders may
have chosen not to purchase the additional shares. If this had happened, the

company would have to make a public offering in order to raise the required
cash. A public offer that is this small is not economical.

f. The dividend cut is due to the restrictions on retained earnings and the
amount of cash needed to fund the plant addition.
g. Retained earnings are not the same as cash. The company is borrowing
$500,000 cash because that is how much additional cash will be needed to
build the plant addition. The restriction on retained earnings simply prevents
the company from using available cash to pay cash dividends.
The projected 5% decline in net income will reduce net income from $7,800,000
last year to $7,410,000 this year. The proposed stock buyback of 600,000
shares at midyear would reduce the weighted average shares outstanding from
4,000,000 to 3,700,000 (4,000,000 x 6/12 + 3,400,000 x 6/12). The resulting
earnings per share would be $7,410,000 / 3,700,000 = $2.00 per share.
Plummer is likely concerned about the proposal because the stock repurchase
appears to manipulate EPS in order to achieve the goal of increasing EPS each
year, earning management a nice bonus. This raises ethical concerns, since the
cash might be better used to make profitable investments or pay a cash dividend
to shareholders.
A less obvious question is why Sunlight has so much “excess cash?” If the cash
that would be used to repurchase stock (600,000 shares x market price per
share) were invested in a profitable investment, management may be able to
make up for the expected decline in earnings. It would be hard to believe that no
Revised 07.21.16
profitable investment opportunities exist. Even a short-term investment in
marketable securities might make up for the $390,000 decrease in earnings.
Chapter 12
Reporting and Analyzing Financial
Investments

Cases
Mini-
Exercises
Projects
LO1 – Explain and interpret the 24 - 27,
three levels of investor influence 11 32, 33 45, 47, 48 49 - 52
over an investee – passive,
significant, and controlling. 35 - 38
LO2 – Describe the term “fair
value” and the fair value 14 45, 47 51, 52
hierarchy.
24 - 27, 29,
LO3 – Describe and analyze 12, 13,
accounting for passive 32, 33, 45, 47 49 - 52
20, 21, 22
investments. 35 - 37
26,
LO4 – Explain and analyze
accounting for investments with 15, 16, 19 30 - 32 , 47, 48 49 - 52
significant influence. 37, 38
LO5 – Describe and analyze 17,18,19, 28, 34, 41,
accounting for investments with 46 - 48 51
23 42
control.
LO6 – Appendix 12A –
Illustrate and analyze
43 48
accounting mechanics for
equity method investments.
LO7 – Appendix 12B – Apply
equity method accounting 39, 40, 42 46, 48
mechanics to consolidations.
LO8 – Appendix 12C – Discuss
the reporting of derivative 44
securities.

QUESTIONS
Q12-1. a) Trading securities are reported at their fair value in the balance sheet.
b) Available-for-sale securities are reported at their fair value in the
balance sheet. c) Held-to-maturity securities are reported at their
amortized cost in the balance sheet.
Q12-2. An unrealized holding gain (loss) is an increase (decrease) in the fair
value of an asset (in this case, an investment security) that is still owned.
Q12-3. Unrealized holding gains and losses related to trading securities are
reported in the current-year income statement (and also retained
earnings). Unrealized holding gains and losses related to
available-for-sale securities are reported as a separate component of
stockholders' equity called Other Comprehensive Income (OCI).
Q12-4. Significant influence gives the owner of the stock the ability to
significantly influence the operating and financing activities of the
company whose stock is owned. Normally, this is accomplished with a
20% through 50% ownership of the company's voting stock.
The equity method is used to account for investments with significant
influence. Such an investment is initially recorded at cost; the investment
is increased by the proportionate share of the investee company's net
income, and equity income is reported in the income statement; the
investment account is decreased by dividends received on the
investment; and the investment account is reported in the balance sheet
at its book value. Unrealized appreciation in the market value of the
investment is not recognized.
Q12-5. Yetman Company's investment in Livnat Company is an investment with
significant influence, and should, therefore, be accounted for using the
equity method. At year-end, the investment should be reported in the
balance sheet at $258,000 [$250,000 + (40% × $80,000) - (40% x
$60,000)].
Q12-6. A stock investment representing more than 50% of the investee
company's voting stock is generally viewed as conferring “control” over
the investee company. The investor and investee companies must be
consolidated for financial reporting purposes.
Q12-7. Consolidated financial statements attempt to portray the financial
position, operating results, and cash flows of affiliated companies as a
single economic unit so that the scope of the entire (whole) entity is
more realistically conveyed.

Q12-8. The $750,000 investment in Murray Company appearing in Finn
Company's balance sheet and the $300,000 common stock and
$450,000 retained earnings appearing on Murray Company's balance
sheet are eliminated. The two balance sheets (less the accounts
eliminated) are then summed to yield the consolidated balance sheet.
Q12-9.B The $75,000 accounts payable on Dee's balance sheet and the $75,000
accounts receivable on Bradshaw's balance sheet are eliminated. In a
consolidation, all intercompany items are eliminated so that the
consolidated statements show only the interests of outsiders.
Q12-10. Limitations of consolidated statements include the possibility that the
performances of poor companies in a group are "masked" in
consolidation. Likewise, rates of return, other ratios, and percentages
calculated from consolidated statements might prove deceptive because
they are composites. Consolidated statements also eliminate detail
about product lines, divisional operations, and the relative profitability of
various business segments. (Some of this information is likely to be
available in the footnote disclosures relating to the business segments of
certain public firms.) Finally, shareholders and creditors of subsidiary
companies find it difficult to isolate amounts related to their legal rights
by inspecting only consolidated statements.

MINI EXERCISES
a. SI
Griffin owns > 20% of Wright.
b. P
Bond investments are always classified as passive.
c. P
2,000 shares of Google is well below the number necessary to exert influence
d. C
Watts owns more than half of Zimmerman stock
e. SI
Even though Shevlin owns less than 20% of Bowen, the fact that it buys 60%
of Bowen’s output means it is capable of exercising significant influence.
a. Available-for-sale securities are reported at fair value on the balance sheet.

For 2014, this is equal to the original cost ($44,619 million) plus unrecognized
gains ($759 million) and less unrealized losses ($30 million), or $45,348
million.
b. Unrealized gains (and losses) on available-for-sale securities are reported as

a component of Accumulated Other Comprehensive Income (AOCI) in the
shareholders’ equity section of the balance sheet.
a. Wasley will report the dividends received of $6,600 (6,000 shares × $1.10 per
share) as income. If the investment is accounted for as available-for-sale, the
increase in the market price of the stock will not be recognized as income
until the stock is sold. Unrealized gains (losses) are reported as Other
Comprehensive Income in the stockholders’ equity section of the balance
sheet.

b. If the investment is accounted for as “trading,” Wasley will report $6,600 of
dividend income plus income relating to the increase in the market price of
the stock of $6,000 ($13 - $12 price increase for 6,000 shares).

a. All of these investments are marked to fair value, but the determination differs.
Level 1 fair values are determined by reference to an active market where
identical assets are traded. Level 2 fair values are determined by using a
model (discounted cash flow, prices of similar assets, etc.) for which the inputs
and assumptions can be found from observable value. Level 3 fair values are
also determined by using a model, but the inputs and assumptions are not
observable except to the reporting company.
b. Only Level 1 investments are marked-to-fair value, the others are marked-to-
model. Level 1 values would be the most objective since they come from an
active market. Level 3 would be most subjective because they depend
significantly on management’s judgments.
c. Level 1 assets are most liquid, because they are traded in active markets.
Level 3 assets are likely to be least liquid because their value depends
significantly on information that is not publicly known.
a. Given the 30% ownership, “significant influence” is presumed and the

investment must be accounted for using the equity method. The year-end
balance of the investment account is computed as follows:
Beginning balance ........................ $1,000,000
% Lang income earned ................ 30,000 ($100,000 × 0.3)
% Dividends received ................... (12,000) ($40,000 × 0.3)
Ending balance ............................ $1,018,000
b. $30,000 ($100,000 × 0.3) - Equity earnings are computed as the reported net
income of the investee (Lang Company) multiplied by the percentage of the
outstanding common stock owned.
c. (1) In contrast to the market method, the equity method of accounting does not
report investments at market value. The unrealized gain of $200,000 is not
reflected in either the balance sheet or the income statement.
d.
1. Investment in Lang Company (+A) ................................................... 1,000,000
Cash (-A) ........................................................................................... 1,000,000
2. Investment in Lang Company (+A) ...................................................
30,000
Investment income (+R, +SE) ........................................................... 30,000
3. Cash (+A) ..........................................................................................
12,000

Investment in Lang Company (-A) .................................................... 12,000

e.
+ Cash (A) - - Investment Income (R) +
1,000,000 1. 30,000 2.
3. 12,000
+ Investment in Lang Company

(A) -
1. 1,000,000
2. 30,000
12,000 3.
f.
Purchase -1,000,000 +1,000,000 = - =
stock in Lang Cash Investment
Company.
Recognize +30,000 = +30,000 +30,000 - = +30,000

share of Lang Investment Retained Investment
income. Earnings Income
Receive +12,000 -12,000 = - =

dividend from Cash Investment
Lang.
Equity income on this investment is computed as the investee company (Penno)

earnings multiplied by the percentage of the company owned. In this case, equity
earnings equal:
$600,000 × 40% = $240,000
Note that dividends are treated as a return of investment (reduce the investment
balance by $80,000, computed as $200,000 × 40%), and not as income. Also,
the investment is recorded at adjusted cost, not at market value, and unrealized
gains (losses) are neither recognized on the balance sheet nor in the income
statement.
The $600,000 investment in Hirst Company appearing on Philipich Company's

balance sheet and the $300,000 common stock and $450,000 retained earnings
of Hirst Company would be eliminated.

In addition, a $150,000 noncontrolling interest [20% of ($300,000 + $450,000)]
would appear on the consolidated balance sheet. Many analysts treat the
noncontrolling interest as an equity account, and FASB has issued an exposure
draft requiring presentation as such if the proposal becomes GAAP.

Benartzi Company net income .................................................... $600,000

90% of $150,000 Liang Company net income ........................... 135,000
Consolidated net income............................................................. $735,000
a. If DeFond purchases 100% of Verduzco’s common stock, then it must

produce consolidated reports.
DeFond DeFond
Company Company DeFond
(before (after
Verduzco Eliminating Company
investment) investment) Company Entries (Consolidated)
Current assets $ 800 $ 500 $ 100 $ 600

Investment – 300 – (300) –
Noncurrent 2,000 2,000 900 2,900
assets
Liabilities 2,200 2,200 700 2,900
Shareholders’ 600 600 300 (300) 600
Equity
b. If DeFond purchases 50% of the common stock of Lin Company, it uses the
equity method.
DeFond Company DeFond Company Lin

(before investment) (after investment) Company
Current assets $ 800 $ 500 $ 200
Investment – 300 –
Noncurrent assets 2,000 2,000 1,800
Liabilities 2,200 2,200 1,400
Shareholders’ 600 600 600
Equity
c. If we compare DeFond’s consolidated balance sheet to the equity method

balance sheet, we can see that the total assets are higher and the liabilities
are higher. DeFond’s stockholders’ equity accounts are the same. So, the
Debt-to-Equity ratio will be higher if DeFond purchases the subsidiary rather
than investing in the joint venture. If reported profits are the same under
either scenario, then purchasing the subsidiary would produce a lower Return

on Assets than the joint venture. Other ratios would change as well (like the
Current Ratio), but not in a predictable direction.

a. 2015
10/1 Investment in Skyline, Inc. (+A) ........................................................
486,000
Cash (-A) ................................................................ 486,000
12/31 Interest receivable (+A) ................................................................

8,750
Interest revenue (+R, +SE) ................................ 8,750
12/31 Investment in Skyline, Inc. (+A) ........................................................

4,000
Unrealized gain (+R, +SE) ................................ 4,000
2016
3/31 Cash (+A) ........................................................................................
17,500
Interest receivable (-A) ............................................................... 8,750
Interest revenue (+R, +SE) ......................................................... 8,750
4/1 Cash (+A) ........................................................................................

492,300
Realized gain (+R, +SE) ............................................................. 2,300
Investment in Skyline, Inc. (-A) ................................ 490,000
b. Assuming the firm’s fiscal year ends 12/31, the unrealized gain of $4,000 in
Skyline Inc. bonds is closed to retained earnings in 2015 increasing net
income and retained earnings.
+ Cash (A) - - Interest Revenue (R) +

486,000 10/1/15 8,750 12/31/15
3/31/16 17,500 8,750 3/31/16
4/1/16 492,300
+ Investment in Skyline Bonds (A) - Unrealized Gain (R) +

-
10/1/15 486,000 4,000 12/31/15
12/31/15 4,000 490,000 4/1/16
+ Interest Receivable (A) - - Realized Gain (R) +

12/31/15 8,750 8,750 3/31/16 2,300 4/1/16

c.
10/1/15 -486,000 + 486,000 = - =

Purchase Cash Investment
$500,000 of
Skyline bonds
at 97.
12/31/15 +8,750 = +8,750 +8,750 - = +8,750

Recognize Interest Retained Interest
revenue.
12/31/15 +4,000 = +4,000 +4,000 - = +4,000

Record Investment Retained Unrealized
unrealized Earnings Gain
gain.
3/31/16 +17,500 -8,750 = +8,750 +8,750 - = +8,750

Recognize Cash Interest Retained Interest
income.
4/1/16 +492,300 -490,000 = +2,300 +2,300 - = +2,300

Sold Skyline Cash Investment Retained Realized
investment. Earnings Gain
a. 2015
11/15 Investment in Lane, Inc. (+A) .................................................. 171,200
Cash (-A) ................................................................................ 171,200
12/22 Cash (+A) ................................................................................10,000

Dividend income (+R, +SE) .................................................... 10,000
12/31 Unrealized loss (+E, -SE) ........................................................16,200

Investment in Lane, Inc. (-A) ................................................... 16,200
2016
1/20 Cash (+A) .........................................................................................
150,000
Loss on sale of investment in Lane, Inc. (+E, -SE) .......................... 5,000
Investment in Lane, Inc. (-A) ............................................................. 155,000

b. Assuming the firm’s fiscal year ends 12/31, the unrealized loss of $16,200 is
closed to the income summary in 2015, reducing net income and retained
earnings.
+ Cash (A) - + Investment in Lane Inc (A) -

12/22 10,000 171,20 11/15 11/15 171,200 16,200 12/31
0
1/20 150,000 155,000 1/20
+ Loss (E) -
1/20
5,000
+ Unrealized Loss (E) - - Dividend Income (R) +

12/31 16,200 10,000
12/22
c.
Cash Noncash Liabil Contrib. Earned Net
Transaction Asset + Assets = -ities + Capital + Capital Revenues - Expenses = Income
11/15 -171,200 +171,200 = =

10,000 shares
of Lane Inc
common.
12/22 +10,000 = +10,000 +10,000 = +10,000

Dividend Cash Retained Dividend
12/31 -16,200 = -16,200 +16,200 = -16,200

Decrease in Investment Retained Unrealized
Investment. Earnings Loss
1/20 +150,000 -155,000 = -5,000 +5,000 = -5,000

Sale of Lane Cash Investment Retained Realized
common. Earnings Loss

The main effect is to defer the loss in value experienced in 2015 to the year
2016.
2015
11/15 Investment in Lane, Inc. (+A) 171,200
Cash (-A) 171,200
12/22 Cash (+A) 10,000

Dividend income (+R, +SE) 10,000
12/31 Unrealized loss – AOCI (-SE) 16,200

Investment in Lane, Inc. (-A) 16,200
2016 The adjusting entry can be done on the date of sale or 12/31/2014.
1/20 Cash (+A) ..........................................................................................

150,000
Loss on sale of investment in Lane, Inc. (+E, -SE) ........................... 21,200
Unrealized loss – AOCI (+SE) .......................................................... 16,200
Investment in Lane, Inc. (-A) .............................................................155,000
+ Cash (A) - + Investment in Lane Inc (A) -

12/22 10,000 171,20 11/15 11/15 171,200 16,200 12/31
0
1/20 150,000 155,000 1/20
+ Loss (E) -
1/20
21,200
+ Unrealized Loss (AOCI) - - Dividend Income (R) +

12/31 16,200 16,200 1/20 10,000
11/22
Note that most of the loss occurred in 2015, but was not recognized on the
income statement until management decided to sell the securities in 2016.
continued next page

Cash Noncash Liabil Contrib. Earned Net
Transaction Asset + Assets = -ities + Capital + Capital Revenues - Expenses = Income
11/15 Purchase -171,200 +171,200 = =
10,000 shares of Cash Investment
Lane Inc
common.
12/22 Dividend +10,000 = +10,000 +10,000 = +10,000
income. Cash Retained Dividend
Earnings Income
12/31 Decrease -16,200 = -16,200 =
in Investment. Investment AOCI
1/20 Sale +150,000 -155,000 = +16,200 +21,200 = -21,200
of Lane Cash Investment AOCI Realized
common. -21,200 Loss
Retained
Earnings
Halen Inc. now owns all of Jolson. The company reports will be consolidated.
The total in the consolidated stockholder’s equity section on 1/1 is the
stockholders’ equity section of the parent company, determined as follows:
Common stock $600,000
Total Equity $910,000
Jolson’s equity accounts are eliminated in the consolidation process.

EXERCISES
a. Trading securities
1. Investment in Liu, Inc. (+A) ...........................................................72,000
Cash (-A) ....................................................................................... 72,000
2. Cash (+A) ...................................................................................... 6,600

Dividend income (+R, +SE) ........................................................... 6,600
3. Unrealized loss (+E, -SE) .............................................................. 4,500

Investment in Liu, Inc. (-A) ............................................................ 4,500
4. Cash (+A) ......................................................................................66,900

Loss on sale of investment (+E, -SE) ............................................ 600
Investment in Liu, Inc. (-A) ............................................................. 67,500
b.
+ Cash (A) - + Investment in Liu (A) -
2. 6,600 72,000 1. 1. 72,000 4,500 3.
4. 66,900 67,500 4.
- Dividend Income (R) +

6,600 2.
+ Unrealized Loss (E) - + Loss on Sale (E) -

3. 4,500 4. 600
c.
1. Purchased 6,000 -72,000 +72,000 = - =
common shares of Cash Investment
Liu, Inc., for $12
per share.
2. Received a cash +6,600 = +6,600 +6,600 - = +6,600
dividend of $1.10 Cash Retained Dividend
per common share Earnings Income
from Liu.
3. Year-end market -4,500 = -4,500 - +4,500 = -4,500
price of Liu Investment Retained Unrealized
common stock is Earnings Loss
$11.25 per share.

4. Sold all 6,000 +66,900 - 67,500 = –600 - +600 = –600
common shares of Cash Investment Retained Loss
Liu for $66,900. Earnings

d. Available-for-Sale Securities
1. Investment in Liu, Inc. (+A) ............................................................... 72,000

Cash (-A) ........................................................................................... 72,000
2. Cash (+A) ..........................................................................................6,600

Dividend income (+R, +SE) .............................................................. 6,600
3. Unrealized loss (-SE) ........................................................................4,500

Investment in Liu, Inc. (-A) ................................................................ 4,500
4. Cash (+A) ..........................................................................................

66,900
Loss on sale of investment (+E, -SE) ................................................5,100
Unrealized loss (+SE) ................................................................ 4,500
Investment in Liu, Inc. (-A) ................................................................ 67,500
+ Cash (A) - + Investment in Liu (A) -

2. 6,600 72,000 1. 1. 72,000 4,500 3.
4. 66,900 67,500 4.

6,600 2.
- Unrealized Loss (SE) + + Loss (E) -

3. 4,500 4,500 4. 4. 5,100

1. Purchased -72,000 +72,000 = - =

6,000 common Cash Investment
shares of Liu,
Inc., for $12
per share.
2. Received a +6,600 = +6,600 +6,600 - = +6,600

cash dividend Cash Retained Dividend
of $1.10 per Earnings Income
common share
from Liu.
3. Year-end -4,500 = -4,500 - =

market price of Investment AOCI
Liu common
stock is $11.25
per share.

+4,500
4. Sold all 6,000 +66,900 -67,500 = - +5,100 = –5,100
AOCI
common Cash Investment Loss
shares of Liu -5,100
for $66,900. Retained
Earnings

a. Investments classified as trading securities
1. Investment in Freeman, Co. (+A) ............................................80,000

Cash (-A) ................................................................................. 80,000
2. Cash (+A) ................................................................................ 6,250

Dividend income (+R, +SE) ..................................................... 6,250
3. Investment in Freeman, Co. (+A) ............................................ 7,500

Unrealized gain (+R, +SE) ...................................................... 7,500
4. Cash (+A) ................................................................................86,400

Loss on sale of investment (+E, -SE) ...................................... 1,100
Investment in Freeman, Co. (-A) ................................ 87,500
+ Cash (A) - + Investment in Freeman (A) -

2. 6,250 80,000 1. 1. 80,000
4. 86,400 3. 87,500 4.
7,500

6,250 2.
- Unrealized Gain (R) + + Loss on Sale (E) -

7,500 3. 4. 1,100

1. Ohlson Co. -80,000 +80,000 = - =
purchases 5,000 Cash Investment
common shares
of Freeman Co.
at $16 cash per
share.
2. Ohlson Co. +6,250 = +6,250 +6,250 - = +6,250
receives a cash Cash Retained Dividend
dividend of Earnings Income
$1.25 per
common share
from Freeman.
3. Year-end market +7,500 = +7,500 +7,500 - = +7,500

price of Freeman Investment Retained Unrealized
common stock is Earnings Gain
$17.50 per share.

4. Ohlson Co. sells +86,400 -87,500 = + -1,100 - +1,100 = -1,100
all 5,000 common Cash Investment Retained Loss
shares of Freeman Earnings
for $86,400 cash.

b. Available for Sale Securities
1. Investment in Freeman, Co. (+A) ......................................................80,000

Cash (-A) ...........................................................................................
80,000
2. Cash (+A) ..........................................................................................

6,250
Dividend income (+R, +SE) ............................................................... 6,250
3. Investment in Freeman, Co. (+A) ......................................................

7,500
Unrealized gain (+SE) ................................................................ 7,500
4. Cash (+A) ..........................................................................................

86,400
Unrealized gain (-SE) ................................................................7,500
Gain on sale of investment (+R, +SE) ................................ 6,400
Investment in Freeman, Co. (-A) ........................................................ 87,500
+ Cash (A) - + Investment in Freeman (A) -

2. 6,250 80,000 1. 1. 80,000
4. 86,400 3. 87,500 4.
7,500

6,250 2.
- Unrealized Gain (SE) + - Gain on Sale ( R) +

4. 7,500 7,500 3 6,400
4.

1. Ohlson Co. -80,000 +80,000 = - =
purchases Cash Investment
5,000 common
shares of
Freeman Co. at
$16 cash per
share.
2. Ohlson Co. +6,250 = +6,250 +6,250 - = +6,250
receives a cash Cash Retained Dividend
$1.25 per
common share
from Freeman.
3. Year-end +7,500 = +7,500 - =
market price of Investment AOCI
Freeman
common stock
is $17.50 per
share.

4. Ohlson Co. sells +86,400 -87,500 = -7,500 +6,400 - = +6,400
all 5,000 Cash Investment AOCI Gain
common shares +6,400
of Freeman for Retained
$86,400 cash. Earnings

a. The amortized cost of the Coca-Cola shares was $110 thousand, or $0.0023
per share (the result of many stock splits over the years.). Coca-Cola’s
shares would be a Level 1 fair value, meaning they are “marked-to-market” at
the end of the year. The value was $2,324,826 thousand, or $48.25 per
share. The difference between the two values is an unrealized holding gain
that would appear as part of AOCI in the SunTrust shareholders’ equity
section of the balance sheet.
b. Selling all the shares would result in the maximum realized holding gain,
which is the same as the unrealized gain in the footnote table – $2,324,716
thousand. After-tax, that would increase net income and retained earnings by
(1.0 – 0.35)·$2,324,716 thousand, or $1,511,065 thousand (about a billion
and a half).
c. The proceeds will be $51.00·4.605 million = $234,855,000. The original cost

of the shares is $0.0023·4.605 million = $10,592, producing a realized gain of
$234,844,408 (=$234,855,000 - $10,592). The book value of the shares at
the end of 2006 is $48.25·4.605 million = $222,191,250. Therefore, the
journal entry will be the following:
Cash (+A) ..........................................................................................

234,855,000
Unrealized Gain (-AOCI, -SE) …………………................. 222,180,658
Common stock of The Coca-Cola Company (-A) ............................... 222,191,250
Gain on sale of securities (+R, +SE)………………….. 234,844,408
a. 2015
11/1 Investment in Joos, Inc. (+A) .............................................. 306,900
Cash (-A) ............................................................................. 306,900
12/31 Interest receivable (+A) ....................................................... 4,500

Interest revenue (+R, +SE) ................................................. 4,500
12/31 Unrealized loss (+E, -SE) .................................................... 5,400

Investment in Joos, Inc. (-A) ............................................... 5,400
2016
4/30 Cash (+A) ............................................................................ 13,500
Interest receivable (-A) ........................................................ 4,500
Interest revenue (+R, +SE) ................................................. 9,000
5/1 Cash (+A) ............................................................................ 300,900

Loss on sale of investments (+E, -SE) ................................ 600
Investment in Joos, Inc. (-A) ................................................ 301,500

b.
+ Cash (A) - + Investment in Joos Inc. (A) -
4/30 13,500 306,90 11/1 11/1 306,900 5,400 12/31
0
5/1 300,900 301,500 5/1
+ Unrealized Loss (E) - + Interest Receivable (A) -

12/31 5,400 12/31 4,500 4,500
4/30
- Interest Revenue (R) + + Loss on Sale of Investments (E) -

4,500 12/31 5/1 600
9,000 4/30

c.
11/1 -306,900 +306,900 = - =

Buy $300,000 Cash Investment
Joos bonds
@102.
12/31 +4,500 = +4,500 +4,500 - = +4,500

Accrue Interest Retained Interest
interest. Receivable Earnings Revenue
12/31 -5,400 = -5,400 - +5,400 = -5,400

Recognize Investment Retained Unrealized
decline in Earnings Loss
value of
bonds.
4/30 +13,500 -4,500 = +9,000 +9,000 - = +9,000

Receive Cash Interest Retained Interest
interest. Receivable Earnings Revenue
5/1 Sold +300,900 -301,500 = -600 - +600 = -600

Joos bonds. Cash Investment Retained Loss
Earnings

Baylor Company now owns 75% of Reed. The company reports will be
consolidated. The total in the consolidated stockholders’ equity section on 1/1 is
determined as follows:
Common stock……………………………………………. 900,000

Retained earnings………………………………….…….. 440,000
Baylor Company shareholders’ equity $1,340,000
Noncontrolling interests 200,000
Total equity $1,540,000
a. The investment portfolio is reported at its current fair value of $40,990 million.
The cost of the portfolio is $37,545 million, there are $3,544 million in
unrealized gains and $99 million of unrealized losses.
b. Because the investments are accounted for as available-for-sale, unrealized

gains (losses) on investments are reported in Accumulated Other
Comprehensive Income (AOCI), rather than current income. The investments
are reported on the balance sheet at current market value on the statement
date.
c. Impairment losses are recognized in current income when the securities

decline in market value and the decline is deemed to be other than
temporary. Gains and losses realized from the sale of securities are
recognized in current income. A reclassification adjustment is required in
Other Comprehensive Income. Because the gains and losses from the sale
of securities will be recognized in current income (and retained earnings),
they need to be removed from AOCI to avoid double-counting the gains and
losses in stockholders’ equity.

a. 1. Investment in Barth Co. (+A) .............................................................

108,000
Cash (-A) ..........................................................................................108,000
2. Cash (+A) ..........................................................................................

15,000
Investment in Barth Co. (-A) ............................................................. 15,000
3. Investment in Barth Co. (+A) .............................................................

24,000
Investment income (+R, +SE) .......................................................... 24,000
4. Cash (+A) ..........................................................................................

120,500
Investment in Barth Co. (-A) .............................................................117,000
b.
+ Cash (A) - + Investment in Barth (A) -
2. 15,000 108,00 1. 1. 108,000 15,000 2.
0
4. 120,500 3. 117,000 4.
24,000
- Gain (R) + - Investment Income (R) +

3,500 4. 24,000 3.
c.
1. Buy 30% of -108,000 +108,000 = - =

Barth stock. Cash Investment
2. Receive +15,000 -15,000 = - =

dividend. Cash Investment
3. Recognize +24,000 = +24,000 +24,000 - = +24,000

share of net Investment Retained Investment
income of Earnings Income
Barth.
4. Sold Barth +120,500 -117,000 = +3,500 +3,500 - = +3,500

investment. Cash Investment Retained Gain
Earnings

a.
1. Investment in Palepu Co. (+A) .................................................. 120,000
Cash (-A) ................................................................................... 120,000
2. Cash (+A) ..................................................................................12,000

Investment in Palepu Co. (-A) ................................................... 12,000
3. Investment in Palepu Co. (+A) ..................................................30,000

Investment income (+R, +SE) ................................................... 30,000
4. Cash (+A) ..................................................................................

140,000
Investment in Palepu Co. (-A) ................................................... 138,000
b.
+ Cash (A) - + Investment in Palepu (A) -
2. 12,000 120,00 1. 1. 120,000 12,000 2.
0
4. 140,000 3. 30,000 138,000 4.
- Gain (R) + - Investment Income (R) +

2,000 4. 30,000 3.
c.
1. Buy 25% -120,000 +120,000 = - =

of Palepu Cash Investment
stock.
2. Receive +12,000 -12,000 = - =

dividend. Cash Investment
3. Recognize +30,000 = +30,000 +30,000 - = +30,000

share of Investment Retained Investment
net income Earnings Income
of Palepu.
4. Sold +140,000 -138,000 = +2,000 +2,000 - = +2,000

Palepu Cash Investment Retained Gain
investment. Earnings

a. 1. Market Value Method (AFS Securities)
1. Investment in Leftwich Co. (+A) .................................... 150,000

Cash (-A) ........................................................................ 150,000
2. No entry
3. Cash (+A) ....................................................................... 11,000

Dividend income (+R, +SE) ............................................ 11,000
4. Investment in Leftwich Co. (+A) .................................... 40,000

Unrealized gain (+SE) .................................................... 40,000
2.
+ Cash (A) - + Investment in Leftwich (A) -
3. 11,000 150,00 1. 1. 150,000
0
4.
40,000
- Unrealized Gain (AOCI) + - Dividend Income (R) +

40,000 4. 11,000 3.
3.
1. Purchase -150,000 +150,000 = - =

Common Cash Investment
shares.
2. No entry. = - =
3. Received +11,000 = +11,000 +11,000 - = +11,000

a cash Cash Retained Dividend
$1.10 per
common
share.
4. Recognize +40,000 = +40,000 - =

increase in Investment AOCI
investment
value at
year end .

b. 1. Equity Value Method
1. Investment in Leftwich Co. (+A) ................................................................

150,000
Cash (-A) ................................................................................................ 150,000
2. Investment in Leftwich Co. (+A) ................................................................

24,000
Investment income (+R, +SE) ................................................................ 24,000
3. Cash (+A) ................................................................................................

11,000
Investment in Leftwich Co. (-A) ................................................................ 11,000
4. No entry
2.
+ Cash (A) - + Investment in Leftwich (A) -
3. 11,000 150,00 1. 1. 150,000 11,000 3.
0
2.
24,000
- Investment Income (R) +

24,000 2.
3.
1. Purchase -150,000 +150,000 = - =

Common Cash Investment
shares.
2. Recognize +24,000 = +24,000 +24,000 - = +24,000

30% Investment Retained Investment
portion of Earnings Income
Leftwich
net
income.
3. Received +11,000 -11,000 = - =

a cash Cash Investment
dividend of
$1.10 per
common
share.
4. No entry. = - =

a. Siemens’ available-for-sale securities are reported at Fair value. In 2014, that

amount was €925 million for the current portion of its portfolio and €1,611
million for the non-current financial assets. The total value is €2,536 million.
The unrealized gains include €37 million in the current portion of the portfolio
and €1,419 (€1,611-€192) in the non-current portion of the portfolio. In total
unrealized gain of €1,456 million is included in AOCI in stockholders’ equity.
b. Analyzing the investment portfolio at cost:

Beginning balance (at cost) 580
+ Securities purchased +613
- Cost of securities sold (plug) -305
Ending balance (at cost) 888
The original cost of securities sold was €305 million. The cash flow statement
reported that cash proceeds from the sale of these securities totaled €317
million. Thus, the realized gain on the sale of securities was €12 million (€317-
€305).
c. If the current portion of Siemens’ available-for-sale securities were classified

as trading securities, the unrealized gains would be reported in income. For
fiscal 2014, that means that the change in the net unrealized gains (€37 - €20
= €17 million) would be added to the realized gain of €12 million for a total
gain of €29 million.
a. The amounts reported for all these separately-identifiable assets and liabilities
must be fair values at the date of the acquisition. So, any inventory would be
reported at what we would expect to get for it, rather than historical cost. Any
financial liabilities would be estimated at the value required to discharge them
at the date of the acquisition. In the fair value hierarchy, most of these
amounts will be determined using Level 2 or Level 3 approaches.
b. Goodwill is equal to the amount of consideration given for the transaction

minus the fair value of the net assets acquired. Other than goodwill, the asset
fair value is $35.9 million and the fair value of liabilities is $15.5 million. So,
the fair value of separately-identifiable net assets is $20.4 million (= $35.9
million - $15.5 million). As a result, the goodwill is $29.6 million (= $50 million
- $20.4 million). This amount would not be amortized in the future, but
Medtronic would have to assess its value annually for impairment. If the
goodwill value is impaired, the goodwill asset is reduced and a charge is
recognized in income.

c. Investors are likely to prefer acquisitions of identifiable net assets
(even if intangible), rather than vaguely-defined “synergy effects.” When the
acquired company goes to the highest bidder, there is a real risk that the highest
bidder was the one that most overestimated the potential for future synergies.
When purchase price allocations are disclosed subsequent to the acquisition,
stock prices respond favorably (unfavorably) to the disclosure that less (more)
goodwill was acquired.

a. 2015:
11/15 Investment in Core, Inc. (+A) ............................................... 80,900
Cash (-A) .............................................................................. 80,900
12/22 Cash (+A) .............................................................................6,250

Dividend income (+R, +SE) .................................................. 6,250
12/31 Investment in Core, Inc. (+A) ...............................................6,600

Unrealized gain (+R, +SE) .................................................... 6,600
2016:
1/20 Cash (+A) .............................................................................
86,400
Loss on sale of investment (+E, -SE) ...................................1,100
Investment in Core, Inc. (-A) ................................................. 87,500
b. Assuming the firm’s fiscal year ends 12/31, the unrealized gain of 6,600
increases net income and retained earnings in 2015.
+ Cash (A) - + Investment in Core Inc (A) -

12/22/1 6,250 80,900 11/15/1 11/15/15 80,900
5 5
1/20/16 86,400 12/31/15 87,500 1/20/16
6,600
+ Loss on Sale of Investment (E) -

1/20/16
1,100
- Unrealized Gain (R) + - Dividend Income (R) +

6,600 12/31/1 6,250
5 12/22/1
5
c.
11/15 -80,900 +80,900 = =

5,000 shares
of Core Inc
common.

12/22 +6,250 = +6,250 +6,250 = +6,250
Dividend Cash Retained Dividend
12/31 +6,600 = +6,600 +6,600 = +6,600

Increase in Investment Retained Unrealized
Investment. Earnings Gain
1/20 +86,400 -87,500 = -1,100 +1,100 = -1,100

Sale of Core Cash Investment Retained Loss
common. Earnings on Sale

E12-36 (30 minutes)
a. 2015:
11/15 Investment in Core, Inc. (+A) ............................................... 80,900
Cash (-A) .............................................................................. 80,900
12/22 Cash (+A) .............................................................................6,250

Dividend income (+R, +SE) .................................................. 6,250
12/31 Investment in Core, Inc. (+A) ...............................................6,600

Unrealized gain (+SE) .......................................................... 6,600
2016:
1/20 Cash (+A) .............................................................................
86,400
Unrealized gain (-SE) ...........................................................6,600
Investment in Core, Inc. (-A) ................................................ 87,500
b.
+ Cash (A) - + Investment in Core Inc (A) -
12/22/15 6,250 80,900 11/15/1 11/15/15 80,900
3
1/20/16 86,400 12/31/15 87,500 1/20/16
6,600
- Gain on Sale of Investment (R) +

5,500 1/20/16
- Unrealized Gain (AOCI) + - Dividend Income (R) +

1/20/16 6,600 6,600 12/31/1 6,250
3 12/22/1
5
c.
11/15
Purchase
-80,900 +80,900
5,000 shares = - =
Cash Investment
of Core Inc
common.
12/20 +6,250 +6,250

+6,250
Dividend = Retained Dividend - = +6,250
Cash

12/31
+6,600 +6,600
Increase in = - =
Investment AOCI
Investment.
1/20 +86,400 -87,500 = -6,600 +5,500 - = +5,500

Sale of Core Cash Investment AOCI Gain
common.
+5,500
Retained
Earnings

a. The trading stock investments will be reported at $225,300. This amount is

computed using their market values at year-end; specifically, $65,300 +
$160,000, or $225,300.
b. The available-for-sale stock investments will be reported at $346,700. This

amount is computed using their market values at year-end; specifically,
$192,000 + 154,700, or $346,700.
c. The equity method stock investments will be reported at $236,000. This amount
is computed using their equity method value at year-end; specifically, $100,000
+ $136,000, or $236,000.
d. Unrealized holding losses of $5,200 will appear in the 2016 income statement.
These losses relate to the trading securities; specifically— Barth: $68,000 -
$65,300 = $2,700; Foster: $162,500 - $160,000 = $2,500; total of $2,700 +
$2,500 = $5,200.
e. (i) Unrealized holding losses of $7,300 will appear in the stockholders' equity
section of the December 31, 2016, balance sheet under other
comprehensive income. These losses relate to the available-for-sale
securities; specifically— McNichols: $197,000 - $192,000 = $5,000; Patell:
$157,000 - $154,700 = $2,300; total of $5,000 + $2,300 = $7,300.
(ii) Unrealized holding losses of $5,200 will appear in the stockholders’ equity
section of the December 31, 2016, balance sheet under retained earnings.
These losses relate to the trading securities; specifically— Barth: $68,000 -
$65,300 = $2,700; Foster: $162,500 - $160,000 = $2,500; total of $2,700 +
$2,500 = $5,200.
(iii) Total unrealized holding losses in equity of $12,500—total of (i) & (ii)
f. (i) A fair value adjustment to investments of $7,300 will appear in the

December 31, 2016, balance sheet. This adjustment relates to the
available-for-sale securities. See part (e) for the supporting computations.
The fair value adjustment decreases the book value of the available-for-sale
securities to their year-end market value.
(ii) A fair value adjustment to investments of $5,200 will appear in the

December 31, 2016, balance sheet. This adjustment relates to the trading
securities. See part (e) for supporting computations. The fair value
adjustment decreases the book value of the trading securities to their
year-end market value.
(iii) Total fair value adjustment is $12,500—total of (i) & (ii)

(Entries in $ millions)
a. Record share of income:
... Investment in affiliates (+A)……………………………. 257

Income from affiliates (+R, +SE)…………... 257
b. Record receipt of cash dividends:
Cash (+A)………………………………………………… 185

Investment in affiliates (-A)…………………… 185
c. Record divestiture of AstraZeneca LP:
Cash (+A)………………………………………………….. 2,050

Gain on AstraZeneca disposal (+R, +SE)……. 1,400
Investment in affiliates (-A)…………………….. 650
d. The ending balance should be $1,600 million + $257 million - $185 million -
$1,400 million = $272 million. The actual balance, $337 million, was $65
million higher. Merck reports its investments at “$1.6 billion” in 2013 and its
investment in AstraZeneca at “$1.4 billion;” rounding of these amounts could
explain all or part of the difference. In addition, the difference could be due to
advances (loans) made to the affiliates or AOCI adjustments at the affiliates
or some other transactions (or adjustments) besides the ones described
above.

E12-39.B (40 minutes)
1 and 2.
Consolidating
Healy Miller Adjustments Consolidated
Current assets $1,700,000 $120,000 $ 1,820,000
Investment in Miller 500,000 $(500,000) 0
Plant assets ........................ 3,000,000 410,000 15,000 3,425,000
Goodwill .............................. _________ ________ 45,000 45,000
Total assets ........................ $5,200,000 $530,000 $5,290,000
Liabilities ............................. $ 700,000 $ 90,000 $790,000

Contributed capital ............. 3,500,000 400,000 (400,000) 3,500,000
Retained earnings .............. 1,000,000 40,000 (40,000) 1,000,000
Total liabilities &
stockholders’ equity......... $5,200,000 $530,000 $5,290,000
3. Miller contributed capital (-SE) ............................................................

400,000
Miller retained earnings (-SE) ..............................................................
40,000
Plant assets (+A) ................................................................ 15,000
Goodwill (+A) ......................................................................................
45,000
Investment in Miller Co. (-A) ............................................................. 500,000
4.
+ Investment in Miller Co. (A) - + Goodwill (A) -
500,00 1/1 1/1 45,000
0
- Miller Contributed Capital (SE) +

1/1
400,000
+ Plant Assets (A) - - Miller Retained Earnings (SE) +

1/1 15,000 1/1 40,000
5.


1/1 -500,000 = -400,000 - =
To consolidate Investment Miller
Healy & Miller. in Miller Contributed
+45,000 Capital
Goodwill -40,000
+15,000 Miller
Plant Retained
Assets Earnings

1 and 2.
Rayburn Company purchased all of Kanodia Company's common stock for

cash on January 1, after which the separate balance sheets of the two
corporations appeared as follows:
Consolidating
Rayburn Kanodia Adjustments Consolidated
Investment in Kanodia ....... $ 600,000 (600,000) $ 0
Other assets ....................... 2,300,000 $700,000 20,000 3,020,000
Goodwill .............................. . . 40,000 40,000
Total assets ........................ $2,900,000 $700,000 $3,060,000
Liabilities ............................. $ 900,000 $160,000 $1,060,000
Contributed capital ............. 1,400,000 300,000 (300,000) 1,400,000
Retained earnings .............. 600,000 240,000 (240,000) 600,000
Total liabilities &
stockholders’ equity ........ $2,900,000 $700,000 $3,060,000
3. Kanodia contributed capital (-SE) .......................................................

300,000
Kanodia retained earnings (-SE) .........................................................
240,000
Other assets (+A) ................................................................ 20,000
Goodwill (+A) ......................................................................................
40,000
Investment in Kanodia Co. (-A).......................................................... 600,000
4.
+ Investment in Kanodia Inc. (A) + Goodwill (A) -
-
600,00 1/1 1/1 40,000
0
- Kanodia Contributed Capital (SE) +

1/1
300,000
+ Other Assets (A) - - Kanodia Retained Earnings (SE) +

1/1 20,000 1/1 240,000
5.

1/1 -600,000 = -300,000 =
To Investment in Kanodia
consolidate Kanodia Contributed
Rayburn & +40,000 Capital
Kanodia. Goodwill -240,000
+20,000 Kanodia
Other Assets Retained
Earnings


a. The investment is initially recorded on Engel’s balance sheet at the purchase

price of $16.8 million, including $600,000 of goodwill. Because the fair value of
Ball is less than the carrying amount of the investment on Engel’s balance
sheet, the goodwill may be deemed to be impaired. To determine impairment,
the imputed value of the goodwill is determined to be 12.5 million - $12.3 million
= $200,000. Because this is less than the carrying amount of the goodwill, it is
deemed to be impaired.
b. Goodwill must be written down by $400,000. The write-down will reduce the
carrying amount of goodwill by $400,000, and the write-down will be recorded
as a loss in Engel’s income statement, thereby reducing retained earnings by
that amount.
a.
Cash paid .......................................................................... $210,000
Fair market value of shares issued .................................... 180,000
Purchase price ................................................................... 390,000
Less: Book value of Harris ................................................. 280,000
Excess payment ................................................................ 110,000
Excess payment assigned to specific accounts based on fair market value:

Buildings ............................................................................ 40,000
Patent ................................................................................ 30,000
Goodwill ............................................................................. $ 40,000
$110,000
b.
Easton Harris Consolidation Consolidated
Accounts Company Co. Entries Totals
Cash $ 84,000 $ 40,000 $ 124,000
Receivables 160,000 90,000 250,000
Inventory 220,000 130,000 350,000
Investment in Harris 390,000 [S] $(280,000) -

[A] (110,000)
Land 100,000 60,000 160,000
Buildings, net 400,000 110,000 [A] 40,000 550,000
Equipment, net 120,000 50,000 170,000
Patent 0 --- [A] 30,000 30,000
Goodwill - -- [A] 40,000 40,000
Totals $1,474,000 $480,000 $1,674,000

Table continued next page

Table continued from previous page
Easton Harris Consolidation Consolidated
Accounts Company Co. Entries Totals
Accounts payable $ 160,000 $ 30,000 $ 190,000
Long-term liabilities 380,000 170,000 550,000
Common stock 500,000 40,000 [S] (40,000) 500,000
Additional paid-in
capital 74,000 - 74,000
Retained earnings 360,000 240,000 [S] (240,000) 360,000

Totals $1,474,000 $ 480,000 $1,674,000
c. The tangible assets are accounted for just like any other acquired asset. The
receivables are removed when collected, inventories affect future cost of goods
sold, and depreciable assets are depreciated over their estimated useful lives.
Intangible assets with a determinable life are amortized (depreciated) over that
useful life. Finally, intangible assets with an indeterminate useful life (such as
goodwill) are not amortized, but are either tested annually for impairment, or
more often if circumstances require.
E12-43.A (20 minutes)
a. Investment in Harris Company (+A) ...................................................

28,800
Equity in earnings of Harris Company (-SE) ................................ 28,800
The equity in earnings of Harris Company is calculated as follows:
40% x [$80,000 – ($40,000 ÷ 20) – ($30,000 ÷ 5)] = $28,800
b. $156,000 + $28,800 – 40% x $40,000 = $168,800.
E12-44.C (20 minutes)
a. Companies use derivative securities in order to mitigate risks, such as

commodity price risks, risks relating to foreign exchange fluctuations, or risks
relating to fluctuations in interest rates.
b. Derivatives are reported on the balance sheet as are the assets or liabilities to
which they relate. Generally, derivatives and the related assets/liabilities are
reported on the balance sheet at their fair market value.
c. The unrealized gains (losses) on HP’s derivatives are reported in the

Accumulated Other Comprehensive Income section of its stockholders’ equity.
This reporting indicates that they have not yet affected HP’s profits. Once the

underlying transaction is settled, these unrealized gains (losses) will be
removed from AOCI and transferred into current income, thus affecting HP’s
profitability.

PROBLEMS
a. Available-for-sale investments are reported at market value on the balance

sheet. Thus, Met Life’s bond investments are reported at:
$365,425 million as of 2014

$350,187 million as of 2013
b. Net unrealized gains (losses) at the end of 2014 are:
$30,757 million ($32,634 million - $1,877 million)
Net unrealized gains (losses) at the end of 2013 are:
$16,806 million ($21,180 million - $4,374 million)
Because the investments are accounted for as available-for-sale, these

unrealized gains (losses) did not affect reported income for 2014 and 2013.
(Note: Had these investments been accounted for as trading securities, those
unrealized gains (losses) would have affected reported income.)
c. Realized gains (losses) are gains (losses) that occur as a result of sales of
securities. These are reported in the income statement and affect reported
income.
Unrealized gains (losses) reflect the difference between the current market
price of the security and its acquisition cost. Only unrealized gains (losses)
from trading securities are reported in income. If MetLife had sold all of the
AFS securities on which it had gains, its pre-tax income would have increased
by $30,757 million.
d. The evaluation of investment performance is difficult as companies have

discretion over the timing of realized investment gains (losses) and can,
thereby, affect reported income. By including unrealized gains (losses) in the
analysis, we are able to get a clearer picture of overall investment
performance—albeit, with an understanding that these gains and losses are
not yet realized. These returns could then be compared with those of
competitors and market rates in general for investments of comparable risk.
We believe this reporting metric provides useful insights as noted.

P12-46.B (30 minutes)
Consolidating
Gem Alpine Adjustments Consolidated
Current assets ................... $258,000 $160,000 $ 418,000
Investment in Alpine .......... 392,000 $(392,000) 0
Plant assets (net) .............. 265,000 460,000 725,000
Total assets ........................ $915,000 $620,000 $1,143,000
Liabilities............................. $ 50,000 $ 60,000 $ 110,000

Common stock ................... 700,000 420,000 (420,000) 700,000
Retained earnings ............. 165,000 140,000 (140,000) 165,000
Noncontrolling interest....... 168,000 168,000
Total liabilities &
stockholders’ equity ........ $915,000 $620,000 $1,143,000
a. The trading security investments will be reported at $375,300. This value is

$270,000.
b. The available-for-sale investments will be reported at $359,000. This value is

160,000.
c. The held-to-maturity bond investments will be reported at $237,200. This value

is computed using their amortized cost value at year-end; specifically, $101,200
+ $136,000.
d. Unrealized holding gains of $10,400 will appear in the 2016 income statement.
These gains relate to the trading securities; specifically— Ling: $105,300 -
$102,400 = $2,900 gain; Wren: $270,000 - $262,500 = $7,500; total of $2,900 +
$7,500 = $10,400. The calculation is only possible because this is the first year
the bonds have been held. Therefore, the entire price difference occurred this
year.
e. (i) Unrealized holding gains of $8,000 will appear in the stockholders' equity
section of the December 31, 2016, balance sheet under accumulated other
comprehensive income (AOCI). These losses relate to the available-for-sale
securities; specifically — Olanamic: $199,000 - $197,000 = $2,000; Fossil:
$160,000 - $154,000 = $6,000; total of $2,000 + $6,000 = $8,000.

(ii) Unrealized holding gains of $10,400 will appear in the stockholders’ equity
section of the December 31, 2016, balance sheet under retained earnings
(see answer to requirement d).
(iii) Total unrealized holding gains in equity of $18,400—totals of (i) & (ii).

f. (i) A fair market value adjustment to investments of $8,000 will appear in the
December 31, 2016, balance sheet. This adjustment relates to the
available-for-sale securities. See part (e) for the supporting computations.
The fair value adjustment increases the book value of the available-for-sale
securities to their year-end market value.
(ii) A fair market value adjustment to investments of $10,400 will appear in the
December 31, 2016, balance sheet. This adjustment relates to the trading
securities. See part (d) for supporting computations. The fair value
adjustment increases the book value of the trading securities to their
year-end market value.
(iii) No fair market adjustment is made to the bonds to be held to maturity.

However, the reported value of each bond is adjusted for the amortization of
premium or discount. Thus, the Meander bond will be shown at a value of
$101,200 and the Resin bond will be valued at $136,000. The changes in
these asset values on the Columbia Company balance sheet will be
matched by the related interest revenue.
P12-48.A,B (60 minutes)
a. Yes, each individual company (e.g., parent and subsidiary) maintains its own
financial statements. This approach is necessary to report on the activities of
the individual units and to report to the respective stakeholders of each unit.
The purpose of consolidation is to combine these separate statements to

more clearly reflect the operations and financial condition of the combined
(whole) entity.
b. The Investment in Financial Products Subsidiaries is reported on the parent’s

(Machinery and Power Systems’) balance sheet at $4,488 million.
This amount is the same balance as reported for stockholders’ equity of the
Financial Products subsidiary.
This relation will always exist so long as the investment is originally

purchased at book value (e.g., no goodwill from the purchase).
c. The consolidated balance sheet more clearly reflects the actual assets and
liabilities of the combined company vis-à-vis that revealed in the equity
method of accounting. That is, it better reflects operations as one entity as far
as investors and creditors are concerned.
The equity method of accounting that is used by the parent company to

account for its investment in the subsidiary reflects only its proportionate

share (100% in this case) of the investee company stockholders’ equity and
does not report the individual assets and liabilities comprising that equity.

d. The consolidating adjustments generally accomplish three objectives:
(i) They eliminate the equity method investment on the parent’s balance
sheet and replace it with the actual assets and liabilities of the investee
company to which it relates.
(ii) They record any additional assets that are included in the investment
balance that may not be reflected on the subsidiary’s balance sheet, like
goodwill, for example.
(iii) They eliminate any intercompany sales and receivables/payables.
e. The consolidated stockholders’ equity and the stockholders’ equity of the

parent company are equal. This equality will always be the case. The
consolidation process replaces the investment account with the assets and
liabilities to which it relates. Thus, stockholders’ equity remains unaffected.
f. Consolidated net income will equal the net income of the parent company.
The reason for this result is that the parent reflects the income of the
subsidiary via the equity method of accounting for its investment. The
consolidation process merely replaces the equity income account with the
actual and individual sales and expenses to which it relates. Net income is
unaffected.
g. The equity method of accounting reports investments at adjusted cost

(beginning balance plus equity earnings and less dividends received)—this
contrasts with the market method. Unrealized gains for a subsidiary are,
therefore, not reflected on the consolidated balance sheet and income
statement. Instead, the subsidiary is reflected on the balance sheet at its
purchase price net of depreciation and amortization, just like any other asset.
The consolidation process merely replaces the investment account with the
actual assets and liabilities to which it relates. Thus, there can exist
substantial unrealized gains subsequent to the acquisition that are not
reflected in the consolidated financial statements.

CASES
a. Yahoo!’s sale of 140 million shares of Alibaba resulted in a realized gain of

$10.3 billion which was reported in “other income” in the income statement.
Most of Yahoo!’s reported earnings in 2014 are due to this gain.
As a result of Alibaba’s IPO and Yahoo!’s sale of 140 million shares, Yahoo!’s
share of Alibaba fell from 24% to 15%. Prior to the IPO, Yahoo! reported its
investment in Alibaba using the equity method. It would have reported 24%
of Alibaba’s earnings (or losses) in “Earnings in equity interests, net.”
After the IPO, Yahoo used the available-for-sale method to report this
investment. The change in reporting method means that Yahoo! would need
to mark its investment in Alibaba to fair value at the end of 2014. Thus, even
though its share of Alibaba’s stock decreased from 24% to 15%, the
investment account on Yahoo!’s balance sheet increased significantly. The
unrealized gain of $37,154,305 ($39,867,789 - $2,713,484) would not be
reported in the income statement. Instead, it is credited to “other
comprehensive income” and included in AOCI in the balance sheet.
b. ROA:
2014: $7,532,142 ÷ [($61,960,344 + $16,804,959)/2] = 19.1%
2013: $1,376,566 ÷ [($16,804,959 + $17,103,253)/2] = 8.1%
c. NOPAT ($ thousands):
2014: $7,532,142 – [$10,369,439 x (1-0.35)] = $ 792,006.65
2013: $1,376,566 – [$43,357 x (1-0.35)] = $1,348,383.95
RNOA:
2014: $792,006.65 ÷ [($11,416,323 + $11,144,097)/2] = 7.0%
2013: $1,348,383.95 ÷ [($11,144,097 + $10,961,873)/2] = 12.2%
continued next page

ROA divides net income by average total assets, while RNOA includes only
operating sources of income in the numerator and operating assets (less
operating liabilities) in the denominator. Equity method investments are
generally classified as operating, while available-for-sale investments are
considered nonoperating. As a consequence, the realized gain of $10.3
billion (before tax) significantly increases Yahoo!’s ROA from 8.1% in 2013 to
19.1% in 2014. The $10.3 billion gain does not affect RNOA. RNOA
decreases from 12.2% in 2013 (when the equity method investment in
Alibaba is included) to 7.0% in 2014 (when the available-for-sale method
investment in Alibaba is excluded).
d. Yahoo! reported its investment in Alibaba at fair value -- $39,867,789

thousand – in its 2014 balance sheet. Yahoo!’s balance sheet would also
include the unrealized gain of $37,154,305 in AOCI within stockholders’
equity. Its income statement would report only the $10.3 billion realized gain
from the sale of 140 million shares.
e. If this investment had been classified as trading securities, the unrealized

gain of $37,154,305 would be recognized as other income in the income
statement. Assuming a 35% incremental tax rate, 2014 ROA would be
calculated as follows (note that 2013 ROA is unchanged):
2014: [$7,532,142 + $37,154,305 x (1-.35)] ÷ [($61,960,344 + $16,804,959)/2] =

80.4%
2013: $1,376,566 ÷ [($16,804,959 + $17,103,253)/2] = 8.1%
RNOA is not affected by the choice between available-for-sale and trading

classification.
f. If the equity method had been used, Yahoo! would report its investment in
Alibaba at cost plus/minus its share (15%) of the undistributed earnings.
Consequently, total assets would be lower by about $37.2 billion. This would
increase Yahoo!’s ROA.
The cost of the investment ($2,713,484) would be added to net operating
assets. In addition, 15% of Alibaba’s income (loss) would be added to
(subtracted from) Yahoo!’s operating income (and NOPAT). The effect on
RNOA is uncertain given the information available.

a. 2016:
1/2 Investment in Dye, Inc. (+A) ..............................................................
420,000
Cash (-A) ................................................................ 420,000
12/31 Dividend receivable (+A) ................................................................

16,000
Dividend income (+R, +SE) ................................ 16,000
12/31 Unrealized loss (+E, -SE) ................................................................

60,000
Investment in Dye, Inc. (-A) ................................ 60,000
2017:
1/18 Cash (+A) ..........................................................................................
16,000
Dividend receivable (-A) ................................................................ 16,000
b.
+ Cash (A) - + Investment in Dye Inc. (A) -
1/18/17 16,000 420,00 1/2/16 1/2/16 420,000 60,000 12/31/1
0 6
+ Dividend Receivable (A) -

12/31/16 16,000 1/18/17
16,000
+ Unrealized Loss (E) - - Dividend Income (R) +

12/31/16 60,000 16,000
12/31/1
6
c.

1/2/16 -420,000 +420,000 = - =

Buy 20,000 Cash Investment
shares of
Dye.
12/31/16 +16,000 = +16,000 +16,000 - = +16,000

Declare Dividend Retained Dividend
dividend Receivable Earnings Income
$.8/share.
12/31/16 -60,000 = -60,000 - +60,000 = -60,000

Recognize Investment Retained Unrealized
decline in Earnings Loss
investment.

1/18/17 +16,000 -16,000 = - =
Receipt of Cash Dividend
dividend. Receivable

d. 2016:
420,000
Cash (-A) ...........................................................................................
420,000
12/31 Dividend receivable (+A) ................................................................

16,000
Investment in Dye, Inc. (-A) ...............................................................16,000

112,000
Investment income (+R, +SE) ...........................................................112,000
2017:
1/18 Cash (+A) ..........................................................................................
16,000
Dividend receivable (-A) ................................................................ 16,000
e.
+ Cash (A) - + Investment in Dye Inc. (A) -
1/18/11 16,000 420,00 1/2/10 1/2/10 420,000
0
12/31/10 112,000 16,000 12/31/1
0
- Investment Income (R) + + Dividend Receivable (A) -

112,00 12/31/1 12/31/10 16,000 1/18/11
0 0 16,000
f.
1/2/16 -420,000 +420,000 = - =
Buy 20,000 Cash Investment
shares of
Dye.
12/31/16 +16,000 = - =
Declare Dividend
dividend Receivable
$.8/share.
-16,000
Investment
12/31/16 +112,000 = +112,000 +112,000 - = +112,000

Recognize Investment Retained Investment
income from Earnings Income
investment.
1/18/17 +16,000 -16,000 = - =

Receipt of Cash Dividend
dividend. Receivable

a. Consolidated statements present the total assets and liabilities of all firms in
which the reporting firm has more than a fifty percent ownership with
intercompany accounts and transactions eliminated.
b. Demski has a controlling interest in Asare and Demski Finance. Therefore,

their assets and liabilities are all added to those of Demski Inc. Demski does
not have a controlling interest in Knechel. Therefore, it must show its
investment in Knechel Inc. as a financial asset.
c. This excess is the amount paid to Asare in excess of the net book value of
Asare’s assets (assets less liabilities assumed) when Asare was acquired by
Demski. The amount is known more commonly as Goodwill and reflects the
fact that Demski believed the company was worth more than the net book
value of its assets.
d. The amount represents the outside ownership claim on Asare’s net assets,
which are aggregated in the balances of Demski’s accounts.
a. While the approach recommended by Gayle is not disallowed by a specific

accounting standard, it is not consistent with the intent of GAAP. Certainly
from a position of representational faithfulness, it specifically does not
represent how management regards the investment or intends to treat it in the
future. The approach recommended is a flagrant attempt to violate the spirit of
GAAP in order to manage earnings.
Such practice may get by the firm’s auditors once or twice, but failure to be
consistent in the accounting treatment over time is unlikely to be tolerated
under SOX and the increased scrutiny applied by the SEC in the wake of the
numerous accounting scandals of the recent past.
Further, such practice can lead to lawsuits by investors who can argue that
management was not accounting truthfully.
b. We believe the practice to be highly unethical.



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Chapter 1

Introducing Financial Accounting

Learning Objectives – coverage by question

LO1 – Identify the users of

LO2 – Describe a company’s

LO3 – Introduce the four key

LO4 – Describe the institutions

46, 47, 48,

©Cambridge Business Publishers, 2017

LO6 – Appendix 1A – Explain

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Q1-1. Organizations undertake planning activities that subsequently shape

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©Cambridge Business Publishers, 2017

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M1-19. (10 minutes)

M1-20. (10 minutes)

M1-21. (15 minutes)

The percent of owner financing for each company follows:

©Cambridge Business Publishers, 2017

©Cambridge Business Publishers, 2017

Assets = Liabilities + Equity

$231,839 = $120,292 + $111,547

M1-23. (20 minutes)

M1-24. (20 minutes)

a. BS d. BS and SE g. SCF and SE

©Cambridge Business Publishers, 2017

• You/Manager—your reputation, self-esteem, and potentially your

M1-26. (10 minutes)

Internal controls are rules and procedures that involve monitoring an

©Cambridge Business Publishers, 2017

E1-27. (15 minutes)

($ millions) Assets = Liabilities + Equity

The percent of owner financing for each company follows:

E1-28. (15 minutes)

2. Creditors, who seek answers for questions such as:

3. Employees (and potential employees), who seek answers to questions such

©Cambridge Business Publishers, 2017

b. Starting with the accounting equation at the beginning of the year:

Using the accounting equation at the end of the year:

Alternative approach to solving part (b):

c. Starting with the accounting equation at the end of the year:

Using the accounting equation at the beginning of the year:

©Cambridge Business Publishers, 2017

E1-31. (20 minutes)

E1-32. (15 minutes)

a. Return on equity (ROE) = Net income / Average stockholders’ equity

b. Debt-to-equity = Total liabilities / Stockholders’ equity

*$11,340 = $13,876 - $2,536

©Cambridge Business Publishers, 2017

a. Return on equity (ROE) = Net income / Average stockholders’ equity

b. Debt-to-equity = Total liabilities / Stockholders’ equity

*€125,155 = €168,518 - €43,363

E1-34. (20 minutes)

a. Financial information provides users with information that is useful in

b. First, the preparation of financial statements involves and understanding of

E1-35. (15 minutes)

©Cambridge Business Publishers, 2017

P1-36. (40 minutes)

Year Assets Liabilities Equity Net Income

2012 $132,244 $68,209 $64,035 $10,904