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Survey of Accounting 6Th Edition By Carl S . warren –
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SAMPLE QUESTIONS

 

 

Survey of Accounting

 

S i x t h e d i t i o n

 

Carl S . warren

 

Chapter 1 The role of accounting in Business

 

Class Discussion Questions

  1. What is the objective of most businesses?
  2. What is the difference between a manufacturing

business and a merchandising business?

Give an example of each type of business.

  1. What is the difference between a manufacturing

business and a service business? Is a

restaurant a manufacturing business, a service

business, or both?

  1. Why are most large companies like Apple,

Pepsi, General Electric, and Intel organized as

corporations?

  1. Both KIA and BMW produce and sell automobiles.

Describe and contrast the business

emphasis of KIA and BMW.

  1. Assume that a friend of yours operates a

family-

owned pharmacy. A Super Wal-Mart,

scheduled to open in the next several months,

will also offer pharmacy services. What business

emphasis would your friend use to compete

with the Super Wal-Mart pharmacy?

  1. What services does eBay offer its customers?
  2. A business’s stakeholders can be classified

into capital market, product or service market,

government, and internal stakeholders. Will

the interests of all the stakeholders within a

classification be the same? Use bankers

and

stockholders of the capital market as an example

in answering this question.

  1. The three business activities are financing,

investing, and operating. Using Southwest

Airlines,

give an example of a financing, investing,

and operating activity.

  1. What is the role of accounting in business?
  2. Briefly describe the nature of the information

provided by each of the following financial

statements: the income statement,

the retained earnings statement, the balance

sheet, and the statement of cash flows. In

your descriptions, indicate whether each of

the financial statements covers a period of

time or is for a specific date.

  1. For the year ending July 3, 2010, Sara Lee

Corporation had revenues of $10,793 million

and total expenses of $10,287 million. Did

Sara Lee Corporation incur a net loss or realize

net income?

  1. What particular item of financial or operating

data appears on both the income statement

and the retained earnings statement? What

item appears on both the balance sheet and

the retained earnings statement? What item

appears on both the balance sheet and statement

of cash flows?

 

  1. Billy Jessop is the owner of Valley Delivery

Service. Recently, Billy paid interest of $6,000

on a personal loan of $75,000 that he used

to begin the business. Should Valley Delivery

Service record the interest payment? Explain.

  1. On October 1, Wok Repair Service extended

an offer of $100,000 for land that had been

priced for sale at $150,000. On December

19, Wok Repair Service accepted the seller’s

counteroffer of $110,000. Describe how Wok

Repair Service should record the land.

  1. Land with an assessed value of $500,000 for

property tax purposes is acquired by a business

for $600,000. Four years later, the plot of

land has an assessed value of $750,000 and the

business receives an offer of $975,000 for it.

Should the monetary amount assigned to the

land in the business records now be increased?

 

Exercises

E1-1 Types of businesses

Indicate whether each of the following companies is primarily a service, merchandise,

or manufacturing business. If you are unfamiliar with the company,

you may use the Internet to locate the company’s home page or use the finance

Web site of Yahoo.com.

  1. Allstate 9. First BanCorp
  2. Best Buy 10. Ford Motor
  3. Boeing 11. Goodyear Tire & Rubber
  4. Caterpillar 12. Hilton Hotels
  5. Citigroup 13. H&R Block Inc.
  6. CVS Caremark 14. Pfizer
  7. Dow Chemical 15. Sears Roebuck
  8. Eli Lilly

E1-2 Business emphasis

Identify the primary business emphasis of each of the following companies as

(a) a low-cost emphasis or (b) a premium-price emphasis. If you are unfamiliar

with the company, you may use the Internet to locate the company’s home page

or use the finance Web site of Yahoo.com.

  1. Allegiant Travel Services 7. Lowe’s
  2. Best Buy 8. Nike
  3. BMW 9. Pepsi
  4. Dollar Tree 10. Staples
  5. E*TRADE 11. Sub-Zero
  6. Goldman Sachs Group 12. Trader Joe’s

E1-3 Accounting equation

The total assets and total liabilities for a recent year of Best Buy and Gamestop are

shown below.

Best Buy

(in millions)

Gamestop

(in millions)

Assets $18,302 $4,955

Liabilities 11,982 2,232

Determine the stockholders’ equity of each company.

E1-4 Accounting equation

The total assets and total liabilities for a recent year of Apple and Dell are shown here.

Apple

(in millions)

Dell

(in millions)

Assets $75,183 $33,652

Liabilities 27,392 28,011

Determine the stockholders’ equity of each company.

E1-5 Accounting equation

Determine the missing amount for each of the following:

Assets 5 Liabilities 1 Stockholders’ Equity

  1. X 5 $ 70,000 1 $90,000
  2. $ 95,000 5 X 1 $18,000
  3. $675,000 5 $227,000 1 X

E1-6 Accounting equation

Determine the missing amounts (in millions) for the condensed balance sheets

shown below.

Costco Target Wal-Mart

Assets $23,815 $44,533 $ (c)

Liabilities 12,986 (b) 97,777

Stockholders’ equity (a) 15,347 72,929

E1-7 N et income and dividends

The income statement of a corporation for the month of November indicates a net

income of $90,000. During the same period, $100,000 in cash dividends were paid.

Would it be correct to say that the business incurred a net loss of $10,000

during the month? Discuss.

E1-8 N et income and stockholders’ equity for four businesses

Four different companies—Iowa, Nevada, Ohio, and Texas—show the same balance

sheet data at the beginning and end of a year. These data, exclusive of the

amount of stockholders’ equity, are summarized as follows:

Total Assets Total Liabilities

Beginning of the year $400,000 $150,000

End of the year 675,000 315,000

On the basis of the preceding data and the following additional information

for the year, determine the net income (or loss) of each company for the year.

(Hint: First determine the amount of increase or decrease in stockholders’ equity

during the year.)

Company Iowa: No additional capital stock was issued, and no dividends were

paid.

Company Nevada: No additional capital stock was issued, but dividends of

$20,000 were paid.

Company Ohio: Capital stock of $75,000 was issued, but no dividends were paid.

Company Texas: Capital stock of $75,000 was issued, and dividends of $20,000

were paid.

E1-9 Accounting equation and income statement

Staples, Inc., is a leading office products distributor, with retail stores in the United

States, Canada, Asia, Europe, and South America. The following financial statement

data were adopted from Staples’ financial statements as of January 29, 2011

and January 30, 2010:

2011 (in thousands) 2010 (in thousands)

Total assets $13,911,667 $13,717,334

Total liabilities (1) 6,945,448

Total stockholders’ equity 6,943,710 (2)

Sales 24,545,113

Cost of goods sold 17,938,958

Selling and administrative expenses 4,913,188

Other expense (net) 342,993

Income tax expense 468,026

  1. Determine the missing data indicated for (1) and (2).
  2. Using the income statement data for 2011, determine the amount of net income

or loss.

E1-10 Balance sheet items

From the following list of selected items taken from the records of Wright Appliance

Service as of a specific date, identify those that would appear on the

balance sheet.

  1. Accounts Receivable 6. Salaries Expense
  2. Capital Stock 7. Salaries Payable
  3. Cash 8. Supplies
  4. Fees Earned 9. Supplies Expense
  5. Rent Expense 10. Utilities Expense

E1-11 Income statement items

Based on the data presented in Exercise 1-10, identify those items that would

appear on the income statement.

E1-12 Financial statement items

Identify each of the following items as (a) an asset, (b) a liability, (c) revenue,

(d) an expense, or (e) a dividend:

  1. Amounts due from customers 6. Equipment
  2. Amounts owed suppliers 7. Note payable owed to the bank
  3. Cash on hand 8. Rent paid for the month
  4. Cash paid to stockholders 9. Sales commissions paid to salespersons
  5. Cash sales 10. Wages paid to employees

E1-13 Retained earnings statement

Financial information related to Westwood Company for the month ended June 30,

2012, is as follows:

Net income for June $230,000

Dividends during June 45,000

Retained earnings, June 1, 2012 615,000

Prepare a retained earnings statement for the month ended June 30, 2012.

E1-14 Income statement

Mancini Services was organized on February 1, 2012. A summary of the revenue

and expense transactions for February follows:

Fees earned $925,000

Wages expense 400,000

Miscellaneous expense 25,000

Rent expense 92,000

Supplies expense 13,000

Prepare an income statement for the month ended February 29.

E1-15 M issing amounts from balance sheet and income statement data

One item is omitted in each of the following summaries of balance sheet and

income statement data for four different corporations, AL, CO, KS, and MT.

AL CO KS MT

Beginning of the year:

Assets 400,000 300,000 550,000 $ (d)

Liabilities 200,000 130,000 325,000 350,000

End of the year:

Assets 800,000 460,000 660,000 1,200,000

Liabilities 450,000 110,000 360,000 700,000

During the year:

Additional issue of capital stock (a) 50,000 100,000 100,000

Dividends 50,000 20,000 (c) 90,000

Revenue 175,000 (b) 115,000 420,000

Expenses 65,000 70,000 130,000 480,000

Determine the missing amounts, identifying them by letter. [Hint: First determine

the amount of increase or decrease in stockholders’ equity during the year.]

E1-16 Balance sheets, net income

Financial information related to Oak Tree Interiors for October and November

2012 is as follows:

October 31, 2012 November 30, 2012

Accounts payable $ 40,000 $ 65,000

Accounts receivable 75,000 118,000

Capital stock 60,000 60,000

Retained earnings ? ?

Cash 110,000 140,000

Supplies 15,000 20,000

  1. Prepare balance sheets for Oak Tree Interiors as of October 31 and as of

November 30, 2012.

  1. Determine the amount of net income for November, assuming that no

additional

capital stock was issued and no dividends were paid during the

month.

  1. Determine the amount of net income for November, assuming that no

additional

capital stock was issued but dividends of $20,000 were paid during

the month.

E1-17 Financial statements

Each of the following items is shown in the financial statements of ExxonMobil

Corporation. Identify the financial statement (balance sheet or income statement)

in which each item would appear.

  1. Accounts payable
  2. Cash equivalents
  3. Crude oil inventory
  4. Equipment
  5. Exploration expenses
  6. Income taxes payable
  7. Investments
  8. Long-term debt
  9. Marketable securities
  10. Notes and loans payable
  11. Operating expenses
  12. Prepaid taxes
  13. Retained earnings
  14. Sales
  15. Selling expenses

E1-18 Statement of cash flows

Indicate whether each of the following cash activities would be reported on the

statement of cash flows as (a) an operating activity, (b) an investing activity, or

(c) a financing activity.

  1. Issued capital stock
  2. Paid rent
  3. Paid for office equipment
  4. Sold services
  5. Issued a note payable
  6. Sold excess office equipment
  7. Paid officers’ salaries
  8. Paid for advertising
  9. Paid insurance
  10. Paid dividends

E1-19 Statement of cash flows

Indicate whether each of the following activities would be reported on the statement

of cash flows as (a) an operating activity, (b) an investing activity, or

(c) a financing activity.

  1. Cash received from investment by stockholders
  2. Cash received from fees earned
  3. Cash paid for expenses
  4. Cash paid for land

E1-20 Statement of cash flows

Watts Inc. was organized on July 1, 2013. A summary of cash flows for July

follows.

Cash receipts:

Cash received from customers $600,000

Cash received from sale of capital stock 200,000

Cash received from note payable 75,000

Cash payments:

Cash paid out for expenses $380,000

Cash paid out for purchase of equipment 95,000

Cash paid as dividends 25,000

Prepare a statement of cash flows for the month ended July 31, 2013.

E1-21 U sing financial statements

A company’s stakeholders often differ in their financial statement focus. For example,

some stakeholders focus primarily on the income statement, while others

may focus primarily on the statement of cash flows or the balance sheet. For

each of the following situations, indicate which financial statement would be the

likely focus for the stakeholder. Choose either the income statement, balance

sheet, or statement of cash flows and justify your choice.

Situation 1: Assume that you are considering purchasing a personal computer

from Dell.

Situation 2: Assume that you are considering investing in LinkedIn (capital market

stakeholder).

Situation 3: Assume that you are employed by Sara Lee Corporation (product market

stakeholder) and are considering whether to extend credit for a 60-

day period to a new grocery store chain that has recently opened

throughout the Midwest.

Situation 4: Assume that you are considering taking a job (internal stakeholder)

with either Sears or JCPenney.

Situation 5: Assume that you are a banker for US Bank (capital market

stakeholder),

and you are considering whether to grant a major

credit line (loan) to Target. The credit line will allow Target to

borrow up to $400 million for a 5-year period at the market rate

of interest.

E1-22 Financial statement items

Amazon.com, Inc., operates as an online retailer in North America and internationally.

Both Amazon and third parties, via the Amazon.com Web site, sell products

across various product categories.

The following items were adapted from the annual report of Amazon.com

for the year ending December 31, 2010:

In millions

  1. Accounts payable $ 8,051
  2. Accounts receivable 1,587
  3. Interest expense 39
  4. Inventories 3,202
  5. Cost of sales 26,561
  6. Selling, general, and administrative expenses 6,237
  7. Income tax expense 352
  8. Net cash provided by operating activities 3,495
  9. Net cash flows used for investing activities 3,360
  10. Net sales 34,204
  11. Other income 137
  12. Property, plant, and other long-term assets 5,050
  13. Repurchase of capital stock 600
  14. Retained earnings (Dec. 31, 2010) 1,324

Using the following notations, indicate on which financial statement you would

find each of the preceding items. (Note: An item may appear on more than one

statement.)

IS Income statement

RE Retained earnings statement

BS Balance sheet

SCF Statement of cash flows

E1-23 Income statement

Based on the Amazon.com, Inc. financial statement data shown in Exercise 1-22,

prepare an income statement for the year ending December 31, 2010.

E1-24 Financial statement items

Though the McDonald’s menu of hamburgers, cheeseburgers, the Big Mac®,

Quarter

Pounder®, Filet-O-Fish®, and Chicken McNuggets® is easily recognized,

McDonald’s

financial statements may not be as familiar. The following items were

adapted from a recent annual report of McDonald’s Corporation:

  1. Accounts payable
  2. Accrued interest payable
  3. Capital stock outstanding
  4. Cash
  5. Cash provided by operations
  6. Food and packaging costs used in

operations

  1. Income tax expense
  2. Interest expense
  3. Inventories
  4. Long-term debt payable
  5. Net income
  6. Net increase in cash
  7. Notes payable
  8. Notes receivable
  9. Occupancy and rent expense
  10. Payroll expense
  11. Prepaid expenses not yet used in

operations

  1. Property and equipment
  2. Retained earnings
  3. Sales

Identify the financial statement on which each of the preceding items would appear.

An item may appear on more than one statement. Use the following notations:

IS Income statement

RE Retained earnings statement

BS Balance sheet

SCF Statement of cash flows

E1-25 Financial statements

Fretwell Realty, organized August 1, 2013, is owned and operated by Brad

Fretwell. How many errors can you find in the following financial statements

for Fretwell Realty, prepared after its first month of operations? Assume that the

cash balance on August 31, 2013, is $51,600 and that cash flows from operating

activities is reported correctly.

FRETWELL REALTY

Income Statement

August 31, 2013

Sales commissions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $408,400

Operating expenses:

Office salaries expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $272,600

Rent expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,200

Miscellaneous expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,200

Automobile expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,900

Total operating expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . 313,900

Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $134,500

BRAD FRETWELL

Retained Earnings Statement

August 31, 2012

Retained earnings, August 1, 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,800

Less dividends during August. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

$ 5,800

Net income for the month. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 134,500

Retained earnings, August 31, 2013. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,300

Balance Sheet

For the Month Ended August 31, 2013

Assets

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 51,600

Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,500

Land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $129,100

Liabilities

Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 81,200

Prepaid expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,200

Stockholders’ Equity

Capital stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $100,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140,300 240,300

Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . $328,700

Statement of Cash Flows

August 31, 2013

Cash flows from operating activities:

Cash received from customers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $327,200

Cash paid for operating expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . 303,600

Net cash flow from operating activities. . . . . . . . . . . . . . . . . . . . . . . $ 23,600

Cash flows from financing activities:

Cash received from issuance of capital stock. . . . . . . . . . . . . . . . . . $100,000

Dividends paid to stockholders. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (12,000)

Net cash flow from financing activities . . . . . . . . . . . . . . . . . . . . . . . 88,000

Net cash flow and cash balance as of January 31, 2013. . . . . . . . . . . . . $111,600

E1-26 Accounting concepts

Match each of the following statements with the appropriate accounting concept.

Some concepts may be used more than once, while others may not be used at

all. Use the notations shown to indicate the appropriate accounting concept.

Accounting Concept Notation

Accounting period concept P

Adequate disclosure concept D

Business entity concept B

Cost concept C

Going concern concept G

Matching concept M

Objectivity concept O

Unit of measure concept U

Statements

  1. Assume that a business will continue forever.
  2. Material litigation involving the corporation is described in a note.
  3. Monthly utilities costs are reported as expenses along with the monthly revenues.
  4. Personal transactions of owners are kept separate from the business.
  5. This concept supports relying on an independent actuary (statistician), rather

than the chief operating officer of the corporation, to estimate a pension liability.

  1. Changes in the use of accounting methods from one period to the next are

described in the notes to the financial statements.

  1. Land worth $800,000 is reported at its original purchase price of $220,000.
  2. This concept justifies recording only transactions that are expressed in dollars.
  3. If this concept was ignored, the confidence of users in the financial statements

could not be maintained.

  1. The changes in financial condition are reported at the end of the month.

E1-27 Business entity concept

Crazy Mountain Sports sells hunting and fishing equipment and provides guided

hunting and fishing trips. Crazy Mountain is owned and operated by Karl Young,

a well-known sports enthusiast and hunter. Karl’s wife, Mila, owns and operates

Mila’s Boutique, a women’s clothing store. Karl and Mila have established a trust

fund to finance their children’s college education. The trust fund is maintained

by First Bank in the names of their children, Steve and Isabelle.

For each of the following transactions, identify which of the entities listed

should record the transaction in its records.

Entities

C Crazy Mountain Sports

B First Bank Trust Fund

M Mila’s Boutique

X None of the above

  1. Karl paid a local doctor for a physical, which was required by the workmen’s

compensation insurance policy carried by Crazy Mountain Sports.

  1. Karl received a cash advance from customers for a guided hunting trip.
  2. Mila paid her dues to the YWCA.
  3. Karl paid a breeder’s fee for an English Springer spaniel to be used as a

hunting guide dog.

  1. Mila deposited a $10,000 personal check in the trust fund at First Bank.
  2. Karl paid for an advertisement in a hunters’ magazine.
  3. Mila authorized the trust fund to purchase mutual fund shares.
  4. Mila donated several dresses from the store’s inventory to a local charity

auction

for the benefit of a women’s abuse shelter.

  1. Karl paid for dinner and a movie to celebrate the couple’s fifteenth wedding

anniversary.

  1. Mila purchased two dozen spring dresses from a Boise designer for a special

spring sale.

 

Problems

P1-1 Income statement, retained earnings statement, and balance sheet

The amounts of the assets and liabilities of Gilmore Travel Service as of April

30, 2012, the end of the current year, and its revenue and expenses for the year

are listed below. The retained earnings were $300,000, and the capital stock

was $90,000 as of May 1, 2011, the beginning of the current year. Dividends of

$75,000 were paid during the current year.

Accounts payable $ 71,500

Accounts receivable 188,100

Cash 428,300

Fees earned 1,594,200

Miscellaneous expense 16,000

Rent expense 226,800

Supplies 20,100

Supplies expense 42,600

Taxes expense 33,600

Utilities expense 135,000

Wages expense 890,200

Instructions

  1. Prepare an income statement for the current year ended April 30, 2012.
  2. Prepare a retained earnings statement for the current year ended April 30,

2012.

  1. Prepare a balance sheet as of April 30, 2012.

P1-2 M issing amounts from financial statements

The financial statements at the end of Hamel Realty’s first month of operations

are shown below.

HAMEL REALTY

Income Statement

For the Month Ended November 30, 2012

Fees earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $149,300

Operating expenses:

Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (a)

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,400

Supplies expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,100

Miscellaneous expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,950

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . 69,300

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (b)

HAMEL REALTY

Retained Earnings Statement

For the Month Ended November 30, 2012

Net income for November . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (c)

Less dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (d)

Retained earnings, November 30, 2012 . . . . . . . . . . . . . . . . . . $ (e)

HAMEL REALTY

Balance Sheet

November 30, 2012

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 99,200

Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (f )

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (g)

Liabilities

Note payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,200

Stockholders’ Equity

Capital stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (h)

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (i)

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . (j)

Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . $ (k)

HAMEL REALTY

Statement of Cash Flows

For the Month Ended November 30, 2012

Cash flows from operating activities:

Cash received from customers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (l)

Deduct cash payments for expenses and payments to creditors. . . 68,100

Net cash flows from operating activities. . . . . . . . . . . . . . . . . . . . . . . . . $ (m)

Cash flows used for investing activities:

Cash payments for acquisition of land. . . . . . . . . . . . . . . . . . . . . . . . . . . (216,000)

Cash flows from financing activities:

Cash received from issuing capital stock. . . . . . . . . . . . . . . . . . . . . . . . . $270,000

Deduct dividends. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36,000

Net cash flows from financing activities . . . . . . . . . . . . . . . . . . . . . . . . . (n)

Net cash flow and November 30, 2012, cash balance. . . . . . . . . . . . . . . . . . $ (o)

Instructions

  1. Would you classify a realty business such as Hamel Realty as a manufacturing,

merchandising, or service business?

  1. By analyzing the interrelationships among the financial statements, determine

the proper amounts for (a) through (o).

P1-3 Income statement, retained earnings statement, and balance sheet

The following financial data were adapted from the annual report of Target

Corporation

for the year ending January 29, 2011.

In millions

Accounts payable $ 6,625

Capital stock 2,789

Cash 1,712

Cost of goods sold 45,725

Debt and other borrowings 15,726

Income tax expense 1,575

Interest expense 757

Inventories 7,596

Other assets 2,751

Other expenses 2,944

Other liabilities 5,867

Other credit card revenue 1,604

Property, plant, and equipment 25,493

Receivables 6,153

Sales 65,786

Selling, general, and administrative expenses 13,469

Instructions

  1. Prepare Target’s income statement for the year ending January 29, 2011.
  2. Prepare Target’s retained earnings statement for the year ending January 29,
  3. (Note: The retained earnings at January 30, 2010, was $12,947. During

the year, Target paid dividends and had other reductions in retained earnings

of $3,169.)

  1. Prepare a balance sheet as of January 29, 2011, for Target.

P1-4 Statement of cash flows

The following cash data were adapted from the annual report of Google Inc. for

the year ended December 31, 2010. The cash balance as of January 1, 2010, was

$10,198 (in millions).

In millions

Receipts from issuing debt, etc. $ 3,031

Purchases of property, plant, and equipment, etc. 50,140

Receipts from sale of investments (net) 39,460

Net cash flows from operating activities 11,081

Instructions

Prepare Google’s statement of cash flows for the year ended December 31,

2010.

P1-5 Financial statements, including statement of cash flows

Gemstones Corporation began operations on January 1, 2013, as an online retailer

of computer software and hardware. The following financial statement data

were taken from Gemstones’ records at the end of its first year of operations,

December 31, 2013.

Accounts payable $ 20,000

Accounts receivable 110,000

Capital stock 252,000

Cash ?

Cash payments for operating activities 657,000

Cash receipts from operating activities 690,000

Cost of sales 435,000

Dividends 30,000

Income tax expense 53,000

Income taxes payable 8,000

Interest expense 2,000

Inventories 115,000

Note payable (due in 2019) 50,000

Property, plant, and equipment 265,000

Retained earnings ?

Sales 800,000

Selling and administrative expenses 80,000

Instructions

  1. Prepare an income statement for the year ended December 31, 2013.
  2. Prepare a retained earnings statement for the year ended December 31, 2013.
  3. Prepare a balance sheet as of December 31, 2013.
  4. Prepare a statement of cash flows for the year ended December 31, 2013.

 

Activities

A1-1 Integrity, objectivity, and ethics at The Hershey Company

The management of The Hershey Company has asked union workers in two of its

highest cost Pennsylvania plants to accept higher health insurance premiums

and take a wage cut. The workers’ portion of the insurance cost would double

from 6% of the premium to 12%. In addition, workers hired after January 2000

would have their hourly wages cut by $4, which would be partially offset by a

2% annual raise. Management says that the plants need to be more cost competitive.

Management has indicated that if the workers accept the proposal, the

company would invest $30 million to modernize the plants and move future

projects to the plants. Management has refused, however, to guarantee more

work at the plants even if the workers approve the proposal. If the workers

reject the proposal, management implies that it would move future projects to

other plants and that layoffs might be forthcoming. Do you consider management’s

actions ethical?

Source: Susan Govzdas, “Hershey to Cut Jobs or Wages,” Central Penn Business Journal, September 24, 2004.

A1-2 Ethics and professional conduct in business

Loretta Smith, president and owner of Custom Enterprises, applied for a $250,000

loan from City National Bank. The bank requested financial statements from Custom

Enterprises as a basis for granting the loan. Loretta has told her accountant

to provide the bank with a balance sheet. Loretta has decided to omit the other

financial statements because there was a net loss during the past year.

In groups of three or four, discuss the following questions:

  1. Is Loretta behaving in a professional manner by omitting some of the financial

statements?

  1. a. What types of information about their businesses would owners be willing

to provide bankers? What types of information would owners not be willing

to provide?

  1. What types of information about a business would bankers want before

extending a loan?

  1. What common interests are shared by bankers and business owners?

A1-3 How businesses make money

Assume that you are the chief executive officer for a national poultry producer.

The company’s operations include hatching chickens through the use of breeder

stock and feeding, raising, and processing the mature chicks into finished products.

The finished products include breaded chicken nuggets and patties and

deboned, skinless, and marinated chicken. The company sells its products to

schools, military services, fast-food chains, and grocery stores.

In groups of four or five, discuss the following business emphasis and risk

issues:

  1. In a commodity business like poultry production, what do you think is the

dominant business emphasis? What are the implications in this dominant

emphasis

for how you would run the company?

  1. Identify at least two major business risks for operating the company.
  2. How could the company try to differentiate its products?

A1-4 N et income versus cash flow

On January 9, 2013, Dr. Susan Tempkin established DocMed, a medical practice

organized as a professional corporation. The below conversation took place the

following September between Dr. Tempkin and a former medical school classmate,

Dr. Phil Anzar, at an American Medical Association convention in London.

Dr. Anzar: Susan, good to see you again. Why didn’t you call when you were

in Chicago? We could have had dinner together.

Dr. Tempkin: Actually, I never made it to Chicago this year. My husband and kids

went to our Wisconsin Dells condo twice, but I got stuck in New York. I opened

a new consulting practice this January and haven’t had any time for myself since.

Dr. Anzar: I heard about it . . . Doc . . . something . . . right?

Dr. Tempkin: Yes, DocMed. My husband chose the name.

Dr. Anzar: I’ve thought about doing something like that. Are you making any

money? I mean, is it worth your time?

Dr. Tempkin: You wouldn’t believe it. I started by opening a bank account with

$40,000, and my August bank statement has a balance of $215,000. Not bad for

eight months—all pure profit.

Dr. Anzar: Maybe I’ll try it in Chicago. Let’s have breakfast together tomorrow

and you can fill me in on the details.

Comment on Dr. Tempkin’s statement that the difference between the opening

bank balance ($40,000) and the August statement balance ($215,000) is pure profit.

A1-5 The accounting equation

Obtain the annual reports for three well-known companies, such as Ford Motor Co.,

General Motors, IBM, Microsoft, or Amazon.com. These annual reports can be obtained

from the library, the company’s Web site under “Investor Relations,” http://

www.finance.yahoo.com (type in the company name for Get Quotes), or the

company’s 10-K filing with the Securities and Exchange Commission at http://

www.sec.gov/.

To obtain annual report information under Filings & Forms, click on “Search

for Company Filings.” Next, click on “Companys or funds, ticker symbol.…” Key

in the company name. The Electronic Data Gathering, Analysis, and Retrieval

system (EDGAR) will list the reports available for the company. Click on the

10-K (or 10-K405) report for the year you want to download. If you wish, you

can save the whole 10-K report to a file on your computer.

Examine the balance sheet for each company and determine the total assets,

liabilities, and stockholders’ equity. Verify that total assets equal the total of the

liabilities plus stockholders’ equity.

A1-6 Hershey’s annual report

The financial statements of The Hershey Company are shown in Exhibits 6

through 9 of this chapter. Based upon these statements, answer the following

questions.

  1. What are Hershey’s sales (in millions)?
  2. What is Hershey’s cost of sales (in millions)?
  3. What is Hershey’s net income (in millions)?
  4. What is Hershey’s percent of the cost of sales to sales? Round to one decimal

place.

  1. The percent that a company adds to its cost of sales to determine the selling

price is called a markup. What is Hershey’s markup percent? Round to one

decimal place.

  1. What is the percentage of net income to sales for Hershey? Round to one

decimal place.

A1-7 Income statement analysis

The following data (in millions) were adapted from the December 31, 2010, financial

statements of Tootsie Roll Industries Inc.:

Sales $521

Cost of goods sold 349

Net income 54

  1. What is Tootsie Roll’s percent of the cost of sales to sales? Round to one

decimal place.

  1. The percent a company adds to its cost of sales to determine selling price is

called a markup. What is Tootsie Roll’s markup percent? Round to one decimal

place.

  1. What is the percentage of net income to sales for Tootsie Roll? Round to one

decimal place.

  1. Compare your answer to (3) with that of The Hershey Company in Activity 1-6.

What are your conclusions?

A1-8 Financial analysis of Enron Corporation

Enron Corporation, headquartered in Houston, Texas, provided products and services

for natural gas, electricity, and communications to wholesale and retail customers.

Enron’s operations were conducted through a variety of subsidiaries and

affiliates that involved transporting gas through pipelines, transmitting electricity,

and managing energy commodities. The following data were taken from Enron’s

December 31, 2000, financial statements:

In millions

Total revenues $100,789

Total costs and expenses 98,836

Operating income 1,953

Net income 979

Total assets 65,503

Total liabilities 54,033

Total stockholders’ equity 11,470

Net cash flows from operating activities 4,779

Net cash flows from investing activities (4,264)

Net cash flows from financing activities 571

Net increase in cash 1,086

 

Answers to Self-Examination Questions

  1. D A corporation, organized in accordance

with state or federal statutes, is a separate legal

entity in which ownership is divided into

shares of stock (answer D). A proprietorship

(answer A) is an unincorporated business

owned by one individual. A service business

(answer B) provides services to its customers.

It can be organized as a proprietorship, partnership,

or corporation. A partnership (answer

  1. C) is an unincorporated business owned

by two or more individuals.

  1. A The resources owned by a business are

called assets (answer A). The debts of the

business are called liabilities (answer B),

and the equity of the owners is called stockholders’

equity (answer D). The relationship

among assets, liabilities, and stockholders’ equity

is expressed as the accounting equation

(answer C).

  1. A The balance sheet is a listing of the assets,

liabilities, and stockholders’ equity of a

business at a specific date (answer A). The

income statement (answer B) is a summary

of the revenue and expenses of a business

for a specific period of time. The retained

earnings statement (answer C) summarizes

the changes in retained earnings during a

specific period of time. The statement of

cash flows (answer D) summarizes the cash

receipts and cash payments for a specific

period of time.

  1. D The accounting equation is:

Assets 5 Liabilities 1 Stockholders’ Equity

Therefore, if assets are $20,000 and liabilities

are $12,000, stockholders’ equity is $8,000

(answer D), as indicated in the following

computation:

Assets 5 Liabilities 1 Stockholders’ Equity

1$20,000 5 $12,000 + Stockholders’ Equity

1$20,000 2 $12,000 5 Stockholders’ Equity

1$8,000 5 Stockholders’ Equity

  1. B Net income is the excess of revenue over

expenses, or $7,500 (answer B). If expenses

exceed revenue, the difference is a net loss.

Dividends are the opposite of the stockholders

investing in the business and do not

affect

the amount of net income or net loss.

 

Chapter 2 Basic accounting

 

Class Discussion Questions

  1. What are the basic elements of a financial

accounting system? Do these elements apply

to all businesses, from a local restaurant to

Google Inc.? Explain.

  1. Provide an example of a transaction that

affects

(a) only one element of the accounting

equation, (b) two elements of the accounting

equation, (c) three elements of the

accounting equation.

  1. Indicate whether the following error would

cause the accounting equation to be out of

balance and, if so, indicate how it would be

out of balance. The payment of utilities of

$1,200 was recorded as a decrease in cash of

$1,200 and a decrease in retained earnings

(utilities expense) of $2,100.

  1. For each of the following errors, indicate

whether the error would cause the accounting

equation to be out of balance and, if so,

indicate how it would be out of balance. (a)

The purchase of land for $85,000 cash was

recorded as an increase in land of $85,000

and a decrease in cash of $58,000. (b) The receipt

of $7,000 for fees earned was recorded

as an increase in cash of $7,000 and an increase

in liabilities of $7,000.

  1. What is a primary control for determining

the accuracy of a business’s record keeping?

  1. Capstone Consulting Services acquired land

5 years ago for $200,000. Millstone recently

signed an agreement to sell the land for

$375,000. In accordance with the sales agreement,

the buyer transferred $375,000 to Capstone’s

bank account on February 20. How

would elements of the accounting equation

be affected by the sale?

  1. (a) How does the payment of dividends of

$15,000 affect the three elements of the accounting

equation? (b) Is net income affected

by the payment of dividends? Explain.

  1. Assume that Esquire Consulting erroneously

recorded the payment of $30,000 of

dividends as salary expense. (a) How would

this error affect the equality of the accounting

equation? (b) How would this error affect

the income statement, retained earnings

statement, balance sheet, and statement of

cash flows?

  1. Assume that Larsh Realty Inc. borrowed

$75,000 from Country Bank and Trust. In

recording the transaction, Larsh erroneously

recorded the receipt as an increase

in cash, $75,000, and an increase in fees

earned, $75,000. (a) How would this error

affect the equality of the accounting equation?

(b) How would this error affect the

income statement, retained earnings statement,

balance sheet, and statement of cash

flows?

  1. Assume that as of January 1, 2013, Sylvester

Consulting has total assets of $500,000 and

total liabilities of $150,000. As of December

31, 2013, Sylvester has total liabilities

of $200,000 and total stockholders’ equity

of $400,000. (a) What was Sylvester’s stockholders’

equity as of December 31, 2012? (b)

Assume that Sylvester did not pay any dividends

during 2013. What was the amount of

net income for 2013?

  1. Using the January 1 and December 31, 2013,

data given in Question 10, answer the following

question: If Sylvester Consulting paid

$18,000 of dividends during 2013, what was

the amount of net income for 2013?

 

Exercises

E2-1 Accounting equation

Determine the missing amount for each of the following:

Assets 5 Liabilities 1 Stockholders’ Equity

  1. X 5 $250,000 1 $750,000
  2. $480,000 5 X 1 $130,000
  3. $115,000 5 $7,500 1 X

E2-2 Accounting equation

The Walt Disney Company had the following assets and liabilities (in millions) as of

October 3, 2009.

Assets $63,117

Liabilities 29,383

  1. Determine the stockholders’ equity of Walt Disney as of October 3, 2009.
  2. If assets increased by $6,089 million and stockholders’ equity increased by

$3,785 million, what was the increase or decrease in liabilities for the year ending

October 2, 2010?

  1. What were the total assets, liabilities, and stockholders’ equity as of October 2,

2010?

  1. Based upon your answer to (c), does the accounting equation balance?

E2-3 Accounting equation

Campbell Soup Co. had the following assets and liabilities (in millions) as of August

2, 2009.

Assets $6,056

Liabilities 5,328

  1. Determine the stockholders’ equity of Campbell Soup as of August 2, 2009.
  2. If assets increased by $220 million and liabilities increased by $22 million,

what was the increase or decrease in stockholders’ equity for the year ending

August 1, 2010?

  1. What were the total assets, liabilities, and stockholders’ equity as of August 1,

2010?

  1. Based upon your answer to (c), does the accounting equation balance?

E2-4 Accounting equation

One item is omitted in each of the following summaries of balance sheet and

income statement data (in millions) for Google and Verizon Communications as of

December 31, 2009 and 2010.

Google Verizon

December 31, 2009:

Assets $40,497 (e)

Liabilities (a) (f )

Stockholders’ equity (b) $84,143

Increase (Decrease) in assets, liabilities,

and stockholders’ equity during 2010:

Assets $17,354 (g)

Liabilities 7,117 $(9,671)

Stockholders’ equity 10,237 (h)

December 31, 2010:

Assets (c) $220,005

Liabilities $11,610 (i)

Stockholders’ equity (d) 86,912

Determine the amounts of the missing items (a) through (i).

E2-5 Accounting equation

Bella Warren is the sole stockholder and operator of PressOn, a motivational consulting

business. At the end of its accounting period, December 31, 2012, PressOn

has assets of $990,000 and liabilities of $360,000. Using the accounting equation

and considering each case independently, determine the following amounts:

  1. Stockholders’ equity, as of December 31, 2012.
  2. Stockholders’ equity, as of December 31, 2013, assuming that assets increased

by $200,000 and liabilities increased by $85,000 during 2013.

  1. Stockholders’ equity, as of December 31, 2013, assuming that assets decreased

by $50,000 and liabilities increased by $60,000 during 2013.

  1. Stockholders’ equity, as of December 31, 2013, assuming that assets increased

by $100,000 and liabilities decreased by $45,000 during 2013.

  1. Net income (or net loss) during 2013, assuming that as of December 31, 2013,

assets were $1,200,000, liabilities were $475,000, and there were no dividends

and no additional capital stock was issued.

E2-6 E ffects of transactions on stockholders’ equity

For Target Corporation, indicate whether the following transactions would (1) increase,

(2) decrease, or (3) have no effect on stockholders’ equity.

  1. Borrowed money from the bank.
  2. Paid creditors.
  3. Made cash sales to customers.
  4. Purchased store equipment.
  5. Paid dividends.
  6. Paid store rent.
  7. Paid interest expense.
  8. Sold store equipment at a gain.
  9. Received interest revenue.
  10. Paid taxes.

E2-7 E ffects of transactions on accounting equation

Describe how the following business transactions affect the three elements of

the accounting equation.

  1. Received cash for services performed.
  2. Paid for utilities used in the business.
  3. Borrowed cash at local bank.
  4. Issued capital stock for cash.
  5. Purchased land for cash.

E2-8 E ffects of transactions on accounting equation

A vacant lot acquired for $300,000, on which there is a balance owed of $120,000,

is sold for $415,000 in cash. The seller pays the $120,000 owed. What is the effect

of these transactions on the total amount of the seller’s (1) assets, (2) liabilities,

and (3) stockholders’ equity?

E2-9 E ffects of transactions on stockholders’ equity

Indicate whether each of the following types of transactions will (a) increase

stockholders’ equity or (b) decrease stockholders’ equity.

  1. Issued capital stock for cash.
  2. Received cash for fees earned.
  3. Paid cash for utilities expense.
  4. Paid cash for rent expense.
  5. Paid cash dividends.

E2-10 Transactions

Speedy Delivery Service had the following selected transactions during April:

  1. Received cash from issuance of capital stock, $100,000.
  2. Paid rent for April, $4,200.
  3. Paid advertising expense, $3,000.
  4. Received cash for providing delivery services, $27,000.
  5. Purchased supplies for cash, $2,500.
  6. Billed customers for delivery services on account, $81,200.
  7. Paid creditors on account, $8,300.
  8. Received cash from customers on account, $25,600.
  9. Determined that the cost of supplies on hand was $900; therefore, $1,600 of

supplies had been used during the month.

  1. Paid dividends, $3,000.

Indicate the effect of each transaction on the accounting equation by listing the

numbers identifying the transactions, (1) through (10), in a vertical column, and

inserting at the right of each number the appropriate letter from the following list:

  1. Increase in an asset, decrease in another asset.
  2. Increase in an asset, increase in a liability.
  3. Increase in an asset, increase in stockholders’ equity.
  4. Decrease in an asset, decrease in a liability.
  5. Decrease in an asset, decrease in stockholders’ equity.

E2-11 Nature of transactions

Cheryl Alder operates her own catering service. Summary financial data for March

are presented in equation form as follows. Each line designated by a number

indicates the effect of a transaction on the balance sheet. Each increase and decrease

in stockholders’ equity, except transaction (4), affects net income.

Cash + Land = Liabilities + Capital Stock + Retained Earnings

Bal. 40,000 100,000 16,000 24,000 100,000

  1. +28,000 +28,000
  2. –20,000 +20,000
  3. –18,000 –18,000
  4. –1,000 –1,000

Bal. 29,000 120,000 16,000 24,000 109,000

  1. Describe each transaction.
  2. What is the amount of net decrease in cash during the month?
  3. What is the amount of net increase in retained earnings during the month?
  4. What is the amount of the net income for the month?
  5. How much of the net income for the month was retained in the business?
  6. What is the amount of net cash flows from operating activities?
  7. What is the amount of net cash flows from investing activities?
  8. What is the amount of net cash flows from financing activities?

E2-12 Net income and dividends

The income statement of a corporation for the month of February indicates a net

income of $32,000. During the same period, $40,000 in cash dividends were paid.

Would it be correct to say that the business incurred a net loss of $8,000

during the month? Discuss.

E2-13 Net income and stockholders’ equity for four businesses

Four different companies, Oscar, Papa, Quebec, and Romeo, show the same balance

sheet data at the beginning and end of a year. These data, exclusive of the

amount of stockholders’ equity, are summarized as follows:

Total Assets Total Liabilities

Beginning of the year $350,000 $125,000

End of the year 550,000 210,000

On the basis of the preceding data and the following additional information

for the year, determine the net income (or loss) of each company for the year.

(Suggestion: First determine the amount of increase or decrease in stockholders’

equity during the year.)

Oscar: No additional capital stock was issued, and no dividends were paid.

Papa: No additional capital stock was issued, but dividends of $45,000 were paid.

Quebec: Capital stock of $100,000 was issued, but no dividends were paid.

Romeo: Capital stock of $100,000 was issued, and dividends of $45,000 were paid.

E2-14 M issing amounts from balance sheet and income statement data

One item is omitted from each of the following summaries of balance sheet and

income statement data for four different corporations.

Carbon Krypton Fluorine Radium

Beginning of the year:

Assets $333,000 $250,000 $100,000 (d)

Liabilities 118,000 130,000 76,000 $120,000

End of the year:

Assets 495,000 350,000 90,000 248,000

Liabilities 160,000 110,000 80,000 136,000

During the year:

Additional issuance

of capital stock (a) 50,000 10,000 40,000

Dividends 7,500 16,000 (c) 60,000

Revenue 90,000 (b) 115,000 112,000

Expenses 39,000 64,000 122,500 128,000

Determine the amounts of the missing items, identifying them by letter. (Suggestion:

First determine the amount of increase or decrease in stockholders’ equity during

the year.)

E2-15 Net income, retained earnings, and dividends

Use the following data (in millions) for Dell, Inc., for the year ending January 28,

2011, to answer the questions below:

Retained earnings, January 29, 2010 $22,110

Retained earnings, January 28, 2011 24,744

Net cash flows from operating activities 3,969

Net increase in cash 3,278

Net cash flows provided by financing activities 474

  1. Determine the amount of earnings retained in Dell for the year ended January

28, 2011.

  1. Determine the net cash flows used for investing activities for the year ended

January 28, 2011.

E2-16 Balance sheet, net income, and cash flows

Financial information related to Abby’s Interiors for October and November of

2013 is as follows:

October 31, 2013 November 30, 2013

Notes payable $200,000 $250,000

Land 500,000 575,000

Capital stock 75,000 90,000

Retained earnings ? ?

Cash 50,000 175,000

  1. Prepare balance sheets for Abby’s Interiors as of October 31 and November 30,

2013.

  1. Determine the amount of net income for November, assuming that dividends

of $12,000 were paid.

  1. Determine the net cash flows from operating activities for November.
  2. Determine the net cash flows from investing activities for November.
  3. Determine the net cash flows from financing activities for November.
  4. Determine the net increase or decrease in cash for November.

E2-17 Income statement

After its first month of operation, the following amounts were taken from the

accounting records of Benjamin Realty Inc. as of April 30, 2013.

Capital stock $25,000 Notes payable $ 35,000

Cash 53,000 Rent expense 5,000

Dividends 10,000 Retained earnings 0

Interest expense 2,000 Salaries expense 75,000

Land 42,000 Sales commissions 145,000

Miscellaneous expense 3,000 Utilities expense 15,000

Prepare an income statement for the month ending April 30, 2013.

E2-18 R etained earnings statement

Using the financial data shown in Exercise 2-17 for Benjamin Realty Inc., prepare

a retained earnings statement for the month ending April 30, 2013.

E2-19 Balance sheet

Using the financial data shown in Exercise 2-17 for Benjamin Realty Inc., prepare

a balance sheet as of April 30, 2013.

E2-20 Statement of cash flows

Using the financial data shown in Exercise 2-17 for Benjamin Realty Inc., prepare

a statement of cash flows for the month ending April 30, 2013.

E2-21 E ffects of transactions on accounting equation

Describe how the following transactions of Sun Microsystems, Inc., would affect the

three elements of the accounting equation.

  1. Paid research and development expenses for the current year.
  2. Purchased machinery and equipment for cash.
  3. Received cash from issuing stock.
  4. Received cash from the issuance of long-term debt.
  5. Made cash sales.
  6. Paid selling expenses.
  7. Paid employee pension expenses for the current year.
  8. Received proceeds from selling a portion of manufacturing operations for a

gain on the sale.

  1. Paid officer salaries.
  2. Paid taxes.
  3. Paid off long-term debt.
  4. Paid dividends.

E2-22 Statement of cash flows

Based upon the financial transactions for Sun Microsystems, Inc., shown in Exercise

2-21, indicate whether the transaction would be reported in the cash flows from

operating, investing, or financing sections of the statement of cash flows.

 

Problems

P2-1 T ransactions and financial statements

Jo Birde established an insurance agency on March 1, 2013, and completed the

following transactions during March:

  1. Opened a business bank account in the name of Birde Insurance Inc., with a

deposit of $50,000 in exchange for capital stock.

  1. Borrowed $25,000 by issuing a note payable.
  2. Received cash from fees earned, $28,000.
  3. Paid rent on office and equipment for the month, $3,000.
  4. Paid automobile expense for the month, $1,800, and miscellaneous expense,

$900.

  1. Paid office salaries, $4,200.
  2. Paid interest on the note payable, $100.
  3. Purchased land as a future building site, $55,000.
  4. Paid dividends, $4,000.

Instructions

  1. Indicate the effect of each transaction and the balances after each transaction,

using the integrated financial statement framework.

  1. Briefly explain why the stockholders’ investments and revenues increased stockholders’

equity, while dividends and expenses decreased stockholders’ equity.

  1. Prepare an income statement and retained earnings statement for March.
  2. Prepare a balance sheet as of March 31, 2013.
  3. Prepare a statement of cash flows for March.

P2-2 T ransactions and financial statements

Jesse Duncan established Bear Computer Services on August 1, 2013. The effect

of each transaction and the balances after each transaction for August are shown

below in the integrated financial statement framework.

Instructions

  1. Prepare an income statement for the month ended August 31, 2013.
  2. Prepare a retained earnings statement for the month ended August 31, 2013.
  3. Prepare a balance sheet as of August 31, 2013.
  4. Prepare a statement of cash flows for the month ended August 31, 2013.

P2-3 Financial statements

The following amounts were taken from the accounting records of Ferguson

Services, Inc., as of May 31, 2013. Ferguson Services began its operations on

June 1, 2012.

Capital stock $ 30,000

Cash 62,000

Dividends 13,000

Fees earned 300,000

Interest expense 2,000

Land 98,000

Miscellaneous expense 8,000

Notes payable 30,000

Rent expense 28,000

Salaries expense 87,000

Taxes expense 22,000

Utilities expense 40,000

Instructions

  1. Prepare an income statement for the year ending May 31, 2013.
  2. Prepare a retained earnings statement for the year ending May 31, 2013.
  3. Prepare a balance sheet as of May 31, 2013.
  4. Prepare a statement of cash flows for the year ending May 31, 2013.

P2-4 Financial statements

After its second year of operations, the following amounts were taken from the

accounting records of Ferguson Services, Inc., as of May 31, 2014. Ferguson

Services

began its operations on June 1, 2012 (see Problem 2-3).

Capital stock $ 55,000

Cash ?

Dividends 40,000

Fees earned 515,000

Interest expense 3,000

Land 240,000

Miscellaneous expense 11,000

Notes payable 40,000

Rent expense 36,000

Salaries expense 155,000

Taxes expense 28,000

Utilities expense 52,000

Instructions

  1. Prepare an income statement for the year ending May 31, 2014.
  2. Prepare a retained earnings statement for the year ending May 31, 2014.

(Note: The retained earnings at June 1, 2013, was $100,000.)

  1. Prepare a balance sheet as of May 31, 2014.
  2. Prepare a statement of cash flows for the year ending May 31, 2014. (Hint: You

should compare the asset and liability amounts of May 31, 2014, with those

of May 31, 2013, to determine cash used in investing and financing activities.

See Problem 2-3 for the May 31, 2013, balance sheet amounts.)

P2-5 M issing amounts from financial statements

The financial statements at the end of Sayre Realty, Inc.’s first month of operation

are shown below. By analyzing the interrelationships among the financial

statements, fill in the proper amounts for (a) through (s).

SAYRE REALTY , INC.

Income Statement

For the Month Ended December 31, 2013

Fees earned . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (a)

Operating expenses:

Wages expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $33,120

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000

Utilities expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (b)

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800

Miscellaneous expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,960

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67,500

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (c)

SAYRE REALTY , INC.

Retained Earnings Statement

For the Month Ended December 31, 2013

Retained earnings, December 1, 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(d)

Net income for December . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 57,500

Less dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (e) (f )

Retained earnings, December 31, 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(g)

SAYRE REALTY , INC.

Balance Sheet

December 31, 2013

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (h)

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $225,500

Liabilities

Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $105,000

Stockholders’ Equity

Capital stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     $(i)

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .     (j)

Total stockholders’ equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (k)

Total liabilities and stockholders’ equity. . . . . . . . . . . . . . . . . . . . . . . . $ (l)

SAYRE REALTY , INC.

Statement of Cash Flows

For the Month Ended December 31, 2013

Cash flows from operating activities:

Cash received from customers. . . . . . . . . . . . . . . . . . . $125,000

Deduct cash payments for expenses. . . . . . . . . . . . . 67,500

Net cash flows from operating activities . . . . . . . . . . . . . . $ (m)

Cash flows used in investing activities:

Cash payment for purchase of land. . . . . . . . . . . . . . . . (175,000)

Cash flows from financing activities:

Cash received from sale of capital stock. . . . . . . . . . $75,000

Cash received from issuing notes payable. . . . . . . . (n) $ (o)

Deduct cash dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Net cash flows from financing activities. . . . . . . . . . . . . . . . . . (p)

Net increase in cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (q)

December 1, 2013, cash balance . . . . . . . . . . . . . . . . . . . . . . . . . (r)

December 31, 2013, cash balance. . . . . . . . . . . . . . . . . . . $ (s)

P2-6 Financial statements

Moffet Realty, Inc., organized July 1, 2013, is operated by Jill Moffet. How many

errors can you find in the following financial statements for Moffet Realty, Inc.,

prepared after its first month of operation?

MOFFET REALTY , INC.

Income Statement

July 31, 2013

Sales commissions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $72,200

Operating expenses:

Office salaries expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16,300

Rent expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,600

Automobile expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500

Dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000

Miscellaneous expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,550

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,950

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $31,250

JILL MOFFET

Retained Earnings Statement

July 31, 2012

Net income for the month. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $31,250

Retained earnings, July 31, 2012. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $31,250

Balance Sheet

For the Month Ended July 31, 2012

Assets

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $35,850

Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $50,850

Liabilities

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $40,400

Stockholders’ Equity

Capital stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,250

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51,250

Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . $91,650

MOFFET REALTY , INC.

Statement of Cash Flows

July 31, 2013

Cash flows from operating activities:

Cash receipts from sales commissions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 72,200

Cash flows used for investing activities:

Cash payments for land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (40,400)

Cash flows from financing activities:

Cash receipts from retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31,250

Net increase in cash during July . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 63,050

Cash as of July 1, 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0

Cash as of July 31, 2013 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 63,050

Obj 3, 5

 

Activities

A2-1 Business emphasis

Assume that you are considering developing a nationwide chain of women’s clothing

stores. You have contacted a Seattle-based firm that specializes in financing

new business ventures and enterprises. Such firms, called venture capital firms,

finance new businesses in exchange for a percentage of the ownership.

  1. In groups of four or five, discuss the different business emphases that you

might use in your venture.

  1. For each emphasis you listed in (1), provide an example of a real-world business

using the same emphasis.

  1. What percentage of the ownership would you be willing to give the venture

capital firm in exchange for its financing?

A2-2 Cash accounting

On August 1, 2013, Dr. Ruth Turner established SickCo, a medical practice

organized

as a professional corporation. The following conversation occurred

the following February between Dr. Turner and a former medical school

classmate,

Dr. Shonna Rees, at an American Medical Association convention

in New York City.

Dr. Rees: Ruth, good to see you again. Why didn’t you call when you were in

Denver? We could have had dinner together.

Dr. Turner: Actually, I never made it to Denver this year. My husband and kids

went up to our Vail condo twice, but I got stuck in Fort Lauderdale. I opened a

new consulting practice this August and haven’t had any time for myself since.

Dr. Rees: I heard about it … Sick… something … right?

Dr. Turner: Yes, SickCo. My husband chose the name.

Dr. Rees: I’ve thought about doing something like that. Are you making any

money? I mean, is it worth your time?

Dr. Turner: You wouldn’t believe it. I started by opening a bank account with

$45,000, and my January bank statement has a balance of $100,000. Not bad for

six months—all pure profit.

Dr. Rees: Maybe I’ll try it in Denver! Let’s have breakfast together tomorrow and

you can fill me in on the details.

Comment on Dr. Turner’s statement that the difference between the opening bank

balance ($45,000) and the January statement balance ($100,000) is pure profit.

A2-3 Business emphasis

Amazon.com, an Internet retailer, was incorporated in the early 1990s and opened

its virtual doors on the Web shortly thereafter. On its statement of cash flows,

would you expect Amazon.com’s net cash flows from operating, investing, and

financing activities to be positive or negative for its first three years of operation?

Use the following format for your answers, and briefly explain your logic.

A2-4 Financial information

Yahoo.com’s finance Internet site provides summary financial information about

public companies, such as stock quotes, recent financial filings with the Securities

and Exchange Commission, and recent news stories. Go to Yahoo.com’s financial

Web site (http://finance.yahoo.com/) and enter Apple, Inc.’s stock symbol, AAPL.

Answer the following questions concerning Apple, Inc. by clicking on the various

items under the tab “More Reports for AAPL.”

  1. At what price did Apple’s stock last trade?
  2. What is the 52-week range of Apple’s stock?
  3. When was the last time Apple’s stock hit a 52-week high?
  4. Over the last six months, has there been any insider selling or buying of

Apple’s stock?

  1. Who is the chief executive officer of Apple Inc., and how old is the president?
  2. What was the salary of the president of Apple Inc.?
  3. What is the annual dividend of Apple’s stock?
  4. How many current broker recommendations are strong buy, buy, hold, sell,

or strong sell? What is the average of the broker recommendations?

  1. What is the net cash flow from operations for this year?
  2. What is the operating margin for this year?

A2-5 Analyzing financial information

On February 25, 2009, Gabriel Madway wrote an article entitled “Apple Investors

Get No Satisfaction on Jobs,” which appeared on Reuters.com. The article raises

concerns about Steve Jobs’s health and the possible reoccurrence of his pancreatic

cancer. The following excerpt is taken from the article:

Jobs—who co-founded Apple and is credited with transforming it into a

consumer juggernaut after returning as CEO a decade ago—announced . . .

he would take a five-month leave of absence, handing over the reins of the firm

and saying his health problems were “more complex” than originally thought.

Answer the following questions:

  1. Is the article favorable, neutral, or unfavorable regarding future prospects for

Apple Inc.?

  1. Assuming you owned stock in Apple Inc., would you sell your stock based

only on this article? If not, what additional information would you want?

  1. Would it be a prudent investment strategy to rely only on published financial

statements in deciding whether to invest in a company’s stock?

  1. What sources do you think financial analysts use in making investment decisions

and recommendations?

 

Answers to Self-Examination Questions

  1. D Even though a recording error has been

made, the accounting equation will balance

(answer D). However, assets (cash) will be

overstated by $50,000, and liabilities (notes

payable) will be overstated by $50,000. Answer

A is incorrect because although cash is

overstated by $50,000, the accounting equation

will balance. Answer B is incorrect because

although notes payable are overstated

by $50,000, the accounting equation will balance.

Answer C is incorrect because the accounting

equation will balance and assets will

not exceed liabilities.

  1. C Total assets will exceed total liabilities and

stockholders’ equity by $16,000. This is because

stockholders’ equity (retained earnings)

was decreased instead of increased by $8,000.

Thus, stockholders’ equity will be understated

by a total of $16,000.

  1. C The accounting equation is:

Assets 5 Liabilities 1 Stockholders’ Equity

Therefore, if assets increased by $20,000

and liabilities increased by $12,000, stockholders’

equity must have increased by $8,000

(answer C), as indicated in the following

computation:

Assets 5 Liabilities 1 Stockholders’ Equity

1$20,000 5 $12,000 + Stockholders’ Equity

1$20,000 2 $12,000 5 Stockholders’ Equity

1$8,000 5 Stockholders’ Equity

  1. B Net income is the excess of revenue over

expenses, or $15,000 (answer B). If expenses

exceed revenue, the difference is a net loss.

Dividends are the opposite of the stockholders

investing in the business and do not affect

the amount of net income or net loss.

  1. B The purchase of land for cash changes the

mix of assets and does not affect liabilities

or stockholders’ equity (answer B). Borrowing

cash from a bank (answer A) increases

assets and liabilities. Receiving cash for fees

earned (answer C) increases cash and stockholders’

equity (retained earnings). Paying

office salaries (answer D) decreases cash and

stockholders’ equity (retained earnings).

 

 

 

Chapter 3 accrual accounting

 

Class Discussion Questions

  1. Would AT&T and Microsoft use the cash basis or

the accrual basis of accounting? Explain.

  1. How are revenues and expenses reported on

the income statement under (a) the cash basis

of accounting and (b) the accrual basis of

accounting?

  1. Fees for services provided are billed to a customer

during 2012. The customer remits the

amount owed in 2013. During which year

would the revenues be reported on the income

statement under (a) the cash basis? (b) the

accrual basis?

  1. Employees performed services in 2012, but the

wages were not paid until 2013. During which

year would the wages expense be reported on

the income statement under (a) the cash basis?

(b) the accrual basis?

  1. Which of the following accounts would appear

only in an accrual basis accounting system, and

which could appear in either a cash basis or

an accrual basis accounting system? (a) Capital

Stock, (b) Fees Earned, (c) Accounts Receivable,

(d) Land, (e) Utilities Expense, and (f) Wages

Payable.

  1. Is the Land balance before the accounts have

been adjusted the amount that should normally

be reported on the balance sheet? Explain.

  1. Is the Supplies balance before the accounts

have been adjusted the amount that should

normally be reported on the balance sheet?

Explain.

  1. Why are adjustments needed at the end of an

accounting period?

  1. Identify the four different categories of

adjustments

frequently required at the end of

an accounting period.

  1. If the effect of an adjustment is to increase the

balance of a liability account, which of the following

statements describes the effect of the

adjustment on the other account?

  1. Increases the balance of a revenue account
  2. Increases the balance of an expense account
  3. Increases the balance of an asset account
  4. If the effect of an adjustment is to increase the

balance of an asset account, which of the following

statements describes the effect of the

adjustment on the other account?

  1. Increases the balance of a revenue account
  2. Increases the balance of a liability account
  3. Increases the balance of an expense account
  4. Does every adjustment have an effect on determining

the amount of net income for a period?

Explain.

  1. (a) Explain the purpose of the accounts Depreciation

Expense and Accumulated Depreciation.

(b) Is it customary for the balances of

the two accounts to be equal? (c) In what

financial statements, if any, will each account

appear?

  1. Describe the nature of the assets that compose

the following sections of a balance sheet:

  • current asse

 

Exercises

E3-1 T ransactions using accrual accounting

Derma Care is owned and operated by Marilyn McColley, the sole stockholder. During

February 2013, Derma Care entered into the following transactions:

  1. Marilyn McColley invested $30,000 in Derma Care in exchange for capital stock.
  2. Paid $7,200 on February 1 for an insurance premium on a 1-year policy.
  3. Purchased supplies on account, $1,200.
  4. Received fees of $43,500 during February.
  5. Paid expenses as follows: wages, $8,000; rent, $2,500; utilities, $1,000; and miscellaneous,

$850.

  1. Paid dividends of $5,000.

Record the preceding transactions using the integrated financial statement framework.

After each transaction, you should enter a balance for each item.

E3-2 A djustment process

Using the data from Exercise 3-1, record the adjusting entries at the end of February

to record the insurance expense and supplies expense. There was $800 of supplies

on hand as of February 28. Identify the adjusting entry for insurance as (a1) and

supplies as (a2).

E3-3 Financial statements

Using the data from Exercises 3-1 and 3-2, prepare financial statements for February,

including income statement, retained earnings statement, balance sheet, and statement

of cash flows.

E3-4 R econcile net income and net cash flows from operations.

Using the income statement and statement of cash flows you prepared in Exercise

3-3, reconcile net income with the net cash flows from operations.

E3-5 A ccrual basis of accounting

Baxter Pauline established Summit Services, P.C., a professional corporation, on December

1 of the current year. Summit Services offers financial planning advice to its

clients. The effect of each transaction on the balance sheet and the balances after each

transaction for December are as follows. Each increase or decrease in stockholders’

equity, except transaction (h), affects net income.

  1. Describe each transaction.
  2. What is the amount of the net income for December?

E3-6 Classify accruals and deferrals

Classify the following items as (a) deferred expense (prepaid expense), (b) deferred

revenue (unearned revenue), (c) accrued expense (accrued liability), or (d) accrued

revenue (accrued asset).

  1. Subscriptions received in advance by a magazine publisher.
  2. A three-year premium paid on a fire insurance policy.
  3. Fees received but not yet earned.
  4. Fees earned but not yet received.
  5. Utilities owed but not yet paid.
  6. Supplies on hand.
  7. Salary owed but not yet paid.
  8. Taxes owed but payable in the following period.

E3-7 Classify adjustments

The following accounts were taken from the unadjusted trial balance of Inter Circle

Co., a congressional lobbying firm. Indicate whether or not each account would

normally require an adjusting entry. If the account normally requires an adjusting

entry, use the following notations to indicate the type of adjustment:

AE—Accrued Expense

AR—Accrued Revenue

DR—Deferred Revenue

DE—Deferred Expense

To illustrate, the answer for the first account is as follows.

Account Answer

Accounts Receivable Normally requires adjustment (AR).

Accumulated Depreciation

Capital Stock

Dividends

Interest Payable

Interest Receivable

Land

Office Equipment

Prepaid Rent

Supplies

Unearned Fees

Wages Expense

E3-8 A djustment for supplies

Answer each of the following independent questions concerning supplies and the

adjustment for supplies.

  1. The balance in the supplies account, before adjustment at the end of the year,

is $4,000. What is the amount of the adjustment if the amount of supplies on

hand at the end of the year is $1,750?

  1. The supplies

account has a balance of $1,100, and the supplies expense account

has a balance of $3,100 at December 31, 2013. If 2013 was the first year

of operations, what was the amount of supplies purchased during the year?

E3-9 A djustment for prepaid insurance

The prepaid insurance account had a balance of $14,400 at the beginning of the

year. The account was increased for $9,600 for premiums on policies purchased

during the year. What is the adjustment required at the end of the year for each

of the following independent situations? Indicate each account affected, whether

the account is increased or decreased, and the amount of the increase or decrease.

  1. The amount of unexpired insurance applicable to future periods is $13,500.
  2. The amount of insurance expired during the year is $18,300.

E3-10 Adjustment for unearned fees

The balance in the unearned fees account, before adjustment at the end of the

year, is $48,000. What is the adjustment if the amount of unearned fees at the

end of the year is $15,600? Indicate each account affected, whether the account

is increased or decreased, and the amount of the increase or decrease.

E3-11 Adjustment for unearned revenue

For the year ending June 30, 2010, Microsoft Corporation reported short-term unearned

revenue of $13,652 million. For the year ending June 30, 2010, Microsoft

also reported total revenues of $62,484 million.

  1. Assuming that Microsoft recognized $7,000 million of unearned revenue as

revenue during the year, what entry for unearned revenue did Microsoft make

during the year? Indicate each account affected, whether the account is increased

or decreased, and the amount of the increase or decrease.

  1. What percentage of total revenues is the short-term unearned revenue as of

June 30, 2010? Round to one decimal place.

E3-12 E ffect of omitting adjustment

At the end of January, the first month of the business year, the usual adjustment

transferring rent earned of $29,500 to a revenue account from the unearned rent

account was omitted. Indicate which items will be incorrectly stated, because

of the error, on (a) the income statement for January and (b) the balance sheet

as of January 31. Also indicate whether the items in error will be overstated or

understated.

E3-13 A djustment for accrued salaries

North Slope Realty Co. pays weekly salaries of $7,900 on Friday for a five-day

week ending on that day. What is the adjustment at the end of the accounting

period, assuming that the period ends (a) on Wednesday, (b) on Thursday? Indicate

each account affected, whether the account is increased or decreased, and

the amount of the increase or decrease.

E3-14 Determine wages paid

The balances of the two wages accounts at December 31, after adjustments at

the end of the first year of operations, are Wages Payable, $9,175, and Wages

Expense, $565,000. Determine the amount of wages paid during the year.

E3-15 E ffect of omitting adjustment

Accrued salaries of $6,750 owed to employees for December 30 and 31 are not

considered in preparing the financial statements for the year ended December

31, 2012. Indicate which items will be erroneously stated, because of the error,

on (a) the income statement for December 2012 and (b) the balance sheet as of

December 31, 2012. Also indicate whether the items in error will be overstated

or understated.

E3-16 E ffect of omitting adjustment

Assume that the error in Exercise 3-15 was not corrected and that the $6,750 of

accrued salaries was included in the first salary payment in January 2013. Indicate

which items will be erroneously stated, because of failure to correct the initial

error, on (a) the income statement for January 2013 and (b) the balance sheet

as of January 31, 2013.

E3-17 E ffects of errors on financial statements

For a recent year, the balance sheet for The Campbell Soup Company includes accrued

expenses of $560,000,000. The income before taxes for the year was

$1,242,000,000.

  1. Assume the accruals apply to the current year and were not recorded at the end

of the year. By how much would income before taxes have been misstated?

  1. What is the percentage of the misstatement in (a) to the reported income of

$1,242,000,000? Round to one decimal place.

E3-18 E ffects of errors on financial statements

The accountant for Eagle Medical Co., a medical services consulting firm, mistakenly

omitted adjusting entries for (a) unearned revenue earned during the

year ($30,000) and (b) accrued wages ($8,200). Indicate the effect of each error,

considered individually, on the income statement for the current year ended

March 31. Also indicate the effect of each error on the March 31 balance sheet.

Set up a table similar to the following, and record your answers by inserting

the dollar amount in the appropriate spaces. Insert a zero if the error does not

affect the item.

Error (a) Error (b)

Overstated

Understated

Overstated

Understated

  1. Revenue for the year would be $ $ $ $
  2. Expenses for the year would be $ $ $ $
  3. Net income for the year would be $ $ $ $
  4. Assets at March 31 would be $ $ $ $
  5. Liabilities at March 31 would be $ $ $ $
  6. Stockholders’ equity at March 31 would be $ $ $ $

E3-19 E ffects of errors on financial statements

If the net income for the current year had been $723,675 in Exercise 3-18, what

would have been the correct net income if the proper adjustments had been

made?

E3-20 A djustment for accrued fees

At the end of the current year, $19,900 of fees have been earned but not billed

to clients.

  1. What is the adjustment to record the accrued fees? Indicate each account

affected,

whether the account is increased or decreased, and the amount of

the increase or decrease.

  1. If the cash basis rather than the accrual basis had been used, would an adjustment

have been necessary? Explain.

E3-21 A djustments for unearned and accrued fees

The balance in the unearned fees account, before adjustment at the end of the

year, is $240,000. Of these fees, $115,000 have been earned. In addition, $66,000

of fees have been earned but not billed to clients. What are the adjustments (a)

to adjust the unearned fees account and (b) to record the accrued fees? Indicate

each account affected, whether the account is increased or decreased, and the

amount of the increase or decrease.

E3-22 E ffect on financial statements of omitting adjustment

The adjustment for accrued fees of $13,400 was omitted at July 31, the end of

the current

year. Indicate which items will be in error, because of the omission,

on (a) the income statement for the current year and (b) the balance sheet as of

July 31. Also indicate whether the items in error will be overstated or understated.

E3-23 A djustment for depreciation

The estimated amount of depreciation on equipment for the current year is $41,700.

  1. How is the adjustment recorded? Indicate each account affected, whether the

account

is increased or decreased, and the amount of the increase or decrease.

  1. If the adjustment in (a) was omitted, which items would be erroneously stated

on (1) the income statement for the year and (2) the balance sheet as of

December

31?

E3-24 Adjustments

Clean Air Company is a consulting firm specializing in pollution control. The following

adjustments were made for Clean Air Company:

Adjustments

Account Increase (Decrease)

Accounts Receivable $11,250

Supplies (1,350)

Prepaid Insurance (1,800)

Accumulated Depreciation—Equipment 7,500

Wages Payable 4,500

Unearned Rent (9,000)

Fees Earned 11,250

Wages Expense 4,500

Supplies Expense 1,350

Rent Revenue 9,000

Insurance Expense 1,800

Depreciation Expense 7,500

Identify each of the six pairs of adjustments. For each adjustment, indicate the account,

whether the account is increased or decreased, and the amount of the adjustment.

No account is affected by more than one adjustment. Use the following format. The

first adjustment is shown as an example.

Adjustment Account Increase or Decrease Amount

  1. Accounts Receivable Increase $11,250

Fees Earned Increase 11,250

E3-25 Book value of fixed assets

For a recent year, Barnes & Noble Inc. reported Property, Plant, and Equipment of

$2,815,233,000 and Accumulated Depreciation of $2,003,199,000.

  1. What was the book value of the fixed assets?
  2. Would the book values of Barnes & Noble’s fixed assets normally approximate

their fair market values?

E3-26 Classify assets

Identify each of the following as (a) a current asset or (b) property, plant, and

equipment:

  1. Accounts Receivable 4. Office Equipment
  2. Building 5. Prepaid Insurance
  3. Cash 6. Supplies

E3-27 Balance sheet classification

At the balance sheet date, a business owes a five-year mortgage note payable of

$480,000, the terms of which provide for monthly payments of $8,000. Explain how

the liability should be classified on the balance sheet.

E3-28 Classified balance sheet

Loser Health Co. offers personal weight reduction consulting services to individuals.

On April 30, 2012, the balances of selected accounts of Loser Health Co. are as follows:

Accounts Payable $ 45,200 Prepaid Insurance $ 9,600

Accounts Receivable 43,000 Prepaid Rent 7,200

Accum. Depreciation—Equipment 40,000 Retained Earnings 235,000

Capital Stock 100,000 Salaries Payable 8,800

Cash ? Supplies 16,000

Equipment 330,000 Unearned Fees 6,000

Prepare a classified balance sheet that includes the correct balance for Cash.

E3-29 Classified balance sheet

La-Z-Boy Inc. is one of the world’s largest manufacturers of furniture and is best known

for its reclining chairs. The following data (in thousands) were adapted from its 2010

annual report:

Accounts payable $ 54,718

Accounts receivable 165,038

Accrued expenses 91,496

Accumulated depreciation 287,269

Capital stock 237,533

Cash 108,421

Intangible assets (trade names) 3,100

Inventories 134,187

Debt due within one year 1,066

Long-term debt 46,917

Other current assets 20,464

Other long-term assets 38,751

Other long-term liabilities 68,381

Property, plant, and equipment 426,126

Retained earnings 108,707

Prepare a classified balance sheet as of April 24, 2010.

E3-30 Balance sheet

List any errors you can find in the following balance sheet. Prepare a corrected

balance

sheet.

AT LAS SERVI CES CO.

Balance Sheet

For the Year Ended May 31, 2012

Assets

Current assets:

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47,900

Supplies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800

Prepaid insurance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17,400

Land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000

Total current assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $482,100

Property, plant, and equipment:

Building. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $225,000

Equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90,000

Total property, plant, and equipment . . . . . . . . . . . . . . . . . 315,000

Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $797,100

Liabilities

Current liabilities:

Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,800

Accumulated depreciation—building. . . . . . . . . . . . . . . . . 54,600

Accumulated depreciation—equipment. . . . . . . . . . . . . . 32,400

Net loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44,200

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $172,000

Stockholders’ Equity

Wages payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,100

Capital stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000

Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 447,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 655,100

Total liabilities and stockholders’ equity. . . . . . . . . . . . . . . . . . . . $797,100

 

Problems

P3-1 A ccrual basis accounting

Oasis Health Care Inc. is owned and operated by Dr. George Hancock, the sole stockholder.

During January 2013, Oasis Health Care entered into the following transactions:

Jan. 1 Received $15,000 from Rivers Company as rent for the use of a vacant office

in Oasis Health Care’s building. Rivers paid the rent six months in advance.

1 Paid $4,200 for an insurance premium on a general business policy.

6 Purchased supplies of $1,800 on account.

9 Collected $27,500 for services provided to customers on account.

11 Paid creditors $3,000 on account.

18 Invested an additional $25,000 in the business in exchange for capital stock.

20 Billed patients $62,000 for services provided on account.

25 Received $12,900 for services provided to customers who paid cash.

30 Paid expenses as follows: wages, $24,000; utilities, $6,000; rent on medical

equipment, $5,000; interest, $200; and miscellaneous, $2,500.

30 Paid dividends of $15,000 to stockholders (Dr. Hancock).

Instructions

Analyze and record the January transactions for Oasis Health Care Inc., using the

integrated financial statement framework. Record each transaction by date, and show

the balance for each item after each transaction. The January 1, 2013, balances for

the balance sheet are shown below.

Assets 5 Liabilities 1

Stockholders’

Equity

Accts. Pre. Acc. Accts. Un. Wages Notes Capital Retained

Cash 1 Rec. 1 Ins. 1 Supp. 1Building2 Depr. 1 Land 5 Pay. 1Rev.1 Pay. 1 Pay. 1 Stock 1 Earnings

Bal., Jan. 1 20,000 34,500 700 1,000 150,000 211,200 120,000 7,500 0 0 30,000 50,000 227,500

P3-2 A djustment process

Adjustment data for Oasis Health Care Inc. for January are as follows:

  1. Insurance expired, $800.
  2. Supplies on hand on January 31, $1,100.
  3. Depreciation on building, $2,000.
  4. Unearned rent revenue earned, $2,500.
  5. Wages owed employees but not paid, $1,700.
  6. Services provided but not billed to patients, $10,000.

Instructions

Based on the transactions recorded in January for Problem 3-1, record the adjustments

for January using the integrated financial statement framework.

P3-3 Financial statements

Data for Oasis Health Care for January are provided in Problems 3-1 and 3-2.

Instructions

Prepare an income statement, retained earnings statement, and a classified balance

sheet for January. The note payable is due in 2017.

P3-4 S tatement of cash flows

Data for Oasis Health Care for January are provided in Problems 3-1, 3-2, and 3-3.

Instructions

  1. Prepare a statement of cash flows for January.
  2. Reconcile the net cash flows from operating activities with the net income for

January. (Hint: See the appendix to this chapter and use adjusted balances in

computing increases and decreases in accounts.)

P3-5 A djustments and errors

At the end of May, the first month of operations, the following selected data were

taken from the financial statements of Julie Mortenson, Attorney at Law, P.C.:

Net income for May $127,500

Total assets at May 31 480,000

Total liabilities at May 31 150,000

Total stockholders’ equity at May 31 330,000

In preparing the financial statements, adjustments for the following data were

overlooked:

  1. Unbilled fees earned at May 31, $9,700
  2. Depreciation of equipment for May, $8,000
  3. Accrued wages at May 31, $1,150
  4. Supplies used during May, $975

Instructions

Determine the correct amount of net income for May and the total assets, liabilities,

and stockholders’ equity at May 31. In addition to indicating the corrected amounts,

indicate the effect of each omitted adjustment by setting up and completing a columnar

table similar to the one shown below. Adjustment (a) is presented as an example.

P3-6 A djustment process and financial statements

Adjustment data for Ms. Ellen’s Laundry Inc. for the year ended December 31, 2013,

are as follows:

  1. Wages accrued but not paid at December 31, $2,150
  2. Depreciation of equipment during the year, $12,500
  3. Laundry supplies on hand at December 31, $1,500
  4. Insurance premiums expired, $4,600

Instructions

  1. Using the following integrated financial statement framework, record each adjustment

to the appropriate accounts, identifying each adjustment by its letter. After

all adjustments are recorded, determine the balances.

Obj 3, 4

  1. Net income,

$82,750

Statement of

Cash Flows

Income

Statement

Balances, Dec. 31, 2013 53,000 9,000 6,000 250,000 –65,000 7,000 0 50,000 196,000

Balance Sheet

Assets Liabilities Stockholders’

Equity =

Accts.

+ + – = Payable

Wages

Payable

Prepaid

Insurance

Laundry

Equip.

Acc.

Cash + Depr.

Laundry

Supplies +

Capital

+ Stock

Retained

+ Earnings

+

Statement of Cash Flows Income Statement

Laundry revenue 275,000

Wages expense –110,000

Rent expense –30,000

Utilities expense –18,000

Misc. expense –7,500

Financing (Capital Stock)

Operating (Expenses)

Investing (Equipment)

Financing (Dividends)

Operating (Revenues) 275,000

25,000

–200,000

–50,000

–15,000

Net increase in cash 35,000

18,000

$53,000

Beginning cash bal., Jan. 1, 2013

Ending cash bal., Dec. 31, 2013

  1. Prepare an income statement and retained earnings statement for the year ended

December 31, 2013. The retained earnings balance as of January 1, 2013, was

$101,500.

  1. Prepare a classified balance sheet as of December 31, 2013.
  2. Prepare a statement of cash flows for the year ended December 31, 2013.

 

Activities

A3-1 A ccrued revenue

The following is an excerpt from a conversation between Monte Trask and Jamie

Palk just before they boarded a flight to Berlin on American Airlines. They are going

to Berlin to attend their company’s annual sales conference.

Monte: Jamie, aren’t you taking an introductory accounting course at college?

Jamie: Yes, I decided it’s about time I learned something about accounting. You know,

our annual bonuses are based on the sales figures that come from the accounting

department.

Monte: I guess I never really thought about it.

Jamie: You should think about it! Last year, I placed a $900,000 order on December

  1. But when I got my bonus, the $900,000 sale wasn’t included. They said it hadn’t

been shipped until January 5, so it would have to count in next year’s bonus.

Monte: A real bummer!

Jamie: Right! I was counting on that bonus including the $900,000 sale.

Monte: Did you complain?

Jamie: Yes, but it didn’t do any good. Sophia, the head accountant, said something

about matching revenues and expenses. Also, something about not recording

revenues until the sale is final. I figured I’d take the accounting course and

find out whether she’s just jerking me around.

Monte: I never really thought about it. When do you think American Airlines

will record its revenues from this flight?

Jamie: Hmmm, I guess it could record the revenue when it sells the ticket …

or when the boarding passes are taken at the door … or when we get off the

plane … or when our company pays for the tickets … or I don’t know. I’ll ask

my accounting instructor.

Discuss when American Airlines should recognize the revenue from ticket sales

to properly match revenues and expenses.

A3-2 A djustments for financial statements

Several years ago, your brother opened Ready Appliance Repairs. He made a small

initial investment and added money from his personal bank account as needed. He

withdrew money for living expenses at irregular intervals. As the business grew, he

hired an assistant. He is now considering adding more employees, purchasing additional

service trucks, and purchasing the building he now rents. To secure funds for

the expansion, your brother submitted a loan application to the bank and included the

most recent financial statements (shown below) prepared from accounts maintained

by a part-time bookkeeper.

READY APPLIANCE REPAIRS

Balance Sheet

March 31, 2012

Assets

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 25,900

Amounts due from customers. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,750

Truck. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .  . . . . . 55,350

Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000

Equities

Owner’s equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000

After reviewing the financial statements, the loan officer at the bank asked your

brother if he used the accrual basis of accounting for revenues and expenses.

Your brother responded that he did and that is why he included an account for

“Amounts Due from Customers.” The loan officer then asked whether or not the

accounts were adjusted prior to the preparation of the statements. Your brother

answered that they had not been adjusted.

  1. Why do you think the loan officer suspected that the accounts had not been

adjusted prior to the preparation of the statements?

  1. Indicate possible accounts that might need to be adjusted before an accurate

set of financial statements could be prepared.

A3-3 Business emphasis

Assume that you and two friends are debating whether to open an automotive and

service retail chain that will be called Auto-Mart. Initially, Auto-Mart will open three

stores locally, but the business plan anticipates going nationwide within five years.

Currently, you and your future business partners are debating whether to focus

Auto-Mart on a “do-it-yourself ” or “do-it-for-me” business. A do-it-yourself business

emphasizes the sale of retail auto parts that customers will use themselves

to repair and service their cars. A do-it-for me business emphasizes the offering

of maintenance and service for customers.

  1. In groups of three or four, discuss whether to implement a do-it-yourself or

do-it-for-me business emphasis. List the advantages of each emphasis, and

arrive at a conclusion as to which emphasis to implement.

  1. Provide examples of real-world businesses that use do-it-yourself or do-it-forme

business emphases.

A3-4 Cash basis income statement

The following operating data (in millions) were adapted from the SEC 10-K filings

of Walgreens and CVS:

  1. Using the preceding data, adjust the operating income for CVS and Walgreens

to an adjusted cash basis. For 2010, the operating income for CVS was $3,439

and for Walgreens it was $2,091 (in millions). (Hint: To convert to a cash basis,

you need to compute the change in each accrual accounting item shown and

then either add or subtract the change to determine the operating income.)

  1. Compute the net difference between the operating income under the accrual

and cash bases.

  1. Express the net difference in (2) as a percentage of operating income under

the accrual basis.

  1. Which company’s operating income, CVS’s or Walgreens’, is closer to the cash

basis? Round to one decimal place.

  1. Do you think most analysts focus on operating income or net income in

assessing

the long-term profitability of a company? Explain.

A3-5 Analysis of income and cash flows

The following data (in millions) were taken from http://finance.yahoo.com.

2010 2009 2008

Company A

Revenues $32,204 $24,509 $19,166

Operating income 1,406 1,129 842

Net income 1,152 902 645

Net cash flows from operating activities 3,495 3,293 1,697

Net cash flows from investing activities (3,360) (2,337) (1,199)

Net cash flows from financing activities 181 (280) (198)

Total assets 18,797 13,813 8,314

Company B

Revenues $31,755 $28,063 $ 22,697

Operating income (loss) 2,217 (324) (8,314)

Net income (loss) 593 (1,237) (8,922)

Net cash flows from operating activities 2,832 1,379 (1,707)

Net cash flows from investing activities (2,026) (1,008) 1,598

Net cash flows from financing activities (2,521) (19) 1,716

Total assets 43,188 43,789 45,014

Company C

Revenues $35,119 $30,990 $31,948

Operating income 8,449 8,231 8,446

Net income 11,809 6,824 5,807

Net cash flows from operating activities 9,532 8,186 7,571

Net cash flows from investing activities (4,405) (4,149) (2,363)

Net cash flows from financing activities (3,465) (2,293) (3,985)

Total assets 72,921 48,671 40,519

Company D

Revenues $82,189 $76,733 $76,148

Operating income (loss) 2,182 1,091 2,452

Net income (loss) 1,116 70 1,249

Net cash flows from operating activities 3,366 2,922 2,896

Net cash flows from investing activities (1,961) (2,327) (2,179)

Net cash flows from financing activities (1,004) (434) (769)

Total assets 23,505 23,126 23,257

  1. Match each of the following companies with the data for Company A, B, C, or D:

Amazon.com

Coca-Cola Inc.

Delta Air Lines

Kroger

  1. Explain the logic underlying your matches.

 

Answers to Self-Examination Questions

  1. A Under the accrual basis of accounting,

revenues are recorded when the services are

rendered. Since the services were rendered during

June, all the fees should be recorded on June

30 (answer A). This is an example of accrued

revenue. Under the cash basis of accounting,

revenues are recorded when the cash is collected,

not necessarily when the fees are earned.

Thus, no revenue would be recorded in June,

$8,500 of revenue would be recorded in July,

and $6,500 of revenue would be recorded in

August (answer D). Answers B and C are incorrect

and are not used under either the accrual

or cash basis.

  1. C The collection of a $5,700 accounts receivable

is recorded as an increase in Cash, $5,700,

and a decrease in Accounts Receivable, $5,700

(answer C). The initial recording of the fees

earned on account is recorded as an increase

in Accounts Receivable and an increase in Fees

Earned (answer B). Services rendered for cash

are recorded as an increase in Cash and an

increase in Fees Earned (answer D). Answer A

is incorrect and would result in the accounting

equation being out of balance because total

assets would exceed total liabilities and stockholders’

equity by $11,400.

  1. A A deferral is the delay in recording an

expense already paid, such as prepaid insurance

(answer A). Wages payable (answer B)

is considered an accrued expense or accrued

liability. Fees earned (answer C) is a revenue

item. Accumulated depreciation (answer D) is

a contra account to a fixed asset.

  1. D The balance in the supplies account, before

adjustment, represents the amount of supplies

available during the period. From this amount,

$2,250, is subtracted the amount of supplies

on hand, $950, to determine the supplies used,

$1,300. The used supplies is recorded as an

increase in Supplies Expense, $1,300, and a

decrease in Supplies, $1,300 (answer D).

  1. C The failure to record the adjusting entry

increasing Rent Revenue, $600, and decreasing

Unearned Rent, $600, would have the effect of

overstating liabilities by $600 and understating

net income by $600 (answer C).

 

 

Chapter 4 accounting for Merchandising Businesses

 

Class Discussion Questions

  1. What distinguishes a merchandising business

from a service business?

  1. Can a business earn a gross profit but incur

a net loss? Explain.

  1. In computing the cost of merchandise sold,

does each of the following items increase

or decrease that cost? (a) freight, (b) beginning

merchandise inventory, (c) purchases

discounts, (d) ending merchandise inventory.

  1. Describe how the periodic method differs

from the perpetual method of accounting for

merchandise inventory.

  1. Differentiate between the multiple-step and

the single-step forms of the income statement.

  1. What are the major advantages and disadvantages

of the single-step form of income statement

compared to the multiple-step statement?

  1. What type of revenue is reported in the

“Other income” section of the multiple-step

income statement?

  1. How are sales to customers using MasterCard

and VISA recorded?

  1. What is the meaning of (a) 2/10, n/30;

(b) n/90; (c) n/eom?

  1. What is the nature of (a) a credit memorandum

issued by the seller of merchandise, (b)

a debit memorandum issued by the buyer of

merchandise?

  1. Who bears the freight when the terms of

sale are (a) FOB shipping point, (b) FOB

destination?

  1. When you purchase a new car, the “sticker

price” includes a “destination” charge. Are

you purchasing the car FOB shipping point

or FOB destination? Explain.

  1. Office Outfitters Inc., which uses a perpetual

inventory system, experienced a normal inventory

shrinkage of $3,750. What accounts

would be increased and decreased to record

the adjustment for the inventory shrinkage

at the end of the accounting period?

  1. Assume that Office Outfitters Inc. in Question

13 experienced an abnormal inventory

shrinkage of $56,900. Office Outfitters Inc.

has decided to record the abnormal inventory

shrinkage so that it would be separately

disclosed on the income statement. What

account

would be increased for the abnormal

inventory shrinkage?

 

Exercises

E4-1 D etermining gross profit

During the current year, merchandise is sold for $1,375,000. The cost of the

merchandise sold is $880,000.

  1. What is the amount of the gross profit?
  2. Compute the gross profit percentage (gross profit divided by sales).
  3. Will the income statement necessarily report a net income? Explain.

E4-2 D etermining cost of merchandise sold

For a recent year, Target Corporation reported revenue of $65,786 million. Its gross profit

was $20,061 million. What was the amount of Target’s cost of merchandise

sold?

E4-3 Identify items missing in determining cost of merchandise sold

For (a) through (d), identify the items designated by “X” and “Y.”

  1. Purchases 2 (X 1 Y) 5 Net purchases.
  2. Net purchases 1 X 5 Cost of merchandise purchased.
  3. Merchandise inventory (beginning) 1 Cost of merchandise purchased 5 X.
  4. Merchandise available for sale 2 X 5 Cost of merchandise sold.

E4-4 Cost of merchandise sold and related items

The following data were extracted from the accounting records of Catz Company

for the year ended April 30, 2013:

Merchandise inventory, May 1, 2012 $ 175,000

Merchandise inventory, April 30, 2013 240,000

Purchases 1,400,000

Purchases returns and allowances 20,000

Purchases discounts 18,000

Sales 2,250,000

Freight in 13,000

  1. Prepare the cost of merchandise sold section of the income statement for the

year ended April 30, 2013, using the periodic inventory system.

  1. Determine the gross profit to be reported on the income statement for the

year ended April 30, 2013.

E4-5 Cost of merchandise sold

Identify the errors in the following schedule of cost of merchandise sold for the

current year ended May 31, 2013:

Cost of merchandise sold:

Merchandise inventory, May 31, 2013 $ 155,000

Purchases $875,000

Plus: Purchases returns and allowances $12,000

Purchases discounts 8,000 20,000

Gross purchases $895,000

Less freight in 15,000

Cost of merchandise purchased 880,000

Merchandise available for sale $1,035,000

Less merchandise inventory, June 1, 2012 125,000

Cost of merchandise sold $ 910,000

E4-6 Income statement for merchandiser

For the fiscal year, sales were $8,300,000, sales discounts were $100,000, sales

returns and allowances were $45,000, and the cost of merchandise sold was

$5,000,000.

  1. What was the amount of net sales?
  2. What was the amount of gross profit?

E4-7 Income statement for merchandiser

The following expenses were incurred by a merchandising business during the

year. In which expense section of the income statement should each be reported:

(a) selling, (b) administrative, or (c) other?

  1. Advertising expense
  2. Depreciation expense on store equipment
  3. Insurance expense on office equipment
  4. Interest expense on notes payable
  5. Rent expense on office building
  6. Salaries of office personnel
  7. Salary of sales manager
  8. Sales supplies used

E4-8 Single-step income statement

Summary operating data for Lock-World Company during the current year ended

November 30, 2012, are as follows: cost of merchandise sold, $4,300,000; administrative

expenses, $500,000; interest expense, $20,000; rent revenue, $100,000;

net sales, $7,200,000; and selling expenses, $750,000. Prepare a single-step income

statement.

E4-9 Multiple-step income statement

On July 31, 2012, the balances of the accounts appearing in the ledger of Vagabond

Furnishings Company, a furniture wholesaler, are as follows:

Administrative Expenses $ 250,000 Office Supplies $ 21,200

Building 1,234,000 Retained Earnings 937,600

Capital Stock 200,000 Salaries Payable 6,000

Cash 97,000 Sales 3,200,000

Cost of Merchandise Sold 1,700,000 Sales Discounts 60,000

Dividends 50,000 Sales Returns and Allowances 190,000

Interest Expense 15,000 Selling Expenses 410,000

Merchandise Inventory 360,000 Store Supplies 15,400

Notes Payable 59,000

  1. Prepare a multiple-step income statement for the year ended July 31, 2012.
  2. Compare the major advantages and disadvantages of the multiple-step and

single-step forms of income statements.

E4-10 D etermining amounts for items omitted from income statement

Two items are omitted in each of the following four lists of income statement

data. Determine the amounts of the missing items, identifying them by letter.

Sales $475,000 $700,000 $1,000,000 $ (g)

Sales returns and allowances (a) 100,000 (e) 7,500

Sales discounts 10,000 18,000 40,000 11,500

Net sales 448,000 (c) 910,000 (h)

Cost of merchandise sold (b) 350,000 (f ) 400,000

Gross profit 180,000 (d) 286,500 120,000

E4-11 Multiple-step income statement

Identify the errors in the following income statement and prepare a corrected

income statement:

CARLSBAD COMPANY

Income Statement

For the Year Ended February 29, 2012

Revenue from sales:

Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,400,000

Add: Sales returns and allowances . . . . . . . . . . . . . . . . . . $120,000

Sales discounts. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000 180,000

Gross sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,580,000

Cost of merchandise sold. . . . . . . . . . . . . . . . . . . . . . . . 2,650,000

Income from operations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,930,000

Expenses:

Selling expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 800,000

Administrative expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000

Delivery expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Total expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,450,000

Other expense: $ 480,000

Interest revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000

Gross profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 440,000

E4-12 Sales-related transactions, including the use of credit cards

Illustrate the effects on the accounts and financial statements of recording the

following transactions:

  1. Sold merchandise for cash, $23,500. The cost of the merchandise sold was $14,000.
  2. Sold merchandise on account, $12,000. The cost of the merchandise sold was

$7,200.

  1. Sold merchandise to customers who used MasterCard and VISA, $190,000. The

cost of the merchandise sold was $115,000.

E4-13 Sales returns and allowances

During the year, sales returns and allowances totaled $90,000. The cost of the

merchandise returned was $54,000. The accountant recorded all the returns and

allowances by decreasing the sales account and decreasing Cost of Merchandise

Sold for $90,000.

Was the accountant’s method of recording returns acceptable? Explain. In

your explanation, include the advantages of using a sales returns and allowances

account.

E4-14 Sales-related transactions

After the amount due on a sale of $40,000, terms 2/10, n/eom, is received from

a customer within the discount period, the seller consents to the return of the

entire shipment. The cost of the merchandise returned was $24,000. (a) What is

the amount of the refund owed to the customer? (b) Illustrate the effects on the

accounts and financial statements of the return and the refund.

E4-15 Sales-related transactions

Merchandise is sold on account to a customer for $12,500, terms FOB

shipping

point, 1/10, n/30. The seller paid the freight of $250. Determine th

following:

(a) amount of the sale, (b) amount debited to Accounts Receivable,

(c) amount of the discount for early payment, and (d) amount due within the

discount period.

E4-16 Purchase-related transaction

Top Notch Company purchased merchandise on account from a supplier for

$13,500, terms 2/10, n/30. Top Notch Company returned $4,000 of the merchandise

before payment was made and received full credit.

  1. If Top Notch Company pays the invoice within the discount period, what is

the amount of cash required for the payment?

  1. Under a perpetual inventory system, what account is decreased by Top Notch

Company to record the return?

E4-17 Purchase-related transactions

A retailer is considering the purchase of 100 units of a specific item from either

of two suppliers. Their offers are as follows:

A: $390 a unit, total of $39,000, 1/10, n/30, plus freight of $750.

B: $400 a unit, total of $40,000, 2/10, n/30, no charge for freight.

Which of the two offers, A or B, yields the lower price?

E4-18 Purchase-related transactions

Milan Co., a women’s clothing store, purchased $120,000 of merchandise from

a supplier on account, terms FOB destination, 2/10, n/30. Milan Co. returned

$16,000 of the merchandise, receiving a credit memorandum, and then paid the

amount due within the discount period. Illustrate the effects on the accounts and

financial statements of Milan Co. to record (a) the purchase, (b) the merchandise

return, and (c) the payment.

E4-19 Purchase-related transactions

Illustrate the effects on the accounts and financial statements of the following

related transactions of Seaside Diagnostic Company:

  1. Purchased $48,000 of merchandise from Davies Co. on account, terms 2/10,

n/30.

  1. Paid the amount owed on the invoice within the discount period.
  2. Discovered that $10,000 of the merchandise was defective and returned items,

receiving credit.

  1. Purchased $7,500 of merchandise from Davies Co. on account, terms n/30.
  2. Received a check for the balance owed from the return in (c), after deducting

for the purchase in (d).

E4-20 D etermining amounts to be paid on invoices

Determine the amount to be paid in full settlement of each of the following

invoices, assuming that credit for returns and allowances was received prior to

payment and that all invoices were paid within the discount period.

Freight Paid

by Seller

Returns and

Allowances

  1. $ 8,250 — FOB shipping point, 1/10, n/30 $ 950
  2. 2,900 $125 FOB shipping point, 2/10, n/30 400
  3. 15,000 600 FOB destination, n/30 800
  4. 10,000 400 FOB shipping point, 2/10, n/30 1,200
  5. 3,850 175 FOB destination, 2/10, n/30 —

E4-21 Sales tax

A sale of merchandise on account for $6,400 is subject to a 7% sales tax. (a)

Should the sales tax be recorded at the time of sale or when payment is received?

(b) What is the amount of the sale? (c) What is the amount of the increase to

Accounts

Receivable? (d) What is the title of the account in which the $448

($6,400 3 7%) is recorded?

E4-22 Sales tax transactions

Illustrate the effects on the accounts and financial statements of recording the

following selected transactions:

  1. Sold $11,250 of merchandise on account, subject to a sales tax of 6%. The

cost of the merchandise sold was $6,750.

  1. Paid $63,120 to the state sales tax department for taxes collected.

E4-23 Sales-related transactions

Steritech Co., a furniture wholesaler, sells merchandise to Butler Co. on account,

$86,000, terms 2/10, n/30. The cost of the merchandise sold is $51,600.

Steritech Co. issues a credit memorandum for $9,000 for merchandise returned

and subsequently receives the amount due within the discount period. The cost

of the merchandise returned is $5,000. Illustrate the effects on the accounts

and financial statements of Steritech Co. for (a) the sale, including the cost of

the merchandise sold, (b) the credit memorandum, including the cost of the

returned merchandise, and (c) the receipt of the check for the amount due

from Butler Co.

E4-24 Purchase-related transactions

Based on the data presented in Exercise 4-23, illustrate the effects on the accounts

and financial statements of Butler Co. for (a) the purchase, (b) the return

of the merchandise for credit, and (c) the payment of the invoice within the

discount period.

E4-25 A djusting entry for merchandise inventory shrinkage

Intrax Inc.’s perpetual inventory records indicate that $815,400 of merchandise

should be on hand on December 31, 2012. The physical inventory indicates that

$798,300 of merchandise is actually on hand. Illustrate the effects on the accounts

and financial statements of the inventory shrinkage for Intrax Inc. for the year

ended December 31, 2012.

 

Problems

P4-1 Multiple-step income statement and report form of balance sheet

The following selected accounts and their current balances appear in the ledger

of Aqua Co. for the fiscal year ended June 30, 2013:

Cash $ 83,500 Sales $3,625,000

Accounts Receivable 150,000 Sales Returns and Allowances 37,800

Merchandise Inventory 380,000 Sales Discounts 20,200

Office Supplies 15,000 Cost of Merchandise Sold 2,175,000

Prepaid Insurance 12,000 Sales Salaries Expense 388,800

Office Equipment 115,200 Advertising Expense 45,900

Accumulated Depreciation— Depreciation Expense—

Office Equipment 49,500 Store Equipment 8,300

Store Equipment 511,500 Miscellaneous Selling Expense 2,000

Accumulated Depreciation— Office Salaries Expense 77,400

Store Equipment 186,700 Rent Expense 39,900

Accounts Payable 48,600 Insurance Expense 22,950

Salaries Payable 9,600 Depreciation Expense—

Note Payable Office Equipment 16,200

(final payment due 2025) 54,000 Office Supplies Expense 1,650

Capital Stock 15,000 Miscellaneous Administrative

Retained Earnings 253,800 Expense 1,900

Dividends 125,000 Interest Expense 12,000

Instructions

  1. Prepare a multiple-step income statement.
  2. Prepare a retained earnings statement.
  3. Prepare a report form of balance sheet, assuming that the current portion of

the note payable is $8,000.

  1. Briefly explain (a) how multiple-step and single-step income statements differ

and (b) how report-form and account-form balance sheets differ.

P4-2 Single-step income statement

Selected accounts and related amounts for Aqua Co. for the fiscal year ended

June 30, 2013, are presented in Problem 4-1.

Instructions

  1. Prepare a single-step income statement in the format shown in Exhibit 3.
  2. Prepare a retained earnings statement.

P4-3 Sales-related transactions

The following selected transactions were completed by Affordable Supplies Co.,

which sells supplies primarily to wholesalers and occasionally to retail customers.

Jan. 6. Sold merchandise on account, $14,000, terms FOB shipping point,

n/eom. The cost of merchandise sold was $8,400.

  1. Sold merchandise on account, $20,000, terms FOB destination, 1/10,

n/30. The cost of merchandise sold was $14,000.

Jan. 16. Sold merchandise on account, $19,500, terms FOB shipping point, 1/10,

n/30. The cost of merchandise sold was $11,700.

  1. Received check for amount due for sale on January 8.
  2. Issued credit memorandum for $4,500 for merchandise returned from

sale on January 16. The cost of the merchandise returned was $2,700.

  1. Received check for amount due for sale on January 16 less credit memorandum

of January 19 and discount.

  1. Paid Cashell Delivery Service $3,000 for merchandise delivered during

January to customers under shipping terms of FOB destination.

  1. Received check for amount due for sale of January 6.

Instructions

Illustrate the effects of each of the preceding transactions on the accounts and

financial statements of Affordable Supplies Co. Identify each transaction by date.

P4-4 Purchase-related transactions

The following selected transactions were completed by Epic Co. during August

of the current year:

Aug. 3. Purchased merchandise for $33,400, terms FOB destination, 2/10, n/30.

  1. Issued debit memorandum for $7,000 of merchandise returned from

purchase on August 3.

  1. Purchased merchandise, $25,000, terms FOB shipping point, n/eom.

Paid freight of $600 on purchase.

  1. Paid for invoice of August 3, less debit memorandum of August 9 and

discount.

  1. Paid for invoice of August 10.

Instructions

Illustrate the effects of each of the preceding transactions on the accounts and

financial statements of Epic Co. Identify each transaction by date.

P4-5 Sales-related and purchase-related transactions for seller and buyer

The following selected transactions were completed during June between Snipes

Company and Beejoy Company:

June 8. Snipes Company sold merchandise on account to Beejoy Company,

$18,250, terms FOB destination, 2/15, n/eom. The cost of the merchandise

sold was $10,000.

  1. Snipes Company paid transportation costs of $400 for delivery of merchandise

sold to Beejoy Company on June 8.

  1. Beejoy Company returned $5,000 of merchandise purchased on account

on June 8 from Snipes Company. The cost of the merchandise returned

was $3,000.

  1. Beejoy Company paid Snipes Company for purchase of June 8, less

discount and less return of June 12.

  1. Snipes Company sold merchandise on account to Beejoy Company,

$15,000, terms FOB shipping point, n/eom. The cost of the merchandise

sold was $9,000.

June 26. Beejoy Company paid transportation charges of $375 on June 24 purchase

from Snipes Company.

  1. Beejoy Company paid Snipes Company on account for purchase of

June 24.

Instructions

Illustrate the effects of each of the preceding transactions on the accounts and

financial statements of (1) Snipes Company and (2) Beejoy Company. Identify

each transaction by date.

P4-6 Statement of cash flows using indirect method

For the year ending March 31, 2013, Omega Systems Inc. reported net income of

$105,450 and paid dividends of $7,500. Comparative balance sheets as of March

31, 2013 and 2012, are as follows:

OMEGA SYSTEMS INC.

Balance Sheets

March 31, Changes

2013 2012 Increase (Decrease)

Assets

Current assets:

Cash $ 39,500 $ 29,250 $ 10,250

Accounts receivable 114,120 78,000 36,120

Merchandise inventory 133,150 122,550 10,600

Office supplies 4,255 4,435 (180)

Prepaid insurance 3,975 4,500 (525)

Total current assets $ 295,000 $238,735 $ 56,265

Property, plant, and equipment:

Land $ 30,000 $ 30,000 $ 0

Store equipment 350,000 285,000 65,000

Accumulated depreciation—store equipment (118,550) (93,900) (24,650)

Office equipment 23,355 15,000 8,355

Accumulated depreciation—office equipment (7,080) (3,345) (3,735)

Total property, plant, and equipment $ 277,725 $232,755 $ 44,970

Total assets $ 572,725 $471,490 $101,235

Liabilities

Current liabilities:

Accounts payable $ 33,630 $ 21,405 $ 12,225

Notes payable (current portion) 7,500 7,500 0

Salaries payable 1,710 2,250 (540)

Unearned rent 2,700 3,600 (900)

Total current liabilities $ 45,540 $ 34,755 $ 10,785

Long-term liabilities:

Notes payable (final payment due 2019) 30,000 37,500 (7,500)

Total liabilities $ 75,540 $ 72,255 $ 3,285

Stockholders’ Equity

Capital stock $ 37,500 $ 37,500 $ 0

Retained earnings 459,685 361,735 97,950

Total stockholders’ equity $ 497,185 $399,235 $ 97,950

Total liabilities and stockholders’ equity $ 572,725 $471,490 $101,235

Instructions

  1. Prepare a statement of cash flows, using the indirect method.
  2. Why is depreciation added to net income in determining net cash flows from

operating activities? Explain.

 

Activities

A4-1 E thics and professional conduct in business

On July 29, 2012, Ever Green Company, a garden retailer, purchased $12,000 of

seed, terms 2/10, n/30, from Fleck Seed Co. Even though the discount period

had expired, Mary Jasper subtracted the discount of $240 when she processed

the documents for payment on August 13, 2012.

Discuss whether Mary Jasper behaved in a professional manner by subtracting

the discount, even though the discount period had expired.

A4-2 Purchases discounts and accounts payable

The Laurel Co. is owned and operated by Paul Laurel. The following is an excerpt

from a conversation between Paul Laurel and Maria Fuller, the chief accountant

for Laurel Co.

Paul: Maria, I’ve got a question about this recent balance sheet.

Maria: Sure, what’s your question?

Paul: Well, as you know, I’m applying for a bank loan to finance our new store

in Clinton, and I noticed that the accounts payable are listed as $180,000.

Maria: That’s right. Approximately $150,000 of that represents amounts due our

suppliers, and the remainder is miscellaneous payables to creditors for utilities,

office equipment, supplies, etc.

Paul: That’s what I thought. But we normally receive a 2% discount from our

suppliers for earlier payment, and we always try to take the discount.

Maria: That’s right. I can’t remember the last time we missed a discount.

Paul: Well, in that case, it seems to me the accounts payable should be listed

minus the 2% discount. Let’s list the accounts payable due suppliers as $147,000,

rather than $150,000. Every little bit helps. You never know. It might make the

difference between getting the loan and not.

How would you respond to Paul Laurel’s request?

A4-3 D etermining cost of purchase

The following is an excerpt from a conversation between Eric Jackson and Carlie

Miller. Eric is debating whether to buy a stereo system from First Audio, a locally

owned electronics store, or Dynamic Sound Systems, an online electronics company.

Eric: Carlie, I don’t know what to do about buying my new stereo.

Carlie: What’s the problem?

Eric: Well, I can buy it locally at First Audio for $890.00. But Dynamic Sound

Systems has the same system listed for $899.99.

Carlie: So what’s the big deal? Buy it from First Audio.

Eric: It’s not quite that simple. Dynamic Sound Systems said something about

not having to pay sales tax, since I was out of state.

Carlie: Yes, that’s a good point. If you buy it at First Audio, they’ll charge you

6% sales tax.

Eric: But Dynamic Sound Systems charges $13.99 for shipping and handling.

If I have them send it next-day air, it’ll cost $44.99 for shipping and handling.

Carlie: I guess it is a little confusing.

Eric: That’s not all. First Audio will give an additional 1% discount if I pay cash. Otherwise,

they will let me use my VISA, or I can pay it off in three monthly installments.

Carlie: Anything else???

Eric: Well… Dynamic Sound Systems says I have to charge it on my VISA. They

don’t accept checks.

Carlie: I am not surprised. Many online stores don’t accept checks.

Eric: I give up. What would you do?

  1. Assuming that Dynamic Sound Systems doesn’t charge sales tax on the sale

to Eric, which company is offering the best buy?

  1. What might be some considerations other than price that might influence Eric’s

decision on where to buy the stereo system?

A4-4 Sales discounts

Your sister operates Harbor Ready Parts Company, an online boat parts distributorship

that is in its third year of operation. The income statement is shown below

and was recently prepared for the year ended October 31, 2012.

HARBOR READY PARTS COMPANY

Income Statement

For the Year Ended October 31, 2012

Revenues:

Net sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,200,000

Interest revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000

Total revenues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,215,000

Expenses:

Cost of merchandise sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000

Selling expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 135,000

Administrative expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000

Interest expense. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21,650

Total expenses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,031,650

Net income. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 183,350

Your sister is considering a proposal to increase net income by offering sales

discounts of 2/15, n/30, and by shipping all merchandise FOB shipping point.

Currently, no sales discounts are allowed and merchandise is shipped FOB

destination.

It is estimated that these credit terms will increase net sales by

15%. The ratio of the cost of merchandise sold to net sales is expected to be

65%. All selling and administrative expenses are expected to remain unchanged,

except

for store supplies, miscellaneous selling, office supplies, and miscellaneous

administrative

expenses, which are expected to increase proportionately with

increased net sales. The amounts of these preceding items for the year ended

October 31, 2012, were as follows:

Store supplies expense $18,000 Office supplies expense $4,000

Miscellaneous selling expense 5,000 Miscellaneous administrative expense 2,000

The other income and other expense items will remain unchanged. The shipment

of all merchandise FOB shipping point will eliminate all delivery expenses, which

for the year ended October 31, 2012, were $28,000.

  1. Prepare a projected single-step income statement for the year ending October

31, 2013, based on the proposal. Assume all sales are collected within the

discount period.

  1. Based on the projected income statement in (1), would you recommend

implementation of the proposed changes?

  1. Describe any possible concerns you may have related to the proposed

changes described in (1).

A4-5 Shopping for a television

Assume that you are planning to purchase a Samsung LED-LCD, 55 inch television.

In groups of three or four, determine the lowest cost for the television, considering

the available alternatives and the advantages and disadvantages of each

alternative. For example, you could purchase locally, through mail order, or

through an Internet shopping service. Consider such factors as delivery charges,

interest-free financing, discounts, coupons, and availability of warranty services.

Prepare a report for presentation to the class.

 

Answers to Self-Examination Questions

  1. A A debit memorandum (answer A), issued

by the buyer, indicates the amount the buyer

proposes to decrease the accounts payable

account. A credit memorandum (answer B),

issued by the seller, indicates the amount

the seller proposes to decrease the accounts

receivable account. An invoice (answer C)

or a bill (answer D), issued by the seller,

indicates the amount and terms of the sale.

  1. C The amount of discount for early payment

is $10 (answer C), or 1% of $1,000. Although

the $50 of transportation costs paid by the

seller increases the customer’s account, the

customer is not entitled to a discount on that

amount.

  1. B The single-step form of income statement

(answer B) is so named because the total of

all expenses is deducted in one step from

the total of all revenues. The multiple-step

form (answer A) includes numerous sections

and subsections with several subtotals. The

account form (answer C) and the report form

(answer D) are two common forms of the

balance sheet.

  1. C Gross profit (answer C) is the excess of

net sales over the cost of merchandise sold.

Operating income (answer A) or income from

operations (answer B) is the excess of gross

profit over operating expenses. Net income

(answer D) is the final figure on the income

statement after all revenues and expenses

have been reported.

  1. B The inventory shrinkage, $15,000, is the difference

between the book inventory, $290,000,

and the physical inventory, $275,000. The

effect of the inventory shrinkage on the accounts

is to increase Cost of Merchandise Sold

and decrease Inventory by $15,000.

 

 

Chapter 5 Sarbanes-Oxley, Internal Control, and Cash

 

Class Discussion Questions

  1. (a) Why did Congress pass the Sarbanes-

Oxley

Act of 2002? (b) What was the purpose

of the Sarbanes-Oxley Act of 2002?

  1. Define internal control.
  2. (a) Name and describe the five elements of

internal control. (b) Is any one element of internal

control more important than another?

  1. How does a policy of rotating clerical employees

from job to job aid in strengthening

the control procedures within the control

environment? Explain.

  1. Why should the responsibility for a sequence

of related operations be divided among different

persons? Explain.

  1. Why should the employee who handles cash receipts

not have the responsibility for maintaining

the accounts receivable records? Explain.

  1. In an attempt to improve operating efficiency,

one employee was made responsible

for all purchasing, receiving, and storing of

supplies. Is this organizational change wise

from an internal control standpoint? Explain.

  1. The ticket seller at a movie theater doubles

as a ticket taker for a few minutes each

day while the ticket taker is on a break.

Which control procedure of a business’s system

of internal control is violated in this

situation?

  1. Why should the responsibility for maintaining

the accounting records be separated from

the responsibility for operations? Explain.

  1. Assume that Leslie Hunter, accounts payable

clerk for Campland Inc., stole $185,000 by

paying fictitious invoices for goods that were

never received. The clerk set up accounts in

the names of the fictitious companies and

cashed the checks at a local bank. Describe a

control procedure that would have prevented

or detected the fraud.

  1. Before a voucher for the purchase of merchandise

is approved for payment, supporting

documents should be compared to verify

the accuracy of the liability. Give an example

of a supporting document for the purchase

of merchandise.

  1. The accounting clerk pays all obligations by

prenumbered checks. What are the strengths

and weaknesses in the internal control over

cash payments in this situation?

  1. The balance of Cash is likely to differ from

the bank statement balance. What two factors

are likely to be responsible for the difference?

  1. What is the purpose of preparing a bank

reconciliation?

  1. Do items reported as a credit memorandum

on the bank statement represent (a) additions

made by the bank to the company’s balance

or (b) deductions made by the bank from

the company’s balance? Explain.

  1. Seatow Inc. has a petty cash fund of $2,500.

(a) Since the petty cash fund is only $2,500,

should Seatow Inc. implement controls over

petty cash? (b) What controls, if any, could

be used for the petty cash fund?

  1. (a) How are cash equivalents reported in

the financial statements? (b) What are some

examples of cash equivalents?

 

Exercises

E5-1 Sarbanes-Oxley internal control report

Using Wikipedia (www.wikipedia.org.), look up the entry for the Sarbanes-Oxley

Act. Look over the table of contents and find the section that describes

Section 404. What does Section 404 require of management’s internal control

report?

E5-2 Internal controls

Oscar Fye has recently been hired as the manager of Janie’s Canyon Coffee, a

national chain of franchised coffee shops. During his first month as store manager,

Oscar encountered the following internal control situations:

  1. Oscar caught an employee putting a case of 100 single-serving tea bags in

her car. Not wanting to create a scene, Oscar smiled and said, “I don’t think

you’re putting those tea bags on the right shelf. Don’t they belong inside the

coffee shop?” The employee returned the tea bags to the stockroom.

  1. Janie’s Canyon Coffee has one cash register. Prior to Oscar’s joining the coffee

shop, each employee working on a shift would take a customer order, accept

payment, and then prepare the order. Oscar made one employee on each shift

responsible for taking orders and accepting the customer’s payment. Other

employees prepare the orders.

  1. Since only one employee uses the cash register, that employee is responsible for

counting the cash at the end of the shift and verifying that the cash in the drawer

matches the amount of cash sales recorded by the cash register. Oscar expects

each cashier to balance the drawer to the penny every time—no exceptions.

State whether you agree or disagree with Oscar’s method of handling each situation

and explain your answer.

E5-3 Internal controls

Lili’s Creations is a retail store specializing in women’s clothing. The store has

established a liberal return policy for the holiday season in order to encourage

gift purchases. Any item purchased during November and December may be returned

through January 31, with a receipt, for cash or exchange. If the customer

does not have a receipt, cash will still be refunded for any item under $100. If

the item is more than $100, a check is mailed to the customer.

Whenever an item is returned, a store clerk completes a return slip, which

the customer signs. The return slip is placed in a special box. The store manager

visits the return counter approximately once every two hours to authorize

the return slips. Clerks are instructed to place the returned merchandise on the

proper rack on the selling floor as soon as possible.

This year, returns at Lili’s Creations reached an all-time high. There are a

large number of returns under $100 without receipts.

  1. How can sales clerks employed at Lili’s Creations use the store’s return policy

to steal money from the cash register?

  1. What internal control weaknesses do you see in the return policy that make

cash thefts easier?

  1. Would issuing a store credit in place of a cash refund for all merchandise returned

without a receipt reduce the possibility of theft? List some advantages

and disadvantages of issuing a store credit in place of a cash refund.

  1. Assume that Lili’s Creations is committed to the current policy of issuing cash

refunds without a receipt. What changes could be made in the store’s procedures

regarding customer refunds in order to improve internal control?

E5-4 Internal controls

Republic City Bank provides loans to businesses in the community through its

Commercial Lending Department. Small loans (less than $250,000) may be approved

by an individual loan officer, while larger loans (greater than $250,000)

must be approved by a board of loan officers. Once a loan is approved, the

funds are made available to the loan applicant under agreed-upon terms. The

president of Republic City Bank has instituted a policy whereby he has the individual

authority to approve loans up to $4,000,000. The president believes that

this policy will allow flexibility to approve loans to valued clients much quicker

than under the previous policy.

As an internal auditor of Republic City Bank, how would you respond to

this change in policy?

E5-5 Internal controls

One of the largest losses in history from unauthorized securities trading involved

a securities trader for the French bank Société Générale. The trader was able to

circumvent internal controls and create over $7 billion in trading losses in six

months. The trader apparently escaped detection by using knowledge of the

bank’s internal control systems learned from a previous back-office monitoring

job. Much of this monitoring involved the use of software to monitor trades.

In addition, traders are usually kept to tight spending limits. Apparently, these

controls failed in this case.

What general weaknesses in Société Générale’s internal controls contributed

to the occurrence and size of the losses?

E5-6 Internal controls

An employee of JHT Holdings, Inc., a trucking company, was responsible for resolving

roadway accident claims under $25,000. The employee created fake accident

claims and wrote settlement checks of between $5,000 and $25,000 to friends

or acquaintances acting as phony “victims.” One friend recruited subordinates at

his place of work to cash some of the checks. Beyond this, the JHT employee

also recruited lawyers, who he paid to represent both the trucking company and

the fake victims in the bogus accident settlements. When the lawyers cashed the

checks, they allegedly split the money with the corrupt JHT employee. This fraud

went undetected for two years.

Why would it take so long to discover such a fraud?

E5-7 Internal controls

Timeless Sound Co. discovered a fraud wherein one of its front office administrative

employees used company funds to purchase goods, such as computers,

digital cameras, DVD players, and other electronic items, for her own use. The

fraud was discovered when employees noticed an increase in delivery frequency

from vendors and the use of unusual vendors. After some investigation, it was

discovered that the employee would alter the description or change the quantity

on an invoice in order to explain the cost on the bill.

What general internal control weaknesses contributed to this fraud?

E5-8 Financial statement fraud

A former chairman, CFO, and controller of Donnkenny, Inc., an apparel company

that makes sportswear for Pierre Cardin and Victoria Jones, pleaded guilty to

financial statement fraud. These managers used false journal entries to record

fictitious sales, hid inventory in public warehouses so that it could be recorded

as “sold,” and required sales orders to be backdated so that the sale could be

moved back to an earlier period. The combined effect of these actions caused

$25 million out of $40 million in quarterly sales to be phony.

  1. Why might control procedures listed in this chapter be insufficient in stopping

this type of fraud?

  1. How could this type of fraud be stopped?

E5-9 Internal control of cash receipts

The procedures used for over-the-counter receipts are as follows. At the close

of each day’s business, the sales clerks count the cash in their respective cash

drawers, after which they determine the amount recorded by the cash register

and prepare the memo cash form, noting any discrepancies. An employee from

the cashier’s office counts the cash, compares the total with the memo, and takes

the cash to the cashier’s office.

  1. Indicate the weak link in internal control.
  2. How can the weakness be corrected?

E5-10 Internal control of cash receipts

Kevin Clavin works at the drive-through window of Big Bad Burgers. Occasionally,

when a drive-through customer orders, Kevin fills the order and pockets the

customer’s money. He does not ring up the order on the cash register.

Identify the internal control weaknesses that exist at Big Bad Burgers, and

discuss what can be done to prevent this theft.

E5-11 Internal control of cash receipts

The mailroom employees send all remittances and remittance advices to the

cashier. The cashier deposits the cash in the bank and forwards the remittance

advices and duplicate deposit slips to the Accounting Department.

  1. Indicate the weak link in internal control in the handling of cash receipts.
  2. How can the weakness be corrected?

E5-12 Entry for cash sales; cash short

The actual cash received from cash sales was $27,199, and the amount indicated

by the cash register total was $27,228.

  1. What is the amount deposited in the bank for the day’s sales?
  2. What is the amount recorded for the day’s sales?
  3. How should the difference be recorded?
  4. If a cashier is consistently over or short, what action should be taken?

E5-13 Recording cash sales; cash over

The actual cash received from cash sales was $14,356, and the amount indicated

by the cash register total was $14,290.

  1. What is the amount deposited in the bank for the day’s sales?
  2. What is amount recorded for the day’s sales?
  3. How should the difference be recorded?
  4. If a cashier is consistently over or short, what action should be taken?

E5-14 Internal control of cash payments

Greenleaf Co. is a small merchandising company with a manual accounting

system. An investigation revealed that in spite of a sufficient bank balance, a

significant amount of available cash discounts had been lost because of failure

to make timely payments. In addition, it was discovered that the invoices for

several purchases had been paid twice.

Outline procedures for the payment of vendors’ invoices, so that the possibilities

of losing available cash discounts and of paying an invoice a second

time will be minimized.

E5-15 Internal control of cash payments

Torpedo Digital Company, a communications equipment manufacturer, recently fell

victim to a fraud scheme developed by one of its employees. To understand the

scheme, it is necessary to review Torpedo’s procedures for the purchase of services.

The purchasing agent is responsible for ordering services (such as repairs

to a photocopy machine or office cleaning) after receiving a service requisition

from an authorized manager. However, since no tangible goods are delivered,

a receiving report is not prepared. When the Accounting Department receives

an invoice billing Torpedo for a service call, the accounts payable clerk calls

the manager who requested the service in order to verify that it was performed.

The fraud scheme involves Ross Dunbar, the manager of plant and facilities.

Ross arranged for his uncle’s company, Capo Industrial Supplies and Service, to

be placed on Torpedo’s approved vendor list. Ross did not disclose the family

relationship.

On several occasions, Ross would submit a requisition for services to be provided

by Capo Industrial Supplies and Service. However, the service requested was

really not needed, and it was never performed. Capo Industrial Supplies and Service

would bill Torpedo for the service and then split the cash payment with Ross.

Explain what changes should be made to Torpedo’s procedures for ordering

and paying for services in order to prevent such occurrences in the future.

E5-16 Bank reconciliation

Identify each of the following reconciling items as: (a) an addition to the cash

balance according to the bank statement, (b) a deduction from the cash balance

according to the bank statement, (c) an addition to the cash balance according

to the company’s records, or (d) a deduction from the cash balance according

to the company’s records. (None of the transactions reported by bank debit and

credit memos have been recorded by the company.)

  1. Bank service charges, $40.
  2. Check drawn by company for $480 but incorrectly recorded by company as

$840.

  1. Check for $100 incorrectly charged by bank as $1,000.
  2. Check of a customer returned by bank to company because of insufficient

funds, $975.

  1. Deposit in transit, $18,800.
  2. Outstanding checks, $12,200.
  3. Note collected by bank, $20,500.

E5-17 Entries based on bank reconciliation

Which of the reconciling items listed in Exercise 5-16 are required to be recorded

in the company’s accounts?

E5-18 Bank reconcilliation

The following data were accumulated for use in reconciling the bank account of

Camela Co. for July:

Obj 2, 3

Obj 5

Obj 5

Adjusted

balance: $24,500

  1. Cash balance according to the company’s records at July 31, $24,010.
  2. Cash balance according to the bank statement at July 31, $22,750.
  3. Checks outstanding, $7,350.
  4. Deposit in transit, not recorded by bank, $9,100.
  5. A check for $170 in payment of an account was erroneously recorded in the

check register as $710.

  1. Bank debit memo for service charges, $50.

Prepare a bank reconciliation, using the format shown in Exhibit 6.

E5-19 Entries for bank reconciliation

Using the data presented in Exercise 5-18, record the effects on the accounts and

financial statements of the company based upon the bank reconciliation.

E5-20 Entries for note collected by bank

Accompanying a bank statement for Nite Lighting Company is a credit memo

for $26,500, representing the principal ($25,000) and interest ($1,500) on a

note that had been collected by the bank. The company had been notified

by the bank at the time of the collection, but had made no recording. Record

the adjustment that should be made by the company to bring the accounting

records up to date.

E5-21 Bank reconciliation

An accounting clerk for Westwind Co. prepared the following bank reconciliation:

WESTWIND CO.

Bank Reconciliation

January 31, 2012

Cash balance according to company’s records $ 6,800

Add: Outstanding checks $4,190

Error by Westwind Co. in recording Check

No. 01-115 as $830 instead of $380 450

Note for $7,500 collected by bank, including interest 8,100 12,740

Deduct: Deposit in transit on January 31 $2,175 $19,540

Bank service charges 40 2,215

Cash balance according to bank statement $17,325

  1. From the bank reconciliation data, prepare a new bank reconciliation for

Westwind Co., using the format shown in the illustrative problem.

  1. If a balance sheet were prepared for Westwind Co. on January 31, 2012, what

amount should be reported for cash?

E5-22 Bank reconciliation

Identify the errors in the following bank reconciliation:

DAKOTA CO.

Bank Reconciliation

For the Month Ended September 30, 2012

Cash balance according to bank statement $22,900

Add outstanding checks:

No. 7715 $1,450

7760 915

7764 1,850

7765 775 4,990

$27,890

Deduct deposit of September 30, not recorded by bank 6,200

Adjusted balance $21,690

Cash balance according to company’s records $15,625

Add: Proceeds of note collected by bank:

Principal $6,000

Interest 360 $6,360

Service charges 30 6,390

$22,015

Deduct: Check returned because of insufficient funds $ 545

Error in recording September 20 deposit of $5,200 as $2,500 2,700 3,245

Adjusted balance $18,770

E5-23 U sing bank reconciliation to determine cash receipts stolen

Pala Co. records all cash receipts on the basis of its cash register tapes. Pala Co.

discovered during April 2012 that one of its sales clerks had stolen an undetermined

amount of cash receipts when she took the daily deposits to the bank.

The following data have been gathered for April:

Cash in bank according to the company records $19,565

Cash according to the April 30, 2012, bank statement 28,175

Outstanding checks as of April 30, 2012 12,100

Bank service charges for April 75

Note receivable, including interest collected by bank in April 3,710

No deposits were in transit on April 30.

  1. Determine the amount of cash receipts stolen by the sales clerk.
  2. What accounting controls would have prevented or detected this theft?

E5-24 Recording petty cash fund transactions

Illustrate the effect on the accounts and financial statements of the following

transactions:

  1. Established a petty cash fund of $750.
  2. The amount of cash in the petty cash fund is now $140. Replenished the fund,

based on the following summary of petty cash receipts: office supplies, $325;

miscellaneous selling expense, $200; miscellaneous administrative expense, $85.

E5-25 Recording petty cash fund transactions

Illustrate the effect on the accounts and financial statements of the following

transactions:

  1. Established a petty cash fund of $500.
  2. The amount of cash in the petty cash fund is now $45. Replenished the fund,

based on the following summary of petty cash receipts: office supplies, $175;

miscellaneous selling expense, $190; miscellaneous administrative expense, $90.

E5-26 Variation in cash flows

Mattel, Inc., designs, manufactures, and markets toy products worldwide. Mattel’s

toys include Barbie™ fashion dolls and accessories, Hot Wheels™, and Fisher-

Price brands. For a recent year, Mattel reported the following net cash flows from

operating activities (in thousands):

First quarter ending March 31 $ (41,844)

Second quarter ending June 30 (184,934)

Third quarter ending September 30 (55,548)

Fourth quarter December 31 955,600

Explain why Mattel reports negative net cash flows from operating activities during

the first three quarters, yet reports positive cash flows for the fourth quarter

and net positive cash flows for the year.

 

Problems

P5-1 Evaluate internal control of cash

The following procedures were recently installed by The Ironworks Shop:

  1. All sales are rung up on the cash register, and a receipt is given to the customer.

All sales are recorded on a record locked inside the cash register.

  1. Each cashier is assigned a separate cash register drawer to which no other

cashier has access.

  1. At the end of a shift, each cashier counts the cash in his or her cash register,

unlocks the cash register record, and compares the amount of cash with the

amount on the record to determine cash shortages and overages.

  1. Vouchers and all supporting documents are perforated with a PAID designation

after being paid by the treasurer.

  1. Disbursements are made from the petty cash fund only after a petty cash

receipt has been completed and signed by the payee.

  1. Checks received through the mail are given daily to the accounts receivable

clerk for recording collections on account and for depositing in the bank.

  1. The bank reconciliation is prepared by the accountant.

Instructions

Indicate whether each of the procedures of internal control over cash represents

(1) a strength or (2) a weakness. For each weakness, indicate why it exists.

P5-2 Bank reconciliation and entries

The cash account for Leisure Systems at February 29, 2012, indicated a balance

of $4,720. The bank statement indicated a balance of $18,650 on February 29,

  1. Comparing the bank statement and the accompanying canceled checks and

memos with the records reveals the following reconciling items:

  1. Checks outstanding totaled $13,960.
  2. A deposit of $9,350, representing receipts of February 29, had been made too

late to appear on the bank statement.

  1. The bank had collected $8,560 on a note left for collection. The face of the

note was $8,000.

  1. A check for $360 returned with the statement had been incorrectly recorded

by Leisure Systems as $630. The check was for the payment of an obligation

to Warwick Co. for the purchase of office supplies on account.

  1. A check drawn for $930 had been incorrectly charged by the bank as $390.
  2. Bank service charges for February amounted to $50.

Instructions

  1. Prepare a bank reconciliation.
  2. Illustrate the effects on the accounts and financial statements of the bank

reconciliation.

P5-3 Bank reconciliation and entries

The cash account for All American Sports Co. on April 1, 2012, indicated a balance

of $23,600. During April, the total cash deposited was $80,150, and checks written

totaled $72,800. The bank statement indicated a balance of $40,360 on April 30,

  1. Comparing the bank statement, the canceled checks, and the accompanying

memos with the records revealed the following reconciling items:

  1. Checks outstanding totaled $14,300.
  2. A deposit of $9,275, representing receipts of April 30, had been made too late

to appear on the bank statement.

  1. A check for $720 had been incorrectly charged by the bank as $270.
  2. A check for $110 returned with the statement had been recorded by All American

Sports Co. as $1,100. The check was for the payment of an obligation to

Garber Co. on account.

  1. The bank had collected for All American Sports Co. $4,320 on a note left for

collection. The face of the note was $4,000.

  1. Bank service charges for April amounted to $75.
  2. A check for $1,300 from Bishop Co. was returned by the bank because of

insufficient funds.

Instructions

  1. Prepare a bank reconciliation as of April 30.
  2. Illustrate the effects on the accounts and financial statements of the bank

reconciliation.

P5-4 Bank reconciliation and entries

Aztec Interiors deposits all cash receipts each Wednesday and Friday in a night

depository, after banking hours. The data required to reconcile the bank statement

as of May 31 have been taken from various documents and records and

are reproduced as follows. The sources of the data are printed in capital letters.

All checks were written for payments on account.

CASH ACCOUNT:

Balance as of May 1 $9,578.00

CASH RECEIPTS FOR MONTH OF May $5,948.81

DUPLICATE DEPOSIT TICKETS:

Date and amount of each deposit in May:

Date Amount Date Amount Date Amount

May 2 $569.50 May 12 $580.70 May 23 $ 331.45

5 701.80 16 600.10 26 601.50

9 819.24 19 701.26 31 1,043.26

CHECKS WRITTEN:

Number and amount of each check issued in May:

Check No. Amount Check No. Amount Check No. Amount

614 $243.50 621 $309.50 628 $ 837.70

615 350.10 622 Void 629 329.90

616 279.90 623 Void 630 882.80

617 395.50 624 707.01 631 1,081.56

618 435.40 625 158.63 632 62.40

619 320.10 626 550.03 633 310.08

620 328.87 627 318.73 634 503.30

Total amount of checks issued in May $8,405.01

BANK RECONCILIATION FOR PRECEDING MONTH (DATED APRIL 30):

Cash balance according to bank statement $ 9,422.80

Add deposit of April 30, not recorded by bank 780.80

$10,203.60

Deduct outstanding checks:

No. 580 $310.10

No. 602 85.50

No. 612 92.50

No. 613 137.50 625.60

Adjusted balance $ 9,578.00

Cash balance according to company’s records $ 9,605.70

Deduct service charges 27.70

Adjusted balance $ 9,578.00

Instructions

  1. Prepare a bank reconciliation as of May 31. If errors in recording deposits or

checks are discovered, assume that the errors were made by the company.

Assume that all deposits are from cash sales except for the note receivable

of $4,000 and interest of $160 collected on May 14. All checks are written to

satisfy accounts payable.

  1. Illustrate the effects on the accounts and financial statements of the bank

reconciliation.

  1. What is the amount of Cash that should appear on the balance sheet as of

May 31?

  1. Assume that a canceled check for $180 has been incorrectly recorded by the

bank as $1,800. Briefly explain how the error would be included in a bank

reconciliation and how it should be corrected.

 

Activities

A5-1 Ethics and professional conduct in business

During the preparation of the bank reconciliation for Apache Grading Co., Sarah

Ferrari, the assistant controller, discovered that Rocky Spring Bank incorrectly

recorded a $610 check written by Apache Grading Co. as $160. Sarah has decided

not to notify the bank but wait for the bank to detect the error. Sarah plans to

record the $450 error as Other Income if the bank fails to detect the error within

the next three months.

Discuss whether Sarah is behaving in a professional manner.

A5-2 Internal controls

The following is an excerpt from a conversation between two sales clerks, Tracy

Rawlin and Jeff Weimer. Both Tracy and Jeff are employed by Magnum Electronics,

a locally owned and operated electronics retail store.

Tracy: Did you hear the news?

Jeff: What news?

Tracy: Bridget and Ken were both arrested this morning.

Jeff: What? Arrested? You’re putting me on!

Tracy: No, really! The police arrested them first thing this morning. Put them in

handcuffs, read them their rights—the whole works. It was unreal!

Jeff: What did they do?

Tracy: Well, apparently they were filling out merchandise refund forms for fictitious

customers and then taking the cash.

Jeff: I guess I never thought of that. How did they catch them?

Tracy: The store manager noticed that returns were twice that of last year and

seemed to be increasing. When he confronted Bridget, she became flustered and

admitted to taking the cash, apparently over $15,000 in just three months. They’re

going over the last six months’ transactions to try to determine how much Ken

stole. He apparently started stealing first.

Suggest appropriate control procedures that would have prevented or detected

the theft of cash.

A5-3 Internal controls

The following is an excerpt from a conversation between the store manager

of La Food Grocery Stores, Amy Locke, and Steve Meyer, president of La Food

Grocery Stores.

Steve: Amy, I’m concerned about this new scanning system.

Amy: What’s the problem?

Steve: Well, how do we know the clerks are ringing up all the merchandise?

Amy: That’s one of the strong points about the system. The scanner automatically

rings up each item, based on its bar code. We update the prices daily, so we’re

sure that the sale is rung up for the right price.

Steve: That’s not my concern. What keeps a clerk from pretending to scan items

and then simply not charging his friends? If his friends were buying 10–15 items,

it would be easy for the clerk to pass through several items with his finger over

the bar code or just pass the merchandise through the scanner with the wrong

side showing. It would look normal for anyone observing. In the old days, we

at least could hear the cash register ringing up each sale.

Amy: I see your point.

Suggest ways that La Food Grocery Stores could prevent or detect the theft of

merchandise as described.

A5-4 Ethics and professional conduct in business

Javier Meza and Sue Quan are both cash register clerks for Healthy Markets. Ingrid

Perez is the store manager for Healthy Markets. The following is an excerpt of

a conversation between Javier and Sue:

Javier: Sue, how long have you been working for Healthy Markets?

Sue: Almost five years this June. You just started two weeks ago, right?

Javier: Yes. Do you mind if I ask you a question?

Sue: No, go ahead.

Javier: What I want to know is, have they always had this rule that if your cash

register is short at the end of the day, you have to make up the shortage out of

your own pocket?

Sue: Yes, as long as I’ve been working here.

Javier: Well, it’s the pits. Last week I had to pay in almost $30.

Sue: It’s not that big a deal. I just make sure that I’m not short at the end of

the day.

Javier: How do you do that?

Sue: I just shortchange a few customers early in the day. There are a few jerks

that deserve it anyway. Most of the time, their attention is elsewhere and they

don’t think to check their change.

Javier: What happens if you’re over at the end of the day?

Sue: Ingrid lets me keep it as long as it doesn’t get to be too large. I’ve not been

short in over a year. I usually clear about $10 to $40 extra per day.

Discuss this case from the viewpoint of proper controls and professional behavior.

A5-5 Bank reconciliation and internal control

The records of Clairemont Company indicate an August 31, 2013, cash balance

of $6,675, which includes undeposited receipts for August 30 and 31. The cash

balance on the bank statement as of August 31 is $5,350. This balance includes

a note of $3,000 plus $210 interest collected by the bank but not recorded in the

journal. Checks outstanding on August 31 were as follows: No. 370, $580; No.

379, $615; No. 390, $900; No. 1148, $225; No. 1149, $300; and No. 1151, $750.

On August 9, the cashier resigned, effective at the end of the month. Before

leaving on August 31, the cashier prepared the following bank reconciliation:

Cash balance per books, August 31, 2013 $6,675

Add outstanding checks:

No. 1148 $225

1149 300

1151 750 1,175

$7,850

Less undeposited receipts 2,500

Cash balance per bank, August 31, 2013 $5,350

Deduct unrecorded note with interest 3,210

True cash, August 31, 2013 $2,140

Calculator Tape of Outstanding Checks:

0*

225

300

750

1,175 *

Subsequently, the owner of Clairemont Company discovered that the cashier had

stolen an unknown amount of undeposited receipts, leaving only $2,500 to be

deposited on August 31. The owner, a close family friend, has asked your help

in determining the amount that the former cashier has stolen.

  1. Determine the amount the cashier stole from Clairemont Company. Show your

computations in good form.

  1. How did the cashier attempt to conceal the theft?
  2. a. Identify two major weaknesses in internal controls that allowed the cashier

to steal the undeposited cash receipts.

  1. Recommend improvements in internal controls, so that similar types of

thefts of undeposited cash receipts can be prevented.

A5-6 Observe internal controls over cash

Select a business in your community and observe its internal controls over cash

receipts and cash payments. The business could be a bank or a bookstore, restaurant,

department store, or other retailer. In groups of three or four, identify and

discuss the similarities and differences in each business’s cash internal controls

 

Answers to Self-Examination Questions

  1. C Compliance with laws and regulations

(answer C) is an objective, not an element,

of internal control. The control environment

(answer A), monitoring (answer B), control

procedures (answer D), risk assessment, and

information and communication are the five

elements of internal control.

  1. C The error was made by the bank, so the

cash balance according to the bank statement

needs to be adjusted. Since the bank deducted

$90 ($540.50 2 $450.50) too little, the error of

$90 should be deducted from the cash balance

according to the bank statement (answer C).

  1. B On any specific date, the cash account in

a company’s records may not agree with the

account in the bank’s records because of delays

and/or errors by either party in recording

transactions. The purpose of a bank reconciliation,

therefore, is to determine the reasons

for any differences between the two account

balances. All errors should then be corrected

by the company or the bank, as appropriate.

In arriving at the adjusted cash balance

according

to the bank statement, outstanding

checks must be deducted (answer B) to adjust

for checks that have been written by the company

but that have not yet been presented to

the bank for payment.

  1. C All reconciling items that are added to and

deducted from the cash balance according to

the company’s records on the bank reconciliation

(answer C) require that adjustments be

recorded by the company to correct errors

made in recording transactions or to bring

the cash account up to date for delays in

recording transactions.

  1. D To avoid the delay, annoyance, and expense

that is associated with paying all obligations

by check, relatively small amounts (answer A)

are paid from a petty cash fund. The fund is

established by estimating the amount of cash

needed to pay these small amounts during a

specified period (answer B), and it is then

reimbursed when the amount of money in the

fund is reduced to a predetermined minimum

amount (answer C).

 

 

Chapter 6 receivables and Inventories

 

Class Discussion Questions

  1. What are the three classifications of receivables?
  2. What types of transactions give rise to accounts

receivable?

  1. In what section of the balance sheet should

a note receivable be listed if its term is (a)

90 days, (b) 12 years?

  1. Give two examples of other receivables.
  2. Carter’s Hardware is a small hardware store in

the rural township of Oglethorpe that rarely

extends credit to its customers in the form of

an account receivable. The few customers that

are allowed to carry accounts receivable are

long-time residents of Oglethorpe and have

a history of doing business at Carter’s. What

method of accounting for uncollectible receivables

should Carter’s Hardware use? Why?

  1. Which of the two methods of accounting for

uncollectible accounts provides for the recognition

of the expense at the earlier date?

  1. What kind of an account (asset, liability, etc.)

is Allowance for Doubtful Accounts?

  1. After the accounts are adjusted at the end of

the fiscal year, Accounts Receivable has a balance

of $475,000 and Allowance for Doubtful

Accounts has a negative balance of $46,800.

Describe how the Accounts Receivable and

the Allowance for Doubtful Accounts are reported

on the balance sheet.

  1. A firm has consistently adjusted its allowance

account at the end of the fiscal year by adding

a fixed percent of the period’s net sales on

account. After 10 years, the balance in Allowance

for Doubtful Accounts has become very

large in relationship to the balance in Accounts

Receivable. Give two possible explanations.

  1. How are manufacturing inventories different

from those of a merchandiser?

  1. Do the terms FIFO and LIFO refer to techniques

used in determining quantities of the

various classes of merchandise on hand?

Explain.

  1. Does the term last-in in the LIFO method

mean that the items in the inventory are assumed

to be the most recent (last) acquisitions?

Explain.

  1. If merchandise inventory is being valued at

cost and the price level is steadily rising,

which of the three methods of costing—

FIFO, LIFO, or average cost—will yield (a)

the highest inventory cost, (b) the lowest

inventory cost, (c) the highest gross profit,

(d) the lowest gross profit?

  1. Which of the three methods of inventory

costing—FIFO, LIFO, or average cost—will

in general yield an inventory cost most nearly

approximating current replacement cost?

  1. If inventory is being valued at cost and the

price level is steadily rising, which of the

three methods of costing—FIFO, LIFO, or

average cost—will yield the lowest annual

income tax expense? Explain.

  1. What is the LIFO reserve, and why would an

analyst be careful in interpreting the earnings

of a company that has liquidated some of its

LIFO reserve?

  1. Under what section should accounts receivable

be reported on the balance sheet?

  1. Because of imperfections, an item of merchandise

cannot be sold at its normal selling

price. How should this item be valued for

financial statement purposes?

  1. How is the method of determining the cost

of inventory and the method of valuing it

disclosed in the financial statements?

 

Exercises

E6-1 Classifications of receivables

Boeing is one of the world’s major aerospace firms, with operations involving

commercial aircraft, military aircraft, missiles, satellite systems, and information

and battle management systems. As of December 31, 2010, Boeing had $2,969

million of receivables involving U.S. government contracts and $1,241 million

of receivables involving commercial aircraft customers, such as Delta Air Lines and

United Airlines.

Should Boeing report these receivables separately in the financial statements,

or combine them into one overall accounts receivable amount? Explain.

E6-2 D etermine due date and interest on notes

Determine the due date and the amount of interest due at maturity on the following

notes:

Date of Note Face Amount Interest Rate Term of Note

  1. January 6 $40,000 9% 45 days
  2. March 23 9,000 10 60 days
  3. May 30 12,000 12 90 days
  4. August 30 18,000 10 120 days
  5. October 1 10,500 8 60 days

E6-3 Nature of uncollectible accounts

MGM Resorts International owns and operates casinos including the MGM Grand and

the Bellagio in Las Vegas, Nevada. For a recent year, the MGM Resorts International

reported accounts and notes receivable of $415,654,000 and allowance for

doubtful accounts of $93,760,000.

International Business Machines (IBM) provides information technology services, including

software, worldwide. For a recent year, IBM reported accounts receivable

of $10,834,000,000 and allowance for doubtful accounts of $324,000,000.

  1. Compute the percentage of the allowance for doubtful accounts to the accounts

and notes receivable for the MGM Mirage.

  1. Compute the percentage of the allowance for doubtful accounts to the accounts

receivable for IBM.

  1. Discuss possible reasons for the difference in the two ratios computed in (a)

and (b).

E6-4 U ncollectible accounts, using direct write-off method

Illustrate the effects on the accounts and financial statements of the

following transactions in the accounts of MedTech Co., a local hospital supply

company that uses the direct write-off method of accounting for uncollectible

receivables:

Feb. 14. Received $9,000 on an account and wrote off the remainder owed of

$45,000 as uncollectible.

Dec. 23. Reinstated the account that had been written off on February 14 and

received $45,000 cash in full payment.

E6-5 U ncollectible receivables, using allowance method

Illustrate the effects on the accounts and financial statements of the following

transactions in the accounts of A1 Kitchen Company, a restaurant supply company

that uses the allowance method of accounting for uncollectible receivables:

Jan. 31. Received $8,000 on an account and wrote off the remainder owed of

$32,000 as uncollectible.

Nov. 2. Reinstated the account that had been written off on January 31 and

received $32,000 cash in full payment.

E6-6 W riting off accounts receivable

Intermountain Technologies, a computer consulting firm, has decided to write

off the $11,575 balance of an account owed by a customer. Illustrate the effects

on the accounts and financial statements to record the write-off (a) assuming

that the direct write-off method is used, and (b) assuming that the allowance

method is used.

E6-7 E stimating doubtful accounts

Newbury Bikes Co. is a wholesaler of motorcycle supplies. An aging of the

company’s accounts receivable on December 31, 2012, and a historical analysis

of the percentage of uncollectible accounts in each age category are as follows:

Age Interval Balance Percent Uncollectible

Not past due $667,000 ½%

1–30 days past due 158,000 2

31–60 days past due 54,000 5

61–90 days past due 20,500 15

91–180 days past due 15,000 40

Over 180 days past due 10,500 75

$925,000

Estimate what the balance of the allowance for doubtful accounts should be

as of December 31, 2012.

E6-8 E ntry for uncollectible accounts

Using the data in Exercise 6-7, assume that the allowance for doubtful accounts for

Newbury Bikes Co. had a negative balance of 2$3,800 as of December 31, 2012.

Illustrate the effects of the adjustment for uncollectible accounts as of

December

31, 2012, on the accounts and financial statements.

E6-9 Providing for doubtful accounts

At the end of the current year, the accounts receivable account has a balance of

$625,000 and net sales for the year total $5,200,000. Determine the amount of

the adjusting entry to provide for doubtful accounts under each of the following

assumptions:

  1. The allowance account before adjustment has a negative balance of 2$1,950.

Bad debt expense is estimated at ¼ of 1% of net sales.

  1. The allowance account before adjustment has a negative balance of 2$1,950.

An aging of the accounts in the customer ledger indicates estimated doubtful

accounts of $17,500.

  1. The allowance account before adjustment has a positive balance of $2,200.

Bad debt expense is estimated at ½ of 1% of net sales.

  1. The allowance account before adjustment has a positive balance of $2,200.

An aging of the accounts in the customer ledger indicates estimated doubtful

accounts of $21,900.

E6-10 E ffect of doubtful accounts on net income

During its first year of operations, Williams Plumbing Supply Co. had net sales

of $6,500,000, wrote off $40,000 of accounts as uncollectible using the direct

write-off method, and reported net income of $590,000. Determine what the

net income would have been if the allowance method had been used, and the

company estimated that 1¾% of net sales would be uncollectible.

E6-11 E ffect of doubtful accounts on net income

Using the data in Exercise 6-10, assume that during the second year of operations

Williams Plumbing Supply Co. had net sales of $7,200,000, wrote off $80,000

of accounts as uncollectible using the direct write-off method, and reported net

income of $625,000.

  1. Determine what net income would have been in the second year if the allowance

method (using 1¾% of net sales) had been used in both the first and

second years.

  1. Determine what the balance of Allowance for Doubtful Accounts would have

been at the end of the second year if the allowance method had been used

in both the first and second years.

E6-12 Manufacturing inventories

Qualcomm Incorporated is a leading developer and manufacturer of digital wireless

telecommunications products and services. Qualcomm reported the following

inventories on September 26, 2010, in the notes to its financial statements:

(In millions)

S eptember 26, 2010

Raw materials $ 15

Work in process 284

Finished goods 229

$528

  1. Why does Qualcomm report three different inventories?
  2. What costs are included in each of the three classes of inventory?

E6-13 Film costs of Dreamworks

Dreamworks Animation SKG Inc. shows “film costs” as an asset on its balance sheet. In

the notes to its financial statements, the following disclosure was made:

December 31,

Film Costs (in thousands) 2010 2009

In release:

Animated feature film $328,174 $204,598

Television specials 56,689 28,511

In production:

Animated feature film 341,319 428,344

Television specials 14,359 13,145

In development 32,127 21,365

Total film osts $772,668 $695,963

  1. Interpret the film cost asset categories.
  2. How are these classifications similar or dissimilar to the inventory classifications

used in a manufacturing firm?

E6-14 I nventory by three methods

The units of an item available for sale during the year were as follows:

Jan. 1 Inventory 27 units at $600

Feb. 4 Purchase 54 units at $690

Aug. 21 Purchase 63 units at $780

Oct. 23 Purchase 56 units at $825

There are 48 units of the item in the physical inventory at December 31. The

periodic inventory system is used. Determine the inventory cost by (a) the first-in,

first-out method, (b) the last-in, first-out method, and (c) the average cost method.

E6-15 I nventory by three methods; cost of merchandise sold

The units of an item available for sale during the year were as follows:

Jan. 1 Inventory 42 units at $180

April 10 Purchase 58 units at $195

Sept. 30 Purchase 20 units at $204

Dec. 12 Purchase 30 units at $210

There are 37 units of the item in the physical inventory at December 31. The

periodic inventory system is used. Determine the inventory cost and the cost of

merchandise sold by three methods, presenting your answers in the following form:

Cost

Inventory Method

Merchandise

Inventory

Merchandise

S old

  1. First-in, firs -out $ $
  2. Last-in, firs -out
  3. Average cost

E6-16 Comparing inventory methods

Assume that a firm separately determined inventory under FIFO and LIFO and

then compared the results.

  1. In each space below, place the correct sign [less than (), greater than (),

or equal (5)] for each comparison, assuming periods of rising prices.

  1. FIFO inventory LIFO inventory
  2. FIFO cost of goods sold LIFO cost of goods sold
  3. FIFO net income LIFO net income
  4. FIFO income tax LIFO income tax
  5. Why would management prefer to use LIFO over FIFO in periods of rising

prices?

E6-17 Receivables in the balance sheet

List any errors you can find in the following partial balance sheet:

ZABEL CO MPA NY

Balance Sheet

December 31, 2012

Assets

Current assets:

Cash $ 75,000

Notes receivable $115,000

Less interest receivable 9,000 106,000

Account receivable $475,000

Plus allowance for doubtful accounts 11,150 486,150

E6-18 L ower-of-cost-or-market inventory

On the basis of the following data, determine the value of the inventory at the

lower of cost or market. Assemble the data in the form illustrated in Exhibit 9.

Commodity

Inventory

Quantity

Unit Cost

Price

Unit Market

Price

Buffal 35 $115 $120

Dakota 67 90 75

Frontier 8 300 280

Midwest 83 40 30

Rainbow 100 90 94

E6-19 Merchandise inventory on the balance sheet

Based on the data in Exercise 6-18 and assuming that cost was determined by

the FIFO method, show how the merchandise inventory would appear on the

balance sheet.

 

Problems

P6-1 A llowance method for doubtful accounts

Natural Hair Company supplies wigs and hair care products to beauty salons

throughout Texas and the Southwest. The accounts receivable clerk for Natural

Hair prepared the following aging-of-receivables schedule as of the end of business

on December 31, 2012:

1

2

3

4

5

30

31

AAA Beauty

Amelia’s Wigs

Zim’s Beauty

Totals

19,500

8,000

6,100

880,000 25,000

8,000

82,700

19,500

575,000

6,100

140,500 36,000

1–30 31–60 61–90

Not

Due

Past

Customer Balance 91–120

Days Past Due

A B C D E F G H

20,800

Over 120

Natural Hair Company has a past history of uncollectible accounts by age

category, as follows:

A ge Class

Percent

Uncollectible

Not past due 1%

1–30 days past due 2

31–60 days past due 8

61–90 days past due 15

91–120 days past due 35

Over 120 days past due 80

Instructions

  1. Estimate the allowance for doubtful accounts, based on the aging-of-receivables

schedule.

  1. Assume that the allowance for doubtful accounts for Natural Hair Company

has a negative balance of 2$3,500 before adjustment on December 31, 2012.

Illustrate the effect on the accounts and financial statements of the adjustment

for uncollectible accounts.

  1. Natural Hair Company reported credit sales of $5,000,000 during 2012. Assume

that instead of using the analysis of receivables method of estimating uncollectible

accounts, Natural Hair Company uses the percent of sales method and

estimates that 1.25% of sales will be uncollectible. Illustrate the effect on the

accounts and financial statements of the adjustment for uncollectible accounts

using the percent of sales method.

  1. Assume that on March 4, 2013, Natural Hair wrote off the $4,350 account of

Top Dog Images as uncollectible. Illustrate the effect on the accounts and

financial statements of the write-off of the Top Dog Images account.

  1. Assume that on August 17, 2013, Top Dog Images paid $4,350 on its account.

Illustrate the effect on the accounts and financial statements of reinstating and

collecting the Top Dog Images account.

  1. Assume that instead of using the allowance method, Natural Hair uses the

direct write-off method. Illustrate the effect on the accounts and financial

statements of the following:

  1. The write-off of the Top Dog Images account on March 4, 2013.
  2. The reinstatement and collection of the Top Dog Images account on

August 17, 2013.

  1. Does Amazon.com use the direct write-off or allowance method of accounting

for uncollectible accounts receivable? Explain.

P6-2 E stimate uncollectible accounts

For several years, EquiPrime Co.’s sales have been on a “cash only” basis. On

January 1, 2009, however, EquiPrime Co. began offering credit on terms of

n/30. The amount of the adjusting entry to record the estimated uncollectible

receivables at the end of each year has been ¼ of 1% of credit sales, which is

the rate reported as the average for the industry. Credit sales and the year-end

credit balances in Allowance for Doubtful Accounts for the past four years are

as follows:

Year Credit S ales

A llowance for

Doubtful A ccounts

2009 $12,500,000 $12,800

2010 12,600,000 23,000

2011 12,800,000 34,000

2012 13,000,000 49,000

Mandy Pulaski, president of EquiPrime Co., is concerned that the method

used to account for and write off uncollectible receivables is unsatisfactory. She

has asked for your advice in the analysis of past operations in this area and for

recommendations for change.

  1. Determine the amount of (a) the addition to Allowance for Doubtful Accounts

and (b) the accounts written off for each of the four years.

  1. a. Advise Mandy Pulaski as to whether the estimate of ¼ of 1% of credit sales

appears reasonable.

  1. Assume that after discussing (a) with Mandy Pulaski, she asked you what

action

might be taken to determine what the balance of Allowance for

Doubtful Accounts should be at December 31, 2012, and what possible

changes, if any, you might recommend in accounting for uncollectible receivables.

How would you respond?

P6-3 Compare two methods of accounting for uncollectible receivables

Cyber Space Company, which operates a chain of 65 electronics supply stores,

has just completed its fourth year of operations. The direct write-off method of

recording bad debt expense has been used during the entire period. Because of

substantial increases in sales volume and the amount of uncollectible accounts, the

firm is considering changing to the allowance method. Information is requested

as to the effect that an annual provision of ½% of sales would have had on the

amount of bad debt expense reported for each of the past four years. It is also

considered desirable to know what the balance of Allowance for Doubtful Accounts

would have been at the end of each year. The following data have been

obtained from the accounts:

Uncollectible A ccounts

Written Off

Year of O rigin of

A ccounts Receivable Written

O ff as Uncollectible

Year S ales 1st 2nd 3rd 4th

1st $2,300,000 $ 5,000 $5,000

2nd 4,750,000 9,000 4,000 $ 5,000

3rd 9,000,000 23,000 2,000 12,000 $ 9,000

4th 9,600,000 37,500 5,500 14,500 $17,500

Instructions

  1. Assemble the desired data, using the following column headings:

Bad Debt Expense

Year

Expense

A ctually

Reported

Expense

Based on

Estimate

Increase (Decrease)

in A mount of

Expense

Balance of

A llowance A ccount,

End of Year

  1. Experience during the first four years of operations indicated that the receivables

were either collected within two years or had to be written off as uncollectible.

Does the estimate of ½% of sales appear to be reasonably close to

the actual experience with uncollectible accounts originating during the first

two years? Explain.

P6-4 I nventory by three cost flow methods

Details regarding the inventory of appliances at January 1, 2012, purchases invoices

during the year, and the inventory count at December 31, 2012, of Icelander

Appliances are summarized as follows:

Inventory, Purchases Invoices Inventory Count,

Model January 1 1st 2nd 3rd December 31

101Sx 9 at $213 7 at $215 6 at $222 6 at $225 9

256Br 20 at $120 12 at $130 4 at $130 4 at $140 8

378Wh 6 at $305 3 at $310 3 at $316 4 at $317 4

590Pm 2 at $520 2 at $527 2 at $530 2 at $535 4

661Qu 6 at $520 8 at $531 4 at $549 6 at $542 7

828Ts — 4 at $222 4 at $232 — 2

913Vn 8 at $35 12 at $36 16 at $37 14 at $39 12

Instructions

  1. Determine the cost of the inventory on December 31, 2012, by the first-in,

first-out method. Present data in columnar form, using the following headings:

Model Quantity Unit Cost Total Cost

If the inventory of a particular model comprises one entire purchase plus

a portion of another purchase acquired at a different unit cost, use a separate

line for each purchase.

  1. Determine the cost of the inventory on December 31, 2012, by the last-in,

first-out method, following the procedures indicated in (1).

  1. Determine the cost of the inventory on December 31, 2012, by the average

cost method, using the columnar headings indicated in (1).

  1. Discuss which method (FIFO or LIFO) would be preferred for income tax

purposes in periods of (a) rising prices and (b) declining prices.

P6-5 L ower-of-cost-or-market inventory

Data on the physical inventory of Moyer Company as of December 31, 2012, are

presented below.

Description

Inventory

Quantity

Unit Market

Price

112Aa 38 $ 83

B300t 33 115

C39f 41 64

Echo9 125 26

F900w 18 550

H687 60 15

J023 5 390

L33y 375 6

R66b 90 18

S77x 6 235

T882m 130 18

Z55p 12 746

Quantity and cost data from the last purchases invoice of the year and the

next-to-the-last purchases invoice are summarized as follows:

L ast Purchases

Invoice

Next-to-the-L ast

Purchases Invoice

Description

Quantity

Purchased Unit Cost

Quantity

Purchased Unit Cost

112Aa 25 $ 80 30 $ 78

B300t 35 118 20 117

C39f 20 66 25 70

Echo9 150 25 100 24

F900w 10 565 10 560

H687 100 15 100 14

J023 10 385 5 384

L33y 500 6 500 6

R66b 80 22 50 21

S77x 5 250 4 260

T882m 100 20 75 19

Z55p 9 750 9 749

Instructions

Determine the inventory at cost and also at the lower of cost or market, using

the first-in, first-out method. Record the appropriate unit costs on an inventory

sheet and complete the pricing of the inventory. When there are two different

unit costs applicable to an item, proceed as follows:

  1. Draw a line through the quantity, and insert the quantity and unit cost of the

last purchase.

  1. On the following line, insert the quantity and unit cost of the next-to-the-last

purchase.

  1. Total the cost and market columns and insert the lower of the two totals in

the LCM column. The first item on the inventory sheet has been completed

below as an example.

Inventory Sheet

December 31, 2012

Total

Description

Inventory

Quantity

Unit Cost

Price

Unit Market

Price Cost Market L CM

112Aa 38 25 $80 $83 $2,000 $2,075

13 78 1,014 1,079

$3,014 $3,154 $3,014

 

Activities

A6-1 E thics and professional conduct in business

Sybil Crumpton, vice president of operations for Bob Marshall Wilderness Bank,

has instructed the bank’s computer programmer to use a 365-day year to compute

interest on depository accounts (payables). Sybil also instructed the programmer

to use a 360-day year to compute interest on loans (receivables).

Discuss whether Sybil is behaving in a professional manner.

A 6-2 Collecting accounts receivable

The following is an excerpt from a conversation between the office manager,

Terry Holland, and the president of Northern Construction Supplies Co., Janet

Austel. Northern Construction Supplies sells building supplies to local contractors.

Terry: Janet, we’re going to have to do something about these overdue accounts

receivable. One-third of our accounts are over 60 days past due, and I’ve had

accounts that have stayed open for almost a year!

Janet: I didn’t realize it was that bad. Any ideas?

Terry: Well, we could stop giving credit. Make everyone pay with cash or a credit

card. We accept MasterCard and Visa already, but only the walk-in customers use

them. Almost all of the contractors put purchases on their bills.

Janet: Yes, but we’ve been allowing credit for years. As far as I know, all of

our competitors allow contractors credit. If we stopped giving credit, we’d lose

many of our contractors. They’d just go elsewhere. You know, some of these

guys run up bills as high as $50,000 or $75,000. There’s no way they could put

that kind of money on a credit card.

Terry: That’s a good point. But we’ve got to do something.

Janet: How many of the contractor accounts do you actually end up writing off

as uncollectible?

Terry: Not many. Almost all eventually pay. It’s just that they take so long!

Suggest one or more solutions to Northern Construction Supplies Co.’s problem

concerning the collection of accounts receivable.

A6-3 E thics and professional conduct in business

Mitchell Co. is experiencing a decrease in sales and operating income for the

fiscal year ending December 31, 2012. Gene Lumpkin, controller of Mitchell

Co., has suggested that all orders received before the end of the fiscal year be

shipped by midnight, December 31, 2012, even if the shipping department must

work overtime. Since Mitchell Co. ships all merchandise FOB shipping point, it

would record all such shipments as sales for the year ending December 31, 2012,

thereby offsetting some of the decreases in sales and operating income.

Discuss whether Gene Lumpkin is behaving in a professional manner.

A6-4 LI FO and inventory flow

The following is an excerpt from a conversation between Evan Eberhard, the

warehouse manager for Greenbriar Wholesale Co., and its accountant, Marty

Hayes. Greenbriar operates a large regional warehouse that supplies produce and

other grocery products to grocery stores in smaller communities.

Evan: Marty, can you explain what’s going on here with these monthly statements?

Marty: Sure, Evan. How can I help you?

Evan: I don’t understand this last-in, first-out inventory procedure. It just doesn’t

make sense.

Marty: Well, what it means is that we assume that the last goods we receive are

the first ones sold. So the inventory is made up of the items we purchased first.

Evan: Yes, but that’s my problem. It doesn’t work that way! We always distribute

the oldest produce first. Some of that produce is perishable! We can’t keep any

of it very long or it’ll spoil.

Marty: Evan, you don’t understand. We only assume that the products we distribute

are the last ones received. We don’t actually have to distribute the goods

in this way.

Evan: I always thought that accounting was supposed to show what really

happened. It all sounds like “make believe” to me! Why not report what really

happens?

Respond to Evan’s concerns.

 

Answers to Self-Examination Questions

  1. B The estimate of uncollectible accounts,

$8,500 (answer C), is the amount of the desired

balance of Allowance for Doubtful Accounts

after adjustment. The amount of the

current provision to be made for bad debt

expense is thus $6,000 (answer B), which is

the amount that must be added to the Allowance

for Doubtful Accounts negative balance

of $2,500 (answer A), so that the account will

have the desired balance of $8,500.

  1. B The amount expected to be realized from

accounts receivable is the balance of Accounts

Receivable, $100,000, less the balance of Allowance

for Doubtful Accounts, $7,000, or

$93,000 (answer B).

  1. D The direct labor costs are introduced into

production initially as work in process. Once

the units are completed, these costs are transferred

to finished goods inventory (answer C).

Materials inventory (answer A) includes only

material costs, not direct labor cost. Merchandise

inventory (answer B) is not used in a

manufacturing setting and thus does not include

direct labor cost.

  1. D The FIFO method of costing is based on

the assumption that costs should be charged

against revenue in the order in which they

were incurred (first-in, first-out). Thus, the

most recent costs are assigned to inventory.

The 35 units would be assigned a unit cost

of $23 (answer D).

  1. B When the price level is steadily rising, the

earlier unit costs are lower than recent unit

costs. Under the FIFO method (answer B),

these earlier costs are matched against revenue

to yield the highest possible net income.

The periodic inventory system (answer D) is

a system and not a method of costing.

 

 

Chapter 7 Fixed assets and Intangible

 

Class Discussion Questions

  1. Which of the following qualities are characteristic

of fixed assets? (a) tangible, (b) capable of

repeated use in the normal operations of the

business, (c) not held for sale in the normal

course of business, (d) not used in the operations

of the business, (e) useful life must be

greater than ten years.

  1. Enterprise Supplies Co. has a fleet of automobiles

and trucks for use by salespersons and

for delivery of office supplies and equipment.

Bizarro Auto Sales Co. has automobiles and

trucks for sale. Under what caption would

the automobiles and trucks be reported on

the balance sheet of (a) Enterprise Supplies

Co., (b) Bizarro Auto Sales Co.?

  1. The Stone Store Co. acquired an adjacent

vacant lot with the hope of selling it in the

future at a gain. The lot is not intended to

be used in The Stone Store’s business operations.

Where should such real estate be listed

in the balance sheet?

  1. Lanier Company solicited bids from several

contractors to construct an addition to its

office building. The lowest bid received

was for $600,000. Lanier Company decided

to construct the addition itself at a cost of

$475,000. What amount should be recorded

in the building account?

  1. Distinguish between the accounting for capital

expenditures and revenue expenditures.

  1. Immediately after a used truck is acquired,

a new motor is installed and the tires are

replaced at a total cost of $4,300. Is this a

capital expenditure or a revenue expenditure?

  1. Classify each of the following expenditures

as either a revenue or capital expenditure: (a)

installation of a video messaging system on

a semitrailer, (b) changing oil in a delivery

truck, (c) purchase of a color copier.

  1. Are the amounts at which fixed assets are

reported in the balance sheet their approximate

market values as of the balance sheet date?

Discuss.

  1. a. Does the recognition of depreciation in the

accounts provide a special cash fund for

the replacement of fixed assets? Explain.

  1. Describe the nature of depreciation as the

term is used in accounting.

  1. Backyard Company purchased a machine

that has a manufacturer’s suggested life of

30 years. The company plans to use the machine

on a special project that will last 18

years. At the completion of the project, the

machine will be sold. Over how many years

should the machine be depreciated?

  1. Is it necessary for a business to use the same

method of computing depreciation (a) for

all classes of its depreciable assets, (b) in

the financial statements and in determining

income taxes?

  1. a. Under what conditions is the use of an

accelerated depreciation method most

appropriate?

  1. Why is an accelerated depreciation method

often used for income tax purposes?

  1. What is the Modified Accelerated Cost

Recovery

System (MACRS), and under

what conditions is it used?

  1. For some of the fixed assets of a business,

the balance in Accumulated Depreciation is

exactly equal to the cost of the asset. (a) Is

it permissible to record additional depreciation

on the assets if they are still useful to

the company? Explain. (b) When should the

cost and the accumulated depreciation be

removed from the accounts?

  1. How is depletion determined?
  2. a. Over what period of time should the

cost of a patent acquired by purchase be

amortized?

  1. In general, what is the required accounting

treatment for research and development

costs?

  1. How should goodwill be amortized?

 

Exercises

E7-1 Costs of acquiring fixed assets

Tina Chester owns and operates Pinebush Print Co. During September, Pinebush

Print Co. incurred the following costs in acquiring two printing presses. One

printing press was new, and the other was used by a business that recently filed

for bankruptcy.

Costs related to new printing press:

  1. Fee paid to factory representative for installation
  2. Freight
  3. Insurance while in transit
  4. New parts to replace those damaged in unloading
  5. Sales tax on purchase price
  6. Special foundation

Costs related to used printing press:

  1. Amount paid to attorney to review purchase agreement
  2. Freight
  3. Installation
  4. Repair of vandalism during installation
  5. Replacement of worn-out parts
  6. Repair of damage incurred in reconditioning the press
  7. Indicate which costs incurred in acquiring the new printing press should

be recorded as an increase to the asset account.

  1. Indicate which costs incurred in acquiring the used printing press should

be recorded as an increase to the asset account.

E7-2 Determine cost of land

Madison Ski Co. has developed a tract of land into a ski resort. The company

has cut the trees, cleared and graded the land and hills, and constructed ski lifts.

(a) Should the tree cutting, land clearing, and grading costs of constructing the

ski slopes be recorded as an increase in the land account? (b) If such costs are

recorded as an increase in Land, should they be depreciated?

E7-3 Determine cost of land

Express Delivery Company acquired an adjacent lot to construct a new warehouse,

paying $80,000 and giving a short-term note for $620,000. Legal fees paid were

$1,900, delinquent taxes assumed were $9,000, and fees paid to remove an old

building from the land were $6,000. Materials salvaged from the demolition of the

building were sold for $1,175. A contractor was paid $800,000 to construct a new

warehouse. Determine the cost of the land to be reported on the balance sheet.

E7-4 Capital and revenue expenditures

Hometown Delivery Co. incurred the following costs related to trucks and vans

used in operating its delivery service:

  1. Changed the oil and greased the joints of all the trucks and vans.
  2. Changed the radiator fluid on a truck that had been in service for the past

four years.

  1. Installed a hydraulic lift to a van.
  2. Installed security systems on four of the newer trucks.
  3. Overhauled the engine on one of the trucks purchased three years ago.
  4. Rebuilt the transmission on one of the vans that had been driven 40,000

miles. The van was no longer under warranty.

  1. Removed a two-way radio from one of the trucks and installed a new radio

with a greater range of communication.

  1. Repaired a flat tire on one of the vans.
  2. Replaced a truck’s suspension system with a new suspension system that allows

for the delivery of heavier loads.

  1. Tinted the back and side windows of one of the vans to discourage theft of

contents.

Classify each of the costs as a capital expenditure or a revenue expenditure.

E7-5 Capital and revenue expenditures

Gwen Jones owns and operates GJ Transport Co. During the past year, Gwen

incurred the following costs related to an 18-wheel truck:

  1. Changed engine oil.
  2. Installed a television in the sleeping compartment of the truck.
  3. Installed a wind deflector on top of the cab to increase fuel mileage.
  4. Modified the factory-installed turbo charger with a special-order kit designed

to add 50 more horsepower to the engine performance.

  1. Removed the old GPS navigation system and replaced it with a newer

model.

  1. Replaced fog and cab light bulbs.
  2. Replaced a headlight that had burned out.
  3. Replaced a shock absorber that had worn out.
  4. Replaced the hydraulic brake system that had begun to fail during her

latest trip through the Rocky Mountains.

  1. Replaced the old radar detector with a newer model that detects additional

frequencies now used by many of the state patrol radar guns. The detector

is wired directly into the cab, so that it is partially hidden. In addition, Gwen

fastened the detector to the truck with a locking device that prevents its

removal.

Classify each of the costs as a capital expenditure or a revenue expenditure.

E7-6 N ature of depreciation

Berger Ironworks Co. reported $2,400,000 for equipment and $750,000 for accumulated

depreciation—equipment on its balance sheet.

Does this mean (a) that the replacement cost of the equipment is $2,400,000

and (b) that $750,000 is set aside in a special fund for the replacement of the

equipment? Explain.

E7-7 Straight-line depreciation rates

Convert each of the following estimates of useful life to a straight-line depreciation

rate, stated as a percentage, assuming that the residual value of the fixed

asset is to be ignored: (a) 2 years, (b) 4 years, (c) 10 years, (d) 20 years, (e) 25

years, (f) 40 years, (g) 50 years.

E7-8 Straight-line depreciation

A refrigerator used by a meat processor has a cost of $86,750, an estimated residual

value of $7,500, and an estimated useful life of 25 years. What is the amount of

the annual depreciation computed by the straight-line method?

E7-9 Depreciation by two methods

A John Deere tractor acquired on January 7 at a cost of $240,000 has an estimated

useful life of 40 years. Assuming that it will have no residual value, determine

the depreciation for each of the first two years by (a) the straight-line method

and (b) the double-declining-balance method.

E7-10 Depreciation by two methods

A storage tank acquired at the beginning of the fiscal year at a cost of $210,000

has an estimated residual value of $30,000 and an estimated useful life of twenty

years. Determine the following: (a) the amount of annual depreciation by the

straight-line method and (b) the amount of depreciation for the first and second

year computed by the double-declining-balance method.

E7-11 Partial-year depreciation

Sandblasting equipment acquired at a cost of $42,000 has an estimated residual

value of $6,000 and an estimated useful life of 10 years. It was placed in service

on October 1 of the current fiscal year, which ends on December 31, 2012. Determine

the depreciation for 2012 and for 2013 by (a) the straight-line method

and (b) the double-declining-balance method.

E7-12 Book value of fixed assets

The following data (in millions) were taken from recent annual reports of Kraft

Foods Inc. Kraft Foods produces and sells packaged foods products throughout the

world. Some of Kraft Foods’ well-known brands include Oreo, Nasbisco, Oscar

Meyer, and Maxwell House coffee.

Dec. 31, 2010 Dec. 31, 2009

Land and land improvements $ 795 $ 492

Buildings and building equipment 4,934 4,231

Machinery and equipment 16,147 13,872

Construction in progress 1,154 828

Accumulated depreciation (9,238) (8,730)

  1. Compute the book value of the fixed assets for 2010 and 2009 and explain

the differences, if any.

  1. Would you normally expect the book value of fixed assets to increase or

decrease during the year?

E7-13 Sale of asset

Equipment acquired on January 3, 2009, at a cost of $415,000, has an estimated

useful life of 15 years, has an estimated residual value of $32,500, and is depreciated

by the straight-line method.

  1. What was the book value of the equipment at December 31, 2012, the

end of the year?

  1. Assuming that the equipment was sold on July 1, 2013, for $285,000,

illustrate

the effects on the accounts and financial statements of (1) depreciation

for the six months until the sale date, and (2) the sale of the equipment.

E7-14 Disposal of fixed asset

Equipment acquired on January 8, 2009, at a cost of $375,000, has an estimated

useful life of 12 years and an estimated residual value of $45,000.

  1. What was the annual amount of depreciation for the years 2009, 2010,

and 2011, using the straight-line method of depreciation?

  1. What was the book value of the equipment on January 1, 2012?
  2. Assuming that the equipment was sold on January 7, 2012, for $280,000,

illustrate the effects on the accounts and financial statements of the sale.

  1. Assuming that the equipment was sold on January 7, 2012, for $300,000

instead of $280,000, illustrate the effects on the accounts and financial statements

of the sale.

E7-15 Recording depletion

Cooper Gate Mining Co. acquired mineral rights for $16,500,000. The mineral

deposit is estimated at 75,000,000 tons. During the current year, 29,800,000 tons

were mined and sold.

  1. Determine the amount of depletion expense for the current year.
  2. Illustrate the effects on the accounts and financial statements of the depletion

expense.

E7-16 Recording amortization

E-Shop Company acquired patent rights on January 10, 2009, for $900,000. The

patent has a useful life equal to its legal life of 12 years. On January 7, 2012,

E-Shop successfully defended the patent in a lawsuit at a cost of $112,500.

  1. Determine the patent amortization expense for the current year ended

December 31, 2012.

  1. Illustrate the effects on the accounts and financial statements to recognize

the amortization.

E7-17 Goodwill impairment

On January 1, 2009, Affordable Financial, Inc., purchased the assets of Bisko

Insurance

Co. for $65,000,000, a price reflecting a $10,000,000 goodwill premium.

On December 31, 2012, Affordable Financial determined that the goodwill from

the Bisko acquisition was impaired and had a value of only $4,000,000.

  1. Determine the book value of the goodwill on December 31, 2012, prior to

making the impairment adjustment.

  1. Illustrate the effects on the accounts and financial statements of the December

31, 2012, adjustment for the goodwill impairment.

E7-18 Book value of fixed assets

Apple, Inc., designs, manufactures, and markets personal computers (iPad™) and

related software. Apple also manufactures and distributes music players (iPod™)

along with related accessories and services, including the online distribution of

third-party music. The following information was taken from a recent annual

report of Apple:

Property, Plant, and Equipment (in millions):

Current Year Preceding Year

Land and buildings $ 1,471 $ 955

Machinery, equipment, and internal-use software 3,589 1,932

Office furniture and equipment 144 115

Other fixed assets related to leases 2,030 1,665

Accumulated depreciation and amortization (2,466) (1,713)

  1. Compute the book value of the fixed assets for the current year and the

preceding year and explain the differences, if any.

  1. Would you normally expect the book value of fixed assets to increase or

decrease during the year?

E7-19 Balance sheet presentation

List the errors you find in the following partial balance sheet:

CH ICO COMPAN Y

Balance Sheet

December 31, 2012

Assets

Total current assets $350,000

Replacement

Cost

Accumulated

Depreciation

Book

Value

Property, plant, and equipment:

Land $ 250,000 $ 20,000 $ 230,000

Buildings 400,000 150,000 250,000

Factory equipment 330,000 175,200 154,800

Office equipment 72,000 48,000 24,000

Patents 48,000 — 48,000

Goodwill 90,000 3,000 87,000

Total property plant,

and equipment $1,190,000 $ 396,200 793,800

 

Problems

P7-1 Allocate payments and receipts to fixed asset accounts

The following payments and receipts are related to land, land improvements,

and buildings acquired for use in a wholesale apparel business. The receipts are

identified by an asterisk.

  1. Architect’s and engineer’s fees for plans and supervision . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 75,000
  2. Cost of filling and grading land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000
  3. Cost of removing building purchased with land in (e) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,500
  4. Cost of paving parking lot to be used by customers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,500
  5. Cost of real estate acquired as a plant site: Land ($375,000) and Building ($25,000) . . . . 400,000
  6. Cost of repairing windstorm damage during construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000
  7. Cost of repairing vandalism damage during construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800
  8. Cost of trees and shrubbery planted . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000
  9. Delinquent real estate taxes on property, assumed by purchaser . . . . . . . . . . . . . . . . . . . . . . 31,750
  10. Fee paid to attorney for title search . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500
  11. Finder’s fee paid to real estate agency . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
  12. Interest incurred on building loan during construction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000
  13. Money borrowed to pay building contractor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 775,000*
  14. Payment to building contractor for new building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000
  15. Proceeds from insurance company for windstorm and vandalism damage . . . . . . . . . . . . 4,500*
  16. Premium on one-year insurance policy during construction . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
  17. Proceeds from sale of salvage materials from old building . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,500*
  18. Refund of premium on insurance policy (p) canceled after 10 months . . . . . . . . . . . . . . . . . 1,000*
  19. Special assessment paid to city for extension of water main to the property . . . . . . . . . . . 9,000

Instructions

  1. Assign each payment and receipt to Land (unlimited life), Land Improvements

(limited life), Building, or Other Accounts. Indicate receipts by an

asterisk. Identify each item by letter and list the amounts in columnar form,

as follows:

Item L and

L and

Improvements Building

Other

Accounts

  1. Determine the increases to Land, Land Improvements, and Building.
  2. The costs assigned to the land, which is used as a plant site, will not be depreciated,

while the costs assigned to land improvements will be depreciated.

Explain this seemingly contradictory application of the concept of depreciation.

P7-2 Compare three depreciation methods

Bayside Coatings Company purchased waterproofing equipment on January 2,

2011, for $190,000. The equipment was expected to have a useful life of four

years and a residual value of $9,000.

Instructions

Determine the amount of depreciation expense for the years ended December 31,

2011, 2012, 2013, and 2014, by (a) the straight-line method and (b) the doubledeclining-

balance method. Also determine the total depreciation expense for the

four years by each method. The following columnar headings are suggested for

recording the depreciation expense amounts:

Depreciation Expense

Year

Straight-L ine

Method

Double-Declining-Balance

Method

P7-3 Depreciation by two methods; partial years

Knife Edge Company purchased tool sharpening equipment on July 1, 2010, for

$16,200. The equipment was expected to have a useful life of three years and a

residual value of $900.

Instructions

Determine the amount of depreciation expense for the years ended December 31,

2010, 2011, 2012, and 2013, by (a) the straight-line method and (b) the doubledeclining-

balance method.

P7-4 Depreciation by two methods; sale of fixed asset

New tire retreading equipment, acquired at a cost of $140,000 at the beginning

of a fiscal year, has an estimated useful life of four years and an estimated residual

value of $10,000. The manager requested information regarding the effect

of alternative methods on the amount of depreciation expense each year. On the

basis of the data presented to the manager, the double-declining-balance method

was selected.

In the first week of the fourth year, the equipment was sold for $23,300.

Instructions

  1. Determine the annual depreciation expense for each of the estimated four

years of use, the accumulated depreciation at the end of each year, and the

book value of the equipment at the end of each year by (a) the straight-line

method and (b) the double-declining-balance method. The following columnar

headings are suggested for each schedule:

Year Depreciation Expense

Accumulated Depreciation,

End of Year

Book Value,

End of Year

  1. Illustrate the effects on the accounts and financial statements of the sale.
  2. Illustrate the effects on the accounts and financial statements of the sale,

assuming

a sale price of $15,250 instead of $23,300.

P7-5 Amortization and depletion entries

Data related to the acquisition of timber rights and intangible assets of Gemini

Company during the current year ended December 31 are as follows:

  1. On December 31, Gemini Company determined that $3,000,000 of goodwill

was impaired.

  1. Governmental and legal costs of $920,000 were incurred by Gemini Company

on June 30 in obtaining a patent with an estimated economic life of 8 years.

Amortization is to be for one-half year.

  1. Timber rights on a tract of land were purchased for $1,350,000 on March 6.

The stand of timber is estimated at 15,000,000 board feet. During the current

year, 3,300,000 board feet of timber were cut and sold.

Instructions

  1. Determine the amount of the amortization, depletion, or impairment for the

current year for each of the foregoing items.

  1. Illustrate the effects on the accounts and financial statements of the adjustments

for each item.

 

Activities

A7-1 Ethics and professional conduct in business

Rowel Baylon, CPA, is an assistant to the controller of Arches Consulting Co. In

his spare time, Rowel also prepares tax returns and performs general accounting

services for clients. Frequently, Rowel performs these services after his normal

working hours, using Arches Consulting Co.’s computers and laser printers. Occasionally,

Rowel’s clients will call him at the office during regular working hours.

Discuss whether Rowel is performing in a professional manner.

A7-2 Financial vs. tax depreciation

The following is an excerpt from a conversation between two employees of

Linquest

Technologies, Don Corbet and Rita Shevlin. Don is the accounts payable

clerk, and Rita is the cashier.

Don: Rita, could I get your opinion on something?

Rita: Sure, Don.

Don: Do you know Margaret, the fixed assets clerk?

Rita: I know who she is, but I don’t know her real well. Why?

Don: Well, I was talking to her at lunch last Tuesday about how she liked her

job, etc. You know, the usual … and she mentioned something about having to

keep two sets of books … one for taxes and one for the financial statements.

That can’t be good accounting, can it? What do you think?

Rita: Two sets of books? It doesn’t sound right.

Don: It doesn’t seem right to me either. I was always taught that you had to use

generally accepted accounting principles. How can there be two sets of books?

What could be the difference between the two?

How would you respond to Rita and Don if you were Margaret?

A7-3 Effect of depreciation on net income

Einstein Construction Co. specializes in building replicas of historic houses. Bree

Andrus, president of Einstein Construction, is considering the purchase of various

items of equipment on July 1, 2010, for $300,000. The equipment would have

a useful life of five years and no residual value. In the past, all equipment has

been leased. For tax purposes, Bree is considering depreciating the equipment

by the straight-line method. She discussed the matter with her CPA and learned

that although the straight-line method could be elected, it was to her advantage

to use the Modified Accelerated Cost Recovery System (MACRS) for tax purposes.

She asked for your advice as to which method to use for tax purposes.

  1. Compute depreciation for each of the years (2010, 2011, 2012, 2013, 2014, and

2015) of useful life by (a) the straight-line method and (b) MACRS. In using

the straight-line method, one-half year’s depreciation should be computed for

2010 and 2015. Use the MACRS rates presented in the chapter.

  1. Assuming that income before depreciation and income tax is estimated to be

$800,000 uniformly per year and that the income tax rate is 40%, compute

the net income for each of the years 2010, 2011, 2012, 2013, 2014, and 2015,

if (a) the straight-line method is used and (b) MACRS is used.

  1. What factors would you present for Bree’s consideration in the selection of a

depreciation method?

A7-4 L ease or buy

You are planning to acquire an asset for use in your business. In groups of three

or four, use the Internet to research some factors that should be considered in

deciding whether to purchase or lease an asset. Summarize the considerations

you have identified on purchasing or leasing an asset.

A7-5 Applying for patents, copyrights, and trademarks

Go to the Internet and review the procedures for applying for a patent, a copyright,

and a trademark. One Internet site that is useful for this purpose is www

.idresearch.com. Prepare a written summary of these procedures.

A7-6 Ethics and professional conduct in business

The following is an excerpt from a conversation between the chief executive

officer, Kim Jenkins, and the chief financial officer, Steve Mueller, of Quatro

Group Inc.:

Kim: Steve, as you know, the auditors are coming in to audit our year-end financial

statements pretty soon. Do you see any problems on the horizon?

Steve: Well, you know about our “famous” Scher Company acquisition of a couple

of years ago. We booked $9,000,000 of goodwill from that acquisition, and the

accounting rules require us to recognize any impairment of goodwill.

Kim: Uh-oh.

Steve: Yeah, right. We had to shut the old Scher Company operations down this

year because those products were no longer selling. Thus, our auditor is going to

insist that we write off the $9,000,000 of goodwill to reflect the impaired value.

Kim: We can’t have that—at least not this year! Do everything you can to push

back on this one. We just can’t take that kind of a hit this year. The most we

could stand is $5,000,000. Steve, keep the write-off to $5,000,000 and promise

anything in the future. Then we’ll deal with that down the road.

How should Steve respond to Kim?

 

Answers to Self-Examination Questions

  1. C All amounts spent to get a fixed asset (such

as machinery) in place and ready for use are

proper additions to the asset account. In the

case of machinery acquired, the freight (answer

  1. A) and the installation costs (answer B)

are both (answer C) proper charges to the

machinery account.

  1. C The periodic charge for depreciation under

the double-declining-balance method for

the second year is determined by first computing

the depreciation charge for the first

year. The depreciation for the first year of

$6,000 (answer A) is computed by multiplying

the cost of the equipment, $9,000, by

2/3 (the straight-line rate of 1/3 multiplied

by 2). The depreciation for the second year

of $2,000 (answer C) is then determined by

multiplying the book value at the end of the

first year, $3,000 (the cost of $9,000 minus

the first-year depreciation of $6,000), by 2/3.

The third year’s depreciation is $400 (answer

D). It is determined by multiplying the book

value at the end of the second year, $1,000,

by 2/3, thus yielding $667. However, the

equipment

cannot be depreciated below its

residual value of $600; thus, the third-year

depreciation is $400 ($1,000 2 $600).

  1. B A depreciation method that provides for a

higher depreciation amount in the first year

of the use of an asset and a gradually declining

periodic amount thereafter is called an

accelerated depreciation method. The doubledeclining-

balance method (answer B) is an

example of such a method.

  1. B $252,000. The depletion expense is determined

by first computing a depletion rate.

For Hyde Inc. the depletion rate is $1.44 per

ton ($3,600,000/2,500,000 tons). The depletion

rate of $1.44 per ton is then multiplied

by the number of tons mined during the year,

or 175,000 tons, to determine the depletion

expense of $252,000 (175,000 tons 3 $1.44).

  1. D Long-lived assets that are useful in operations,

not held for sale, and without physical

qualities are called intangible assets. Patents,

goodwill, and copyrights are examples of intangible

assets (answer D).

 

 

Chapter 8 liabilities and Stockholders’ equity

 

Class Discussion Questions

  1. What two types of transactions cause most

current liabilities?

  1. When are short-term notes payable issued?
  2. When should the liability associated with a

product warranty be recorded? Discuss.

  1. Deere & Company, a company well known for

manufacturing farm equipment, reported more

than $800 million of product warranties in recent

financial statements. How would costs of

repairing a defective product be recorded?

  1. Delta Air Lines’ SkyMiles program allows frequent

flyers to earn credit toward free tickets

and other amenities.

  1. Does Delta Air Lines have a contingent

liability for award redemption

by its Sky-

Miles members?

  1. When should a contingent liability be

recorded?

  1. For each of the following payroll-related

taxes, indicate whether it generally applies to

(1) employees only, (2) employers only, or

(3) both employees and employers:

  1. Federal income tax
  2. Federal unemployment compensation tax
  3. Medicare tax
  4. Social security tax
  5. State unemployment compensation tax
  6. To match revenues and expenses properly,

should the expense for employee vacation

pay be recorded in the period during which

the vacation privilege is earned or during the

period in which the vacation is taken? Discuss.

  1. Identify the two distinct obligations incurred

by a corporation when issuing bonds.

  1. A corporation issues $40,000,000 of 6% bonds

to yield an effective interest rate of 8%.

  1. Was the amount of cash received from

the sale of the bonds more or less than

$40,000,000?

  1. Identify the following amounts related to

the bond issue: (1) face amount, (2) market

rate of interest, (3) contract rate of

interest, and (4) maturity amount.

  1. The following data relate to an $8,000,000,

7% bond issue for a selected semiannual

interest

period:

Bond carrying amount at beginning of period $8,190,000

Interest paid at end of period 560,000

Interest expense allocable to the period 540,500

  1. Were the bonds issued at a discount or

at a premium?

  1. What expense account was decreased to

amortize the discount or premium?

  1. Of two corporations organized at approximately

the same time and engaged in competing

businesses, one issued $75 par common

stock, and the other issued $1 par common

stock. Do the par designations provide any

indication as to which stock is preferable as

an investment? Explain.

  1. When a corporation issues stock at a premium,

is the premium income? Explain.

  1. a. In what respect does treasury stock differ

from unissued stock?

  1. How should treasury stock be presented

on the balance sheet?

  1. A corporation reacquires 18,000 shares of its

own $50 par common stock for $2,250,000,

recording it at cost.

  1. What effect does this transaction have on

revenue or expense of the period?

  1. What effect does it have on stockholders’

equity?

  1. The treasury stock in Question 14 is resold

for $2,400,000.

  1. What is the effect on the corporation’s

revenue of the period?

  1. What is the effect on stockholders’ equity?
  2. A corporation with preferred stock and

common stock outstanding has a substantial

balance in its retained earnings account

at the beginning of the current fiscal year.

Although net income for the current year is

sufficient to pay the preferred dividend of

$150,000 each quarter and a common dividend

of $40,000 each quarter, the board of

directors declares dividends only on the preferred

stock. Suggest possible reasons that

the board passes the dividends on the common

stock.

  1. An owner of 300 shares of Colorado Spring

Company common stock receives a stock

dividend of 6 shares.

  1. What is the effect of the stock dividend

on the stockholder’s proportionate interest

(equity) in the corporation?

  1. How does the total equity of 306 shares

compare with the total equity of 300

shares before the stock dividend?

  1. What is the primary purpose of a stock split?

 

Exercises

E8-1 Current liabilities

Carabiner Co. sold 28,000 annual magazine subscriptions for $40 during December

  1. These new subscribers will receive monthly issues, beginning in January
  2. In addition, the business had taxable income of $130,000 during the first

calendar quarter of 2013. The federal tax rate is 40%. A quarterly tax payment

will be made on April 15, 2013.

Prepare the Current Liabilities section of the balance sheet for Carabiner Co.

on March 31, 2013.

E8-2 Notes payable

A business issued a 30-day, 7% note for $36,000 to a creditor on account. Illustrate

the effects on the accounts and financial statements of recording (a) the issuance

of the note and (b) the payment of the note at maturity, including interest.

E8-3 Recording income taxes

Illustrate the effects on the accounts and financial statements of recording the

following selected transactions of Sid’s Leather Co.:

Apr. 15. Paid the first installment of the estimated income tax for the current

fiscal year ending December 31, $29,000. No entry had been made to

record the liability.

Dec. 31. Recorded the estimated income tax liability for the year just ended and

the deferred income tax liability, based on the April 15 transaction and

the following data:

Income tax rate 40%

Income before income tax $300,000

Taxable income according to tax return $280,000

Assume that the June 15 and September 15 installments of $29,000 were also paid.

E8-4 Deferred income taxes

Warehouse System Inc. recognized service revenue of $960,000 on its financial

statements in 2011. Assume, however, that the tax code requires this amount to

be recognized for tax purposes in 2012. The taxable income for 2011 and 2012

is $7,100,000 and $8,900,000, respectively. Assume a tax rate of 40%.

Illustrate the effects on the accounts and financial statements of the tax expense,

deferred taxes, and taxes payable for 2011 and 2012, respectively.

E8-5 Accrued product warranty

Fungus Audio Works Inc. warrants its products for one year. The estimated

product warranty is 3% of sales. Assume that sales were $680,000 for January. In

February, a customer received warranty repairs requiring $4,200 of parts.

  1. Determine the warranty liability at January 31, the end of the first month of

the current year.

  1. What accounts are decreased for the warranty work provided in February?

E8-6 Accrued product warranty

Ford Motor Company disclosed the following estimated product warranty payable

for two recent years.

December 31,

Year 2 Year 1

(in millions)

Product warranty payable $2,646 $3,147

Ford’s sales were $128,954 million in Year 2 and $116,283 million in Year 1.

Assume

that the total paid on warranty claims during Year 2 was $2,176 million.

  1. Illustrate the effects on the accounts and financial statements for the Year 2

product warranty expense.

  1. Assuming $2,176 million in warranty claims paid during Year 2, explain the

$501 ($3,147 2 $2,646) million decrease in the total warranty liability from

Year 1 to Year 2.

E8-7 Contingent liabilities

Several months ago, Maltese Chemical Company experienced a hazardous materials

spill at one of its plants. As a result, the Environmental Protection Agency

(EPA) fined the company $750,000. The company is contesting the fine. In addition,

an employee is seeking $300,000 damages related to the spill. Lastly, a

homeowner has sued the company for $180,000. The homeowner lives 15 miles

from the plant, but believes that the incident has reduced the home’s resale

value by $180,000.

Maltese’s legal counsel believes that it is probable that the EPA fine will stand.

In addition, counsel indicates that an out-of-court settlement of $90,000 has recently

been reached with the employee. The final papers will be signed next

week. Counsel believes that the homeowner’s case is much weaker and will be

decided in favor of Maltese. Other litigation related to the spill is possible, but

the damage amounts are uncertain.

  1. Illustrate the effects of the contingent liabilities associated with the hazardous

materials spill on the accounts and financial statements.

  1. Prepare a note disclosure relating to this incident.

E8-8 Contingent liabilities

The following note accompanied recent financial statements for Goodyear Tire and

Rubber Company:

We are a defendant in numerous lawsuits alleging various asbestos-related personal

injuries purported to result from alleged exposure to certain asbestos products

manufactured by us or present in certain of our facilities. Typically, these

lawsuits have been brought against multiple defendants in state and federal

courts. To date, we have disposed of approximately 90,700 claims by defending

and obtaining the dismissal thereof or by entering into a settlement. The sum of

our accrued asbestos-related liability, . . . including legal costs totaled approximately

$365 million through December 31, 2010. . . .

  1. Illustrate the effects on the accounts and financial statements of recording the

contingent liability of $365,000,000.

  1. Why was the contingent liability recorded?

E8-9 Calculate payroll

An employee earns $35 per hour and 1.5 times that rate for all hours in excess

of 40 hours per week. Assume that the employee worked 52 hours during

the week, and that the gross pay prior to the current week totaled $62,000.

Assume further that the social security tax rate was 6.0% (on earnings up to

$100,000), the Medicare tax rate was 1.5%, and federal income tax to be withheld

was $128.

  1. Determine the gross pay for the week.
  2. Determine the net pay for the week.

E8-10 S ummary payroll data

In the following summary of data for a payroll period, some amounts have been

intentionally omitted:

Earnings:

  1. At regular rate ?
  2. At overtime rate $ 45,200
  3. Total earnings ?

Deductions:

  1. FICA tax 21,750
  2. Income tax withheld 57,900
  3. Medical insurance 29,150
  4. Union dues ?
  5. Total deductions 117,900
  6. Net amount paid 196,500

Accounts increased:

  1. Factory Wages 220,600
  2. Sales Salaries ?
  3. Office Salaries 40,000

Calculate the amounts omitted in lines (1), (3), (7), and (11).

E8-11 Recording payroll taxes

According to a summary of the payroll of Apline Publishing Co., $460,000 was

subject to the 7.5% FICA tax. Also, $39,000 was subject to state and federal

unemployment

taxes.

  1. Calculate the employer’s payroll taxes, using the following rates: state unemployment,

4.3%; federal unemployment, 0.8%.

  1. Illustrate the effects on the accounts and financial statements of recording the

accrual of payroll taxes.

E8-12 Accrued vacation pay

A business provides its employees with varying amounts of vacation per year,

depending on the length of employment. The estimated amount of the current

year’s vacation pay is $518,400. Illustrate the effects on the accounts and financial

statements of the adjustment required on January 31, the end of the first month

of the current year, to record the accrued vacation pay.

E8-13 Bond price

Walt Disney 7% bonds due in 2032 were selling for 136.89 on October 26, 2011.

Were the bonds selling at a premium or at a discount? Explain.

E8-14 Issuing bonds

Cyber Tech Inc. produces and distributes fiber optic cable for use by telecommunications

companies. Cyber Tech Inc. issued $50,000,000 of 20-year, 6%

bonds on March 1 at their face amount, with interest payable on March 1 and

September 1. The fiscal year of the company is the calendar year. Illustrate

the effects on the accounts and financial statements of recording the following

selected transactions for the current year:

Mar. 1. Issued the bonds for cash at their face amount.

Sept. 1. Paid the interest on the bonds.

Dec. 31. Recorded accrued interest for four months.

E8-15 Dividends per share

Scan Tech Inc., a developer of radiology equipment, has stock outstanding as

follows: 24,000 shares of 2% preferred stock of $75 par, and 100,000 shares of

$8 par common. During its first four years of operations, the following amounts

were distributed as dividends: first year, $19,200; second year, $30,000; third

year, $75,000; fourth year, $120,000. Calculate the dividends per share on each

class of stock for each of the four years.

E8-16 Dividends per share

Sea Horse Inc., a software development firm, has stock outstanding as follows:

80,000 shares of 1% preferred stock of $15 par, and 200,000 shares of $65 par

common. During its first four years of operations, the following amounts were

distributed as dividends: first year, $4,000; second year, $10,400; third year,

$40,000; fourth year, $90,000. Calculate the dividends per share on each class of

stock for each of the four years.

E8-17 Issuing par stock

On January 29, Quality Marble Inc., a marble contractor, issued for cash 75,000

shares of $10 par common stock at $23, and on May 31, it issued for cash 100,000

shares of $4 par preferred stock at $6.

  1. Illustrate the effects on the accounts and financial statements of the January 29

and May 31 transactions.

  1. What is the total amount invested (total paid-in capital) by all stockholders as

of May 31?

E8-18 Issuing stock for assets other than cash

On August 7, Easy Up Corporation, a wholesaler of hydraulic lifts, acquired land

in exchange for 20,000 shares of $10 par common stock with a current market

price of $14.

Illustrate the effect on the accounts and financial statements of the purchase

of the land.

E8-19 Treasury stock transactions

Hayden Valley Inc. bottles and distributes spring water. On July 14 of the current

year, Hayden Valley reacquired 7,500 shares of its common stock at $120 per share.

  1. What is the balance of Treasury Stock on December 31 of the current year?
  2. Where will the balance of Treasury Stock be reported on the balance sheet?
  3. For what reasons might Hayden Valley have purchased the treasury stock?

E8-20 Treasury stock transactions

Sun Dance Gardens Inc. develops and produces spraying equipment for lawn

maintenance and industrial uses. On June 3 of the current year, Sun Dance

Gardens Inc. reacquired 28,000 shares of its common stock at $37 per share.

  1. What is the balance of Treasury Stock on December 31 of the current year?
  2. How will the balance in Treasury Stock be reported on the balance sheet?
  3. Assume that Sun Dance Gardens sold 10,000 shares of its treasury stock at $40

on November 2. What accounts would be affected by the sale of the treasury

stock?

E8-21 Treasury stock transactions

Banff Water Inc. bottles and distributes spring water. On April 2 of the current year,

Banff Water Inc. reacquired 30,000 shares of its common stock at $33 per share.

  1. What is the balance of Treasury Stock on December 31 of the current year?
  2. Where will the balance of Treasury Stock be reported on the balance sheet?
  3. For what reasons might Banff Water Inc. have purchased the treasury stock?
  4. Assume that on January 25 of the following year, Banff Water Inc. sold 20,000

shares of its treasury stock for $40 per share. Illustrate the effects on the

accounts

and financial statements of the sale of the treasury stock.

E8-22 Cash dividends

The dates of importance in connection with a cash dividend declared and paid

of $55,350 on a corporation’s common stock are February 6, March 9, and

April 8. Illustrate the effects on the accounts and financial statements for each date.

E8-23 Effect of cash dividend and stock split

Indicate whether the following actions would (+) increase, (−) decrease, or (0)

not affect Loma Express Inc.’s total assets, liabilities, and stockholders’ equity:

Assets Liabilities

Stockholders’

Equity

(1) Declaring a cash dividend

(2) Paying the cash dividend declared in (1)

(3) Authorizing and issuing stock certifi

cates in a stock split

(4) Declaring a stock dividend

(5) Issuing stock certific tes for the stock

dividend declared in (4)

E8-24 Effect of stock split

Papa’s Restaurant Corporation wholesales ovens and ranges to restaurants

throughout the Northeast. Papa’s Restaurant Corporation, which had 18,000 shares

of common stock outstanding, declared a 4-for-1 stock split (3 additional shares

for each share issued).

  1. What will be the number of shares outstanding after the split?
  2. If the common stock had a market price of $280 per share before the stock

split, what would be an approximate market price per share after the split?

E8-25 S tockholders’ equity section of balance sheet

The following accounts and their balances appear in the ledger of Amazon Properties

Inc. on April 30 of the current year:

Common Stock, $25 par $ 900,000

Paid-In Capital in Excess of Par 216,000

Paid-In Capital from Sale of Treasury Stock 24,000

Retained Earnings 7,680,000

Treasury Stock 204,000

Prepare the Stockholders’ Equity section of the balance sheet as of April 30.

Fifty thousand shares of common stock are authorized, and 4,000 shares have

been reacquired.

E8-26 S tockholders’ equity section of balance sheet

Premium Imports Inc. retails racing products for BMWs, Porsches, and Ferraris.

The following accounts and their balances appear in the ledger of Premium

Imports

Inc. on November 30, the end of the current year:

Common Stock, $8 par $ 3,200,000

Paid-In Capital in Excess of Par—Common Stock 700,000

Paid-In Capital in Excess of Par—Preferred Stock 182,000

Paid-In Capital from Sale of Treasury Stock—Common 150,000

Preferred 2% Stock, $80 par 2,080,000

Retained Earnings 17,250,000

Treasury Stock—Common 744,000

Forty thousand shares of preferred and 500,000 shares of common stock are

authorized. There are 62,000 shares of common stock held as treasury stock.

Prepare the Stockholders’ Equity section of the balance sheet as of November

30, the end of the current year.

E8-27 Effect of financing on earnings per share

BSF Co., which produces and sells skiing equipment, is financed as follows:

Bonds payable, 8% (issued at face amount) $7,500,000

Preferred 2% stock, $10 par 7,500,000

Common stock, $50 par 7,500,000

Income tax is estimated at 40% of income.

Determine the earnings per share of common stock, assuming that the income

before bond interest and income tax is (a) $1,000,000, (b) $3,000,000, and

(c) $4,500,000.

E8-28 Evaluate alternative financing plans

Based on the data in Exercise 8-27, discuss factors other than earnings per share

that should be considered in evaluating such financing plans.

 

Problems

P8-1 Income tax allocation

Differences between the accounting methods applied to accounts and financial

reports and those used in determining taxable income yielded the following

amounts for the first four years of a corporation’s operations:

First Year Second Year Third Year Fourth Year

Income before income taxes $425,000 $750,000 $900,000 $1,350,000

Taxable income 350,000 650,000 700,000 1,725,000

The income tax rate for each of the four years was 40% of taxable income,

and each year’s taxes were promptly paid.

Instructions

  1. Determine for each year the amounts described by the following captions,

presenting the information in the form indicated:

Year

Income Tax

Deducted on

Income Statement

Income Tax

Payments

for the Year

Deferred Income Tax Payable

Year’s Addition

(Deduction)

Year-End

Balance

  1. Total the first three amount columns.
  2. Illustrate the effects of recording the current and deferred tax liabilities on the

accounts and financial statements for the first year.

P8-2 Recording payroll and payroll taxes

The following information about the payroll for the week ended July 17 was

obtained from the records of Anaconda Mining Co.:

Salaries: Deductions:

Sales salaries $315,000 Income tax withheld $98,000

Warehouse salaries 185,000 U.S. savings bonds 15,000

Office salaries 125,000 Group insurance 12,500

$625,000

Tax rates assumed:

FICA tax, 7.5% of employee annual earnings

State unemployment (employer only), 4.2%

Federal unemployment (employer only), 0.8%

Instructions

  1. For the July 17 payroll, determine the employee FICA tax payable.
  2. Illustrate the effect on the accounts and financial statements of paying and

recording the July 17 payroll.

  1. Determine the following amounts for the employer payroll taxes related to

the July 17 payroll: (a) FICA tax payable, (b) state unemployment tax payable,

and (c) federal unemployment tax payable.

  1. Illustrate the effect on the accounts and financial statements of recording the

liability for the July 17 payroll taxes.

P8-3 Bond premium; bonds payable transactions

Beaufort Vaults Corporation produces and sells burial vaults. On July 1, 2012,

Beaufort Vaults Corporation issued $25,000,000 of 10-year, 8% bonds at par.

Interest on the bonds is payable semiannually on December 31 and June 30. The

fiscal year of the company is the calendar year.

Instructions

  1. Illustrate the effects of the issuance of the bonds on July 1, 2012, on the accounts

and financial statements.

  1. Illustrate the effects of the first semiannual interest payment on December 31,

2012, on the accounts and financial statements.

  1. Illustrate the effects of the payment of the face value of bonds at maturity on

the accounts and financial statements.

  1. If the market rate of interest were 7% on July 1, 2012, would the bonds have

sold at a discount or premium?

P8-4 S tock transactions for corporate expansion

Vaga Optics produces medical lasers for use in hospitals. The accounts and their

balances appear in the ledger of Vaga Optics on December 31 of the current

year as follows:

Preferred 2% Stock, $120 par (50,000 shares authorized, 25,000 shares issued) $ 3,000,000

Paid-In Capital in Excess of Par—Preferred Stock 400,000

Common Stock, $75 par (500,000 shares authorized, 300,000 shares issued) 22,500,000

Paid-In Capital in Excess of Par—Common Stock 540,000

Retained Earnings 55,000,000

At the annual stockholders’ meeting on January 31, the board of directors

presented a plan for modernizing and expanding plant operations at a cost of

approximately $9,500,000. The plan provided (a) that the corporation borrow

$4,500,000, (b) that 20,000 shares of the unissued preferred stock be issued

through an underwriter, and (c) that a building, valued at $1,200,000, and the land

on which it is located, valued at $900,000, be acquired in accordance with preliminary

negotiations by the issuance of 27,400 shares of common stock. The plan

was approved by the stockholders and accomplished by the following transactions:

Mar. 8. Borrowed $4,500,000 from Conrad National Bank, giving a 6% mortgage

note.

  1. Issued 20,000 shares of preferred stock, receiving $130 per share in cash.
  2. Issued 27,400 shares of common stock in exchange for land and a building,

according to the plan.

No other transactions occurred during March.

Instructions

Illustrate the effects on the accounts and financial statements of each of the

preceding transactions.

P8-5 Dividends on preferred and common stock

Yukon Bike Corp. manufactures mountain bikes and distributes them through retail

outlets in Canada, Montana, Idaho, Oregon, and Washington. Yukon Bike Corp. has

declared the following annual dividends over a six-year period ending December 31 of

each year: 2008, $28,000; 2009, $44,000; 2010, $48,000; 2011, $60,000; 2012, $76,000;

and 2013, $140,000. During the entire period, the outstanding stock of the company

was composed of 40,000 shares of 2% preferred stock, $65 par, and 50,000 shares of

common stock, $1 par.

Instructions

  1. Determine the total dividends and the per-share dividends declared on each

class of stock for each of the six years. Summarize the data in tabular form,

using the following column headings:

Year

Total

Dividends

Preferred Dividends Common Dividends

Total Per Share Total Per Share

2008 $ 28,000

2009 44,000

2010 48,000

2011 60,000

2012 76,000

2013 140,000

  1. Calculate the average annual dividend per share for each class of stock for

the six-year period.

  1. Assuming that the preferred stock was sold at $57.50 and common stock was

sold at $5.00 at the beginning of the six-year period, calculate the average annual

percentage return on initial shareholders’ investment, based on the average

annual dividend per share (a) for preferred stock and (b) for common stock.

P8-6 Effect of financing on earnings per share

Three different plans for financing a $5,000,000 corporation are under consideration

by its organizers. Under each of the following plans, the securities will

be issued at their par or face amount, and the income tax rate is estimated at

40% of income.

Plan 1 Plan 2 Plan 3

8% bonds — — $2,500,000

Preferred 4% stock, $100 par — $2,500,000 1,250,000

Common stock, $5 par $5,000,000 2,500,000 1,250,000

Total $5,000,000 $5,000,000 $5,000,000

Instructions

  1. Determine for each plan the earnings per share of common stock, assuming

that the income before bond interest and income tax is $1,000,000.

  1. Determine for each plan the earnings per share of common stock, assuming

that the income before bond interest and income tax is $300,000.

  1. Discuss the advantages and disadvantages of each plan.

 

Activities

A8-1 Ethics and professional conduct in business

Jas Carillo was discussing summer employment with Maria Perez, president of

Valparaiso Construction Service:

Maria: I’m glad that you’re thinking about joining us for the summer. We could

certainly use the help.

Jas: Sounds good. I enjoy outdoor work, and I could use the money to help

with next year’s school expenses.

Maria: I’ve got a plan that can help you out on that. As you know, I’ll pay you

$4 per hour; but in addition, I’d like to pay you with cash. Since you’re only

working for the summer, it really doesn’t make sense for me to go to the trouble

of formally putting you on our payroll system. In fact, I do some jobs for my

clients on a strictly cash basis, so it would be easy to just pay you that way.

Jas: Well, that’s a bit unusual, but I guess money is money.

Maria: Yeah, not only that, it’s tax-free!

Jas: What do you mean?

Maria: Didn’t you know? Any money that you receive in cash is not reported to

the IRS on a W-2 form; therefore, the IRS doesn’t know about the income—hence,

it’s the same as tax-free earnings.

  1. Why does Maria Perez want to conduct business transactions using cash (not

check or credit card)?

  1. How should Jas respond to Maria’s suggestion?

A8-2 Contingent liabilities

Altria Group, Inc., has a note dedicated to describing contingent liabilities in its

recent financial statements. This note includes extensive descriptions of multiple

contingent liabilities. Use the Internet to research Altria Group, Inc., at http://

www.altria.com.

  1. What are the major business units of Altria Group?
  2. Based on your understanding of this company, why would Altria Group require

a note on contingent liabilities?

A8-3 Issuing stock

Sahara Unlimited Inc. began operations on January 2, 2012, with the issuance of

250,000 shares of $8 par common stock. The sole stockholders of Sahara Unlimited

Inc. are Karina Takemoto and Dr. Noah Grove, who organized Sahara Unlimited

Inc. with the objective of developing a new flu vaccine. Dr. Grove claims that the

flu vaccine, which is nearing the final development stage, will protect individuals

against 80% of the flu types that have been medically identified. To complete the

project, Sahara Unlimited Inc. needs $25,000,000 of additional funds. The banks

have been unwilling to loan the funds because of the lack of sufficient collateral

and the riskiness of the business. The following is a conversation between Karina

Takemoto, the chief executive officer of Sahara Unlimited Inc., and Dr. Noah

Grove, the leading researcher:

Karina: What are we going to do? The banks won’t loan us any more money, and

we’ve got to have $25 million to complete the project. We are so close! It would

be a disaster to quit now. The only thing I can think of is to issue additional

stock. Do you have any suggestions?

Noah: I guess you’re right. But if the banks won’t loan us any more money, how

do you think we can find any investors to buy stock?

Karina: I’ve been thinking about that. What if we promise the investors that

we will pay them 2% of net sales until they have received an amount equal to

what they paid for the stock?

Noah: What happens when we pay back the $25 million? Do the investors get

to keep the stock? If they do, it’ll dilute our ownership.

Karina: How about, if after we pay back the $25 million, we make them turn

in their stock for what they paid for it? Plus, we could pay them an additional

$50 per share. That’s a $50 profit per share for the investors.

Noah: It could work. We get our money, but don’t have to pay any interest or

dividends until we start generating net sales. At the same time, the investors

could get their money back plus $50 per share.

Karina: We’ll need current financial statements for the new investors. I’ll get

our accountant working on them and contact our attorney to draw up a legally

binding contract for the new investors. Yes, this could work.

In late 2012, the attorney and the various regulatory authorities approved the

new stock offering, and shares of common stock were privately sold to new

investors for $25,000,000.

In preparing financial statements for 2012, Karina Takemoto and Glenn Bergum,

the controller for Sahara Unlimited Inc., have the following conversation:

Glenn: Karina, I’ve got a problem.

Karina: What’s that, Glenn?

Glenn: Issuing common stock to raise that additional $25 million was a great

idea. But …

Karina: But what?

Glenn: I’ve got to prepare the 2012 annual financial statements, and I am not

sure how to classify the common stock.

Karina: What do you mean? It’s common stock.

Glenn: I’m not so sure. I called the auditor and explained how we are contractually

obligated to pay the new stockholders 2% of net sales until they receive what

they paid for the stock. Then, we may be obligated to pay them $50 per share.

Karina: So …

Glenn: So the auditor thinks that we should classify the additional issuance of

$25 million as debt, not stock! And, if we put the $25 million on the balance

sheet as debt, we will violate our other loan agreements with the banks. And, if

these agreements are violated, the banks may call in all our debt immediately. If

they do that, we are in deep trouble. We’ll probably have to file for bankruptcy.

We just don’t have the cash to pay off the banks.

  1. Discuss the arguments for and against classifying the issuance of the $25 million

of stock as debt.

  1. What do you think might be a practical solution to this classification problem?

A8-4 Preferred stock vs. bonds

Living Smart Inc. has decided to expand its operations to owning and operating

long-term health care facilities. The following is an excerpt from a conversation

between the chief executive officer, Mark Vierra, and the vice president of finance,

Jolin Kilcup.

Mark: Jolin, have you given any thought to how we’re going to finance the

acquisition of St. George Health Care?

Jolin: Well, the two basic options, as I see it, are to issue either preferred

stock or bonds. The equity market is a little depressed right now. The rumor

is that the Federal Reserve Bank may increase the interest rates either this

month or next.

Mark: Yes, I’ve heard the rumor. The problem is that we can’t wait around to

see what’s going to happen. We’ll have to move on this next week if we want

any chance to complete the acquisition of St. George.

Jolin: Well, the bond market is strong right now. Maybe we should issue debt

this time around.

Mark: That’s what I would have guessed as well. St. George’s financial statements

look pretty good, except for the volatility of its income and cash flows. But that’s

characteristic of the industry.

Discuss the advantages and disadvantages of issuing preferred stock versus bonds.

A8-5 F inancing business expansion

You hold a 30% common stock interest in the family-owned business, a vending

machine company. Your sister, who is the manager, has proposed an expansion

of plant facilities at an expected cost of $6,000,000. Two alternative plans have

been suggested as methods of financing the expansion. Each plan is briefly

described as follows:

Plan 1. Issue $6,000,000 of 15-year, 8% notes at face amount.

Plan 2. Issue an additional 100,000 shares of $20 par common stock at $25 per

share, and $3,500,000 of 15-year, 8% notes at face amount.

The balance sheet as of the end of the previous fiscal year is as follows:

MO JAVE O AS IS , INC.

Balance Sheet

December 31, 2012

Assets

Current assets $10,000,000

Property, plant, and equipment 15,000,000

Total assets $25,000,000

Liabilities and Stockholders’ Equity

Liabilities $ 7,000,000

Common stock, $20 8,000,000

Paid-in capital in excess of par 300,000

Retained earnings 9,700,000

Total liabilities and stockholders’ equity $25,000,000

Net income has remained relatively constant over the past several years. The

expansion program is expected to increase yearly income before bond interest

and income tax from $900,000 in the previous year to $1,200,000 for this year.

Your sister has asked you, as the company treasurer, to prepare an analysis of

each financing plan.

  1. Prepare a table indicating the expected earnings per share on the common

stock under each plan. Assume an income tax rate of 25%.

  1. (1) Discuss the factors that should be considered in evaluating the two plans.

(2) Which plan offers the greater benefit to the present stockholders? Give

reasons for your opinion.

A8-6 Profiling a corporation

Select a public corporation you are familiar with or which interests you. Using

the Internet, your school library, and other sources, develop a short (one t

two pages) profile of the corporation. Include in your profile the following

information:

  1. Name of the corporation
  2. State of incorporation
  3. Nature of its operations
  4. Total assets for the most recent balance sheet
  5. Total revenues for the most recent income statement
  6. Net income for the most recent income statement
  7. Classes of stock outstanding
  8. Market price of the stock outstanding
  9. High and low price of the stock for the past year
  10. Dividends paid for each share of stock during the past year

In groups of three or four, discuss each corporate profile. Select one of the

corporations, assuming that your group has $100,000 to invest in its stock. Summarize

why your group selected the corporation it did and how financial accounting

information may have affected your decision. Keep track of the performance

of your corporation’s stock for the remainder of the term.

Note: Most major corporations maintain “home pages” on the Internet. This

home page provides a variety of information on the corporation and often includes

the corporation’s financial statements. In addition, the New York Stock Exchange

Web site (http://www.nyse.com) includes links to the home pages of many

listed companies. Financial statements also can be accessed using EDGAR, the

electronic archives of financial statements filed with the Securities and Exchange

Commission (SEC).

SEC documents can also be retrieved using the EdgarScan™ service at http://

www.sec.gov/edgar/searchedgar/webusers.htm. To obtain annual report information,

key in a company name in the appropriate space. EDGAR will list the

reports available to you for the company you’ve selected. Select the most recent

annual report filing, identified as a 10-K or 10-K405.

 

Answers to Self-Examination Questions

  1. C The maturity value is $5,100, determined

as follows:

Face amount of note $5,000

Plus interest ($5,000 × 0.12 × 60/360) 100

Maturity value $5,100

  1. B Employers are usually required to withhold

a portion of their employees’ earnings for payment

of federal income taxes (answer A), FICA

tax (answer C), and state and local income

taxes (answer D). Generally, federal unemployment

compensation taxes (answer B) are

levied against the employer only and thus are

not deducted from employee earnings.

  1. D The employer incurs an expense for FICA

tax (answer A), federal unemployment compensation

tax (answer B), and state unemployment

compensation tax (answer C). The

employees’ federal income tax (answer D) is

not an expense of the employer. It is withheld

from the employees’ earnings.

  1. B Since the contract rate on the bonds is

higher than the prevailing market rate, a rational

investor would be willing to pay more than

the face amount, or a premium (answer B),

for the bonds. If the contract rate and the market

rate were equal, the bonds could be expected

to sell at their face amount (answer A).

Likewise, if the market rate is higher than the

contract rate, the bonds would sell at a price

below their face amount (answer D) or at a

discount (answer C).

  1. C If a corporation that holds treasury stock

declares a cash dividend, the dividends are

not paid on the treasury shares. To do so

would place the corporation in the position

of earning income through dealing with itself.

Thus, the corporation will record $44,000 (answer

  1. C) as cash dividends [(25,000 shares issued

less 3,000 shares held as treasury stock)

3 $2 per share dividend].

 

 

Chapter 9 Financial Statement analysis

 

Class Discussion Questions

  1. What is the difference between horizontal

and vertical analysis of financial statements?

  1. What is the advantage of using comparative

statements for financial analysis rather than

statements for a single date or period?

  1. The current year’s amount of net income

(after income tax) is 9% larger than that of

the preceding year. Does this indicate an improved

operating performance? Discuss.

  1. How would you respond to a horizontal

analysis that showed an expense increasing

by over 70%?

  1. How would the current and quick ratios of

a service business compare?

  1. For Belzer Corporation, the working capital

at the end of the current year is $24,000 more

than the working capital at the end of the

preceding year, reported as follows:

Current

Year

Preceding

Year

Current assets:

Cash, temporary

investments, and

receivables $ 81,000 $ 72,000

Inventories 171,000 126,000

Total current assets $252,000 $198,000

Current liabilities 90,000 60,000

Working capital $162,000 $138,000

Has the current position improved? Explain.

  1. Why would the accounts receivable turnover

ratio be different between Wal-Mart and Procter &

Gamble?

  1. A company that grants terms of n/30 on

all sales has a yearly accounts receivable

turnover, based on monthly averages, of 9.

Is this a satisfactory turnover? Discuss.

  1. a. Why is it advantageous to have a high

inventory turnover?

  1. Is it possible for the inventory turnover

to be too high? Discuss.

  1. Is it possible to have a high inventory

turnover and a high number of days’ sales

in inventory? Discuss.

  1. What do the following data taken from a

comparative balance sheet indicate about the

company’s ability to borrow additional funds

on a long-term basis in the current year as

compared to the preceding year?

Current

Year

Preceding

Year

Fixed assets (net) $1,800,000 $1,260,000

Total long-term liabilities 450,000 350,000

  1. a. How does the rate earned on total

assets differ from the rate earned on

stockholders’ equity?

  1. Which ratio is normally higher? Explain.
  2. a. Why is the rate earned on stockholders’

equity by a thriving business ordinarily

higher than the rate earned on total assets?

  1. Should the rate earned on common

stockholders’ equity normally be higher

or lower than the rate earned on total

stockholders’ equity? Explain.

  1. The net income (after income tax) of Fleming

Inc. was $4.80 per common share in the

latest year and $7.50 per common share for

the preceding year. At the beginning of the

latest year, the number of shares outstanding

was doubled by a stock split. There were no

other changes in the amount of stock outstanding.

What were the earnings per share

in the preceding year, adjusted for comparison

with the latest year?

  1. The price-earnings ratio for the common stock

of In-Work Company was 15 at December

31, the end of the current fiscal year. What

does the ratio indicate about the selling price

of the common stock in relation to current

earnings?

  1. Why would the dividend yield differ significantly

from the rate earned on common

stockholders’ equity?

  1. Favorable business conditions may bring

about certain seemingly unfavorable ratios,

and unfavorable business operations may

result in apparently favorable ratios. For

example,

Shaddox Company increased its

sales and net income substantially for the

current year, yet the current ratio at the end

of the year is lower than at the beginning of

the year. Discuss some possible causes of the

apparent weakening of the current position,

while sales and net income have increased

substantially.

  1. Describe two reports provided by independent

auditors in the annual report to shareholders.

 

 

Exercises

E9-1 Vertical analysis of income statement

Revenue and expense data for Searle Technologies Co. are as follows:

2012 2011

Sales $900,000 $725,000

Cost of goods sold 558,000 435,000

Selling expenses 117,000 116,000

Administrative expenses 63,000 65,250

Income tax expense 76,500 58,000

  1. Prepare an income statement in comparative form, stating each item for both

2012 and 2011 as a percent of sales. Round to one decimal place.

  1. Comment on the significant changes disclosed by the comparative income

statement.

E9-2 Vertical analysis of income statement

The following comparative income statement (in thousands of dollars) for two

recent years was adapted from the annual report of Speedway Motorsports, Inc., owner

and operator of several major motor speedways, such as the Atlanta, Texas, and

Las Vegas Motor Speedways.

Year 2 Year 1

Revenues:

Admissions $163,087 $188,036

Event-related revenue 178,805 211,630

NASCAR broadcasting revenue 173,803 168,159

Other operating revenue 34,827 43,168

Total revenue $550,522 $610,993

Expenses and other:

Direct expense of events $100,922 $113,477

NASCAR purse and sanction fees 123,078 118,766

General and administrative 84,250 84,029

Depreciation and amortization 52,654 48,146

Other expenses 155,556 68,230

Total expenses and other $516,460 $432,648

Income from continuing operations before taxes $ 34,062 $178,345

  1. Prepare a comparative income statement for Years 1 and 2 in vertical form,

stating each item as a percent of revenues. Round to one decimal place.

  1. Comment on the significant changes.

E9-3 Common-sized income statement

Revenue and expense data for the current calendar year for Garrity Electronics

Company and for the electronics industry are as follows. The Garrity Electronics

Company data are expressed in dollars. The electronics industry averages are

expressed in percentages.

Garrity

Electronics

Company

Electronics

Industry

Average

Sales $4,728,800 102.5%

Sales returns and allowances 128,800 2.5

Net sales $4,600,000 100.0%

Cost of goods sold 2,668,000 61.0

Gross profit $1,932,000 39.0%

Selling expenses $1,472,000 23.0%

Administrative expenses 368,000 10.0

Total operating expenses $1,840,000 33.0%

Operating income $ 92,000 6.0%

Other income 138,000 3.0

$ 230,000 9.0%

Other expense 46,000 1.0

Income before income tax $ 184,000 8.0%

Income tax expense 115,000 2.5

Net income $ 69,000 5.5%

  1. Prepare a common-sized income statement comparing the results of operations

for Garrity Electronics Company with the industry average.

  1. As far as the data permit, comment on significant relationships revealed by

the comparisons.

E9-4 Vertical analysis of balance sheet

Balance sheet data for Otter Creek Company on December 31, the end of the

fiscal year, are shown below.

2012 2011

Current assets $700,000 $504,000

Property, plant, and equipment 945,000 770,000

Intangible assets 105,000 126,000

Current liabilities 280,000 294,000

Long-term liabilities 595,000 560,000

Common stock 140,000 140,000

Retained earnings 735,000 406,000

Prepare a comparative balance sheet for 2012 and 2011, stating each asset

as a percent of total assets and each liability and stockholders’ equity item as a

percent of the total liabilities and stockholders’ equity.

E9-5 Horizontal analysis of the income statement

Income statement data for Montana Images Company for the years ended

December

31, 2012 and 2011, are as follows:

2012 2011

Sales $579,000 $500,000

Cost of goods sold 343,500 300,000

Gross profit $235,500 $200,000

Selling expenses $ 46,000 $ 40,000

Administrative expenses 11,000 10,000

Total operating expenses $ 57,000 $ 50,000

Income before income tax $178,500 $150,000

Income tax expense 45,000 37,500

Net income $133,500 $112,500

  1. Prepare a comparative income statement with horizontal analysis, indicating

the increase (decrease) for 2012 when compared with 2011. Round to one

decimal place.

  1. What conclusions can be drawn from the horizontal analysis?

E9-6 Current position analysis

The following data were taken from the balance sheet of Fairmont Company:

Dec. 31, 2012 Dec. 31, 2011

Cash $ 150,000 $ 100,000

Temporary investments 400,000 250,000

Accounts and notes receivable (net) 1,050,000 1,000,000

Inventories 580,000 500,000

Prepaid expenses 60,000 100,000

Total current assets $2,240,000 $1,950,000

Accounts and notes payable (short-term) $ 600,000 $ 575,000

Accrued liabilities 200,000 175,000

Total current liabilities $ 800,000 $ 750,000

  1. Determine for each year (1) the working capital, (2) the current ratio, and

(3) the quick ratio.

  1. What conclusions can be drawn from these data as to the company’s ability

to meet its currently maturing debts?

E9-7 Current position analysis

PepsiCo, Inc., the parent company of Frito-Lay™ snack foods and Pepsi beverages,

had the following current assets and current liabilities at the end of two recent

years:

Year 2 (in millions) Year 1 (in millions)

Cash and cash equivalents $ 5,943 $3,943

Short-term investments, at cost 426 192

Accounts and notes receivable, net 6,323 4,624

Inventories 3,372 2,618

Prepaid expenses and other current assets 1,505 1,194

Short-term obligations 4,898 464

Accounts payable and other current liabilities 10,923 8,127

Income taxes payable 71 165

  1. Determine the (1) current ratio and (2) quick ratio for both years. Round to

one decimal place.

  1. What conclusions can you draw from these data?

E9-8 Current position analysis

The bond indenture for the 10-year, 8% debenture bonds dated January 2, 2011,

required working capital of $200,000, a current ratio of 2.0, and a quick ratio of

1.0 at the end of each calendar year until the bonds mature. At December 31,

2012, the three measures were computed as follows:

  1. Current assets:

Cash $120,000

Temporary investments 150,000

Accounts and notes receivable (net) 240,000

Inventories 190,000

Prepaid expenses 50,000

Intangible assets 30,000

Property, plant, and equipment 540,000

Total current assets (net) $1,320,000

Current liabilities:

Accounts and short-term notes payable $440,000

Accrued liabilities 160,000

Total current liabilities 600,000

Working capital $ 720,000

  1. Current ratio 2.2 $1,320,000 4 $600,000
  2. Quick ratio 1.5 $660,000 4 $440,000
  3. List the errors in the determination of the three measures of current position

analysis.

  1. Is the company satisfying the terms of the bond indenture?

E9-9 Accounts receivable analysis

The following data are taken from the financial statements of Encore Technology

Inc. Terms of all sales are 2/10, n/45.

2012 2011 2010

Accounts receivable, end of year $ 160,000 $ 150,000 $120,000

Net sales on account 1,519,000 1,215,000

  1. For 2012 and 2011, determine (1) the accounts receivable turnover and (2) the

number of days’ sales in receivables. Round to nearest dollar and one decimal

place.

  1. What conclusions can be drawn from these data concerning accounts receivable

and credit policies?

E9-10 Accounts receivable analysis

Bassett Stores Company and Fox Stores Inc. are large retail department stores.

Both companies offer credit to their customers through their own credit car

operations. Information from the financial statements for both companies for two

recent years is as follows (all numbers are in millions):

Bassett Fox

Merchandise sales $726,000 $2,470,000

Credit card receivables—beginning 75,000 350,000

Credit card receviables—ending 90,000 410,000

  1. Determine (1) the accounts receivable turnover and (2) the number of days’

sales in receivables for both companies. Round to nearest dollar and one decimal

place.

  1. Compare the two companies with regard to their credit card policies.

E9-11 Inventory analysis

The following data were extracted from the income statement of Brecca Systems Inc.:

Current Year Preceding Year

Sales $9,700,000 $7,175,000

Beginning inventories 420,000 400,000

Cost of goods sold 5,820,000 4,305,000

Ending inventories 550,000 420,000

  1. Determine for each year (1) the inventory turnover and (2) the number of

days’ sales in inventory. Round to nearest dollar and one decimal place.

  1. What conclusions can be drawn from these data concerning the inventories?

E9-12 Inventory analysis

Dell Inc. and Hewlett-Packard Company (HP) compete with each other in the personal

computer market. Dell’s primary strategy is to assemble computers to customer

orders, rather than for inventory. Thus, for example, Dell will build and deliver

a computer within four days of a customer entering an order on a Web page.

Hewlett-Packard, on the other hand, builds some computers prior to receiving

an order, then sells from this inventory once an order is received. Below is selected

financial information for both companies from a recent year’s financial

statements (in millions):

Dell Inc. Hewlett-Packard Company

Sales $61,494 $126,033

Cost of goods sold 50,098 96,089

Inventory, beginning of period 1,051 6,128

Inventory, end of period 1,301 6,466

  1. Determine for both companies (1) the inventory turnover and (2) the number

of days’ sales in inventory. Round to one decimal place.

  1. Interpret the inventory ratios by considering Dell’s and Hewlett-Packard’s

operating strategies.

E9-13 Ratio of liabilities to stockholders’ equity and number of times interest

charges earned

The following data were taken from the financial statements of Starr Construction

Inc. for December 31, 2012 and 2011:

Dec. 31, 2012 Dec. 31, 2011

Accounts payable and other liabilities $ 1,700,000 $2,325,000

Current maturities of bonds payable 500,000 500,000

Serial bonds payable, 8%, issued 2008, due 2018 5,000,000 5,500,000

Common stock, $5 par value 250,000 250,000

Paid-in capital in excess of par 1,500,000 1,500,000

Retained earnings 10,250,000 7,500,000

The income before income tax was $2,816,000 and $2,640,000 for the years

2012 and 2011, respectively.

  1. Determine the ratio of liabilities to stockholders’ equity at the end of each year.
  2. Determine the number of times the bond interest charges are earned during

the year for both years.

  1. What conclusions can be drawn from these data as to the company’s ability

to meet its currently maturing debts?

E9-14 Ratio of liabilities to stockholders’ equity and number of times interest

charges earned

Hasbro and Mattel, Inc., are the two largest toy companies in North America. Condensed

liabilities and stockholders’ equity from a recent balance sheet are shown

for each company as follows (in millions):

Hasbro Mattel

Current liabilities $ 719 $ 1,350

Long-term debt 1,759 1,439

Total liabilities $ 2,478 $ 2,789

Shareholders’ equity:

Common stock $ 105 $ 441

Additional paid in capital 626 1,706

Retained earnings 2,978 2,721

Accumulated other equity items 8 (359)

Treasury stock, at cost (2,102) (1,881)

Total stockholders’ equity $ 1,615 $ 2,628

Total liabilities and stockholders’ equity $ 4,093 $ 5,417

The income from operations and interest expense from the income statement

for both companies were as follows (in millions):

Hasbro Mattel

Income from operations before tax $508 $847

Interest expense 82 65

  1. Determine the ratio of liabilities to stockholders’ equity for both companies.

Round to one decimal place.

  1. Determine the number of times interest charges are earned for both companies.

Round to one decimal place.

  1. Interpret the ratio differences between the two companies.

E9-15 Ratio of liabilities to stockholders’ equity and ratio of fixed assets to

long-term liabilities

Recent balance sheet information for two companies in the food industry, H.J.

Heinz Company and The Hershey Company, are as follows (in thousands of dollars):

H.J. Heinz Hershey

Net property, plant, and equipment $2,091,796 $1,437,702

Current liabilities 2,175,359 1,298,845

Long-term debt 4,559,152 1,541,825

Other long-term liabilities 1,449,855 529,746

Stockholders’ equity 1,891,345 720,459

  1. Determine the ratio of liabilities to stockholders’ equity for both companies.

Round to one decimal place.

  1. Determine the ratio of fixed assets to long-term liabilities for both companies.

Round to one decimal place.

  1. Interpret the ratio differences between the two companies.

E9-16 Ratio of net sales to assets

Three major segments of the transportation industry are motor carriers, such

as YRC Worldwide; railroads, such as Union Pacific; and transportation arrangement

services, such as C.H. Robinson Worldwide Inc. Recent financial statement information

for these three companies is shown as follows (in thousands of dollars):

YRC Worldwide Union Pacific

C.H. Robinson

Worldwide Inc.

Net sales $4,334,640 $16,965,000 $9,274,305

Average total assets 2,812,504 42,636,000 1,914,974

  1. Determine the ratio of net sales to assets for all three companies. Round to

one decimal place.

  1. Assume that the ratio of net sales to assets for each company represents that

company’s respective industry segment. Interpret the differences in the ratio

of net sales to assets in terms of the operating characteristics of each of the

respective segments.

E9-17 Profitability ratios

The following selected data were taken from the financial statements of The

O’Malley Group Inc. for December 31, 2012, 2011, and 2010:

December 31

2012 2011 2010

Total assets $2,700,000 $2,300,000 $2,000,000

Notes payable (8% interest) 750,000 750,000 750,000

Common stock 250,000 250,000 250,000

Preferred $5 stock, $100 par

(no change during year) 400,000 400,000 400,000

Retained earnings 1,300,000 900,000 600,000

The 2012 net income was $430,000, and the 2011 net income was $320,000.

No dividends on common stock were declared between 2010 and 2012.

  1. Determine the rate earned on total assets, the rate earned on stockholders’

equity, and the rate earned on common stockholders’ equity for the years

2011 and 2012. Round to one decimal place.

  1. What conclusions can be drawn from these data as to the company’s profitability?

E9-18 Profitability ratios

Macy’s, Inc., sells merchandise through company-owned retail stores and Internet

Web sites. Recent financial information for Macy’s is provided below (all numbers

in millions).

Year 3 Year 2

Net income $847 $329

Interest expense 579 562

Year 3 Year 2 Year 1

Total assets $20,631 $21,300 $22,145

Total stockholders’ equity 5,530 4,653 4,646

Assume the apparel industry average rate earned on total assets is 8.2%, and

the average rate earned on stockholders’ equity is 10.0% for Year 3.

  1. Determine the rate earned on total assets for Macy’s for Years 3 and 2. Round

to one decimal place.

  1. Determine the rate earned on stockholders’ equity for Macy’s for Years 3 and
  2. Round to one decimal place.
  3. Evaluate the two-year trend for the profitability ratios determined in (a) and (b).

E9-19 Six measures of liquidity or profitability

The following data were taken from the financial statements of Whiting Enterprises

Inc. for the current fiscal year. Assuming that long-term investments totaled

$1,000,000 for the past two years and that total assets were $14,400,000 at the

beginning of the year, determine the following: (a) ratio of fixed assets to longterm

liabilities, (b) ratio of liabilities to stockholders’ equity, (c) ratio of net sales

to assets, (d) rate earned on total assets, (e) rate earned on stockholders’ equity,

and (f) rate earned on common stockholders’ equity. Round to one decimal place.

Property, plant, and equipment (net) $ 7,000,000

Liabilities:

Current liabilities $ 200,000

Mortgage note payable, 8%, issued 2010, due 2020 5,000,000

Total liabilities $ 5,200,000

Stockholders’ equity:

Preferred $2 stock, $20 par (no change during year) $ 3,000,000

Common stock, $2 par (no change during year) 500,000

Retained earnings:

Balance, beginning of year $6,525,000

Net income 725,000 $7,250,000

Preferred dividends $ 300,000

Common dividends 50,000 350,000

Balance, end of year 6,900,000

Total stockholders’ equity $10,400,000

Net sales $36,400,000

Interest expense $ 400,000

E9-20 Six financial ratios

The balance sheet for Shryer Industries Inc. at the end of the current fiscal year

indicated the following:

Bonds payable, 5% (issued in 2000, due in 2020) $ 8,000,000

Preferred $4 stock, $75 par 15,000,000

Common stock, $7 par 3,500,000

Income before income tax was $3,400,000, and income taxes were $1,000,000

for the current year. Cash dividends paid on common stock during the current

year totaled $100,000. The common stock was selling for $8 per share at the

end of the year. Determine each of the following: (a) number of times bond

interest charges are earned, (b) number of times preferred dividends are earned,

(c) earnings per share on common stock, (d) price-earnings ratio, (e) dividends

per share of common stock, and (f) dividend yield. Round to one decimal place

except earnings per share, which should be rounded to two decimal places.

E9-21 Earnings per share, price-earnings ratio, dividend yield

The following information was taken from the financial statements of Monarch

Resources Inc. for December 31 of the current fiscal year:

Common stock, $125 par value (no change during the year) $12,500,000

Preferred $6 stock, $90 par (no change during the year) 2,250,000

The net income was $1,300,000, and the declared dividends on the common

stock were $460,000 for the current year. The market price of the common stock

is $92 per share.

For the common stock, determine (a) the earnings per share, (b) the priceearnings

ratio, (c) the dividends per share, and (d) the dividend yield.

E9-22 Price-earnings ratio, dividend yield

The table below shows the stock price, earnings per share, and dividends per

share for three companies as of June 3, 2011.

Price Earnings per Share Dividends per Share

McDonald’s Corporation $80.54 $4.73 $2.44

eBay Inc. 30.43 1.42 0.00

The Coca-Cola Company 65.53 5.19 1.88

  1. Determine the price-earnings ratio and dividend yield for the three companies.

Round to one decimal place.

  1. Explain the differences in these ratios across the three companies.

E9-23 Earnings per share

The net income reported on the income statement of Bellach Co. was $4,100,000.

There were 250,000 shares of $40 par common stock and 60,000 shares of $3 preferred

stock par value $100 outstanding throughout the current year. The income

statement included two extraordinary items: a $600,000 gain from condemnation of

land and a $150,000 loss arising from flood damage, both after applicable income

tax. Determine the per-share figures for common stock for (a) income before extraordinary

items and (b) net income.

E9-24 Unusual income statement items

Assume that the amount of each of the following items is material to the financial

statements. Classify each item as either normally recurring (NR) or unusual

items. If unusual item, then specify if it is a discontinued operations item (DI)

or extraordinary (E).

  1. Interest revenue on notes receivable.
  2. Gain on sale of land condemned by the local government for a public works

project.

  1. Gain on sale of segment of the company’s operations that manufactures bottling

equipment.

  1. Loss on sale of investments in stocks and bonds.
  2. Uncollectible accounts expense.
  3. Uninsured loss on building due to hurricane damage. The building was purchased

by the company in 1980 and had not previously incurred hurricane

damage.

  1. Uninsured flood loss. (Flood insurance is unavailable because of periodic

flooding in the area.)

E9-25 Income statement and earnings per share for extraordinary items and

discontinued operations

Leadbetter Inc. reports the following for 2012:

Income from continuing operations before income tax $766,250

Extraordinary property loss from hurricane $60,000*

Gain from discontinued operations $180,000*

Applicable tax rate 40%

*Net of any tax effect.

  1. Prepare a partial income statement for Leadbetter Inc. beginning with income

from continuing operations before income tax.

  1. Assuming 75,000 shares, calculate the earnings per common share for Leadbetter

Inc. including per-share amounts for unusual items.

 

Problems

P9-1 Horizontal analysis for income statement

For 2012, Greyhound Technology Company reported its most significant decline

in net income in years. At the end of the year, Duane Vogel, the president, is

presented with the following condensed comparative income statement:

Greyhound Technology Company

Comparative Income Statement

For the Years Ended December 31, 2012 and 2011

2012 2011

Sales $880,000 $800,000

Sales returns and allowances 18,000 15,000

Net sales $862,000 $785,000

Cost of goods sold 650,000 500,000

Gross profit $212,000 $285,000

Selling expenses $ 44,000 $ 40,000

Administrative expenses 27,000 25,000

Total operating expenses $ 71,000 $ 65,000

Income from operations $141,000 $220,000

Other income 2,300 2,000

Income before income tax $143,300 $222,000

Income tax expense 13,000 20,000

Net income $130,300 $202,000

Instructions

  1. Prepare a comparative income statement with horizontal analysis for the twoyear

period, using 2011 as the base year. Round to one decimal place.

  1. To the extent the data permit, comment on the significant relationships revealed

by the horizontal analysis prepared in (1).

P9-2 Vertical analysis for income statement

For 2012, Blue Buffalo Company initiated a sales promotion campaign that included

the expenditure of an additional $60,000 for advertising. At the end of the

year, Tamara Wasnuk, the president, is presented with the following condensed

comparative income statement:

Blue Buffalo Company

Comparative Income Statement

For the Years Ended December 31, 2012 and 2011

2012 2011

Sales $1,545,000 $1,224,000

Sales returns and allowances 45,000 24,000

Net sales $1,500,000 $1,200,000

Cost of goods sold 960,000 780,000

Gross profit $ 540,000 $ 420,000

Selling expenses $ 285,000 $ 216,000

Administrative expenses 90,000 96,000

Total operating expenses $ 375,000 $ 312,000

Income from operations $ 165,000 $ 108,000

Other income 36,000 36,000

Income before income tax $ 201,000 $ 144,000

Income tax expense 42,000 28,800

Net income $ 159,000 $ 115,200

Instructions

  1. Prepare a comparative income statement for the two-year period, presenting

an analysis of each item in relationship to net sales for each of the years.

  1. To the extent the data permit, comment on the significant relationships revealed

by the vertical analysis prepared in (1).

P9-3 Effect of transactions on current position analysis

Data pertaining to the current position of Newlan Company are as follows:

Cash $ 80,000

Temporary investments 160,000

Accounts and notes receivable (net) 235,000

Inventories 190,000

Prepaid expenses 10,000

Accounts payable 158,000

Notes payable (short-term) 80,000

Accrued expenses 12,000

Instructions

  1. Compute (a) the working capital, (b) the current ratio, and (c) the quick ratio.
  2. List the following captions on a sheet of paper:

Transaction Working Capital Current Ratio Quick Ratio

Compute the working capital, the current ratio, and the quick ratio after each

of the following transactions, and record the results in the appropriate columns.

Consider each transaction separately and assume that only that transaction affects

the data given above. Round to one decimal place.

  1. Sold temporary investments at no gain or loss, $50,000.
  2. Paid accounts payable, $40,000.
  3. Purchased goods on account, $75,000.
  4. Paid notes payable, $30,000.
  5. Declared a cash dividend, $15,000.
  6. Declared a stock dividend on common stock, $24,000.
  7. Borrowed cash from bank on a long-term note, $150,000.
  8. Received cash on account, $72,000.
  9. Issued additional shares of stock for cash, $300,000.
  10. Paid cash for prepaid expenses, $10,000.

P9-4 Nineteen measures of liquidity, solvency, and profitability

The comparative financial statements of Tec Solutions Inc. are as follows. The market

price of Tec Solutions Inc. common stock was $89.75 on December 31, 2012.

Tec Solution s Inc.

Comparative Income Statement

For the Years Ended December 31, 2012 and 2011

2012 2011

Sales $1,940,000 $1,450,000

Sales returns and allowances 15,000 10,000

Net sales $1,925,000 $1,440,000

Cost of goods sold 780,000 575,000

Gross profit $1,145,000 $ 865,000

Selling expenses $ 385,000 $ 365,000

Administrative expenses 215,000 200,000

Total operating expenses $ 600,000 $ 565,000

Income from operations $ 545,000 $ 300,000

Other income 25,000 43,000

$ 570,000 $ 343,000

Other expense (interest) 115,000 75,000

Income before income tax $ 455,000 $ 268,000

Income tax expense 91,000 40,000

Net income $ 364,000 $ 228,000

Tec Solution s Inc.

Comparative Retained Earnings Statement

For the Years Ended December 31, 2012 and 2011

2012 2011

Retained earnings, January 1 $381,000 $168,000

Add net income for year 364,000 228,000

Total $745,000 $396,000

Deduct dividends:

On preferred stock $ 5,000 $ 5,000

On common stock 40,000 10,000

Total $ 45,000 $ 15,000

Retained earnings, December 31 $700,000 $381,000

TEc Solution s Inc.

Comparative Balance Sheet

December 31, 2012 and 2011

Dec. 31, 2012 Dec. 31, 2011

Assets

Current assets:

Cash $ 175,000 $ 200,000

Temporary investments 250,000 292,000

Accounts receivable (net) 190,000 160,000

Inventories 300,000 260,000

Prepaid expenses 50,000 13,000

Total current assets $ 965,000 $ 925,000

Long-term investments 400,000 100,000

Property, plant, and equipment (net) 1,135,000 875,000

Total assets $2,500,000 $1,900,000

Liabilities

Current liabilities $ 200,000 $ 419,000

Long-term liabilities:

Mortgage note payable, 8%, due 2020 $ 500,000 —

Bonds payable, 10%, due 2030 750,000 $ 750,000

Total long-term liabilities $1,250,000 $ 750,000

Total liabilities $1,450,000 $1,169,000

Stockholders’ Equity

Preferred $5 stock, $100 par $ 100,000 $ 100,000

Common stock, $5 par 250,000 250,000

Retained earnings 700,000 381,000

Total stockholders’ equity $1,050,000 $ 731,000

Total liabilities and stockholders’ equity $2,500,000 $1,900,000

Instructions

Determine the following measures for 2012, rounding to one decimal place:

  1. Working capital
  2. Current ratio
  3. Quick ratio
  4. Accounts receivable turnover
  5. Number of days’ sales in receivables
  6. Inventory turnover
  7. Number of days’ sales in inventory
  8. Ratio of fixed assets to long-term liabilities
  9. Ratio of liabilities to stockholders’ equity
  10. Number of times interest charges earned
  11. Number of times preferred dividends earned
  12. Ratio of net sales to assets
  13. Rate earned on total assets
  14. Rate earned on stockholders’ equity
  15. Rate earned on common stockholders’ equity
  16. Earnings per share on common stock
  17. Price-earnings ratio
  18. Dividends per share of common stock
  19. Dividend yield

P9-5 Trend analysis

Critelli Company has provided the following comparative information:

2012 2011 2010 2009 2008

Net income $1,785,000 $1,330,000 $ 990,000 $ 768,800 $ 664,000

Interest expense 400,000 350,000 300,000 240,000 200,000

Income tax expense 615,000 340,000 270,000 71,200 16,000

Average total assets 9,500,000 8,000,000 6,000,000 5,200,000 4,500,000

Average stockholders’ equity 5,400,000 4,300,000 3,100,000 2,650,000 2,200,000

You have been asked to evaluate the historical performance of the company

over the last five years.

Selected industry ratios have remained relatively steady at the following levels

for the last five years:

2008–2012

Rate earned on total assets 15%

Rate earned on stockholders’ equity 18%

Number of times interest charges earned 3.5

Instructions

  1. Prepare three line graphs, with the ratio on the vertical axis and the years on

the horizontal axis for the following three ratios (rounded to one decimal place):

  1. Rate earned on total assets
  2. Rate earned on stockholders’ equity
  3. Number of times interest charges earned

Display both the company ratio and the industry benchmark on each graph.

That is, each graph should have two lines.

  1. Prepare an analysis of the graphs in (1).

 

Activities

A9-1 Analysis of financing corporate growth

Assume that the president of Elkhead Brewery made the following statement in

the Annual Report to Shareholders:

“The founding family and majority shareholders of the company do not believe in

using debt to finance future growth. The founding family learned from hard experience

during Prohibition and the Great Depression that debt can cause loss of

flexibility and eventual loss of corporate control. The company will not place itself

at such risk. As such, all future growth will be financed either by stock sales to the

public or by internally generated resources.”

As a public shareholder of this company, how would you respond to this policy?

A9-2 Receivables and inventory turnover

Thornby Inc. has completed its fiscal year on December 31, 2012. The auditor, Kim

Holmes, has approached the CFO, Brad Potter, regarding the year-end receivables

and inventory levels of Thornby Inc.. The following conversation takes place:

Kim: We are beginning our audit of Thornby Inc. and have prepared ratio

analyses to determine if there have been significant changes in operations or

financial position. This helps us guide the audit process. This analysis indicates

that the inventory turnover has decreased from 5.1 to 3.8, while the accounts

receivable turnover has decreased from 12.5 to 9. I was wondering if you could

explain this change in operations.

Brad: There is little need for concern. The inventory represents computers that

we were unable to sell during the holiday buying season. We are confident,

however, that we will be able to sell these computers as we move into the

next fiscal year.

Kim: What gives you this confidence?

Brad: We will increase our advertising and provide some very attractive price

concessions to move these machines. We have no choice. Newer technology is

already out there, and we have to unload this inventory.

Kim: . . . and the receivables?

Brad: As you may be aware, the company is under tremendous pressure to expand

sales and profits. As a result, we lowered our credit standards to our commercial

customers so that we would be able to sell products to a broader customer base.

As a result of this policy change, we have been able to expand sales by 28%.

Kim: Your responses have not been reassuring to me.

Brad: I’m a little confused. Assets are good, right? Why don’t you look at our

current ratio? It has improved, hasn’t it? I would think that you would view

that very favorably.

Why is Kim concerned about the inventory and accounts receivable turnover

ratios and Brad’s responses to them? What action may Kim need to take? How

would you respond to Brad’s last comment?

A9-3 Vertical analysis

The condensed income statements through income from operations for Apple Inc.

and Dell Inc. are reproduced below for recent fiscal years (numbers in millions

of dollars).

Apple Inc. Dell Inc.

Sales (net) $65,225 $61,494

Cost of sales 39,541 50,098

Gross profit $25,684 $11,396

Selling, general, and administrative expenses $ 5,517 $ 7,302

Research and development 1,782 661

Operating expenses $ 7,299 $ 7,963

Income from operations $18,385 $ 3,433

Prepare comparative common-sized statements, rounding percents to one decimal

place. Interpret the analyses.

A9-4 Profitability and stockholder ratios

Harley-Davidson, Inc., is a leading motorcycle manufacturer in the United States. The

company manufactures and sells a number of different types of motorcycles, a

complete line of motorcycle parts, and brand-related accessories, clothing, and

collectibles. In recent years, Harley-Davidson has attempted to expand its dealer

network and product lines internationally.

The following information is available for three recent years (in millions except

per-share amounts):

Year 3 Year 2 Year 1

Net income (loss) $147 $(55) $655

Preferred dividends $0.00 $0.00 $0.00

Interest expense $90 $22 $5

Shares outstanding for computing

earnings per share 233 233 234

Cash dividend per share $0.40 $0.40 $1.29

Average total assets $9,293 $8,493 $6,743

Average stockholders’ equity $2,157 $2,112 $2,246

Average stock price per share $29.94 $21.09 $31.84

  1. Calculate the following ratios for each year:
  2. Rate earned on total assets
  3. Rate earned on stockholders’ equity
  4. Earnings per share
  5. Dividend yield
  6. Price-earnings ratio
  7. What is the ratio of average liabilities to average stockholders’ equity for

Year 3, Year 2, and Year 1?

  1. Explain the direction of the dividend yield and price-earnings ratio in light of

Harley-Davidson’s profitability trend.

  1. Based on these data, evaluate Harley-Davidson’s strategy to expand to international

markets.

A9-5 Comprehensive profitability and solvency analysis

Marriott International, Inc., and Wyndham Worldwide Corporation are two major owners and

managers of lodging and resort properties in the United States. Abstracted income

statement information for the two companies is as follows for a recent year:

Marriott

(in millions)

Wyndham

(in millions)

Operating profit before other expenses and interest $ 695 $ 718

Other income (expenses) 36 12

Interest expense (180) (167)

Income before income taxes $ 551 $ 563

Income tax expense 93 184

Net income $ 458 $ 379

Balance sheet information is as follows:

Marriott

(in millions)

Wyndham

(in millions)

Total liabilities $7,398 $6,499

Total stockholders’ equity 1,585 2,917

Total liabilities and stockholders’ equity $8,983 $9,416

The average liabilities, stockholders’ equity, and total assets were as follows:

Marriott

(in millions)

Wyndham

(in millions)

Average total liabilities $7,095 $6,582

Average total stockholders’ equity 1,363 2,802

Average total assets 8,458 9,384

  1. Determine the following ratios for both companies (round to one decimal

place after the whole percent):

  1. Rate earned on total assets
  2. Rate earned on total stockholders’ equity
  3. Number of times interest charges are earned
  4. Ratio of liabilities to stockholders’ equity
  5. Analyze and compare the two companies, using the information in (1).

 

Answers to Self-Examination Questions

  1. A Percentage analysis indicating the relationship

of the component parts to the total in a

financial statement, such as the relationship

of current assets to total assets (20% to 100%)

in the question, is called vertical analysis (answer

A). Percentage analysis of increases and

decreases in corresponding items in comparative

financial statements is called horizontal

analysis (answer B). An example of horizontal

analysis would be the presentation of the

amount of current assets in the preceding balance

sheet, along with the amount of current

assets at the end of the current year, with the

increase or decrease in current assets between

the periods expressed as a percentage. Profitability

analysis (answer C) is the analysis of

a firm’s ability to earn income. Contribution

margin analysis (answer D) is discussed in a

later managerial accounting chapter.

  1. D Various liquidity and solvency measures,

categorized as current position analysis, indicate

a firm’s ability to meet currently maturing

obligations. Each measure contributes to the

analysis of a firm’s current position and is

most useful when viewed with other measures

and when compared with similar measures for

other periods and for other firms. Working

capital (answer A) is the excess of current

assets over current liabilities; the current ratio

(answer B) is the ratio of current assets to current

liabilities; and the quick ratio (answer C)

is the ratio of the sum of cash, receivables, and

temporary investments to current liabilities.

  1. D The ratio of current assets to current liabilities

is usually called the current ratio (answer

A). It is sometimes called the working capital

ratio (answer B) or bankers’ ratio (answer C).

  1. C The ratio of the sum of cash, receivables,

and temporary investments (sometimes called

quick assets) to current liabilities is called the

quick ratio (answer C) or acid-test ratio. The

current ratio (answer A), working capital ratio

(answer B), and bankers’ ratio (answer D) are

terms that describe the ratio of current assets

to current liabilities.

  1. C The number of days’ sales in inventory

(answer C), which is determined by dividing

the average inventory by the average daily

cost of goods sold, expresses the relationship

between the cost of goods sold and inventory.

It indicates the efficiency in the management

of inventory. The working capital ratio (answer

  1. A) indicates the ability of the business

to meet currently maturing obligations (debt).

The quick ratio (answer B) indicates the “instant”

debt-paying ability of the business. The

ratio of fixed assets to long-term liabilities

(answer D) indicates the margin of safety for

long-term creditors.

 

 

Chapter 10 accounting Systems for Manufacturing

 

Class Discussion Questions

  1. List three differences in how managerial

accounting

differs from financial accounting.

  1. For a company that produces desktop computers,

would memory chips be considered

a direct or an indirect materials cost of each

computer produced?

  1. How is product cost information used by

managers?

  1. a. Name two principal types of cost accounting

systems.

  1. Which system provides for a separate record

of each particular quantity of product

that passes through the factory?

  1. Which system accumulates the costs for

each department or process within the

factory?

  1. What kind of firm would use a job order cost

system?

  1. Hewlett-Packard Company assembles inkjet printers

in which a high volume of standardized

units are assembled and tested. Is the job

order cost system appropriate in this situation?

  1. How does the use of the materials requisition

help control the issuance of materials from

the storeroom?

  1. a. Differentiate between the clock card and

the time ticket.

  1. Why should the total time reported on

an employee’s time tickets for a payroll

period

be compared with the time reported

on the employee’s clock cards for

the same period?

  1. Describe the source of the data for increasing

Work in Process for (a) direct materials,

(b) direct labor, and (c) factory overhead.

  1. Discuss how the predetermined factory overhead

rate can be used in job order cost accounting

to assist management in pricing jobs.

  1. a. How is a predetermined factory overhead

rate calculated?

  1. Name three common bases used in calculating

the rate.

  1. a. What is (1) overapplied factory overhead

and (2) underapplied factory overhead?

  1. If the factory overhead account has a positive

balance, was factory overhead underapplied

or overapplied?

  1. At the end of the fiscal year, there was a

relatively minor balance in the factory overhead

account. What procedure can be used

for disposing of the balance in the account?

  1. What is the difference between a product

cost and a period cost?

  1. How can job cost information be used to

identify cost improvement opportunities?

  1. Describe how a job order cost system can be

used for professional service businesses.

  1. What is the benefit of just-in-time processing?
  2. What are some examples of non-value-added

lead time?

  1. Why do just-in-time manufacturers favor pull

or make-to-order manufacturing?

  1. Why would a just-in-time manufacturer strive

to produce zero defects?

  1. How is supplier partnering different from

traditional supplier relationships?

  1. How can activity-based costing be used in

service companies?

 

Exercises

E10-1 Classifying costs as materials, labor, or factory overhead

Indicate whether each of the following costs of an airplane manufacturer would

be classified as direct materials cost, direct labor cost, or factory overhead cost:

  1. Aircraft engines
  2. Controls for flight deck
  3. Depreciation of welding equipment
  4. Salary of test pilot
  5. Steel used in landing gear
  6. Tires
  7. Wages of assembly line worker
  8. Welding machinery lubricants

E10-2 Classifying costs as materials, labor, or factory overhead

Indicate whether the following costs of Colgate-Palmolive Company would be classified

as direct materials cost, direct labor cost, or factory overhead cost:

  1. Wages paid to Packaging Department employees
  2. Maintenance supplies
  3. Plant manager salary for the Morristown, Tennessee, toothpaste plant
  4. Packaging materials which are a significant product cost
  5. Depreciation on production machinery
  6. Salary of process engineers
  7. Depreciation on the Clarksville, Indiana, soap plant
  8. Resins for soap and shampoo products
  9. Scents and fragrances
  10. Wages of production line employees

E10-3 Classifying costs as factory overhead

Which of the following items are properly classified as part of factory overhead

for Caterpillar?

  1. Factory supplies used in the Morganton, North Carolina, engine parts plant
  2. Amortization of patents on new assembly process
  3. Steel plate
  4. Vice president of finance’s salary
  5. Sales incentive fees to dealers
  6. Depreciation on Peoria, Illinois, headquarters building
  7. Interest expense on debt
  8. Plant manager’s salary at Aurora, Illinois, manufacturing plant
  9. Consultant fees for a study of production line employee productivity
  10. Property taxes on the Danville, Kentucky, tractor tread plant

E10-4 Classifying costs as product or period costs

For apparel manufacturer Ann Taylor, Inc., classify each of the following costs as

either a product cost or a period cost:

  1. Sales commissions
  2. Advertising expenses
  3. Fabric used during production
  4. Property taxes on factory building and equipment
  5. Depreciation on sewing machines
  6. Factory janitorial supplies
  7. Depreciation on office equipment
  8. Wages of sewing machine operators
  9. Repairs and maintenance costs for sewing machines
  10. Salary of production quality control supervisor
  11. Salaries of distribution center personnel
  12. Research and development costs
  13. Oil used to lubricate sewing machines
  14. Corporate controller’s salary
  15. Utility costs for office building
  16. Travel costs of salespersons
  17. Factory supervisors’ salaries

E10-5 Concepts and terminology

From the choices presented in the parentheses, choose the appropriate term for

completing each of the following sentences:

  1. Advertising expenses are usually viewed as (period, product) costs.
  2. The balance sheet of a manufacturer would include an account for (cost of

goods sold, work-in-process inventory).

  1. Materials that are an integral part of the manufactured product are classified

as (direct materials, materials inventory).

  1. An example of factory overhead is (plant depreciation, sales office depreciation).
  2. Implementing automatic factory robotics equipment normally (increases, decreases)

the factory overhead component of product costs.

  1. Direct labor costs combined with factory overhead costs are called (prime,

conversion) costs.

  1. The wages of an assembly worker are normally considered a (period, product)

cost.

  1. Payments of cash or its equivalent or the commitment to pay cash in the future

for the purpose of generating revenues are (costs, expenses).

E10-6 T ransactions in a job order cost system

Five selected transactions for the current month are indicated by letters in the

following accounts in a job order cost accounting system:

Materials Work in Process

(a) decrease (a) increase

(b) increase

(c) increase

(d) decrease

Wages Payable Finished Goods

(b) increase (d) increase

(e) decrease

Factory Overhead Cost of Goods Sold

(a) increase (e) increase

(b) increase

(c) decrease

Describe each of the five transactions.

E10-7 Cost flow relationships

The following information is available for the first month of operations of Beek

Inc., a manufacturer of art and craft items:

Sales $478,000

Gross profit 286,800

Indirect labor 48,000

Indirect materials 11,300

Other factory overhead 14,700

Materials purchased 124,000

Total manufacturing costs for the period 325,000

Materials inventory, end of period 34,900

Using the above information, determine the following:

  1. Cost of goods sold
  2. Direct materials cost
  3. Direct labor cost

E10-8 Cost of materials issuances

An incomplete subsidiary ledger of wire cable for July is as follows:

RECEIVED ISSUED BALANCE

Receiving

Report

Number Quantity

Unit

Price

Materials

Requisition

Number Quantity Amount Date Quantity Amount

Unit

Price

July 1 250 $1,500 $6.00

309 400 $7.50 July 5

7401 480 July 10

422 800 8.00 July 20

7639 650 July 26

  1. Complete the materials issuances and balances for the wire cable subsidiary

ledger.

  1. Determine the balance of wire cable at the end of July.
  2. Determine the total amount of materials transferred to Work in Process for

July.

  1. Explain how the materials ledger might be used as an aid in maintaining

inventory

quantities on hand.

E10-9 Recording issuing of materials

Materials issued for the current month are as follows:

Requisition No. Material Job No. Amount

945 Fiberglass 78 $17,600

946 Plastic 93 8,600

947 Glue Indirect 955

948 Wood 99 3,150

949 Aluminium 108 33,450

  1. Determine the amount of materials transferred to Work in Process and Factory

Overhead for the current month.

  1. Illustrate the effect on the accounts and financial statements of the materials

transferred in (a).

E10-10 Amounts for materials

Cherokee Furniture Company manufactures furniture. Cherokee Furniture uses a

job order cost system. Balances on April 1 from the materials ledger are as follows:

Fabric $ 6,140

Polyester filling 5,900

Lumber 17,400

Glue 1,800

The materials purchased during April are summarized from the receiving reports

as follows:

Fabric $67,750

Polyester filling 40,000

Lumber 92,350

Glue 8,000

Materials were requisitioned to individual jobs as follows:

Fabric Polyester Filling Lumber Glue Total

Job 304 $12,460 $ 5,175 $18,300 $ 35,935

Job 305 19,170 10,225 29,950 59,345

Job 306 31,570 26,100 40,250 97,920

Factory overhead—indirect

materials $7,350 7,350

Total $63,200 $41,500 $88,500 $7,350 $200,550

The glue is not a significant cost, so it is treated as indirect materials (factory

overhead).

  1. The wages of an assembly worker are normally considered a (period, product)

cost.

  1. Payments of cash or its equivalent or the commitment to pay cash in the future

for the purpose of generating revenues are (costs, expenses).

E10-6 T ransactions in a job order cost system

Five selected transactions for the current month are indicated by letters in the

following accounts in a job order cost accounting system:

Materials Work in Process

(a) decrease (a) increase

(b) increase

(c) increase

(d) decrease

Wages Payable Finished Goods

(b) increase (d) increase

(e) decrease

Factory Overhead Cost of Goods Sold

(a) increase (e) increase

(b) increase

(c) decrease

Describe each of the five transactions.

E10-7 Cost flow relationships

The following information is available for the first month of operations of Beek

Inc., a manufacturer of art and craft items:

Sales $478,000

Gross profit 286,800

Indirect labor 48,000

Indirect materials 11,300

Other factory overhead 14,700

Materials purchased 124,000

Total manufacturing costs for the period 325,000

Materials inventory, end of period 34,900

Using the above information, determine the following:

  1. Cost of goods sold
  2. Direct materials cost
  3. Direct labor cost

E10-8 Cost of materials issuances

An incomplete subsidiary ledger of wire cable for July is as follows:

RECEIVED ISSUED BALANCE

Receiving

Report

Number Quantity

Unit

Price

Materials

Requisition

Number Quantity Amount Date Quantity Amount

Unit

Price

July 1 250 $1,500 $6.00

309 400 $7.50 July 5

7401 480 July 10

422 800 8.00 July 20

7639 650 July 26

  1. Complete the materials issuances and balances for the wire cable subsidiary

ledger.

  1. Determine the balance of wire cable at the end of July.
  2. Determine the total amount of materials transferred to Work in Process for

July.

  1. Explain how the materials ledger might be used as an aid in maintaining

inventory

quantities on hand.

E10-9 Recording issuing of materials

Materials issued for the current month are as follows:

Requisition No. Material Job No. Amount

945 Fiberglass 78 $17,600

946 Plastic 93 8,600

947 Glue Indirect 955

948 Wood 99 3,150

949 Aluminium 108 33,450

  1. Determine the amount of materials transferred to Work in Process and Factory

Overhead for the current month.

  1. Illustrate the effect on the accounts and financial statements of the materials

transferred in (a).

E10-10 Amounts for materials

Cherokee Furniture Company manufactures furniture. Cherokee Furniture uses a

job order cost system. Balances on April 1 from the materials ledger are as follows:

Fabric $ 6,140

Polyester filling 5,900

Lumber 17,400

Glue 1,800

The materials purchased during April are summarized from the receiving reports

as follows:

Fabric $67,750

Polyester filling 40,000

Lumber 92,350

Glue 8,000

Materials were requisitioned to individual jobs as follows:

Fabric Polyester Filling Lumber Glue Total

Job 304 $12,460 $ 5,175 $18,300 $ 35,935

Job 305 19,170 10,225 29,950 59,345

Job 306 31,570 26,100 40,250 97,920

Factory overhead—indirect

materials $7,350 7,350

Total $63,200 $41,500 $88,500 $7,350 $200,550

The glue is not a significant cost, so it is treated as indirect materials (factory

overhead).

  1. Determine the total purchase of materials in April.
  2. Determine the amounts of materials transferred to Work in Process and Factory

Overhead for the requisition of materials in April.

  1. Determine the April 30 balances that would be shown in the materials ledger

accounts.

E10-11 Recording factory labor costs

A summary of the time tickets for October is as follows:

Job No. Amount Job No. Amount

3467 $ 4,350 3478 $ 5,800

3470 2,190 3480 6,300

3471 7,180 3497 8,050

Indirect labor 13,600 3501 11,130

  1. Determine the amounts of factory labor costs transferred to Work in Process

and Factory Overhead for October.

  1. Illustrate the effect on the accounts and financial statements of the factory

labor costs transferred in (a).

E10-12 Recording factory labor costs

The weekly time tickets indicate the following distribution of labor hours for

three direct labor employees:

Hours

Job 560A Job 560B Job 560C

Process

Improvement

Eva Leavitt 15 15 6 4

Micah Stone 10 15 13 2

Travis Hendrix 12 14 10 4

The direct labor rate earned by the three employees is as follows:

Leavitt $31

Stone 28

Hendrix 20

The process improvement category includes training, quality improvement,

housekeeping, and other indirect tasks.

  1. Determine the amounts of factory labor costs transferred to Work in Process

and Factory Overhead for the week.

  1. Assume that Jobs 560A and 560B were completed but not sold during the

week and that Job 560C remained incomplete at the end of the week. How

would the direct labor costs for all three jobs be reflected on the financial

statements at the end of the week?

E10-13 Recording direct labor and factory overhead

Chamlee Industries Inc. manufactures recreational vehicles. Chamlee Industries uses

a job order cost system. The time tickets from May jobs are summarized below.

Job 5-100 $6,400

Job 5-101 3,900

Job 5-102 4,800

Job 5-103 2,900

Factory supervision 1,750

Factory overhead is applied to jobs on the basis of a predetermined overhead

rate of $30 per direct labor hour. The direct labor rate is $25 per hour.

  1. Determine the total factory labor costs transferred to Work in Process and

Factory Overhead for May.

  1. Determine the amount of factory overhead applied to production for May.
  2. Illustrate the effects of the factory overhead applied in (b) on the accounts

and financial statements.

E10-14 Factory overhead rates and account balances

Lakeland Industries operates two factories. The manufacturing operation of Factory

1 is machine intensive, while the manufacturing operation of Factory 2 is

labor intensive. The company applies factory overhead to jobs on the basis of

machine hours in Factory 1 and on the basis of direct labor hours in Factory 2.

Estimated factory overhead costs, direct labor hours, and machine hours are as

follows:

Factory 1 Factory 2

Estimated factory overhead cost for fiscal year

beginning January 1 $560,000 $1,750,000

Estimated direct labor hours for year 200,000

Estimated machine hours for year 17,500

Actual factory overhead costs for January $ 28,000 $ 150,500

Actual direct labor hours for January 17,400

Actual machine hours for January 850

  1. Determine the factory overhead rate for Factory 1.
  2. Determine the factory overhead rate for Factory 2.
  3. Determine the factory overhead applied to production in each factory for January.
  4. Determine the balances of the factory accounts for each factory as of January

31, and indicate whether the amounts represent overapplied or underapplied

factory overhead.

  1. Explain why Factory 1 might use machine hours to allocate factory overhead

while Factory 2 uses direct labor hours.

E10-15 Predetermined factory overhead rate

Ace Engine Shop uses a job order cost system to determine the cost of performing

engine repair work. Estimated costs and expenses for the coming period are

as follows:

Engine parts $325,000

Shop direct labor 296,000

Shop and repair equipment depreciation 18,000

Shop supervisor salaries 110,000

Shop property taxes 20,500

Shop supplies 7,500

Advertising expense 30,000

Administrative office salaries 75,000

Administrative office depreciation expense 8,000

Total costs and expenses $890,000

The average shop direct labor rate is $18.50 per hour. Determine the predetermined

shop overhead rate per direct labor hour.

E10-16 Predetermined factory overhead rate

St. Lukes Medical Center has a single operating room that is used by local

physicians

to perform surgical procedures. The cost of using the operating room is accumulated

by each patient procedure and includes the direct materials costs (drugs

and medical devices), physician surgical time, and operating room overhead. On

July 1 of the current year, the annual operating room overhead is estimated to be:

Disposable supplies $ 330,000

Depreciation expense 59,400

Utilities 34,100

Nurse salaries 496,500

Technician wages 151,000

Total operating room overhead $1,071,000

The overhead costs will be assigned to procedures based on the number

of surgical room hours. St. Lukes Medical Center expects to use the operating room

an average of 10 hours per day, seven days per week. In addition, the operating

room will be shut down one week per year for general and maintenance repairs.

  1. Determine the predetermined operating room overhead rate for the year.
  2. Vivian Kau had a 3.8-hour procedure on July 23. How much operating room

overhead would be charged to her procedure, using the rate determined in

part (a)?

  1. During July, the operating room was used 280 hours. The actual overhead costs

incurred for July were $83,175. Determine the overhead under- or overapplied

for the period.

E10-17 Recording jobs completed

The following account appears in the ledger after only part of the postings have

been completed for October:

Work in Process

Balance, October 1 $ 42,600

Direct materials 360,000

Direct labor 400,400

Factory overhead 107,000

Jobs finished during October are summarized as follows:

Job 1004 $180,000 Job 1037 $140,000

Job 1030 225,000 Job 1041 280,000

  1. Determine the cost of jobs completed.
  2. Determine the cost of the unfinished jobs at October 31.

E10-18 Determining manufacturing costs

Steuben Printing Inc. began printing operations on March 1. Jobs 3-01 and 3-02

were completed during the month, and all costs applicable to them were recorded

on the related cost sheets. Jobs 3-03 and 3-04 are still in process at the end of

the month, and all applicable costs except factory overhead have been recorded

on the related cost sheets. In addition to the materials and labor charged directly

to the jobs, $3,300 of indirect materials and $4,800 of indirect labor were used

during the month. The cost sheets for the four jobs entering production during

the month are as follows, in summary form:

Job 3-01 Job 3-02

Direct materials 14,000 Direct materials 6,000

Direct labor 5,000 Direct labor 3,000

Factory overhead 3,750 Factory overhead 2,250

Total 22,750 Total 11,250

Job 3-03 Job 3-04

Direct materials 19,000 Direct materials 4,400

Direct labor 5,800 Direct labor 1,000

Factory overhead ? Factory overhead ?

Determine each of the following for March:

  1. Direct and indirect materials used.
  2. Direct and indirect labor used.
  3. Factory overhead applied (a single overhead rate is used based on direct labor

cost).

  1. Cost of completed Jobs 3-01 and 3-02.
  2. Assume that in addition to indirect materials and indirect labor, factory overhead

of $3,700 was incurred during March. Determine the overapplied or

underapplied overhead for March.

E10-19 Financial statements of a manufacturing firm

The following events took place for Bridger Bikes Inc. during July 2012, the first

month of operations, as a producer of road bikes:

  • Purchased $340,000 of materials.
  • Used $329,000 of direct materials in production.
  • Incurred $160,000 of direct labor wages.
  • Applied factory overhead at a rate of 80% of direct labor cost.
  • Transferred $590,000 of work in process to finished goods.
  • Sold goods with a cost of $550,000.
  • Sold goods for $918,000.
  • Incurred $132,500 of selling expenses.
  • Incurred $80,000 of administrative expenses.
  1. Prepare the July income statement for Bridger Bikes Inc. Assume that Bridger

Bikes uses the perpetual inventory method.

  1. Determine the inventory balances at the end of the first month of operations.

E10-20 Decision making with job order costs

Colfax Manufacturing Inc. is a job shop. The management of Colfax Manufacturing

uses the cost information from the job sheets to assess its cost performance.

Information on the total cost, product type, and quantity of items produced is

as follows:

Date Job No. Quantity Product Amount

Jan. 13 1 180 Mercury $ 4,500

Jan. 29 26 1,020 Venus 8,160

Feb. 3 38 1,330 Venus 13,300

Mar. 14 49 550 Mercury 12,100

Mar. 24 65 1,500 Pluto 6,000

May 11 74 1,750 Pluto 10,500

June 12 83 400 Mercury 7,200

Aug. 18 92 2,200 Pluto 19,800

Sept. 5 100 600 Venus 4,800

Nov. 14 109 725 Mercury 10,150

Dec. 15 116 2,000 Pluto 24,000

  1. Develop a graph for each product (three graphs), with Job No. (in date order)

on the horizontal axis and unit cost on the vertical axis. Use this information

to determine Colfax Manufacturing’s cost performance over time for the three

products.

  1. What additional information would you require to investigate Colfax Manufacturing’s

cost performance more precisely?

E10-21 Decision making with job order costs

Creative Trophies Inc. uses a job order cost system for determining the cost

to manufacture award products (plaques and trophies). Among the company’s

products is an engraved plaque that is awarded to participants who complete an

executive education program at a local university. The company sells the plaque

to the university for $40 each.

Each plaque has a brass plate engraved with the name of the participant.

Engraving

requires approximately 20 minutes per name. Improperly engraved

names must be redone. The plate is screwed to a walnut backboard. This assembly

takes approximately 10 minutes per unit. Improper assembly must be redone

using a new walnut backboard.

During the first half of the year, the university had two separate executive

education classes. The job cost sheets for the two separate jobs indicated the

following information:

Job 9-08 September 9

Cost per Unit Units Job Cost

Direct materials:

Wood $ 8.00/unit 60 units $ 480

Brass 6.00/unit 60 units 360

Engraving labor 15.00/hr. 20 hrs. 300

Assembly labor 12.00/hr. 10 hrs. 120

Factory overhead 9.00/hr. 30 hrs. 270

$1,530

Plaques shipped 4 60

Cost per plaque $25.50

Job 10-34 October 29

Cost per Unit Units Job Cost

Direct materials:

Wood $ 8.00/unit 58 units $ 464

Brass 6.00/unit 58 units 348

Engraving labor 15.00/hr. 18 hrs. 270

Assembly labor 12.00/hr. 9 hrs. 108

Factory overhead 9.00/hr. 27 hrs. 243

$1,433

Plaques shipped 4 50

Cost per plaque $28.66

  1. Why did the cost per plaque increase from $25.50 to $28.66?
  2. What improvements would you recommend for Creative Trophies Inc.?

E10-22 Job order cost accounting entries for a service business

Media Connect Inc. provides advertising services for clients across the nation.

Media Connect is presently working on four projects, each for a different client.

Media Connect accumulates costs for each account (client) on the basis

of both direct costs and allocated indirect costs. The direct costs include the

charged time of professional personnel and media purchases (air time and ad

space). Overhead is allocated to each project as a percentage of media purchases.

The predetermined overhead rate is 40% of media purchases. On April 1, the

four advertising projects had the following accumulated costs:

April 1 Balances

First Bank $40,000

Reliable Airlines 18,000

Motel 26 33,000

Blue Mountain Beverages 27,000

During April, Media Connect incurred the following direct labor and media

purchase costs related to preparing advertising for each of the four accounts:

Direct Labor Media Purchases

First Bank $115,000 $ 480,000

Reliable Airlines 84,000 320,000

Motel 26 110,000 200,000

Blue Mountain Beverages 125,000 300,000

Total $434,000 $1,300,000

At the end of April, both the First Bank and Reliable Airlines campaigns were

completed. The costs of completed campaigns are added to the cost of services

account.

Determine each of the following for the month:

  1. Direct labor costs.
  2. Media purchases.
  3. Overhead applied.
  4. Cost of completed First Bank and Reliable Airlines campaigns.

E10-23 Just-in-time principles

The chief executive officer (CEO) of Kankakee Industries has just returned from

a management seminar describing the benefits of the just-in-time philosophy. The

CEO issued the following statement after returning from the conference:

This company will become a just-in-time manufacturing company. Presently, we have too

much inventory. To become just-in-time we need to eliminate the excess inventory. Therefore,

I want all employees to begin reducing inventories until we are just-in-time. Thank

you for your cooperation.

How would you respond to the CEO’s statement?

E10-24 Just-in-time as a strategy

The American textile industry has moved much of its operations offshore in the

pursuit of lower labor costs. Over the past 50 years, textile imports have risen

from 2% of all textile production to over 70%. Offshore manufacturers make long

runs of standard mass-market apparel items. These are then brought to the United

States in container ships, requiring significant time between original order and

delivery. As a result, retail customers must accurately forecast market demands

for imported apparel items.

Assuming that you work for a U.S.-based textile company, how would you

recommend responding to the low-cost imports?

E10-25 Lead time reduction—service company

Onsite Insurance Company takes 10 days to make payments on insurance claims.

Claims are processed through three departments: Data Input, Claims Audit, and

Claims Adjustment. The three departments are on different floors, approximately

one hour apart from each other. Claims are processed in batches of 100. Each

batch of 100 claims moves through the three departments on a wheeled cart.

Management is concerned about customer dissatisfaction caused by the long lead

time for claim payments.

How might this process be changed so that the lead time could be reduced

significantly?

E10-26 Just-in-time principles

Jupiter Shirt Company manufactures various styles of men’s casual wear. Shirts

are cut and assembled by a workforce that is paid by piece rate. This means that

workers are paid according to the amount of work completed during a period

of time. To illustrate, if the piece rate is $0.18 per sleeve assembled, and the

worker assembles 1,000 sleeves during the day, then the worker would be paid

$180 (1,000 3 $0.18) for the day’s work.

The company is considering adopting a just-in-time manufacturing philosophy

by organizing work cells around various types of products and employing pull

manufacturing. However, no change is expected in the compensation policy. On

this point, the manufacturing manager stated the following:

Piecework compensation provides an incentive to work fast. Without it, the workers will

just goof off and expect a full day’s pay. We can’t pay straight hourly wages—at least not

in this industry.

How would you respond to the manufacturing manager’s comments?

E10-27 Supply chain management

The following is an excerpt from a recent article discussing supplier relationships

with the Big Three North American automakers.

“The Big Three select suppliers on the basis of lowest price and annual price reductions,”

said Neil De Koker, president of the Original Equipment Suppliers Association. “They look

globally for the lowest parts prices from the lowest cost countries,” De Koker said. “There

is little trust and respect. Collaboration is missing.” Japanese auto makers want long-term

supplier relationships. They select suppliers as a person would a mate. The Big Three are

quick to beat down prices with methods such as electronic auctions or rebidding work to

a competitor. The Japanese are equally tough on price but are committed to maintaining

supplier continuity. “They work with you to arrive at a competitive price, and they are willing

to pay because they want long-term partnering,” said Carl Code, a vice president at

Ernie Green Industries. “They [Honda and Toyota] want suppliers to make enough money

to stay in business, grow and bring them innovation.” The Big Three’s supply chain model

is not much different from the one set by Henry Ford. In 1913, he set up the system of

independent supplier firms operating at arm’s length on short-term contracts. One consequence

of the Big Three’s low-price-at-all-costs mentality is that suppliers are reluctant to

offer them their cutting-edge technology out of fear the contract will be resourced before

the research and development costs are recouped.

  1. Contrast the Japanese supply chain model with that of the Big Three.
  2. Why might a supplier prefer the Japanese model?
  3. What benefits might accrue to the Big Three by adopting the Japanese supply

chain practices?

Source: Robert Sherefkin and Amy Wilson, “Suppliers Prefer Japanese Business

Model,” Rubber & Plastics News, March 17, 2003, Vol. 24, No. 11.

E10-28 Employee involvement

Quickie Designs Inc. uses teams in the manufacture of lightweight wheelchairs.

Two features of its team approach are team hiring and peer reviews. Under

team hiring, the team recruits, interviews, and hires new team members from

within the organization. Using peer reviews, the team evaluates each member

of the team with regard to quality, knowledge, teamwork, goal performance,

attendance, and safety. These reviews provide feedback to the team member

for improvement.

How do these two team approaches differ from using managers to hire and

evaluate employees?

E10-29 Activity-based costing for a hospital

Hall Regional Hospital plans to use activity-based costing to assign hospital

indirect costs to the care of patients. The hospital has identified the following

activities and activity rates for the hospital indirect costs:

Activity Activity Rate

Room and meals $125 per day

Radiology $180 per image

Pharmacy $15 per physician order

Chemistry lab $90 per test

Operating room $1,200 per operating room hour

The records of two representative patients were analyzed, using the activity

rates. The activity information associated with the two patients is as follows:

Patient Mims Patient Slater

Number of days 2 days 4 days

Number of images 4 images 7 images

Number of physician orders 6 orders 10 orders

Number of tests 2 tests 5 tests

Number of operating room hours 0.9 hour 3.1 hours

  1. Determine the activity cost associated with each patient.
  2. Why is the total activity cost different for the two patients?

E10-30 Activity-based costing in an insurance company

Umbrella Insurance Company carries three major lines of insurance: auto, workers’

compensation, and homeowners. The company has prepared the following

report for 2013:

Umbrella Insura nce Compa ny

Product Profitability Report

For the Year Ended December 31, 2013

Auto

Workers’

Compensation Homeowners

Premium revenue $ 7,200,000 $6,500,000 $9,200,000

Less estimated claims 5,040,000 4,550,000 6,440,000

Underwriting income $2,160,000 $1,950,000 $2,760,000

Underwriting income as a percent

of premium revenue 30% 30% 30%

Management is concerned that the administrative expenses may make some

of the insurance lines unprofitable. However, the administrative expenses have

not been allocated to the insurance lines. The controller has suggested that the

administrative expenses could be assigned to the insurance lines using activitybased

costing. The administrative expenses are comprised of five activities. The

activities and their rates are as follows:

Activity Rates

New policy processing $160 per new policy

Cancellation processing $240 per cancellation

Claim audits $500 per claim audit

Claim disbursements processing $120 per disbursement

Premium collection processing $ 25 per premium collected

Activity-base usage data for each line of insurance were retrieved from the

corporate

records and are shown below.

Auto Workers’ Comp. Homeowners

Number of new policies 1,500 1,450 4,100

Number of canceled policies 350 250 2,000

Number of audited claims 320 100 700

Number of claim disbursements 400 180 750

Number of premiums collected 7,500 1,500 12,000

  1. Complete the product profitability report through the administrative activities.
  2. Determine the underwriting income as a percent of premium revenue.
  3. Determine the income from operations as a percent of premium revenue,

rounded to one decimal.

  1. Interpret the report.

 

Problems

P10-1 Classifying costs

The following is a list of costs that were incurred in the production and sale of

all-terrain vehicles (ATVs).

  1. Attorney fees for drafting a new lease for headquarters offices.
  2. Cash paid to outside firm for janitorial services for factory.
  3. Commissions paid to sales representatives, based on the number of ATVs sold.
  4. Cost of advertising in a national magazine.
  5. Cost of boxes used in packaging ATVs.
  6. Electricity used to run the robotic machinery.
  7. Engine oil used in engines prior to shipment.
  8. Factory cafeteria cashier’s wages.
  9. Filter for spray gun used to paint the ATVs.
  10. Gasoline engines used for ATVs.
  11. Hourly wages of operators of robotic machinery used in production.
  12. License fees for use of patent for transmission assembly, based on the number

of ATVs produced.

  1. Maintenance costs for new robotic factory equipment, based on hours of usage.
  2. Paint used to coat the ATVs.
  3. Payroll taxes on hourly assembly line employees.
  4. Plastic for outside housing of ATVs.
  5. Premiums on insurance policy for factory buildings.
  6. Property taxes on the factory building and equipment.
  7. Salary of factory supervisor.
  8. Salary of quality control supervisor who inspects each ATV before it is shipped.
  9. Salary of vice president of marketing.
  10. Steering wheels for ATVs.
  11. Straight-line depreciation on the robotic machinery used to manufacture the

ATVs.

  1. Steel used in producing the ATVs.
  2. Telephone charges for company controller’s office.
  3. Tires for ATVs.

Instructions

Classify each cost as either a product cost or a period cost. Indicate whether each

product cost is a direct materials cost, a direct labor cost, or a factory overhead

cost. Indicate whether each period cost is a selling expense or an administrative

expense. Use the following tabular headings for your answer, placing an “X” in

the appropriate column.

Product Costs Period Costs

Cost

Direct

Materials

Cost

Direct

Labor

Cost

Factory

Overhead

Cost

Selling

Expense

Administrative

Expense

P10-2 Entries and schedules for unfinished jobs and completed jobs

Shenandoah Equipment Company uses a job order cost system. The following

data summarize the operations related to production for June 2012, the first

month of operations:

  1. Materials purchased on account, $93,600.
  2. Materials requisitioned and factory labor used:

Job Materials Factory Labor

No. 6001 $ 9,400 $ 8,800

No. 6002 11,500 11,880

No. 6003 7,600 5,960

No. 6004 25,800 21,840

No. 6005 16,400 16,600

No. 6006 11,920 10,600

For general factory use 3,440 13,000

  1. Factory overhead costs incurred on account, $18,000.
  2. Depreciation of machinery and equipment, $6,240.
  3. The factory overhead rate is $50 per machine hour. Machine hours used:

Job Machine Hours

No. 6001 72

No. 6002 120

No. 6003 96

No. 6004 300

No. 6005 132

No. 6006 80

Total 800

  1. Jobs completed: 6001, 6002, 6003, and 6005.
  2. Jobs were shipped and customers were billed as follows: Job 6001, $26,000;

Job 6002, $36,000; Job 6003, $48,000.

Instructions

  1. Prepare a schedule summarizing manufacturing costs by job for June. Use the

following form:

Job Direct Materials Direct Labor Factory Overhead Total

  1. Prepare a schedule of jobs finished in June.
  2. Prepare a schedule of jobs sold in June. What account does this schedule

support for the month of June?

  1. Prepare a schedule of completed jobs on hand as of June 30, 2012. What

account

does this schedule support?

  1. Prepare a schedule of unfinished jobs as of June 30, 2012. What account does

this schedule support?

  1. Determine the gross profit for June based upon the jobs sold.

P10-3 Job order cost sheet

Hallmark Furniture Company refinishes and reupholsters furniture. Hallmark Furniture

uses a job order cost system. When a prospective customer asks for a price

quote on a job, the estimated cost data are inserted on an unnumbered job cost

sheet. If the offer is accepted, a number is assigned to the job, and the costs

incurred are recorded in the usual manner on the job cost sheet. After the job is

completed, reasons for the variances between the estimated and actual costs are

noted on the sheet. The data are then available to management in evaluating the

efficiency of operations and in preparing quotes on future jobs.

On February 14, 2012, an estimate of $897.60 for reupholstering a chair and

couch was given to Millard Schmidt. The estimate was based on the following data:

Estimated direct materials:

12 meters at $9 per meter $108.00

Estimated direct labor:

32 hours at $16 per hour 512.00

Estimated factory overhead (25% of direct labor cost) 128.00

Total estimated costs $748.00

Markup (20% of production costs) 149.60

Total estimate $897.60

On February 17, the chair and couch were picked up from the residence of

Millard Schmidt, 315 White Oak Drive, Columbus, Georgia, with a commitment

to return them on March 15. The job was completed on March 9.

The related materials requisitions and time tickets are summarized as follows:

Materials

Requisition No. Description Amount

122 9 meters at $9 $81

129 7 meters at $9 63

Time Ticket No. Description Amount

T344 20 hours at $14 $280

T348 18 hours at $14 252

Instructions

  1. Prepare a job order cost sheet showing the estimate given to the customer.

Use the format shown on the next page.

  1. Assign number 02-019 to the job, record the costs incurred, and complete

the job order cost sheet. Comment on the reasons for the variances between

actual costs and estimated costs. For this purpose, assume that four meters

of materials were spoiled, the factory overhead rate has been proved to be

satisfactory, and an inexperienced employee performed the work.

P10-4 Analyzing manufacturing cost accounts

Summer Boards Company manufactures surf boards in a wide variety of sizes

and styles. The following incomplete ledger accounts refer to transactions that

are summarized for May:

Materials

May 1 Balance 9,000

31 Purchases 40,000

31 Requisitions (A)

Work in Process

May 1 Balance (B)

31 Materials (C)

31 Direct labor (D)

31 Factory overhead applied (E)

31 Completed jobs (F)

Finished Goods

May 1 Balance 0

31 Completed jobs (F)

31 Cost of goods sold (G)

Wages Payable

May 31 Wages incurred 110,000

Factory Overhead

May 1 Balance 23,000

31 Indirect labor (H)

31 Indirect materials 2,500

31 Other overhead 102,900

31 Factory overhead applied (E)

In addition, the following information is available:

  1. Materials and direct labor were applied to six jobs in May:

Job No. Style Quantity Direct Materials Direct Labor

No. 0521 SX 100 $ 5,000 $15,000

No. 0522 SJ 200 8,500 26,000

No. 0523 SK 100 3,500 8,000

No. 0524 T3 125 7,500 25,000

No. 0525 T6 90 5,600 17,500

No. 0526 SX 70 2,000 4,500

Total 685 $32,100 $96,000

  1. Factory overhead is applied to each job at a rate of 120% of direct labor

cost.

  1. The May 1 Work in Process balance consisted of two jobs, as follows:

Job No. Style

Work in Process,

May 1

Job 0521 SX $1,500

Job 0522 SJ 4,000

Total $5,500

  1. Customer jobs completed and units sold in May were as follows:

Job No. Style Completed in May Units Sold in May

No. 0521 SX X 80

No. 0522 SJ X 160

No. 0523 SK 0

No. 0524 T3 X 105

No. 0525 T6 X 75

No. 0526 SX 0

Instructions

  1. Determine the missing amounts associated with each letter. Provide supporting

calculations by completing a table with the following headings:

Job

No. Quantity

May 1

Work in

Process

Direct

Materials

Direct

Labor

Factory

Overhead

Total

Cost

Unit

Cost

Units

Sold

Cost of

Goods

Sold

  1. Determine the May 31 balances for each of the inventory accounts and factory

overhead.

P10-5 Flow of costs and income statement

R-Tunes Inc. is in the business of developing, promoting, and selling musical

talent online and with compact discs (CDs). The company signed a new group,

called Cyclone Panic, on January 1, 2012. For the first six months of 2012, the

company spent $1,000,000 on a media campaign for Cyclone Panic and $175,000

in legal costs. The CD production began on April 1, 2012.

R-Tunes uses a job order cost system to accumulate costs associated with a

CD title. The unit direct materials cost for the CD is:

Blank CD $0.40

Case 0.25

Song lyric insert 0.18

The production process is straightforward. First, the blank CDs are brought

to a production area where the digital soundtrack is copied onto the CD. The

copying machine requires one hour per 3,600 CDs.

After the CDs are copied, they are brought to an assembly area where an

employee packs the CD with a case and song lyric insert. The direct labor cost

is $0.37 per unit.

The CDs are sold to record stores. Each record store is given promotional

materials, such as posters and aisle displays. Promotional materials cost $30 per

record store. In addition, shipping costs average $0.28 per CD.

Total completed production was 500,000 units during the year. Other information

is as follows:

Number of customers (record stores) 50,000

Number of CDs sold 475,000

Wholesale price (to record store) per CD $8

Factory overhead cost is applied to jobs at the rate of $1,800 per copy machine

hour. There were an additional 18,000 copied CDs, packages, and inserts waiting

to be assembled on December 31, 2012.

Instructions

  1. Prepare an annual income statement for the Cyclone Panic CD, including supporting

calculations, from the information above.

  1. Determine the balances in the work-in-process and finished goods inventories

for the Cyclone Panic CD on December 31, 2012.

 

Activities

A10-1 Ethics and professional conduct in business

Ebenezer Manufacturing Company allows employees to purchase, at cost, manufacturing

materials, such as metal and lumber, for personal use. To purchase

materials for personal use, an employee must complete a materials requisition

form, which must then be approved by the employee’s immediate supervisor.

Beth Turner, an assistant cost accountant, charges the employee an amount based

on Ebenezer’s net purchase cost.

Beth Turner is in the process of replacing a deck on her home and has requisitioned

lumber for personal use, which has been approved in accordance with

company policy. In computing the cost of the lumber, Beth reviewed all the

purchase invoices for the past year. She then used the lowest price to compute

the amount due the company for the lumber.

Discuss whether Beth behaved in an ethical manner.

A10-2 Financial vs. managerial accounting

The following statement was made by the vice president of finance of Electro Inc.:

“The managers of a company should use the same information as the shareholders

of the firm. When managers use the same information in guiding their internal

operations as shareholders use in evaluating their investments, the managers will

be aligned with the stockholders’ profit objectives.”

Respond to the vice president’s statement.

A10-3 Classifying costs

Reboot Inc. provides computer repair services for the community. Ashley DaCosta’s

computer was not working, and she called Reboot for a home repair visit.

The Reboot Inc. technician arrived at 2:00 p.m. to begin work. By 4:00 p.m., the

problem was diagnosed as a failed circuit board. Unfortunately, the technician

did not have a new circuit board in the truck, since the technician’s previous

customer had the same problem, and a board was used on that visit. Replacement

boards were available back at Reboot’s shop. Therefore, the technician

drove back to the shop to retrieve a replacement board. From 4:00 to 5:00

p.m., Reboot’s technician drove the round trip to retrieve the replacement board

from the shop.

At 5:00 p.m., the technician was back on the job at Ashley’s home. The replacement

procedure is somewhat complex, since a variety of tests must be performed

once the board is installed. The job was completed at 6:00 p.m.

Ashley’s repair bill showed the following:

Circuit board $ 80

Labor charges 260

Total $340

Ashley was surprised at the size of the bill and asked for some greater detail

supporting the calculations. Reboot responded with the following explanations:

Cost of materials:

Purchase price of circuit board $65

Markup on purchase price to cover

storage and handling 15

Total materials charge $80

The labor charge per hour is detailed as follows:

2:00–3:00 p.m. $ 65

3:00–4:00 p.m. 40

4:00–5:00 p.m. 95

5:00–6:00 p.m. 60

Total labor charge $260

Further explanations in the differences in the hourly rates are as follows:

First hour:

Base labor rate $22

Fringe benefits 10

Overhead (other than storage and handling) 8

Total base labor rate $40

Additional charge for first hour of any job to cover

the cost of vehicle depreciation, fuel, and employee

time in transit. A 30-minute transit time is assumed. 25

$65

Third hour:

Base labor rate $40

The trip back to the shop includes vehicle depreciation

and fuel; therefore, a charge was added to the hourly

rate to cover these costs. The round trip took an hour. 55

$95

Fourth hour:

Base labor rate $40

Overtime premium for time worked in excess of an

eight-hour day (starting at 5:00 P.M.) is equal to the base rate. 20

$60

  1. If you were in Ashley’s position, how would you respond to the bill? Are there

parts of the bill that appear incorrect to you? If so, what argument would you

employ to convince Reboot that the bill is too high?

  1. Use the headings below to construct a table. Fill in the table by first listing the

costs identified in the activity in the left-hand column. For each cost, place a

check mark in the appropriate column identifying the correct cost classification.

Assume that each service call is a job.

Cost Direct Materials Direct Labor Overhead

A10-4 Managerial analysis

The controller of the plant of Martz Industries prepared a graph of the unit costs

from the job cost reports for Product M908t. The graph appeared as follows:

How would you interpret this information? What further information would

you request?

A10-5 Factory overhead rate

Fabricator Inc., a specialized equipment manufacturer, uses a job order costing

system. The overhead is allocated to jobs on the basis of direct labor hours. The

overhead rate is now $3,000 per direct labor hour. The design engineer thinks

that this is illogical. The design engineer has stated the following:

Our accounting system doesn’t make any sense to me. It tells me that every labor

hour carries an additional burden of $3,000. This means that while direct labor

makes up only 5% of our total product cost, it drives all our costs. In addition,

these rates give my design engineers incentives to “design out” direct labor by

using machine technology. Yet, over the past years as we have had less and less

direct labor, the overhead rate keeps going up and up. I won’t be surprised if next

year the rate is $4,000 per direct labor hour. I’m also concerned because small

errors in our estimates of the direct labor content can have a large impact on our

estimated costs. Just a 30-minute error in our estimate of assembly time is worth

$1,500. Small mistakes in our direct labor time estimates really swing our bids

around. I think this puts us at a disadvantage when we are going after business.

  1. What is the engineer’s concern about the overhead rate going “up and up”?
  2. What did the engineer mean about the large overhead rate being a disadvantage

when placing bids and seeking new business?

  1. What do you think is a possible solution?

A10-6 Classifying costs

With a group of students, visit a local copy and graphics shop or a pizza restaurant.

As you observe the operation, consider the costs associated with running

the business. As a group, identify as many costs as you can and classify them

according to the following table headings:

Cost Direct Materials Direct Labor Overhead Selling Expense

A10-7 Just-in-time principles

Warm Space Inc. manufactures electric space heaters. While the CEO, Gwen

Willis,

is visiting the production facility, the following conversation takes place

with the plant manager, Tyra Chastain:

Gwen: As I walk around the facility, I can’t help noticing all the materials inventories.

What’s going on?

Tyra: I have found our suppliers to be very unreliable in meeting their delivery

commitments. Thus, I keep a lot of materials on hand so as to not risk running

out and shutting down production.

Gwen: Not only do I see a lot of materials inventory, but there also seems to be

a lot of finished goods inventory on hand. Why is this?

Tyra: As you know, I am evaluated on maintaining a low cost per unit. The

one way that I am able to reduce my unit costs is by producing as many space

heaters as possible. This allows me to spread my fixed costs over a larger base.

When orders are down, the excess production builds up as inventory, as we are

seeing now. But don’t worry—I’m really keeping our unit costs down this way.

Gwen: I’m not so sure. It seems that this inventory must cost us something.

Tyra: Not really. I’ll eventually use the materials and we’ll eventually sell the

finished goods. By keeping the plant busy, I’m using our plant assets wisely.

This is reflected in the low unit costs that I’m able to maintain.

If you were Gwen Willis, how would you respond to Tyra Chastain? What recommendations

would you provide Tyra Chastain?

 

Answers to Self-Examination Questions

  1. C Sales salaries (answer C) is a selling expense

and is not considered a cost of manufacturing

a product. Direct materials cost

(answer A), factory overhead cost (answer B),

and direct labor cost (answer D) are costs of

manufacturing a product.

  1. B Depreciation of testing equipment (answer
  2. B) is included as part of the factory overhead

costs of the computer manufacturer. The cost

of memory chips (answer A) and the cost of

disk drives (answer D) are both considered

a part of direct materials cost. The wages of

computer assemblers (answer C) are part of

direct labor costs.

  1. B

Predetermined Factory

Overhead Rate 5

Estimated Total

Factory Overhead Costs

Estimated Activity Base

Predetermined Factory

Overhead Rate 5

$420,000

5 $26.25

16,000 dlh

Hours Applied

to the Job 5

$3,000

5 200 hours

$15 per hour

Factory overhead applied to the job:

200 hours 3 $26.25 5 $5,250

  1. B If the amount of factory overhead applied

during a particular period exceeds the actual

overhead costs, the factory overhead account

will have a negative balance and is said to

be overapplied (answer B) or overabsorbed.

If the amount applied is less than the actual

costs, the account will have a positive balance

and is said to be underapplied (answer A)

or underabsorbed (answer C). Since an “estimated”

predetermined overhead rate is used

to apply overhead, a negative balance does

not necessarily represent an error (answer D).

  1. B The just-in-time philosophy embraces a

product-oriented layout (answer A), making

lead times short (answer C), and reducing

setup times (answer D). Pull manufacturing,

the opposite of push manufacturing (answer

B), is also a just-in-time principle.

 

 

Chapter 11 Cost Behavior and Cost-Volume-Profit

 

Class Discussion Questions

  1. Describe how total variable costs and unit

variable costs behave with changes in the

level of activity.

  1. How would each of the following costs be

classified if units produced is the activity

base?

  1. Direct materials costs
  2. Direct labor costs
  3. Electricity costs of $0.09 per kilowatt-hour
  4. Describe the behavior of (a) total fixed costs

and (b) unit fixed costs as the level of activity

increases.

  1. How would each of the following costs be

classified if units produced is the activity

base?

  1. Salary of factory supervisor ($120,000 per

year)

  1. Straight-line depreciation of plant and

equipment

  1. Property rent of $11,500 per month on

plant and equipment

  1. In cost analyses, how are mixed costs

treated?

  1. Which of the following graphs illustrates how

total fixed costs behave with changes in total

units produced?

(a)

Total Cost

0 Total Units Produced

(b)

Total Cost

0 Total Units Produced

  1. Which of the following graphs illustrates how

unit variable costs behave with changes in

total units produced?

(a)

Unit Cost

0 Total Units Produced

(b)

Unit Cost

0 Total Units Produced

  1. Which of the following graphs best illustrates

fixed costs per unit as the activity base

changes?

(a) (b)

Costs per Unit

0 Activity Base

Costs per Unit

0 Activity Base

  1. In applying the high-low method of cost estimation,

how is the total fixed cost estimated?

  1. If fixed costs increase, what would be

the impact on the (a) contribution margin?

(b) income from operations?

  1. An examination of the accounting records of

Larredo Company disclosed a high contribution

margin ratio and production at a level

below maximum capacity. Based on this information,

suggest a likely means of improving

income from operations. Explain.

  1. If the unit cost of direct materials is decreased,

what effect will this change have

on the break-even point?

  1. If insurance rates are increased, what effect

will this change in fixed costs have on the

break-even point?

  1. Both Gouda Company and Cheddar Company

had the same sales, total costs, and income

from operations for the current fiscal year;

yet Gouda Company had a lower break-even

point than Cheddar Company. Explain the reason

for this difference in break-even points.

  1. The reliability of cost-volume-profit (CVP)

analysis depends on several key assumptions.

What are those primary assumptions?

  1. How does the sales mix affect the calculation

of the break-even point?

  1. What does operating leverage measure, and

how is it computed?

 

Exercises

E11-1 Classify costs

Following is a list of various costs incurred in producing computer monitors.

With respect to the production and sale of these monitors, classify each cost as

either variable, fixed, or mixed.

  1. Computer chip (purchased from a vendor)
  2. Electricity costs, $0.18 per kilowatt-hour
  3. Hourly wages of inspectors
  4. Hourly wages of machine operators
  5. Janitorial costs, $6,500 per month
  6. Metal
  7. Packaging
  8. Pension cost, $0.75 per employee hour on the job
  9. Plastic
  10. Property insurance premiums, $2,900 per month plus $0.08 for each dollar

of property over $4,000,000

  1. Property taxes, $650,000 per year on factory building and equipment
  2. Oil used in manufacturing equipment
  3. Rent on warehouse, $32,500 per month plus $3 per square foot of storage used
  4. Salary of plant manager
  5. Straight-line depreciation on the production equipment

E11-2 Identify cost graphs

The following cost graphs illustrate various types of cost behavior:

For each of the following costs, identify the cost graph that best illustrates its

cost behavior as the number of units produced increases.

  1. Electricity costs of $2,000 per month plus $0.09 per kilowatt-hour
  2. Per-unit cost of straight-line depreciation on factory equipment
  3. Per-unit direct labor cost
  4. Salary of quality control supervisor, $10,000 per month
  5. Total direct materials cost

E11-3 Identify activity bases

For a major university, match each cost in the following table with the activity

base most appropriate to it. An activity base may be used more than once, or

not used at all.

Cost Activity Base

  1. Admissions office salaries a. Number of enrollment applications
  2. Financial aid office salaries b. Number of financial aid applications
  3. Housing personnel wages c. Number of student/athletes
  4. Instructor salaries d. Number of enrolled students and alumni
  5. School supplies e. Number of students living on campus
  6. Student records office salaries f. Student credit hours

E11-4 Identify activity bases

From the following list of activity bases for an automobile dealership, select the

base that would be most appropriate for each of these costs: (1) preparation

costs (cleaning, oil, and gasoline costs) for each car received, (2) salespersons’

commission of 6% of the sales price for each car sold, and (3) administrative

costs for ordering cars.

  1. Dollar amount of cars on hand
  2. Dollar amount of cars ordered
  3. Dollar amount of cars received
  4. Dollar amount of cars sold
  5. Number of cars on hand
  6. Number of cars ordered
  7. Number of cars received
  8. Number of cars sold

E11-5 Identify fixed and variable costs

Intuit Inc. develops and sells software products for the personal finance market,

including popular titles such as Quicken® and TurboTax®. Classify each of the

following costs and expenses for this company as either variable or fixed to the

number of units produced and sold:

  1. Shipping expenses
  2. Property taxes on general offices
  3. Straight-line depreciation of computer equipment
  4. Salaries of human resources personnel
  5. President’s salary
  6. Advertising
  7. Sales commissions
  8. CDs
  9. Packaging costs
  10. Salaries of software developers
  11. Wages of telephone order assistants
  12. User’s guides

E11-6 R elevant range and fixed and variable costs

Game Industries Inc. manufactures components for computer games within a

relevant range of 1,000,000 to 2,000,000 disks per year. Within this range, the

following partially completed manufacturing cost schedule has been prepared:

Components produced 1,000,000 1,500,000 2,000,000

Total costs:

Total variable costs $430,000 (d) (j)

Total fixed costs 360,000 (e) (k)

Total costs $790,000 (f ) (I)

Cost per unit:

Variable cost per unit (a) (g) (m)

Fixed cost per unit (b) (h) (n)

Total cost per unit (c) (i) (o)

Complete the cost schedule, identifying each cost by the appropriate letter

(a) through (o).

E11-7 High-low method

Zeta Inc. has decided to use the high-low method to estimate the total cost and

the fixed and variable cost components of the total cost. The data for various

levels of production are as follows:

Units Produced Total Costs

45,000 $1,535,000

50,000 1,650,000

70,000 2,110,000

  1. Determine the variable cost per unit and the fixed cost.
  2. Based on part (a), estimate the total cost for 60,000 units of production.

E11-8 High-low method for service company

Missoula Railroad decided to use the high-low method and operating data from

the past six months to estimate the fixed and variable components of transportation

costs. The activity base used by Missoula Railroad is a measure of railroad

operating activity, termed “gross-ton miles,” which is the total number of tons

multiplied by the miles moved.

Transportation Costs Gross-Ton Miles

January $1,575,000 125,000

February 2,095,800 180,000

March 1,675,000 136,000

April 1,800,000 150,000

May 1,426,600 110,000

June 2,050,000 175,000

Determine the variable cost per gross-ton mile and the fixed cost.

E11-9 Contribution margin ratio

  1. Clearwater Company budgets sales of $3,400,000, fixed costs of $750,000, and

variable costs of $2,244,000. What is the contribution margin ratio for Clearwater

Company?

  1. If the contribution margin ratio for Anaconda Company is 28%, sales were

$1,875,000, and fixed costs were $390,000, what was the income from operations?

E11-10 Contribution margin and contribution margin ratio

For a recent year, McDonald’s company-owned restaurants had the following sales

and expenses (in millions):

Sales $24,075

Food and packaging $ 5,300

Payroll 4,122

Occupancy (rent, depreciation, etc.) 5,016

General, selling, and administrative expenses 2,333

Other expense (income) (169)

$16,602

Income from operations $ 7,473

Assume that the variable costs consist of food and packaging, payroll, and 60%

of the general, selling, and administrative expenses.

  1. What is McDonald’s contribution margin? Round to the nearest million.
  2. What is McDonald’s contribution margin ratio? Round to one decimal place.
  3. How much would income from operations increase if same-store sales increased

by $600 million for the coming year, with no change in the contribution margin

ratio or fixed costs?

E11-11 Break-even sales and sales to realize income from operations

For the current year ending August 31, Bannack Industries expects fixed costs of

$988,800, a unit variable cost of $412, and a unit selling price of $515.

  1. Compute the anticipated break-even sales (units).
  2. Compute the sales (units) required to realize income from operations of

$180,250.

E11-12 Break-even sales

Molson-Coors Brewing Company reported the following operating information for a

recent year (in millions):

Net sales $3,254

Cost of goods sold $1,812

Marketing, general, and admin. expenses 1,013

$2,825

Income from operations $ 429*

“Before special items

Assume that Molson-Coors sold 30 million barrels of beer during the year, variable

costs were 75% of the cost of goods sold and 40% of marketing, general, and

administrative expenses, and that the remaining costs are fixed. For the following

year, assume that Molson-Coors expects pricing, variable costs per barrel, and

fixed costs to remain constant, except that new distribution and general office

facilities are expected to increase fixed costs by $40 million.

Rounding to the nearest cent:

  1. Compute the break-even sales (barrels) for the current year.
  2. Compute the anticipated break-even sales (barrels) for the following year.

E11-13 Break-even sales

Currently, the unit selling price of a product is $80, the unit variable cost is $64,

and the total fixed costs are $420,000. A proposal is being evaluated to increase

the unit selling price to $84.

  1. Compute the current break-even sales (units).
  2. Compute the anticipated break-even sales (units), assuming that the unit selling

price is increased and all costs remain constant.

E11-14 Break-even analysis

The Garden Club of Palm Springs, California, collected recipes from members

and published a cookbook entitled Desert Dishes. The book will sell for $40 per

copy. The chairperson of the cookbook development committee estimated that

the club needed to sell 8,000 books to break even on its $40,000 investment.

What is the variable cost per unit assumed in the Garden Club’s analysis?

E11-15 Break-even analysis

Media outlets such as ESPN and Fox Sports often have Web sites that provide indepth

coverage of news and events. Portions of these Web sites are restricted

to members who pay a monthly subscription to gain access to exclusive news

and commentary. These Web sites typically offer a free trial period to introduce

viewers to the Web site. Assume that during a recent fiscal year, ESPN.com spent

$20,900,000 on a promotional campaign for its Web site, offering two free months

of service for new subscribers. In addition, assume the following information:

Number of months an average new customer stays with the

service (including the two free months) 18 months

Revenue per month per customer subscription $9.95

Variable cost per month per customer subscription $4.20

Determine the number of new customer accounts needed to break even on

the cost of the promotional campaign. In forming your answer, (1) treat the cost

of the promotional campaign as a fixed cost, and (2) treat the revenue less variable

cost per account for the subscription period as the unit contribution margin.

E11-16 Break-even analysis

Sprint Nextel Corporation is one of the largest digital wireless service providers in the

United States. In a recent year, it had approximately 44.5 million direct subscribers

(accounts) that generated revenue of $32,563 million. Costs and expenses for

the year were as follows (in millions):

Cost of revenue $17,492

Selling, general, and administrative expenses 9,438

Depreciation, amortization, and other expenses 6,228

Assume that 75% of the cost of revenue and 35% of the selling, general, and administrative

expenses are variable to the number of direct subscribers (accounts).

  1. What is Sprint Nextel’s break-even number of accounts, using the data and

assumptions above? Round units to one decimal place (in millions).

  1. How much revenue per account would be sufficient for Sprint Nextel to break

even if the number of accounts remained constant?

E11-17 Cost-volume-profit chart

For the coming year, Cabinet Inc. anticipates fixed costs of $60,000, a unit variable

cost of $70, and a unit selling price of $100. The maximum sales within the

relevant range are $500,000.

  1. Construct a cost-volume-profit chart.
  2. Estimate the break-even sales (dollars) by using the cost-volume-profit chart

constructed in part (a).

  1. What is the main advantage of presenting the cost-volume-profit analysis in

graphic form rather than equation form?

E11-18 Profit-volume chart

Using the data for Cabinet Inc. in Exercise 11-17, (a) determine the maximum

possible operating loss, (b) compute the maximum possible income from operations,

(c) construct a profit-volume chart, and (d) estimate the break-even sales

(units) by using the profit-volume chart constructed in part (c).

E11-19 Break-even chart

Name the following chart, and identify the items represented by the letters

  • through (f).

 

E11-21 Sales mix and break-even sales

Dontics Technology Inc. manufactures and sells two products, digital game players

and computer tablets. The fixed costs are $6,640,000, and the sales mix is

65% game players and 35% computer tablets. The unit selling price and the unit

variable cost for each product are as follows:

Products Unit Selling Price Unit Variable Cost

Game players $ 30.00 $ 20.00

Tablets 250.00 150.00

  1. Compute the break-even sales (units) for the overall product, E.
  2. How many units of each product, game players and tablets, would be sold at

the break-even point?

E11-22 Break-even sales and sales mix for a service company

Yellow Dove Airways provides air transportation services between Portland and

Minneapolis. A single Portland to Minneapolis round-trip flight has the following

operating statistics:

Fuel and landing fees $19,400

Flight crew salaries 3,760

Airplane depreciation 2,600

Variable cost per passenger—business class 50

Variable cost per passenger—economy class 20

Round-trip ticket price—business class 750

Round-trip ticket price—economy class 300

It is assumed that the fuel and landing fees, crew salaries, and airplane depreciation

are fixed, regardless of the number of seats sold for the round-trip flight.

  1. Compute the break-even number of seats sold on a single round-trip flight

for the overall product. Assume that the overall product is 10% business class

and 90% economy class tickets.

  1. How many business class and economy class seats would be sold at the breakeven

point?

E11-23 Margin of safety

  1. If Glendive Company, with a break-even point at $792,000 of sales, has actual

sales of $1,200,000, what is the margin of safety expressed (1) in dollars and

(2) as a percentage of sales?

  1. If the margin of safety for Spearfish Company was 30%, fixed costs were

$1,750,000 and variable costs were 80% of sales, what was the amount of

actual sales (dollars)? (Hint: Determine the break-even in sales dollars first.)

E11-24 Break-even and margin of safety relationships

At a recent staff meeting, the management of Black Hat Technologies Inc. was

considering discontinuing the Battle Royale line of electronic games from the

product line. The chief financial analyst reported the following current monthly

data for the Battle Royale:

Units of sales 190,000

Break-even units 215,000

Margin of safety in units 8,000

For what reason would you question the validity of these data?

E11-25 O perating leverage

Rose Inc. and Tulip Inc. have the following operating data:

Rose Inc. Tulip Inc.

Sales $920,000 $1,050,000

Variable costs 552,000 630,000

Contribution margin $368,000 $ 420,000

Fixed costs 288,000 270,000

Income from operations $ 80,000 $ 150,000

  1. Compute the operating leverage for Rose Inc. and Tulip Inc.
  2. How much would income from operations increase for each company if the

sales of each increased by 25%?

  1. Why is there a difference in the increase in income from operations for the

two companies? Explain.

 

Problems

P11-1 Classify costs

Mystique Apparel Co. manufactures a variety of clothing types for distribution to

several major retail chains. The following costs are incurred in the production

and sale of blue jeans:

  1. Brass buttons
  2. Consulting fee of $250,000 paid to industry specialist for marketing advice
  3. Dye
  4. Fabric
  5. Electricity costs of $0.05 per kilowatt-hour
  6. Hourly wages of machine operators
  7. Insurance premiums on property, plant, and equipment, $85,000 per year plus

$6 per $50,000 of insured value over $15,000,000

  1. Janitorial supplies, $3,500 per month
  2. Leather for patches identifying the brand on individual pieces of apparel
  3. Legal fees paid to attorneys in defense of the company in a patent infringement

suit, $50,000 plus $500 per hour

  1. Property taxes on property, plant, and equipment
  2. Rental costs of warehouse, $7,000 per month plus $2 per square foot of storage

used

  1. Rent on experimental equipment, $18,000 per year
  2. Salary of designers
  3. Salary of production vice president
  4. Salesperson’s salary, $45,000 plus 3% of the total sales
  5. Shipping boxes used to ship orders
  6. Straight-line depreciation on sewing machines
  7. Supplies
  8. Thread

Instructions

Classify the preceding costs as either fixed, variable, or mixed. Use the following

tabular headings and place an “X” in the appropriate column. Identify each cost

by letter in the cost column.

Cost Fixed Cost Variable Cost Mixed Cost

P11-2 Break-even sales under present and proposed conditions

Kearney Company, operating at full capacity, sold 400,000 units at a price of

$246.60 per unit during 2012. Its income statement for 2012 is as follows:

Sales $98,640,000

Cost of goods sold 44,500,000

Gross profit $54,140,000

Expenses:

Selling expenses $8,000,000

Administrative expenses 3,000,000

Total expenses 11,000,000

Income from operations $43,140,000

The division of costs between fixed and variable is as follows:

Fixed Variable

Cost of goods sold 28% 72%

Selling expenses 25% 75%

Administrative expenses 80% 20%

Management is considering a plant expansion program that will permit an increase

of $8,631,000 (35,000 units at $246.60) in yearly sales. The expansion will

increase fixed costs by $3,600,000, but will not affect the relationship between

sales and variable costs.

Instructions

  1. Determine for 2012 the total fixed costs and the total variable costs.
  2. Determine for 2012 (a) the unit variable cost and (b) the unit contribution margin.
  3. Compute the break-even sales (units) for 2012.
  4. Compute the break-even sales (units) under the proposed program.
  5. Determine the amount of sales (units) that would be necessary under the

proposed program to realize the $43,140,000 of income from operations that

was earned in 2012.

  1. Determine the maximum income from operations possible with the expanded

plant.

  1. If the proposal is accepted and sales remain at the 2012 level, what will the

income or loss from operations be for 2013?

  1. Based on the data given, would you recommend accepting the proposal? Explain.

P11-3 Break-even sales and cost-volume-profit chart

For the coming year, Bernardino Company anticipates a unit selling price of $85,

a unit variable cost of $15, and fixed costs of $420,000.

Instructions

  1. Compute the anticipated break-even sales (units).
  2. Compute the sales (units) required to realize income from operations of

$70,000.

  1. Construct a cost-volume-profit chart, assuming maximum sales of 10,000 units

within the relevant range.

  1. Determine the probable income (loss) from operations if sales total 8,000 units.

P11-4 Break-even sales and cost-volume-profit chart

Last year, Ridgecrest Inc. had sales of $3,200,000, based on a unit selling price

of $400. The variable cost per unit was $240, and fixed costs were $1,088,000.

The maximum sales within Ridgecrest Inc.’s relevant range are 10,000 units.

Ridgecrest Inc. is considering a proposal to spend an additional $160,000 on

billboard advertising during the current year in an attempt to increase sales and

utilize unused capacity.

Instructions

  1. Construct a cost-volume-profit chart indicating the break-even sales for last

year. Verify your answer, using the break-even equation.

  1. Using the cost-volume-profit chart prepared in part (1), determine (a) the

income from operations for last year and (b) the maximum income from

operations

that could have been realized during the year. Verify your answers

arithmetically.

  1. Construct a cost-volume-profit chart indicating the break-even sales for the

current year, assuming that a noncancelable contract is signed for the additional

billboard advertising. No changes are expected in the unit selling price

or other costs. Verify your answer, using the break-even equation.

  1. Using the cost-volume-profit chart prepared in part (3), determine (a) the income

from operations if sales total 8,000 units and (b) the maximum income

from operations that could be realized during the year. Verify your answers

arithmetically.

P11-5 Sales mix and break-even sales

Data related to the expected sales of kayaks and canoes for River Sports Inc. for

the current year, which is typical of recent years, are as follows:

Products Unit Selling Price Unit Variable Cost Sales Mix

Kayaks $400 $240 80%

Canoes 800 480 20%

The estimated fixed costs for the current year are $1,440,000.

Instructions

  1. Determine the estimated units of sales of the overall product necessary to

reach the break-even point for the current year.

  1. Based on the break-even sales (units) in part (1), determine the unit sales of

kayaks and canoes for the current year.

  1. Assume that the sales mix was 20% kayaks and 80% canoes. Determine the

estimated units of sales of overall product necessary to reach the break-even

point for the current year.

  1. Based upon the break-even sales (units) in part (3), determine the unit sales

of kayaks and canoes for the current year.

  1. Why is the overall enterprise break-even point so different in (1) and (3)?

P11-6 Contribution margin, break-even sales, cost-volume-profit chart, margin

of safety, and operating leverage

Organic Health Care Products Inc. expects to maintain the same inventories at the

end of 2012 as at the beginning of the year. The total of all production costs for

the year is therefore assumed to be equal to the cost of goods sold. With this in

mind, the various department heads were asked to submit estimates of the costs for

their departments during 2012. A summary report of these estimates is as follows:

Estimated

Fixed Cost

Estimated Variable Cost

(per unit sold)

Production costs:

Direct materials — $ 8.00

Direct labor — 3.00

Factory overhead $ 200,000 1.50

Selling expenses:

Advertising 1,450,000 —

Sales salaries and commissions 93,000 1.85

Travel 340,000 —

Miscellaneous selling expense 2,000 0.10

Administrative expenses:

Office and officers’ salaries 300,000 —

Supplies 10,000 0.50

Miscellaneous administrative expense 5,000 0.05

Total $2,400,000 $15.00

It is expected that 400,000 units will be sold at a price of $25 a unit. Maximum

sales within the relevant range are 500,000 units.

Instructions

  1. Prepare an estimated income statement for 2012.
  2. What is the expected contribution margin ratio?
  3. Determine the break-even sales in units.
  4. Construct a cost-volume-profit chart indicating the break-even sales.
  5. What is the expected margin of safety in dollars and as a percentage of sales?
  6. Determine the operating leverage.

 

Activities

A11-1 Ethics and professional conduct in business

Phil Fritz is a financial consultant to Magna Properties Inc., a real estate syndicate.

Magna Properties Inc. finances and develops commercial real estate (office

buildings). The completed projects are then sold as limited partnership interests to

individual investors. The syndicate makes a profit on the sale of these partnership

interests. Phil provides financial information for the offering prospectus, which

is a document that provides the financial and legal details of the limited partnership

offerings. In one of the projects, the bank has financed the construction of

a commercial office building at a rate of 7% for the first four years, after which

time the rate jumps to 9% for the remaining 21 years of the mortgage. The interest

costs are one of the major ongoing costs of a real estate project. Phil has reported

prominently in the prospectus that the break-even occupancy for the first four

years is 48%. This is the amount of office space that must be leased to cover the

interest and general upkeep costs over the first four years. The 48% break even

is very low and thus communicates a low risk to potential investors. Phil uses

the 48% break-even rate as a major marketing tool in selling the limited partnership

interests. Buried in the fine print of the prospectus is additional information

that would allow an astute investor to determine that the break-even occupancy

will jump to 92% after the fourth year because of the contracted increase in the

mortgage interest rate. Phil believes prospective investors are adequately informed

as to the risk of the investment.

Comment on the ethical considerations of this situation.

A11-2 Break-even sales, contribution margin

“Every airline has what is called a break-even load factor. That is, the percentage

of seats the airline . . . (flies) . . . that it must sell . . . to cover its costs.

Since revenue and costs vary from one airline to another, so does the breakeven

factor.

. . . Overall, the break-even load factor for the (airline) industry

in recent years has been approximately 66 percent.”

The airline industry is notorious for boom and bust cycles. Why is airline profitability

very sensitive to these cycles? Do you think that during a down cycle the

strategy to consolidate routes and raise ticket prices is reasonable? What would

make this strategy succeed or fail? Why?

Source: http://www.avjobs.com/history/airline-economics.asp

A11-3 Break-even analysis

Aquarius Games Inc. has finished a new video game, Triathlon Challenge. Management

is now considering its marketing strategies. The following information

is available:

Anticipated sales price per unit $75

Variable cost per unit* $45

Anticipated volume 800,000

Production costs $9,000,000

Anticipated advertising $15,000,000

“The cost of the video game, packaging, and copying costs.

Two managers, Haley Chipana and Dan Gillespie, had the following discussion

of ways to increase the profitability of this new offering:

Haley: I think we need to think of some way to increase our profitability. Do

you have any ideas?

Dan: Well, I think the best strategy would be to become aggressive on price.

Haley: How aggressive?

Dan: If we drop the price to $60 per unit and maintain our advertising budget

at $15,000,000, I think we will generate sales of 2,000,000 units.

Haley: I think that’s the wrong way to go. You’re giving too much up on price.

Instead, I think we need to follow an aggressive advertising strategy.

Dan: How aggressive?

Haley: If we increase our advertising to a total of $20,000,000, we should be

able to increase sales volume to 1,200,000 units without any change in price.

Dan: I don’t think that’s reasonable. We’ll never cover the increased advertising

costs.

Which strategy is best: Do nothing? Follow the advice of Dan Gillespie? Or

follow Haley Chipana’s strategy?

A11-4 Variable costs and activity bases in decision making

The owner of Dawg Prints, a printing company, is planning direct labor needs

for the upcoming year. The owner has provided you with the following information

for next year’s plans:

One Color Two Color Three Color Four Color Total

Number of banners 198 250 352 400 1,200

Each color on the banner must be printed one at a time. Thus, for example, a

four-color banner will need to be run through the printing operation four separate

times. The total production volume last year was 600 banners, as shown below.

One Color Two Color Three Color Total

Number of banners 152 206 242 600

The four-color banner is a new product offering for the upcoming year. The

owner believes that the expected 600-unit increase in volume from last year

means that direct labor expenses should increase by 100% (600 4 600). What

do you think?

A11-5 Variable costs and activity bases in decision making

Sales volume has been dropping at Pinnacle Publishing Company. During this

time, however, the Shipping Department manager has been under severe financial

constraints. The manager knows that most of the Shipping Department’s effort

is related to pulling inventory from the warehouse for each order and performing

the paperwork. The paperwork involves preparing shipping documents for

each order. Thus, the pulling and paperwork effort associated with each sales

order is essentially the same, regardless of the size of the order. The Shipping

Department manager has discussed the financial situation with senior management.

Senior management has responded by pointing out that sales volume has

been dropping, so that the amount of work in the Shipping Department should

be dropping. Thus, senior management told the Shipping Department manager

that costs should be decreasing in the department.

The Shipping Department manager prepared the following information:

Month

Sales

Volume

Number of

Customer Orders

Sales Volume

per Order

January $500,000 1,400 250

February 460,000 1,440 230

March 440,000 1,460 220

April 400,000 1,500 200

May 380,000 1,570 190

June 370,000 1,650 185

July 360,000 1,700 180

August 350,000 1,750 175

Given this information, how would you respond to senior management?

A11-6 Break-even analysis

Break-even analysis is one of the most fundamental tools for managing any kind

of business unit. Consider the management of your school. In a group, brainstorm

some applications of break-even analysis at your school. Identify three areas

where break-even analysis might be used. For each area, identify the revenues,

variable costs, and fixed costs that would be used in the calculation.

 

Answers to Self-Examination Questions

  1. B Variable costs vary in total in direct

proportion

to changes in the level of activity

(answer B). Costs that vary on a per-unit basis

as the level of activity changes (answer A)

or remain constant in total dollar amount as

the level of activity changes (answer C), or

both (answer D), are fixed costs.

  1. D The contribution margin ratio indicates

the percentage of each sales dollar available

to cover the fixed costs and provide income

from operations and is determined as follows:

Contribution Margin

Ratio 5

Sales 2 Variable Costs

Sales

5

$500,000 2 $200,000

$500,000

5 60%

  1. D The break-even sales of 40,000 units

(answer D) is computed as follows:

Break-Even Sales

(units) 5

Fixed Costs

Unit Contribution Margin

5

$160,000

5 40,000 units

$4

  1. D Sales of 45,000 units are required to

realize

income from operations of $20,000,

computed as follows:

Sales (units) 5

Fixed Costs 1 Target Profit

Unit Contribution Margin

5

$160,000 1 $20,000

$4

5 45,000 units

  1. C The operating leverage is 1.8, computed

as follows:

Operating Leverage 5

Contribution Margin

Income from Operations

5

$360,000

5 1.8

$200,000

 

 

 

Chapter 12 Differential analysis and Product Pricing

 

Class Discussion Questions

  1. Explain the meaning of (a) differential revenue,

(b) differential cost, and (c) differential

income.

  1. It was reported that Exabyte Corporation, a fast

growing Colorado marketer of computer

devices has decided to purchase key

components of its product from others.

For example, Sony Corporation of America and

Solectron Corporation provide components to

Exabyte. A former chief executive officer of

Exabyte stated, “If we’d tried to build our

own plants, we could never have grown

that fast or maybe survived.” The decision

to purchase key product components is an

example of what type of decision illustrated

in this chapter?

  1. A company could sell a building for $650,000

or lease it for $5,000 per month. What would

need to be considered in determining if the

lease option would be preferred?

  1. A chemical company has a commodity-grade

and premium-grade product. Why might the

company elect to process the commoditygrade

product further to the premium-grade

product?

  1. A company accepts incremental business

at a special price that exceeds the variable

cost. What other issues must the company

consider in deciding whether to accept the

business?

  1. A company fabricates a component at a

cost of $7.75. A supplier offers to supply

the same component for $6.15. Under what

circumstances is it reasonable to purchase

from the supplier?

  1. Many fast-food restaurant chains, such as

McDonald’s, will occasionally discontinue

restaurants in their system. What are some

financial considerations in deciding to

eliminate a store?

  1. In the long run, the normal selling price must

be set high enough to cover what factors?

  1. Why might the use of ideal standards in applying

the cost-plus approach to product

pricing lead to setting product prices that

are too low?

  1. Although the cost-plus approach to product

pricing may be used by management as a

general guideline, what are some examples

of other factors that managers should also

consider in setting product prices?

  1. What method of determining product cost

may be appropriate in settings where the

manufacturing process is complex?

  1. How does the target cost concept differ from

cost-plus approaches?

  1. Under what circumstances is it appropriate

to use the target cost concept?

  1. What is a production bottleneck?
  2. What is the appropriate measure of a product’s

value when a firm is operating under

production bottlenecks?

 

Exercises

E12-1 Lease or sell decision

Yamada Industries is considering selling excess machinery with a book value of

$220,000 (original cost of $600,000 less accumulated depreciation of $380,000)

for $200,000, less a 6% brokerage commission. Alternatively, the machinery can

be leased for a total of $290,000 for five years, after which it is expected to have

no residual value. During the period of the lease, Yamada Industries’ costs of

repairs, insurance, and property tax expenses are expected to be $71,000.

  1. Prepare a differential analysis report, dated January 9, 2012, for the lease or

sell decision.

  1. On the basis of the data presented, would it be advisable to lease or sell the

machinery? Explain.

E12-2 Differential analysis report for a discontinued product

A condensed income statement by product line for Western Beverages Inc. indicated

the following for Lime Cola for the past year:

Sales $2,450,000

Cost of goods sold 2,100,000

Gross profit $ 350,000

Operating expenses 980,000

Loss from operations $ (630,000)

It is estimated that 30% of the cost of goods sold represents fixed factory overhead

costs and that 25% of the operating expenses are fixed. Since Lime Cola is

only one of many products, the fixed costs will not be significantly affected if

the product is discontinued.

  1. Prepare a differential analysis report, dated February 13, 2012, for the proposed

discontinuance of Lime Cola.

  1. Should Lime Cola be retained? Explain.

E12-3 Differential analysis report for a discontinued product

The condensed product-line income statement for Dinner Ware Company for the

month of August is as follows:

Dinner Ware Company

Product-Line Income Statement

For the Month Ended August 31, 2012

Bowls Plates Cups

Sales $1,500,000 $2,350,000 $ 975,000

Cost of goods sold 900,000 1,400,000 780,000

Gross profit $ 600,000 $ 950,000 $ 195,000

Selling and administrative expenses 270,000 700,000 300,000

Income (loss) from operations $ 330,000 $ 250,000 $(105,000)

Fixed costs are 40% of the cost of goods sold and 18% of the selling and

administrative expenses. Dinner Ware assumes that fixed costs would not be

significantly affected if the Cups line were discontinued.

  1. Prepare a differential analysis report for all three products for the month ended

August 31, 2012.

  1. Should the Cups line be retained? Explain.

E12-4 Segment analysis

Charles Schwab Corporation is one of the more innovative brokerage and financial

service companies in the United States. The company provided information about

its major business segments as follows (in millions) for a recent year.

Individual

Investor

Institutional

Investor

Revenues $2,845 $1,403

Income from operations 780 443

Depreciation and amortization 93 52

  1. How do you believe Schwab defines the difference between the “Individual

Investor” and “Institutional Investor” segments?

  1. Provide a specific example of a variable and fixed cost in the “Individual Investor”

segment.

  1. Estimate the contribution margin for each segment.
  2. If Schwab decided to sell its “Institutional Investor” accounts to another company,

estimate how much operating income would decline.

E12-5 Decision to discontinue a product

On the basis of the following data, the general manager of Footwear Industries

Inc. decided to discontinue Children’s Shoes because it reduced income from

operations by $45,000. What is the flaw in this decision?

Footwear Industries Inc.

Product-Line Income Statement

For the Year Ended May 31, 2012

Children’s

Shoes

Men’s

Shoes

Women’s

Shoes Total

Sales $500,000 $800,000 $1,200,000 $2,500,000

Costs of goods sold:

Variable costs $275,000 $390,000 $ 700,000 $1,365,000

Fixed costs 100,000 160,000 200,000 460,000

Total cost of goods sold $375,000 $550,000 $ 900,000 $1,825,000

Gross profit $125,000 $250,000 $ 300,000 $ 675,000

Selling and administrative expenses:

Variable selling and admin. expenses $130,000 $140,000 $ 160,000 $ 430,000

Fixed selling and admin. expenses 40,000 40,000 50,000 130,000

Total selling and admin. expenses $170,000 $180,000 $ 210,000 $ 560,000

Income (loss) from operations $ (45,000) $ 70,000 $ 90,000 $ 115,000

E12-6 Make-or-buy decision

Balboa Technologies Company has been purchasing carrying cases for its portable

computers at a delivered cost of $20 per unit. The company, which is currently

operating below full capacity, charges factory overhead to production at the rate

of 60% of direct labor cost. The fully absorbed unit costs to produce comparable

carrying cases are expected to be as follows:

Direct materials $ 9.00

Direct labor 7.50

Factory overhead (60% of direct labor) 4.50

Total cost per unit $21.00

If Balboa Technologies Company manufactures the carrying cases, fixed factory

overhead costs will not increase and variable factory overhead costs associated

with the cases are expected to be 20% of the direct labor costs.

  1. Prepare a differential analysis report, dated June 19, 2012, for the make-or-buy

decision.

  1. On the basis of the data presented, would it be advisable to make the carrying

cases or to continue buying them? Explain.

E12-7 Make-or-buy decision

The Wisconsin Arts of Milwaukee employs five people in its Publication Department.

These people lay out pages for pamphlets, brochures, and other publications

for the productions. The pages are delivered to an outside company for

printing. The company is considering an outside publication service for the

layout work. The outside service is quoting a price of $12.50 per layout page.

The budget for the Publication Department for 2013 is as follows:

Salaries $185,000

Benefits 50,000

Supplies 30,000

Office expenses 25,000

Office depreciation 70,000

Computer depreciation 18,000

Total $378,000

The department expects to lay out 30,000 pages for 2013. The computers used

by the department have an estimated residual value of $6,500. The Publication

Department office space would be used for future administrative needs, if the

department’s function were purchased from the outside.

  1. Prepare a differential analysis report, dated September 24, 2012, for the makeor-

buy decision, considering the 2013 differential revenues and costs.

  1. On the basis of your analysis in part (a), should the page layout work be

purchased from an outside company?

  1. What additional considerations might factor into the decision making?

E12-8 Machine replacement decision

Picasso Industries is considering replacing an old piece of machinery, which

cost $150,000 and has $70,000 of accumulated depreciation to date, with a new

machine that costs $175,000. The old equipment could be sold for $60,000. The

annual variable production costs associated with the old machine are estimated

to be $95,000 for eight years. The annual variable production costs for the new

machine are estimated to be $72,000 for eight years.

  1. Determine the total and annualized differential income or loss anticipated from

replacing the old machine.

  1. What is the sunk cost in this situation?

E12-9 Differential analysis report for machine replacement

Sidney Technologies Inc. assembles circuit boards by using a manually operated

machine to insert electronic components. The original cost of the machine

is $60,000, the accumulated depreciation is $24,000, its remaining useful life is

five years, and its residual value is negligible. On February 29, 2012, a proposal

was made to replace the present manufacturing procedure with a fully automatic

machine that will cost $225,000. The automatic machine has an estimated useful

life of five years and no significant residual value. For use in evaluating the

proposal, the accountant accumulated the following annual data on present and

proposed operations:

Present

Operations

Proposed

Operations

Sales $400,000 $400,000

Direct materials $100,000 $100,000

Direct labor 65,000 —

Power and maintenance 8,000 23,000

Taxes, insurance, etc. 4,000 14,000

Selling and administrative expenses 90,000 90,000

Total expenses $267,000 $227,000

  1. Prepare a differential analysis report for the proposal to replace the machine.

Include in the analysis both the net differential change in costs anticipated

over the five years and the net annual differential change in costs anticipated.

  1. Based only on the data presented, should the proposal be accepted?
  2. What are some of the other factors that should be considered before a final

decision is made?

E12-10 Sell or process further

Canyon Ferry Lumber Company incurs a cost of $180 per hundred board feet in

processing certain “rough-cut” lumber, which it sells for $275 per hundred board

feet. An alternative is to produce a “finished cut” at a total processing cost of

$300 per hundred board feet, which can be sold for $450 per hundred board

feet. What is the amount of (a) the differential revenue, (b) differential cost, and

(c) differential income for processing rough-cut lumber into finished cut?

E12-11 Sell or process further

Spokane Coffee Company produces Columbian coffee in batches of 5,000 pounds.

The standard quantity of materials required in the process is 5,000 pounds, which

cost $4.00 per pound. Columbian coffee can be sold without further processing

for $9.00 per pound. Columbian coffee can also be processed further to yield

Decaf Columbian, which can be sold for $12.50 per pound. The processing into

Decaf Columbian requires additional processing costs of $14,110 per batch. The

additional processing will also cause an 8% loss of product due to evaporation.

  1. Prepare a differential analysis report dated April 30, 2013, for the decision to

sell or process further.

  1. Should Spokane Coffee sell Columbian coffee or process further and sell Decaf

Columbian?

  1. Determine the price of Decaf Columbian that would cause neither an advantage

nor a disadvantage for processing further and selling Decaf Columbian.

E12-12 Decision on accepting additional business

Whiskers Inc. has an annual plant capacity of 100,000 units, and current production

is 75,000 units. Monthly fixed costs are $375,000, and variable costs are $26

per unit. The present selling price is $40 per unit. On July 27, 2012, the company

received an offer from Sandstone Company for 17,500 units of the product at $30

each. Sandstone Company will market the units in a foreign country under its

own brand name. The additional business is not expected to affect the domestic

selling price or quantity of sales of Whiskers Inc.

  1. Prepare a differential analysis report for the proposed sale to Sandstone Company.
  2. Briefly explain the reason why accepting this additional business will increase

operating income.

  1. What is the minimum price per unit that would produce a contribution margin?

E12-13 Accepting business at a special price

Trade Winds Company expects to operate at 85% of productive capacity during

June. The total manufacturing costs for June for the production of 42,500 batteries

are budgeted as follows:

Direct materials $340,000

Direct labor 170,000

Variable factory overhead 63,750

Fixed factory overhead 127,500

Total manufacturing costs $701,250

The company has an opportunity to submit a bid for 6,000 batteries to be

delivered by June 30 to a government agency. If the contract is obtained, it is

anticipated that the additional activity will not interfere with normal production

during June or increase the selling or administrative expenses.

  1. What is the June budgeted cost per battery for the production of 42,500 batteries?’
  2. What is the unit cost below which Trade Winds Company should not go in

bidding on the government contract?

E12-14 Decision on accepting additional business

Miramar Tire and Rubber Company has capacity to produce 250,000 tires. Miramar

presently produces and sells 200,000 tires for the North American market

at a price of $40 per tire. Miramar is evaluating a special order from a South

American automobile company, Rio Motors. Rio Motors is offering to buy 40,000

tires for $20 per tire. Miramar’s accounting system indicates that the total cost

per tire is as follows:

Direct materials $10.00

Direct labor 5.00

Factory overhead (45% variable) 4.00

Selling and administrative expenses (75% variable) 3.00

Total $22.00

Miramar pays a selling commission equal to 4% of the selling price on North

American orders, which is included in the variable portion of the selling and

administrative expenses. However, this special order would not have a sales commission.

If the order was accepted, the tires would be shipped overseas for an

additional shipping cost of $1.50 per tire. In addition, Rio has made the order

conditional on Miramar Tire Company receiving a Brazilian safety certification.

Rio estimates that this certification would cost Miramar Tire $20,000.

  1. Prepare a differential analysis report dated August 7, 2012, for the proposed

sale to Rio Motors.

  1. What is the minimum price per unit that would be financially acceptable to

Miramar?

E12-15 Total cost concept of product costing

Global Devices Inc. uses the total cost concept of applying the cost-plus approach

to product pricing. The costs of producing and selling 80,000 units of computer

tablets are as follows:

Variable costs: Fixed costs:

Direct materials $ 90 per unit Factory overhead $800,000

Direct labor 20 Selling and admin. exp. 300,000

Factory overhead 30

Selling and admin. exp. 15

Total $155 per unit

Global Devices desires a profit equal to an 18% rate of return on invested

assets

of $6,000,000.

  1. Determine the amount of desired profit from the production and sale of

computer

tablets.

  1. Determine the total costs and the cost amount per unit for the production and

sale of 80,000 units of computer tablets.

  1. Determine the total cost markup percentage for computer tablets.
  2. Determine the selling price of computer tablets.

E12-16 Product cost concept of product pricing

Based on the data presented in Exercise 12-15, assume that Global Devices Inc.

uses the product cost concept of applying the cost-plus approach to product

pricing.

  1. Determine the total manufacturing costs and the cost amount per unit for the

production and sale of 80,000 units of computer tablets.

  1. Determine the product cost markup percentage for computer tablets.
  2. Determine the selling price of computer tablets.

E12-17 Variable cost concept of product pricing

Based on the data presented in Exercise 12-15, assume that Global Cellular Inc.

uses the variable cost concept of applying the cost-plus approach to product

pricing.

  1. Determine the variable costs and the cost amount per unit for the production

and sale of 80,000 units of computer tablets.

  1. Determine the variable cost markup percentage (rounded to two decimal

places) for computer tablets.

  1. Determine the selling price of computer tablets. Round to the nearest cent.

E12-18 Target costing

Toyota Motor Corporation uses target costing. Assume that Toyota marketing personnel

estimate that the competitive, average selling price for the Rav4 in the

upcoming model year will need to be $24,000. Assume further that the Rav4’s

total unit cost for the upcoming model year is estimated to be $20,500 and that

Toyota requires a 20% profit margin on selling price (which is equivalent to a

25% markup on total cost).

  1. What price will Toyota establish for the Rav4 for the upcoming model year?
  2. What impact will target costing have on Toyota, given the assumed information?

E12-19 Target costing

Millennium Printers Inc. manufactures color laser printers. Model L-1819 presently

sells for $200 and has a total product cost of $160, as follows:

Direct materials $ 40

Direct labor 80

Factory overhead 40

Total $160

It is estimated that the competitive selling price for color laser printers of this

type will drop to $182 next year. Millennium Printers wants to establish a target

cost to maintain its historical markup percentage on product cost. Engineers have

provided the following cost reduction ideas:

  1. Purchase a plastic printer cover with snap-on assembly. This will reduce the

amount of direct labor by six minutes per unit.

  1. Add an inspection step that will add nine minutes per unit of direct labor but

reduce the materials cost by $7.25 per unit.

  1. Decrease the cycle time of the injection molding machine from four minutes

to three minutes per part. Thirty percent of the direct labor and 28% of the

factory overhead is related to running injection molding machines.

The direct labor rate is $20 per hour.

  1. Determine the target cost for Model L-1819 assuming that the historical markup

on product cost is maintained.

  1. Determine the required cost reduction.
  2. Evaluate the three engineering improvements to determine if the required cost

reduction (drift) can be achieved.

E12-20 Product decisions under bottlenecked operations

Yumin Metals Inc. has three grades of metal product, Type A1, Type B3, and

Type E6. Financial data for the three grades are as follows:

Type A1 Type B3 Type E6

Revenues $400,000 $578,000 $300,000

Variable cost $250,000 $380,000 $270,000

Fixed cost 105,000 118,800 20,000

Total cost $355,000 $498,800 $290,000

Income from operations $ 45,000 $ 79,200 $ 10,000

Number of units 4 15,000 4 16,500 4 5,000

Income from operations per unit $ 3.00 $ 4.80 $ 2.00

Yumin Metals’ operations require all three grades to be melted in a furnace

before being formed. The furnace runs 24 hours a day, 7 days a week, and is

a production bottleneck. The furnace hours required per unit of each product

are as follows:

Type A1: 8 hours

Type B3: 10 hours

Type E6: 6 hours

The Marketing Department is considering a new marketing and sales campaign.

Which product should be emphasized in the marketing and sales campaign in

order to maximize profitability?

E12-21 Product decisions under bottlenecked operations

Madero Glass Company manufactures three types of safety plate glass: large,

medium, and small. All three products have high demand. Thus, Madero Glass is

able to sell all the safety glass that it can make. The production process includes

an autoclave operation, which is a pressurized heat treatment. The autoclave is a

production bottleneck. Total fixed costs are $125,000. In addition, the following

information is available about the three products:

Large Medium Small

Unit selling price $180 $150 $135

Unit variable cost 144 130 110

Unit contribution margin $ 36 $ 20 $ 25

Autoclave hours per unit 10 8 4

Total process hours per unit 16 14 10

Budgeted units of production 5,000 5,000 5,000

  1. Determine the contribution margin by glass type and the total company income

from operations for the budgeted units of production.

  1. Prepare an analysis showing which product is the most profitable per bottleneck

hour.

E12-22 Product pricing under bottlenecked operations

Based on the data presented in Exercise 12-21, assume that Madero Glass wanted

to price all products so that they produced the same profit potential as the highest

profit product. Thus, determine the prices for each of the products so that

they would produce a profit equal to the highest profit product.

 

Problems

P12-1 Differential analysis report involving opportunity costs

On November 7, Five Star is considering leasing a building and buying the necessary

equipment to operate a public warehouse. Alternatively, the company could

use the funds to invest in $900,000 of 4% U.S. Treasury bonds that mature in

15 years. The bonds could be purchased at face value. The following data have

been assembled:

Cost of equipment $900,000

Life of equipment 15 years

Estimated residual value of equipment $100,000

Yearly costs to operate the warehouse,

excluding depreciation of equipment $175,000

Yearly expected revenues—years 1–7 $400,000

Yearly expected revenues—years 8–15 $250,000

Instructions

  1. Prepare a report as of November 7, 2012, presenting a differential analysis of

the proposed operation of the warehouse for the 15 years as compared with

present conditions.

  1. Based on the results disclosed by the differential analysis, should the proposal

be accepted?

  1. If the proposal is accepted, what is the total estimated income from operations

of the warehouse for the 15 years?

P12-2 Differential analysis report for machine replacement proposal

Catalina Tooling Company is considering replacing a machine that has been used

in its factory for two years. Relevant data associated with the operations of the

old machine and the new machine, neither of which has any estimated residual

value, are as follows:

Old Machine

Cost of machine, 10-year life $75,000

Annual depreciation (straight-line) 7,500

Annual manufacturing costs, excluding depreciation 33,150

Annual nonmanufacturing operating expenses 10,000

Annual revenue 60,000

Current estimated selling price of the machine 24,000

New Machine

Cost of machine, eight-year life $90,000

Annual depreciation (straight-line) 11,250

Estimated annual manufacturing costs,

exclusive of depreciation 18,200

Annual nonmanufacturing operating expenses 10,000

Annual nonmanufacturing operating expenses and revenue are not expected

to be affected by purchase of the new machine.

Instructions

  1. Prepare a differential analysis report as of October 14, 2012, comparing operations

utilizing the new machine with operations using the present equipment.

The analysis should indicate the differential income that would result over the

eight-year period if the new machine is acquired.

  1. List other factors that should be considered before a final decision is reached.

P12-3 Differential analysis report for sales promotion proposal

Rocket Shoe Company is planning a one-month campaign for August to promote

sales of one of its two shoe products. A total of $500,000 has been budgeted for

advertising, contests, redeemable coupons, and other promotional activities. The

following data have been assembled for their possible usefulness in deciding

which of the products to select for the campaign.

Cross-Trainer

Shoe

Running

Shoe

Unit selling price $90 $112

Unit production costs:

Direct materials $24 $ 30

Direct labor 10 8

Variable factory overhead 6 6

Fixed factory overhead 8 16

Total unit production costs $48 $ 60

Unit variable selling expenses 12 12

Unit fixed selling expenses 4 16

Total unit costs $64 $ 88

Operating income per unit $26 $ 24

No increase in facilities would be necessary to produce and sell the increased

output. It is anticipated that 25,000 additional units of cross-trainer shoes or

18,000 additional units of running shoes could be sold without changing the unit

selling price of either product.

Instructions

  1. Prepare a differential analysis report as of July 25, 2012, presenting the additional

revenue and additional costs anticipated from the promotion of crosstrainer

shoes and running shoes.

  1. The sales manager had tentatively decided to promote cross-trainer shoes,

estimating that operating income would be increased by $150,000 ($26 operating

income per unit for 25,000 units, less promotion expenses of $500,000).

The manager also believed that the selection of running shoes would decrease

operating income by $68,000 ($24 operating income per unit for 18,000 units,

less promotion expenses of $500,000). State briefly your reasons for supporting

or opposing the tentative decision.

P12-4 Differential analysis report for further processing

The management of Dorsch Aluminum Co. is considering whether to process

aluminum ingot further into rolled aluminum. Rolled aluminum can be sold for

$4,100 per ton, and ingot can be sold without further processing for $2,400 per

ton. Ingot is produced in batches of 80 tons by smelting 400 tons of bauxite,

which costs $500 per ton. Rolled aluminum will require additional processing

costs of $750 per ton of ingot, and 1.25 tons of ingot will produce 1 ton of rolled

aluminum (due to trim losses).

Instructions

  1. Prepare a report as of February 3, 2012, presenting a differential analysis

associated with the further processing of aluminum ingot to produce rolled

aluminum.

  1. Briefly report your recommendations.

P12-5 Product pricing using the cost-plus approach concepts; differential

analysis

report for accepting additional business

Twilight Lumina Company recently began production of a new product, the

halogen light, which required the investment of $1,200,000 in assets. The costs

of producing and selling 20,000 halogen lights are estimated as follows:

Variable costs: Fixed costs:

Direct materials $30 per unit Factory overhead $340,000

Direct labor 10 Selling and admin. exp. 160,000

Factory overhead 6

Selling and admin. exp. 4

Total $50 per unit

Twilight Lumina Company is currently considering establishing a selling price

for the halogen light. The president of Twilight Lumina Company has decided to

use the cost-plus approach to product pricing and has indicated that the halogen

light must earn a 20% rate of return on invested assets.

Instructions

  1. Determine the amount of desired profit from the production and sale of the

halogen light.

  1. Assuming that the total cost concept is used, determine (a) the cost amount per

unit, (b) the markup percentage, and (c) the selling price of the halogen light.

  1. Assuming that the product cost concept is used, determine (a) the cost amount

per unit, (b) the markup percentage (round to the nearest two decimal places),

and (c) the selling price of the halogen light (round to the nearest cent).

  1. Assuming that the variable cost concept is used, determine (a) the cost amount

per unit, (b) the markup percentage, and (c) the selling price of the halogen

light.

  1. Comment on any additional considerations that could influence establishing

the selling price for the halogen light.

  1. Assume that as of October 26, 2012, 15,000 units of halogen light have been

produced and sold during the current year. Analysis of the domestic market

indicates that 2,000 additional units of the halogen light are expected to be

sold during the remainder of the year at the normal product price determined

under the total cost concept. On November 8, Twilight Lumina Company

received an offer from Contech Inc. for 3,000 units of the halogen light at

$52 each. Contech Inc. will market the units in Southeast Asia under its own

brand name, and no selling and administrative expenses associated with the

sale will be incurred by Twilight Lumina Company. The additional business

is not expected to affect the domestic sales of the halogen light, and the

additional units could be produced using existing capacity.

  1. Prepare a differential analysis report of the proposed sale to Contech Inc.
  2. Based on the differential analysis report in part (a), should the proposal

be accepted?

P12-6 Product pricing and profit analysis with bottleneck operations

Palomar Chemical Company produces three products: ethylene, butane, and ester.

Each of these products has high demand in the market, and Palomar Chemical

is able to sell as much as it can produce of all three. The reaction operation is a

bottleneck in the process and is running at 100% of capacity. Palomar Chemical

wants to improve chemical operation profitability. The variable conversion cost

is $20 per process hour. The fixed cost is $550,000. In addition, the cost analyst

was able to determine the following information about the three products:

Ethylene Butane Ester

Budgeted units produced 15,000 15,000 15,000

Total process hours per unit 6 6 4

Reactor hours per unit 1.0 0.8 0.5

Unit selling price $400 $350 $250

Direct materials cost per unit $180 $130 $90

The reaction operation is part of the total process for each of these three

products. Thus, for example, 1.0 of the 6 hours required to process ethylene are

associated with the reactor.

Instructions

  1. Determine the unit contribution margin for each of the three products.
  2. Provide an analysis to determine the relative product profitabilities, assuming

that the reactor is a bottleneck.

  1. Assume that management wishes to improve profitability by increasing prices

on selected products. At what price would ethylene and butane need to be

offered in order to produce the same relative profitability as ester?

 

Activities

A12-1 Product pricing

Bev Frazier is a cost accountant for Ocean Atlantic Apparel Inc. Jeff Rangel, vice

president of marketing, has asked Bev to meet with representatives of Ocean

Atlantic Apparel’s major competitor to discuss product cost data. Jeff indicates

that the sharing of these data will enable Ocean Atlantic to determine a fair and

equitable price for its products.

Would it be ethical for Bev to attend the meeting and share the relevant cost

data?

A12-2 Decision on accepting additional business

A manager of Coastal Sporting Goods Company is considering accepting an order

from an overseas customer. This customer has requested an order for 50,000

dozen golf balls at a price of $12 per dozen. The variable cost to manufacture a

dozen golf balls is $9 per dozen. The full cost is $14 per dozen. Coastal Sporting

Goods has a normal selling price of $24 per dozen. Coastal’s plant has just

enough excess capacity on the second shift to make the overseas order.

What are some considerations in accepting or rejecting this order?

A12-3 Accept business at a special price

If you are not familiar with Priceline.com Inc., go to its Web site. Assume that an

individual “names a price” of $90 on Priceline.com for a room in Miami, Florida,

on September 3. Assume that September 3 is a Saturday, with low expected

room demand in Miami at a Marriott International, Inc., hotel, so there is excess

room capacity. The fully allocated cost per room per day is assumed from hotel

records as follows:

Housekeeping labor cost* $ 30

Hotel depreciation expense 50

Cost of room supplies (soap, paper, etc.) 2

Laundry labor and material cost* 6

Cost of desk staff 8

Utility cost (mostly air conditioning) 4

Total cost per room per day $100

* Both housekeeping and laundry staff include many part-time

workers, so that the workload is variable to demand.

Should Marriott accept the customer bid for a night in Miami on September 3

at a price of $90?

A12-4 Cost-plus and target costing concepts

The following conversation took place between Dean Lancaster, vice president

of marketing, and Dina Conaway, controller of Redwood Computer Company:

Dean: I am really excited about our new computer coming out. I think it will

be a real market success.

Dina: I’m really glad you think so. I know that our success will be determined

by our price. If our price is too high, our competitors will be the ones with the

market success.

Dean: Don’t worry about it. We’ll just mark our product cost up by 25% and it

will all work out. I know we’ll make money at those markups. By the way, what

does the estimated product cost look like?

Dina: Well, there’s the rub. The product cost looks as if it’s going to come in at

around $1,000. With a 25% markup, that will give us a selling price of $1,250.

Dean: I see your concern. That’s a little high. Our research indicates that computer

prices are dropping and that this type of computer should be selling for

around $900 when we release it to the market.

Dina: I’m not sure what to do.

Dean: Let me see if I can help. How much of the $1,000 is fixed cost?

Dina: About $300.

Dean: There you go. The fixed cost is sunk. We don’t need to consider it in

our pricing decision. If we reduce the product cost by $300, the new price with

a 25% markup would be right at $875. Boy, I was really worried for a minute

there. I knew something wasn’t right.

  1. If you were Dina, how would you respond to Dean’s solution to the pricing

problem?

  1. How might target costing be used to help solve this pricing dilemma?

A12-5 Pricing decisions and markup on variable costs

Many businesses are offering their products and services over the Internet. Some

of these companies and their Internet addresses are listed below.

Company Name Internet Address (URL) Product

Delta Air Lines http://www.delta.com Airline tickets

Amazon.com http://www.amazon.com Books

Dell Inc. http://www.dell.com Personal computers

  1. In groups of three, assign each person in your group to one of the Internet

sites listed above. For each site, determine the following:

  1. A product (or service) description.
  2. A product price.
  3. A list of costs that are required to produce and sell the product selected

in part (1) as listed in the annual report on SEC Form 10-K.

  1. Whether the costs identified in part (3) are fixed costs or variable costs.
  2. Which of the three products do you believe has the largest markup on variable

cost?

 

Answers to Self-Examination Questions

  1. A Differential cost is the amount of increase

or decrease in cost that is expected from a

particular course of action compared with an

alternative. For Marlo Company, the differential

cost is $19,000 (answer A). This is the

total of the variable product costs ($15,000)

and the variable operating expenses ($4,000),

which would not be incurred if the product

is discontinued.

  1. A A sunk cost is not affected by later

decisions. For Victor Company, the sunk cost

is the $50,000 (answer A) book value of the

equipment, which is equal to the original cost

of $200,000 (answer C) less the accumulated

depreciation of $150,000 (answer B).

  1. C The amount of income that could have

been earned from the best available alternative

to a proposed use of cash is the opportunity

cost. For Henry Company, the opportunity cost

is 12% of $100,000, or $12,000 (answer C).

  1. C Under the variable cost concept of product

pricing (answer C), fixed manufacturing costs,

fixed administrative and selling expenses, and

desired profit are allowed for in determining

the markup. Only desired profit is allowed for

in the markup under the total cost concept

(answer A). Under the product cost concept

(answer B), total selling and administrative

expenses and desired profit are allowed for

in determining the markup. Standard cost

(answer D) can be used under any of the

cost-plus approaches to product pricing.

  1. C Product 3 has the highest unit contribution

margin per bottleneck hour ($14 4 2 5

$7). Product 1 (answer A) has the largest unit

contribution margin, but the lowest unit contribution

per bottleneck hour ($20 4 4 5 $5),

so it is the least profitable product in the

constrained environment. Product 2 (answer

  1. B) has the highest total profitability in March

(1,500 units 3 $18), but this does not suggest

that it has the highest profit potential. Product

2’s unit contribution per bottleneck hour

($18 4 3 5 $6) is between Products 1 and

  1. Answer D is not true, since the products

all have different profit potential in terms of

unit contribution margin per bottleneck hour.

 

 

Chapter 13 Budgeting and Standard Cost Systems

 

Class Discussion Questions

  1. What are the three major objectives of

budgeting?

  1. What is the manager’s role in a responsibility

center?

  1. Briefly describe the type of human behavior

problems that might arise if budget goals are

set too tightly.

  1. Give an example of budgetary slack.
  2. What behavioral problems are associated

with setting a budget too loosely?

  1. What behavioral problems are associated

with establishing conflicting goals within the

budget?

  1. When would a company use zero-based

budgeting?

  1. Under what circumstances would a static

budget be appropriate?

  1. How do computerized budgeting systems aid

firms in the budgeting process?

  1. What is the first step in preparing a master

budget?

  1. Why should the production requirements set

forth in the production budget be carefully

coordinated with the sales budget?

  1. Why should the timing of direct materials

purchases be closely coordinated with the

production budget?

  1. In preparing the budget for the cost of goods

sold, what are the three budgets from which

data on relevant estimates of quantities and

costs are combined with data on estimated

inventories?

  1. a. Discuss the purpose of the cash budget.
  2. If the cash for the first quarter of the fiscal

year indicates excess cash at the end of

each of the first two months, how might

the excess cash be used?

  1. How does a schedule of collections from

sales assist in preparing the cash budget?

  1. Give an example of how the capital expenditures

budget affects other operating budgets.

  1. What are the basic objectives in the use of

standard costs?

  1. How can standards be used by management

to help control costs?

  1. What is meant by reporting by the “principle

of exceptions,” as the term is used in reference

to cost control?

  1. How often should standards be revised?
  2. How are standards used in budgetary performance

evaluation?

  1. a. What are the two variances between the

actual cost and the standard cost for direct

materials?

  1. Discuss some possible causes of these

variances.

  1. The materials cost variance report for Nickols

Inc. indicates a large favorable materials

price variance and a significant unfavorable

materials quantity variance. What might have

caused these offsetting variances?

  1. a. What are the two variances between the

actual cost and the standard cost for direct

labor?

  1. Who generally has control over the direct

labor cost?

  1. A new assistant controller recently was heard

to remark: “All the assembly workers in this

plant are covered by union contracts, so

there should be no labor variances.” Was

the controller’s remark correct? Discuss.

  1. Would the use of standards be appropriate

in a nonmanufacturing setting, such as a fastfood

restaurant?

  1. Briefly explain why firms might use nonfinancial

performance measures.

 

Exercises

E13-1 Flexible budget for selling and administrative expenses

Homeport uses flexible budgets that are based on the following data:

Sales commissions 4% of sales

Advertising expense 12% of sales

Miscellaneous selling expense $3,000 plus 2% of sales

Office salaries expense $40,000 per month

Office supplies expense 1.5% of sales

Miscellaneous administrative expense $1,500 per month plus 1% of sales

Prepare a flexible selling and administrative expenses budget for March 2013 for

sales volumes of $400,000, $600,000, and $800,000. (Use Exhibit 5 as a model.)

E13-2 Static budget vs. flexible budget

The production supervisor of the Machining Department for Paulk Company

agreed to the following monthly static budget for the upcoming year:

Paulk Company

Machining Department

Monthly Production Budget

Wages $2,688,000

Utilities 196,000

Depreciation 45,000

Total $2,929,000

The actual amount spent and the actual units produced in the first three months

of 2013 in the Machining Department were as follows:

Amount Spent Units Produced

January $1,854,000 50,000

February 2,236,800 60,000

March 2,798,000 75,000

The Machining Department supervisor has been very pleased with this performance,

since actual expenditures have been less than the monthly budget.

However, the plant manager believes that the budget should not remain fixed for

every month but should “flex” or adjust to the volume of work that is produced

in the Machining Department. Additional budget information for the Machining

Department is as follows:

Wages per hour $24.00

Utility cost per direct labor hour $1.75

Direct labor hours per unit 1.4

Planned unit production 80,000

  1. Prepare a flexible budget for the actual units produced for January, February,

and March in the Machining Department. Assume depreciation is a fixed cost.

  1. Compare the flexible budget with the actual expenditures for the first three

months. What does this comparison suggest?

E13-3 Flexible budget for Fabrication Department

Steelcase Inc. is one of the largest manufacturers of office furniture in the United

States. In Grand Rapids, Michigan, it produces filing cabinets in two departments:

Fabrication and Trim Assembly. Assume the following information for the

Fabrication

Department:

Steel per filing cabinet 12 pounds

Direct labor per filing cabinet 45 minutes

Supervisor salaries $175,000 per month

Depreciation $18,000 per month

Direct labor rate $22 per hour

Steel cost $0.45 per pound

Prepare a flexible budget for 20,000, 25,000, and 30,000 filing cabinets for

the month of May 2013, similar to Exhibit 5, assuming that inventories are not

significant.

E13-4 Sales and production budgets

Surround Audio Company manufactures two models of speakers, SJ30 and SX99.

Based on the following production and sales data for April 2013, prepare (a) a

sales budget and (b) a production budget.

SJ30 SX99

Estimated inventory (units), April 1 550 250

Desired inventory (units), April 30 800 350

Expected sales volume (units):

East Region 7,000 3,000

West Region 9,000 4,000

Unit sales price $80 $200

E13-5 Professional fees earned budget

Salazar & Crenshaw, CPAs, offer three types of services to clients: auditing,

tax, and small business accounting. Based on experience and projected growth,

the following billable hours have been estimated for the year ending July 31,

2013:

Billable Hours

Audit Department:

Staff 40,000

Partners 6,000

Tax Department:

Staff 30,000

Partners 4,500

Small Business Accounting Department:

Staff 8,000

Partners 1,800

The average billing rate for staff is $150 per hour, and the average billing rate

for partners is $350 per hour. Prepare a professional fees earned budget for Salazar

& Crenshaw, CPAs, for the year ending July 31, 2013, using the following column

headings and showing the estimated professional fees by type of service rendered:

Billable Hours Hourly Rate Total Revenue

E13-6 Professional labor cost budget

Based on the data in Exercise 13-5 and assuming that the average compensation

per hour for staff is $50 and for partners is $200, prepare a professional labor

cost budget for Salazar & Crenshaw, CPAs, for the year ending July 31, 2013.

Use the following column headings:

Staff Partners

E13-7 Direct materials purchases budget

Gino’s Frozen Pizza Inc. has determined from its production budget the following

estimated production volumes for 12” and 16” frozen pizzas for June 2013:

Units

12” Pizza 16” Pizza

Budgeted production volume 18,000 30,000

There are three direct materials used in producing the two types of pizza. The

quantities of direct materials expected to be used for each pizza are as follows:

12” Pizza 16” Pizza

Direct materials:

Dough 0.75 lb. per unit 1.00 lb. per unit

Tomato 0.40 0.80

Cheese 0.60 1.10

In addition, Gino’s has determined the following information about each

material:

Dough Tomato Cheese

Estimated inventory, June 1, 2012 4,000 lbs. 3,000 lbs. 3,400 lbs.

Desired inventory, June 30, 2012 5,500 lbs. 3,500 lbs. 4,000 lbs.

Price per pound $0.90 $1.20 $3.00

Prepare June’s direct materials purchases budget for Gino’s Frozen Pizza Inc.

E13-8 Direct materials purchases budget

Coca-Cola Enterprises is the largest bottler of Coca-Cola® in North America. The company

purchases Coke® and Sprite® concentrate from The Coca-Cola Company, dilutes

and mixes the concentrate with carbonated water, and then fills the blended

beverage into cans or plastic two-liter bottles. Assume that the estimated production

for Coke and Sprite two-liter bottles at the Dallas, Texas, bottling plant are

as follows for the month of October:

Coke 1,500,000 two-liter bottles

Sprite 800,000 two-liter bottles

In addition, assume that the concentrate costs $75 per pound for Coke and

Sprite and is used at a rate of 0.20 pound per 100 liters of carbonated water in

blending Coke and 0.15 pound per 100 liters of carbonated water in blending

Sprite. Assume that two-liter bottles cost $0.04 per bottle and carbonated water

costs $0.03 per liter.

Prepare a direct materials purchases budget for October 2013, assuming no

changes between beginning and ending inventories for all three materials.

E13-9 Direct labor cost budget

Isner Racket Company manufactures two types of tennis rackets, the Ace and Pro

Tour models. The production budget for August for the two rackets is as follows:

Ace Pro Tour

Production budget 12,000 units 5,000 units

Both rackets are produced in two departments, Forming and Assembly. The

direct labor hours required for each racket are estimated as follows:

Forming Department Assembly Department

Ace 0.25 hour per unit 0.40 hour per unit

Pro Tour 0.30 hour per unit 0.70 hour per unit

The direct labor rate for each department is as follows:

Forming Department $20 per hour

Assembly Department $14 per hour

Prepare the direct labor cost budget for August 2013.

E13-10 Production and direct labor cost budgets

Levi Strauss & Co. manufactures slacks and jeans under a variety of brand names,

such as Dockers® and 501 Jeans®. Slacks and jeans are assembled by a variety of

different sewing operations. Assume that the sales budget for Dockers and 501

Jeans shows estimated sales of 62,500 and 48,000 pairs, respectively, for February

  1. The finished goods inventory is assumed as follows:

Dockers 501 Jeans

February 1 estimated inventory 4,500 2,000

February 28 desired inventory 5,000 2,500

Assume the following direct labor data per 10 pairs of Dockers and 501 Jeans

for four different sewing operations:

Direct Labor per 10 Pairs

Dockers 501 Jeans

Inseam 10 minutes 12 minutes

Outerseam 12 9

Pockets 6 6

Zipper 8 3

Total 36 minutes 30 minutes

  1. Prepare a production budget for February. Prepare the budget in two columns:

Dockers™ and 501 Jeans™.

  1. Prepare the February direct labor cost budget for the four sewing operations,

assuming a $14 wage per hour for the inseam and outerseam sewing operations

and an $18 wage per hour for the pocket and zipper sewing operations.

Prepare the direct labor cost budget in four columns: inseam, outerseam,

pockets, and zipper.

E13-11 Factory overhead cost budget

Mickey’s Candy Company budgeted the following costs for anticipated production

for November 2013:

Advertising expenses $180,000 Production supervisor wages $145,000

Manufacturing supplies 8,000 Production control salaries 40,000

Power and light 36,000 Executive officer salaries 300,000

Sales commissions 225,000 Materials management salaries 25,000

Factory insurance 42,000 Factory depreciation 88,000

Prepare a factory overhead cost budget, separating variable and fixed costs.

Assume that factory insurance and depreciation are the only factory fixed costs.

E13-12 Cost of goods sold budget

The controller of Pueblo Ceramics Inc. wishes to prepare a cost of goods sold

budget for April. The controller assembled the following information for constructing

the cost of goods sold budget:

Direct materials: Enamel Paint Porcelain Total

Total direct materials purchases budgeted for April $35,000 $6,000 $140,000 $181,000

Estimated inventory, April 1, 2013 3,000 750 9,250 13,000

Desired inventory, April 30, 2013 3,200 1,000 10,800 15,000

Direct labor cost:

Kiln

Department

Decorating

Department Total

Total direct labor cost budgeted for April $38,000 $162,000 $200,000

Finished goods inventories: Dish Bowl Figurine Total

Estimated inventory, April 1, 2013 $4,500 $3,000 $2,500 $10,000

Desired inventory, April 30, 2013 4,000 750 1,250 6,000

Work in process inventories:

Estimated inventory, April 1, 2013 $ 11,400

Desired inventory, April 30, 2013 9,500

Budgeted factory overhead costs for April:

Indirect factory wages $ 71,500

Depreciation of plant and equipment 19,000

Power and light 12,300

Indirect materials 4,200

Total $107,000

Use the preceding information to prepare a cost of goods sold budget for April 2013.

E13-13 Schedule of cash collections of accounts receivable

Fido & Lucy Wholesale Inc., a pet wholesale supplier, was organized on March 1,

  1. Projected sales for each of the first three months of operations are as follows:

March $ 750,000

April 900,000

May 1,200,000

The company expects to sell 20% of its merchandise for cash. Of sales on

account,

40% are expected to be collected in the month of the sale, 55% in the

month following the sale, and the remainder in the second month following the sale.

Prepare a schedule indicating cash collections from sales for March, April,

and May.

E13-14 Schedule of cash collections of accounts receivable

Innovative Office Inc. has “cash and carry” customers and credit customers.

Innovative

Office estimates that 30% of monthly sales are to cash customers,

while the remaining sales are to credit customers. Of the credit customers, 75%

pay their accounts in the month of sale, while the remaining 25% pay their

accounts

in the month following the month of sale. Projected sales for the first

three months of 2013 are as follows:

January $1,200,000

February 1,450,000

March 1,600,000

The Accounts Receivable balance on December 31, 2012, was $180,000.

Prepare a schedule of cash collections from sales for January, February, and

March.

E13-15 Schedule of cash payments

Peanut Learning Systems Inc. was organized on July 31, 2012. Projected selling

and administrative expenses for each of the first three months of operations are

as follows:

August $137,000

September 165,000

October 140,000

Depreciation, insurance, and property taxes represent $30,000 of the estimated

monthly expenses. The annual insurance premium was paid on July 31,

and property taxes for the year will be paid in December. Sixty percent of the

remainder of the expenses are expected to be paid in the month in which they

are incurred, with the balance to be paid in the following month.

Prepare a schedule indicating cash payments for selling and administrative

expenses for August, September, and October.

E13-16 Schedule of cash payments

Rehab Physical Therapy Inc. is planning its cash payments for operations for

the second quarter (March–May), 2013. The Accrued Expenses Payable balance

on March 1 is $36,000. The budgeted expenses for the next three months are

as follows:

March April May

Salaries $100,000 $105,000 $110,000

Utilities 18,000 20,000 25,000

Other operating expenses 22,000 40,500 38,000

Total $140,000 $165,500 $173,000

Other operating expenses include $7,500 of monthly depreciation expense and

$1,000 of monthly insurance expense that was prepaid for the year on January 1

of the current year. Of the remaining expenses, 80% are paid in the month in

which they are incurred, with the remainder paid in the following month. The

Accrued Expenses Payable balance on March 1 relates to the expenses incurred

in February.

Prepare a schedule of cash payments for operations for March, April, and May.

E13-17 Capital expenditures budget

On August 1, 2012, the controller of Handy Dan Tools Inc. is planning capital

expenditures for the years 2013–2016. The controller interviewed several Handy

Dan executives to collect the necessary information for the capital expenditures

budget. Excerpts of the interviews are shown below.

Director of Facilities: A construction contract was signed in May 2012 for the

construction of a new factory building at a contract cost of $9,000,000. The construction

is scheduled to begin in 2013 and be completed in 2014.

Vice President of Manufacturing: Once the new factory building is finished,

we plan to purchase $3.6 million in equipment in late 2014. I expect that an additional

$500,000 will be needed early in the following year (2015) to test and

install the equipment before we can begin production. If sales continue to grow,

I expect we’ll need to invest another half million in equipment in 2016.

Vice President of Marketing: We have really been growing lately. I wouldn’t

be surprised if we need to expand the size of our new factory building in 2016

by at least 25%. Fortunately, we expect inflation to have minimal impact on construction

costs over the next four years. Additionally, I would expect the cost of

the expansion to be proportional to the size of the expansion.

Director of Information Systems: We need to upgrade our information systems

to wireless network technology. It doesn’t make sense to do this until after the

new factory building is completed and producing product. During 2015, once

the factory is up and running, we should equip the whole facility with wireless

technology. I think it would cost us $400,000 today to install the technology.

However, prices have been dropping by 10% per year, so it should be less

expensive

at a later date.

President: I am excited about our long-term prospects. My only short-term

concern

is financing the $5,000,000 of construction costs on the portion of the

new factory building scheduled to be completed in 2013.

Use the interview information above to prepare a capital expenditures budget

for Handy Dan Tools Inc. for the years 2013–2016.

E13-18 Standard product cost

Oakley Furniture Company manufactures unfinished oak furniture. Oakley uses

a standard cost system. The direct labor, direct materials, and factory overhead

standards for an unfinished dining room table are as follows:

Direct labor: Standard rate $18 per hr.

Standard time per unit 3 hrs.

Direct materials (oak): Standard price $7.50 per bd. ft.

Standard quantity 24 bd. ft.

Variable factory overhead: Standard rate $2.50 per direct labor hr.

Fixed factory overhead: Standard rate $1.40 per direct labor hr.

Determine the standard cost per dining room table.

E13-19 Budget performance report

McAlisters Bottle Company manufactures plastic two-liter bottles for the beverage

industry. The cost standards per 100 two-liter bottles are as follows:

Cost Category

Standard Cost per 100

Two-Liter Bottles

Direct labor $2.75

Direct materials 1.20

Factory overhead 0.35

Total $4.30

At the beginning of May, McAlisters Bottle’s management planned to produce

800,000 bottles. The actual number of bottles produced for May was 750,000

bottles. The actual costs for May of the current year were as follows:

Cost Category

Actual Cost for the Month

Ended May 31, 2012

Direct labor $21,100

Direct materials 9,200

Factory overhead 2,700

Total $33,000

  1. Prepare the May manufacturing standard cost budget (direct labor, direct materials,

and factory overhead) for McAlisters Bottle Company, assuming planned

production.

  1. Prepare a budget performance report for manufacturing costs, showing the total

cost variances for direct materials, direct labor, and factory overhead for May.

  1. Interpret the budget performance report.

E13-20 Direct materials variances

The following data relate to the direct materials cost for the production of 10,000

automobile tires:

Actual: 275,000 lbs. at $2.45 $673,750

Standard: 272,000 lbs. at $2.64 $718,080

  1. Determine the price variance, quantity variance, and total direct materials cost

variance.

  1. To whom should the variances be reported for analysis and control?

E13-21 Standard direct materials cost per unit from variance data

The following data relating to direct materials cost for August of the current year

are taken from the records of Happy Tots Inc., a manufacturer of plastic toys:

Quantity of direct materials used 12,000 lbs.

Actual unit price of direct materials $2.30 per lb.

Units of finished product manufactured 5,900 units

Standard direct materials per unit of finished product 2 lbs.

Direct materials quantity variance—unfavorable $410

Direct materials price variance—favorable $3,000

Determine the standard direct materials cost per unit of finished product, assuming

that there was no inventory of work in process at either the beginning

or the end of the month.

E13-22 Standard product cost, direct materials variance

H.J. Heinz Company uses standards to control its materials costs. Assume that a batch

of ketchup (6,000 pounds) has the following standards:

Standard Quantity Standard Price

Whole tomatoes 7,500 lbs. $0.40 per lb.

Vinegar 600 gal. 1.75 per gal.

Corn syrup 50 gal. 8.00 per gal.

Salt 500 lbs. 0.70 per lb.

The actual materials in a batch may vary from the standard due to tomato

characteristics. Assume that the actual quantities of materials for batch H3001

were as follows:

7,850 lbs. of tomatoes

575 gal. of vinegar

63 gal. of corn syrup

480 lbs. of salt

  1. Determine the standard unit materials cost per pound for a standard batch.
  2. Determine the total direct materials quantity variance for batch H3001.

E13-23 Direct labor variances

The following data relate to labor cost for production of smart telephones:

Actual: 4,200 hrs. at $17.20 $72,240

Standard: 4,260 hrs. at $16.75 $71,355

  1. Determine the rate variance, time variance, and total direct labor cost variance.
  2. Discuss what might have caused these variances.

E13-24 Direct labor variances

Death Valley Bicycle Company manufactures mountain bikes. The following data

for October of the current year are available:

Quantity of direct labor used 1,100 hrs.

Actual rate for direct labor $18.50 per hr.

Bicycles completed in October 350

Standard direct labor per bicycle 3 hrs.

Standard rate for direct labor $19.00 per hr.

Planned bicycles for October 375

Determine the direct labor rate and time variances.

E13-25 Direct materials and direct labor variances

At the beginning of August, Havasu Printers Company budgeted 30,000 books to

be printed in August at standard direct materials and direct labor costs as follows:

Direct materials $15,000

Direct labor 72,000

Total $87,000

The standard materials price is $0.40 per pound. The standard direct labor

rate is $12 per hour. At the end of August, the actual direct materials and direct

labor costs were as follows:

Actual direct materials $13,320

Actual direct labor 60,000

Total $73,320

There were no direct materials price or direct labor rate variances for August.

In addition, assume no changes in the direct materials inventory balances

in August.

Havasu Printers Company actually produced 24,500 units during

August.

Determine the direct materials quantity, direct labor time variances, and the

total variance.

E13-26 Direct labor standards for nonmanufacturing expenses

Southwest Iowa Hospital began using standards to evaluate its Admissions

Department.

The standards were broken into two types of admissions as follows:

Type of Admission

Standard Time to Complete

Admission Record

Unscheduled admission 30 min.

Scheduled admission 15 min.

The unscheduled admission took longer, since name, address, and insurance

information needed to be determined at the time of admission. Information was

collected on scheduled admissions prior to the admissions, which was less time

consuming.

The Admissions Department employs two full-time people (36 hours per week,

with no overtime) at $21 per hour. For the most recent week, the department

handled 55 unscheduled and 210 scheduled admissions.

  1. How much was actually spent on labor for the week?
  2. What are the standard hours for the actual volume for the week?
  3. Compute a time variance. How well did the department perform for the week?

E13-27 N onfinancial performance measures

Indio Palms College wishes to monitor the efficiency and quality of its course

registration process.

  1. List three input and three output measures for this process.
  2. Why would Indio Palms College use nonfinancial measures for monitoring this

process?

E13-28 N onfinancial performance measures

Par, Birdie, Eagle, Inc. is an Internet retailer of golf equipment. Customers order

golf equipment from the company, using an online catalog. The company processes

these orders and delivers the requested product from its warehouse. The

company wants to provide customers with an excellent purchase experience in

order to expand the business through favorable word-of-mouth advertising and

to drive repeat business. To help monitor performance, the company developed

a set of performance measures for its order placement and delivery process.

Average computer response time to customer “clicks”

Dollar amount of returned goods

Elapsed time between customer order and product delivery

Maintenance dollars divided by hardware investment

Number of customer complaints divided by the number of orders

Number of misfilled orders divided by the number of orders

Number of orders per warehouse employee

Number of page faults or errors due to software programming errors

Number of software fixes per week

Server (computer) downtime

Training dollars per programmer

  1. For each performance measure, identify it as either an input or output measure

related to the “order placement and delivery” process.

  1. Provide an explanation for each performance measure.

E13-29 Factory overhead cost variances

The following data relate to factory overhead cost for the production of 8,000

computers:

Actual: Variable factory overhead $101,750

Fixed factory overhead 180,000

Standard: 8,000 hrs. at $31 248,000

If productive capacity of 100% was 10,000 hours and the factory overhead

cost budgeted at the level of 8,000 standard hours was $284,000, determine the

variable factory overhead controllable variance, fixed factory overhead volume

variance, and total factory overhead cost variance. The fixed factory overhead

rate was $18 per hour.

E13-30 Factory overhead cost variances

Osceola Textiles Corporation began May with a budget for 45,000 hours of production

in the Weaving Department. The department has a full capacity of 60,000

hours under normal business conditions. The budgeted overhead at the planned

volumes at the beginning of May was as follows:

Variable overhead $ 990,000

Fixed overhead 300,000

Total $1,290,000

The actual factory overhead was $1,428,000 for May. The actual fixed factory

overhead was as budgeted. During May, the Weaving Department had standard

hours at actual production volume of 52,000 hours.

  1. Determine the variable factory overhead controllable variance.
  2. Determine the fixed factory overhead volume variance.

E13-31 Factory overhead variance corrections

The data related to Danville Sporting Goods Company’s factory overhead cost

for the production of 40,000 units of product are as follows:

Actual: Variable factory overhead $269,000

Fixed factory overhead 325,000

Standard: 105,000 hrs. at $9.00 945,000

($5.75 for variable factory overhead)

Productive capacity at 100% of normal was 100,000 hours, and the factory overhead

cost budgeted at the level of 105,000 standard hours was $720,000. Based

on these data, the chief cost accountant prepared the following variance analysis:

Variable factory overhead controllable variance:

Actual variable factory overhead cost incurred $600,000

Budgeted variable factory overhead for 105,000 hours 603,750

Variance—favorable 2$ 3,750

Fixed factory overhead volume variance:

Normal productive capacity at 100% 100,000 hrs.

Standard for amount produced 105,000

Productive capacity not used 5,000 hrs.

Standard variable factory overhead rate 3 $9.00

Variance—unfavorable 45,000

Total factory overhead cost variance—unfavorable $41,250

Identify the errors in the factory overhead cost variance analysis.

E13-32 Factory overhead cost variance report

Topeka Plastics Inc. prepared the following factory overhead cost budget for the

Trim Department for July 2012, during which it expected to use 25,000 hours

for production:

Variable overhead cost:

Indirect factory labor $20,000

Power and light 18,000

Indirect materials 9,000

Total variable cost $ 47,000

Fixed overhead cost:

Supervisory salaries $50,000

Depreciation of plant and equipment 33,100

Insurance and property taxes 11,400

Total fixed cost 94,500

Total factory overhead cost $141,500

Topeka Plastics has available 30,000 hours of monthly productive capacity in

the Trim Department under normal business conditions. During July, the Trim

Department

actually used 28,000 hours for production. The actual fixed costs

were as budgeted. The actual variable overhead for July was as follows:

Actual variable factory overhead cost:

Indirect factory labor $23,250

Power and light 20,000

Indirect materials 11,100

Total variable cost $54,350

Construct a factory overhead cost variance report for the Trim Department

for July.

 

Problems

P13-1 Sales, production, direct materials purchases, and direct labor cost

The budget director of Royal British Furniture Company requests estimates of

sales, production, and other operating data from the various administrative units

every month. Selected information concerning sales and production for March

2013 is summarized as follows:

  1. Estimated sales of William and Kate chairs for March by sales territory:

Eastern Domestic:

William 7,500 units at $800 per unit

Kate 6,000 units at $650 per unit

Western Domestic:

William 6,000 units at $700 per unit

Kate 5,000 units at $550 per unit

International:

William 2,500 units at $600 per unit

Kate 1,000 units at $350 per unit

  1. Estimated inventories at March 1:

Direct materials: Finished products:

Fabric 5,500 sq. yds. William 1,500 units

Wood 13,700 lineal ft. Kate 300 units

Filler 3,800 cu. ft.

Springs 3,500 units

  1. Desired inventories at March 31:

Direct materials: Finished products:

Fabric 9,000 sq. yds. William 2,000 units

Wood 20,000 lineal ft. Kate 900 units

Filler 5,000 cu. ft.

Springs 7,500 units

  1. Direct materials used in production:

In manufacture of William:

Fabric 4.0 sq. yds. per unit of product

Wood 16 lineal ft. per unit of product

Filler 3.8 cu. ft. per unit of product

Springs 14 units per unit of product

In manufacture of Kate:

Fabric 2.5 sq. yds. per unit of product

Wood 12 lineal ft. per unit of product

Filler 3.2 cu. ft. per unit of product

Springs 10 units per unit of product

  1. Anticipated purchase price for direct materials:

Fabric $9.00 per sq. yd. Filler $1.50 per cu. ft.

Wood 5.00 per lineal ft. Springs 2.00 per unit

  1. Direct labor requirements:

William:

Framing Department 2.5 hrs. at $15 per hr.

Cutting Department 1.0 hr. at $12 per hr.

Upholstery Department 3.0 hrs. at $16 per hr.

Kate:

Framing Department 1.5 hrs. at $15 per hr.

Cutting Department 0.5 hr. at $12 per hr.

Upholstery Department 2.0 hrs. at $16 per hr.

Instructions

  1. Prepare a sales budget for March.
  2. Prepare a production budget for March.
  3. Prepare a direct materials purchases budget for March.
  4. Prepare a direct labor cost budget for March.

P13-2 Budgeted income statement and supporting budgets

The budget director of Jupiter Helmets Inc., with the assistance of the controller,

treasurer, production manager, and sales manager, has gathered the following

data for use in developing the budgeted income statement for May 2013:

  1. Estimated sales for May:

Bicycle helmet 7,500 units at $24 per unit

Motorcycle helmet 5,000 units at $175 per unit

  1. Estimated inventories at May 1:

Direct materials: Finished products:

Plastic 1,480 lbs. Bicycle helmet 200 units at $15 per unit

Foam lining 520 lbs. Motorcycle helmet 100 units at $90 per unit

  1. Desired inventories at May 31:

Direct materials: Finished products:

Plastic 2,000 lbs. Bicycle helmet 400 units at $15 per unit

Foam lining 800 lbs. Motorcycle helmet 300 units at $100 per unit

  1. Direct materials used in production:

In manufacture of bicycle helmet:

Plastic 0.90 lb. per unit of product

Foam lining 0.20 lb. per unit of product

In manufacture of motorcycle helmet:

Plastic 3.50 lbs. per unit of product

Foam lining 1.40 lbs. per unit of product

  1. Anticipated cost of purchases and beginning and ending inventory of direct

materials:

Plastic $4.40 per lb.

Foam lining $0.90 per lb.

  1. Direct labor requirements:

Bicycle helmet:

Molding Department 0.30 hr. at $15 per hr.

Assembly Department 0.10 hr. at $14 per hr.

Motorcycle helmet:

Molding Department 0.50 hr. at $15 per hr.

Assembly Department 0.40 hr. at $14 per hr.

  1. Estimated factory overhead costs for May:

Indirect factory wages $125,000 Power and light $23,000

Depreciation of plant and equipment 45,000 Insurance and property tax 11,000

  1. Estimated operating expenses for May:

Sales salaries expense $175,000

Advertising expense 120,000

Office salaries expense 92,000

Depreciation expense—office equipment 6,000

Miscellaneous expense—selling 5,000

Utilities expense—administrative 3,000

Travel expense—selling 50,000

Office supplies expense 2,500

Miscellaneous administrative expense 1,500

  1. Estimated other income and expense for May:

Interest revenue $14,560

Interest expense 3,000

  1. Estimated tax rate: 25%

Instructions

  1. Prepare a sales budget for May.
  2. Prepare a production budget for May.
  3. Prepare a direct materials purchases budget for May.
  4. Prepare a direct labor cost budget for May.
  5. Prepare a factory overhead cost budget for May.
  6. Prepare a cost of goods sold budget for May. Work in process at the beginning

of May is estimated to be $4,200, and work in process at the end of May is

desired to be $3,800.

  1. Prepare a selling and administrative expenses budget for May.
  2. Prepare a budgeted income statement for May.

P13-3 Cash budget

The controller of Shoe Mart Inc. asks you to prepare a monthly cash budget for

the next three months. You are presented with the following budget information:

January February March

Sales $450,000 $550,000 $700,000

Manufacturing costs 260,000 330,000 420,000

Selling and administrative expenses 100,000 140,000 150,000

Capital expenditures — — 45,000

The company expects to sell about 20% of its merchandise for cash. Of sales

on account, 75% are expected to be collected in full in the month following the

sale and the remainder the following month. Depreciation, insurance, and property

tax expense represent $40,000 of the estimated monthly manufacturing costs. The

annual insurance premium is paid in June, and the annual property taxes are paid

in October. Of the remainder of the manufacturing costs, 90% are expected to

be paid in the month in which they are incurred and the balance in the following

month. All sales and administrative expenses are paid in the month incurred.

Current assets as of January 1 include cash of $45,000, marketable securities

of $65,000, and accounts receivable of $290,000 ($240,000 from December sales

and $50,000 from November sales). Sales on account in November and December

were $200,000 and $240,000, respectively. Current liabilities as of January

1 include a $50,000, 8%, 90-day note payable due March 20 and $18,000 of accounts

payable incurred in December for manufacturing costs. All selling and

administrative expenses are paid in cash in the period they are incurred. It is

expected that $20,000 in dividends will be received in January. An estimated

income tax payment of $15,000 will be made in February. Shoe Mart’s regular

quarterly dividend of $5,000 is expected to be declared in February and paid

in March. Management desires to maintain a minimum cash balance of $35,000.

Instructions

  1. Prepare a monthly cash budget and supporting schedules for January, February,

and March 2013.

  1. On the basis of the cash budget prepared in part (1), what recommendation

should be made to the controller?

P13-4 Direct materials and direct labor variance analysis

Faucet Industries Inc. manufactures faucets in a small manufacturing facility. The

faucets are made from zinc. Manufacturing has 60 employees. Each employee

presently provides 36 hours of labor per week. Information about a production

week is as follows:

Standard wage per hr. $18.00

Standard labor time per faucet 12 min.

Standard number of lbs. of zinc 0.80 lb.

Standard price per lb. of zinc $1.25

Actual price per lb. of zinc $1.40

Actual lbs. of zinc used during the week 10,200 lbs.

Number of faucets produced during the week 12,000

Actual wage per hr. $18.75

Actual hrs. per week 2,160 hrs.

Instructions

Determine (a) the standard cost per unit for direct materials and direct labor;

(b) the price variance, quantity variance, and total direct materials cost variance;

and (c) the rate variance, time variance, and total direct labor cost variance.

P13-5 Direct materials and direct labor, variance analysis; Factory overhead

cost variance analysis

Route 66 Tire Co. manufactures automobile tires. Standard costs and actual costs

for direct materials, direct labor, and factory overhead incurred for the manufacture

of 10,000 tires were as follows:

Standard Costs Actual Costs

Direct materials 85,000 lbs. at $6.25 83,800 lbs. at $6.17

Direct labor 4,000 hrs. at $20.80 4,450 hrs. at $21.00

Factory overhead Rates per direct labor hr.,

based on 100% of normal

capacity of 5,000 direct

labor hrs.:

Variable cost, $2.90 $11,375 variable cost

Fixed cost, $11.40 $57,000 fixed cost

Each tire requires 0.40 hour of direct labor.

Instructions

Determine (a) the price variance, quantity variance, and total direct materials

cost variance; (b) the rate variance, time variance, and total direct labor cost

variance; and (c) Appendix: variable factory overhead controllable variance, the

fixed factory overhead volume variance, and total factory overhead cost variance.

P13-6 Standards for nonmanufacturing expenses

The Radiology Department provides imaging services for Northeast Washington

Medical Center. One important activity in the Radiology Department is transcribing

digitally recorded analyses of images into a written report. The manager of the

Radiology Department determined that the average transcriptionist could type 800

lines of a report in an hour. The plan for the first week in July called for 64,000

typed lines to be written. The Radiology Department has two transcriptionists.

Each transcriptionist is hired from an employment firm that requires temporary

employees to be hired for a minimum of a 40-hour week. Transcriptionists are paid

$18.00 per hour. The manager offered a bonus if the department could type more

than 70,000 lines for the week, without overtime. Due to high service demands,

the transcriptionists typed more lines in the first week of July than planned. The

actual amount of lines typed in the first week of July was 70,400 lines, without

overtime. As a result, the bonus caused the average transcriptionist hourly rate

to increase to $20.00 per hour during the first week in July.

Instructions

  1. If the department typed 64,000 lines according to the original plan, what

would have been the labor time variance?

  1. What was the labor time variance as a result of typing 70,400 lines?
  2. What was the labor rate variance as a result of the bonus?
  3. The manager is trying to determine if a better decision would have been to

hire a temporary transcriptionist to meet the higher typing demands in the

first week of July, rather than paying out the bonus. If another employee was

hired from the employment firm, what would have been the labor time variance

in the first week?

  1. Which decision is better, paying the bonus or hiring another transcriptionist?
  2. Are there any performance-related issues that the labor time and rate variances

fail to consider? Explain.

P13-7 Standard factory overhead variance report

Seabury, Inc., a manufacturer of disposable medical supplies, prepared the following

factory overhead cost budget for the Assembly Department for October

  1. The company expected to operate the department at 100% of normal

capacity

of 25,000 hours.

Variable costs:

Indirect factory wages $150,000

Power and light 29,500

Indirect materials 17,000

Total variable cost $196,500

Fixed costs:

Supervisory salaries $125,000

Depreciation of plant and equipment 49,000

Insurance and property taxes 29,750

Total fixed cost 203,750

Total factory overhead cost $400,250

During October, the department operated at 23,500 hours, and the factory

overhead costs incurred were indirect factory wages, $140,500; power and light,

$28,600; indirect materials, $15,220; supervisory salaries, $125,000; depreciation

of plant and equipment, $49,000; and insurance and property taxes, $29,750.

Instructions

Prepare a factory overhead cost variance report for October. To be useful for cost

control, the budgeted amounts should be based on 23,500 hours.

 

Activities

A13-1 E thics and professional conduct in business

The director of marketing for Truss Industries Inc., Ellen Knutson, had the following

discussion with the company controller, Bud Wyckoff, on February 26 of the

current year:

Ellen: Bud, it looks like I’m going to spend much less than indicated on my

February budget.

Bud: I’m glad to hear it.

Ellen: Well, I’m not so sure it’s good news. I’m concerned that the president

will see that I’m under budget and reduce my budget in the future. The only

reason that I look good is that we’ve delayed an advertising campaign. Once the

campaign

hits in May, I’m sure my actual expenditures will go up. You see, we

are also having our sales convention in May. Having the advertising campaign

and the convention at the same time is going to kill my May numbers.

Bud: I don’t think that’s anything to worry about. We all expect some variation

in actual spending month to month. What’s really important is staying within the

budgeted targets for the year. Does that look as if it’s going to be a problem?

Ellen: I don’t think so, but just the same, I’d like to be on the safe side.

Bud: What do you mean?

Ellen: Well, this is what I’d like to do. I want to pay the convention-related

costs in advance this month. I’ll pay the hotel for room and convention space

and purchase the airline tickets in advance. In this way, I can charge all these

expenditures to February’s budget. This would cause my actual expenses to come

close to budget for February. Moreover, when the big advertising campaign hits

in May, I won’t have to worry about expenditures for the convention on my

May budget as well. The convention costs will already be paid. Thus, my May

expenses should be pretty close to budget.

Bud: I can’t tell you when to make your convention purchases, but I’m not too

sure that it should be expensed on February’s budget.

Ellen: What’s the problem? It looks like “no harm, no foul” to me. I can’t see

that there’s anything wrong with this—it’s just smart management.

How should Bud Wyckoff respond to Ellen Knutson’s request to expense the

advanced payments for convention-related costs against February’s budget?

A13-2 E valuating budgeting systems

Children’s Hospital of the King’s Daughters Health System in Norfolk, Virginia, introduced

a new budgeting method that allowed the hospital’s annual plan to be updated

for changes in operating plans. For example, if the budget was based on 1,000

patient-days (number of patients 3 number of days in the hospital) and the actual

count rose to 1,200 patient-days, the variable costs of staffing, lab work, and

medication costs could be adjusted to reflect this change. The budget manager

stated, “I work with hospital directors to turn data into meaningful information

and effect change before the month ends.”

  1. What budgeting methods are being used under the new approach?
  2. Why are these methods superior to the former approaches?

A13-3 Service company static decision making

A bank manager of Oxford First Bank Inc. uses the managerial accounting system

to track the costs of operating the various departments within the bank.

The departments

include Cash Management, Trust, Commercial Loans, Mortgage

Loans, Operations, Credit Card, and Branch Services. The budget and actual results

for the Operations Department are as follows:

Resources Budget Actual

Salaries $300,000 $300,000

Benefits 40,000 40,000

Supplies 27,000 22,000

Travel 15,000 43,000

Training 13,000 15,000

Overtime 20,000 15,000

Total $415,000 $435,000

Excess of actual over budget $20,000

  1. What information is provided by the budget? Specifically, what questions can

the bank manager ask of the Operations Department manager?

  1. What information does the budget fail to provide? Specifically, could the budget

information be presented differently to provide even more insight for the

bank manager?

A13-4 Objectives of the master budget

Domino’s Pizza LLC operates pizza delivery and carryout restaurants. The annual

report describes its business as follows:

We offer a focused menu of high-quality, value priced pizza with three types of crust

(Hand-Tossed, Thin Crust, and Deep Dish), along with buffalo wings, bread sticks,

cheesy bread, CinnaStix®, and Coca Cola® products. Our hand-tossed pizza is made from

fresh dough produced in our regional distribution centers. We prepare every pizza using

real cheese, pizza sauce made from fresh tomatoes, and a choice of high-quality meat

and vegetable toppings in generous portions. Our focused menu and use of premium

ingredients enable us to consistently and efficiently produce the highest-quality pizza.

Over the 41 years since our founding, we have developed a simple, cost-efficient

model. We offer a limited menu, our stores are designed for delivery and carry-out,

and we do not generally offer dine-in service. As a result, our stores require relatively

small, lower-rent locations and limited capital expenditures.

How would a master budget support planning, directing, and control for Domino’s?

A13-5 I ntegrity and evaluating budgeting systems

The city of Rosebud has an annual budget cycle that begins on July 1 and ends

on June 30. At the beginning of each budget year, an annual budget is established

for each department. The annual budget is divided by 12 months to provide a

constant monthly static budget. On June 30, all unspent budgeted monies for the

budget year from the various city departments must be “returned” to the General

Fund. Thus, if department heads fail to use their budget by year-end, they will

lose it. A budget analyst prepared a chart of the difference between the monthly

actual and budgeted amounts for the recent fiscal year. The chart was as follows:

  1. Interpret the chart.
  2. Suggest an improvement in the budget system.

A13-6 E thics and professional conduct in business using nonmanufacturing

standards

Christy Eisenbeis is a cost analyst with Nations Insurance Company. Nations

Insurance

is applying standards to its claims payment operation. Claims payment

is a repetitive operation that could be evaluated with standards. Christy used

time and motion studies to identify an ideal standard of 24 claims processed per

hour. The Claims Processing Department manager, Everett Boyle, has rejected

this standard and has argued that the standard should be 18 claims processed

per hour. Everett and Christy were unable to agree, so they decided to discuss

this matter openly at a joint meeting with the vice president of operations, who

would arbitrate a final decision. Prior to the meeting, Christy wrote the following

memo to the VP.

To: Megan Wilkins, Vice President of Operations

From: Christy Eisenbeis

Re: Standards in the Claims Processing Department

As you know, Everett and I are scheduled to meet with you to discuss our

disagreement with respect to the appropriate standards for the Claims Processing

Department. I have conducted time and motion studies and have determined that

the ideal standard is 24 claims processed per hour. Everett argues that 18 claims

processed per hour would be more appropriate. I believe he is trying to “pad” the

budget with some slack. I’m not sure what he is trying to get away with, but I believe

a tight standard will drive efficiency up in his area. I hope you will agree when we

meet with you next week.

Discuss the ethical and professional issues in this situation.

A13-7 N onfinancial performance measures

The senior management of Trinity Industries Inc. has proposed the following

three performance measures for the company:

  1. Net income as a percent of stockholders’ equity
  2. Revenue growth
  3. Employee satisfaction

Management believes these three measures combine both financial and nonfinancial

measures and are thus superior to using just financial measures.

What advice would you give Trinity Industries Inc. for improving its performance

measurement system?

A13-8 N onfinancial performance measures

The controller of a manufacturing company used a number of measures to provide

managers information about the performance of its manufacturing operation.

Three measures used by the company are:

  • Scrap Index: The sales dollar value of scrap for the period.
  • Orders Past Due: Sales dollar value of orders that were scheduled for shipment,

but were not shipped during the period.

  • Buyer’s Misery Index: Number of different customers that have orders that are

late (scheduled for shipment, but not shipped).

  1. Why do you think the scrap index is measured at sales dollar value, rather

than at cost?

  1. How is the “orders past due” measure different from the “buyer’s misery

index,”

or are the two measures just measuring the same thing?

A13-9 V ariance interpretation

Harmony Industries Inc. is a small manufacturer of electronic musical instruments.

The plant manager received the following variable factory overhead report for

the period:

Actual

Budgeted Variable

Factory Overhead at

Actual Production

Controllable

Variance

Indirect factory wages $100,800 $ 72,000 $28,800 U

Power and light 38,000 40,000 2,000 F

Supplies 21,000 18,000 3,000 U

Total $159,800 $130,000 $29,800 U

Actual units produced: 15,000 (75% of practical capacity)

The plant manager is not pleased with the $29,800 unfavorable variable factory

overhead controllable variance and has come to discuss the matter with the

controller. The following discussion occurred:

Plant Manager: I just received this factory report for the latest month of

operation.

I’m not very pleased with these figures. Before these numbers go to

headquarters, you and I will need to reach an understanding.

Controller: Go ahead, what’s the problem?

Plant Manager: What’s the problem? Well, everything. Look at the variance.

It’s too large. If I understand the accounting approach being used here, you are

assuming

that my costs are variable to the units produced. Thus, as the production

volume declines, so should these costs. Well, I don’t believe that these costs

are variable at all. I think they are fixed costs. As a result, when we operate

below capacity, the costs really don’t go down at all. I’m being penalized for

costs I have no control over at all. I need this report to be redone to reflect this

fact. If anything, the difference between actual and budget is essentially a volume

variance. Listen, I know that you’re a team player. You really need to reconsider

your assumptions on this one.

If you were in the controller’s position, how would you respond to the plant

manager?

 

Answers to Self-Examination Questions

  1. B Administrative departments (answer B),

such as Purchasing or Human Resources, will

often use static budgeting. Production departments

(answer A) frequently use flexible

budgets. Responsibility centers (answer C) can

use either static or flexible budgeting. Capital

expenditure budgets are used to plan capital

projects (answer D).

  1. B The total production indicated in the production

budget is 257,500 units (answer B),

which is computed as follows:

Sales 250,000 units

Plus desired ending inventory 30,000 units

Total 280,000 units

Less estimated beginning inventory 22,500 units

Total production 257,500 units

  1. C Dixon expects to collect 70% of April

sales ($560,000) plus 30% of the March sales

($195,000) in April, for a total of $755,000

(answer C). Answer A is 100% of April sales.

Answer B is 70% of April sales. Answer D

adds 70% of both March and April sales.

  1. C The unfavorable direct materials price

variance of $2,550 is determined as follows:

Actual price $5.05 per pound

Standard price 5.00

Price variance—unfavorable $0.05 per pound

Direct materials price variance: $2,550 5 $0.05 3 51,000

actual pounds

  1. D The unfavorable direct labor time variance

of $2,400 is determined as follows:

Actual direct labor time 2,200 hours

Standard direct labor time 2,000

Direct labor time variance 200 hours

Direct labor time variance: Unfavorable

$2,400 5 200 3 $12 standard rate

 

 

Chapter 14 Performance evaluation for Decentralized

 

Class Discussion Questions

  1. Differentiate between a cost center and a

profit center.

  1. Differentiate between a profit center and an

investment center.

  1. In what major respect would budget performance

reports prepared for the use of plant

managers of a manufacturing business with

cost centers differ from those prepared for

the use of the various department supervisors

who report to the plant managers?

  1. For what decisions is the manager of a cost

center not responsible?

  1. Weyerhaeuser developed a system that assigns

service department expenses to user divisions

on the basis of actual services consumed

by the division. Here are a number

of Weyerhaeuser’s

activities in its central

Financial

Services Department:

  • Payroll
  • Accounts payable
  • Accounts receivable
  • Database administration—report preparation

For each activity, identify an activity base

that could be used to charge user divisions

for service.

  1. What is the major shortcoming of using

income

from operations as a performance

measure for investment centers?

  1. Why should the factors under the control

of the investment center manager (revenues,

expenses, and invested assets) be considered

in

computing the rate of return on investment?

  1. In a decentralized company in which the divisions

are organized as investment centers,

how could a division be considered the least

profitable, even though it earned the largest

amount of income from operations?

  1. How does using the rate of return on investment

facilitate comparability between divisions

of decentralized companies?

  1. The rates of return on investment for Shear

Co.’s three divisions, North, South, and Midwest

are 38%, 30%, and 22%, respectively. In

expanding operations, which of Shear Co.’s

divisions should be given priority? Explain.

  1. Why would a firm use a balanced scorecard

in evaluating divisional performance?

  1. What is the objective of transfer pricing?
  2. When is the negotiated price approach preferred

over the market price approach in setting

transfer prices?

  1. Why would standard cost be a more appropriate

transfer cost between cost centers than

actual cost?

  1. When using the negotiated price approach

to transfer pricing, within what range should

the transfer price be established?

 

Exercises

E14-1 Budget performance reports for cost centers

Partially completed budget performance reports for Meridian Company, a manufacturer

of air conditioners, are provided below.

Meridian Company

Budget Performance Report—Vice President, Production

For the Month Ended June 30, 2012

Plant Budget Actual Over Budget Under Budget

Orlando, Florida $750,000 $752,000 $2,000

Waco, Texas 400,000 398,200 $1,800

Peoria, Illinois (g) (h) (i)

$ (j) $ (k) $ (l) $1,800

Meridian Company

Budget Peformance Report—Plant Manager, Peoria, Illinois

For the Month Ended June 30, 2012

Department Budget Actual Over Budget Under Budget

Condenser Assembly $ (a) $ (b) $ (c)

Electronic Assembly 75,000 75,300 300

Final Assembly 60,000 59,275 $725

$ (d) $ (e) $ (f ) $725

Meridian Company

Budget Performance Report—Supervisor, Condenser Assembly

For the Month Ended June 30, 2012

Department Budget Actual Over Budget Under Budget

Factory wages $ 30,000 $ 33,400 $ 3,400

Materials 85,000 84,650 $350

Power and light 14,500 16,900 2,400

Maintenance 10,500 15,800 5,300

$140,000 $150,750 $11,100 $350

  1. Complete the budget performance reports by determining the correct amounts

for the lettered spaces.

  1. Compose a memo to Darla Pennington, President of Meridian

Company,

explaining the performance of the Production Division for June.

E14-2 Divisional income statements

The following data were summarized from the accounting records for Statham

Construction Company for the year ended November 30, 2012.

Cost of goods sold: Service department charges:

Residential Division $1,450,000 Residential Division $ 100,000

Industrial Division 3,450,000 Industrial Division 200,000

Administrative expenses: Net sales:

Residential Division $ 175,000 Residential Division $2,300,000

Industrial Division 480,000 Industrial Division 5,750,000

Prepare divisional income statements for Statham Construction Company.

E14-3 Service department charges and activity bases

For each of the following service departments, identify an activity base that could

be used for charging the expense to the profit center.

  1. Accounts Receivable
  2. Central Purchasing
  3. Duplication Services
  4. Electronic Data Processing
  5. Legal
  6. Telecommunications

E14-4 Activity bases for service department charges

For each of the following service departments, select the activity base listed that

is most appropriate for charging service expenses to responsible units.

Service Department Activity Base

  1. Accounts Receivable 1. Number of computers
  2. Central Purchasing 2. Number of trainees
  3. Computer Support 3. Number of employees trained
  4. Conferences 4. Number of payroll checks
  5. Employee Travel 5. Number of purchase requisitions
  6. Payroll Accounting 6. Number of sales invoices
  7. Telecommunications 7. Number of telephone lines
  8. Training 8. Number of travel claims

E14-5 Service department charges

In divisional income statements prepared for Iguana Construction Company, the

Payroll Department costs are charged back to user divisions on the basis of the

number of payroll checks, and the Purchasing Department costs are charged

back on the basis of the number of purchase requisitions. The Payroll Department

had expenses of $42,750, and the Purchasing Department had expenses of

$87,600 for the year. The following annual data for the Residential, Commercial,

and Government Contract divisions were obtained from corporate records:

Residential Commercial

Government

Contract

Sales $9,400,000 $6,800,000 $2,400,000

Number of employees:

Weekly payroll (52 weeks per year) 80 60 25

Monthly payroll 20 10 5

Number of purchase requisitions per year 12,400 8,900 2,700

  1. Determine the total amount of payroll checks and purchase requisitions processed

per year by each division.

  1. Using the activity base information in (a), determine the annual amount of

payroll and purchasing costs charged back to the Residential, Commercial,

and Government Contract divisions from payroll and purchasing services.

  1. Why does the Residential Division have a larger service department charge

than the other two divisions?

E14-6 Service department charges and activity bases

Harris Corporation, a manufacturer of electronics and communications systems,

uses a service department charge system to charge profit centers with Computing

and Communications Services (CCS) service department costs. The following

table identifies an abbreviated list of service categories and activity bases used

by the CCS department. The table also includes some assumed cost and activity

base quantity information for each service for February.

CCS Service

Category

Activity Base Assumed Cost

Assumed Activity

Base Quantity

Help desk Number of calls $135,000 5,000

Network center Number of devices monitored 363,000 7,500

Electronic mail Number of user accounts 45,000 4,000

Local voice support Number of phone extensions 39,000 3,000

One of the profit centers for Harris Corporation is the Electronics Systems sector.

Assume the following information for the Electronics sector:

  • The sector has 2,000 employees, of whom 60% are office employees.
  • All the office employees have a phone, and all of them have a computer on

the network.

  • Ninety-five percent of the employees with a computer also have an e-mail

account.

  • The average number of help desk calls for February was 0.45 call per individual

with a computer.

  • There are 80 additional printers, servers, and peripherals on the network

beyond

the personal computers.

  1. Determine the service charge rate for the four CCS service categories for

February.

  1. Determine the charges to the Electronics sector for the four CCS service categories

for February.

E14-7 Divisional income statements with service department charges

Power Sports Company has two divisions, Wholesale and Retail, and two corporate

service departments, Tech Support and Accounts Payable. The corporate

expenses for the year ended December 31, 2012, are as follows:

Tech Support Department $ 855,000

Accounts Payable Department 390,000

Other corporate administrative expenses 355,000

Total corporate expense $1,600,000

The other corporate administrative expenses include officers’ salaries and other

expenses required by the corporation. The Tech Support Department charges

the divisions for services rendered, based on the number of computers in the

department, and the Accounts Payable Department charges divisions for services,

based on the number of checks issued. The usage of service by the two divisions

is as follows:

Tech Support Accounts Payable

Wholesale Division 250 computers 18,000 checks

Retail Division 500 12,000

Total 750 computers 30,000 checks

The service department charges of the Tech Support Department and the Accounts

Payable Department are considered controllable by the divisions. Corporate administrative

expenses are not considered controllable by the divisions. The revenues, cost

of goods sold, and operating expenses for the two divisions are as follows:

Wholesale Retail

Revenues $24,600,000 $13,750,000

Cost of goods sold 14,500,000 8,000,000

Operating expenses 1,500,000 400,000

Prepare the divisional income statements for the two divisions.

E14-8 Corrections to service department charges

Panda Airlines Inc. has two divisions organized as profit centers, the Passenger

Division and the Cargo Division. The following divisional income statements

were prepared:

Panda Airlines Inc.

Divisional Income Statements

For the Year Ended April 30, 2012

Passenger Division Cargo Division

Revenues $7,500,000 $5,000,000

Operating expenses 4,500,000 2,700,000

Income from operations before

service department charges $3,000,000 $2,300,000

Less service department charges:

Training $300,000 $200,000

Flight scheduling 210,000 140,000

Reservations 153,000 663,000 102,000 442,000

Income from operations $2,337,000 $1,858,000

The service department charge rate for the service department costs was based

on revenues.

The following additional information is available:

Passenger Division Cargo Division Total

Number of personnel trained 600 200 800

Number of flights 4,000 1,000 5,000

Number of reservations requested 750,000 0 750,000

  1. Does the income from operations for the two divisions accurately measure

performance?

  1. Correct the divisional income statements, using the activity bases provided on

the preceding page in revising the service department charges.

E14-9 Profit center responsibility reporting

On-Demand Sports Co. operates two divisions—the Action Sports Division and

the Team Sports Division. The following income and expense accounts were

provided as of November 30, 2012, the end of the current fiscal year, after all

adjustments, including those for inventories, were recorded:

Sales—Action Sports (AS) Division $18,500,000

Sales—Team Sports (TS) Division 30,600,000

Cost of Goods Sold—Action Sports (AS) Division 10,700,000

Cost of Goods Sold—Team Sports (TS) Division 19,200,000

Sales Expense—Action Sports (AS) Division 1,500,000

Sales Expense—Team Sports (TS) Division 2,100,000

Administrative Expense—Action Sports (AS) Division 1,250,000

Administrative Expense—Team Sports (TS) Division 1,450,000

Advertising Expense 3,000,000

Transportation Expense 654,900

Accounts Receivable Collection Expense 400,500

Warehouse Expense 800,000

The bases to be used in allocating expenses, together with other essential

information, are as follows:

  1. Advertising expense—incurred at headquarters, charged back to divisions on

the basis of usage: Action Sports Division, $1,200,000; Team Sports Division,

$1,800,000.

  1. Transportation expense—charged back to divisions at a charge rate of $18.50

per bill of lading: Action Sports Division, 14,000 bills of lading; Team Sports

Division, 21,400 bills of lading.

  1. Accounts receivable collection expense—incurred at headquarters, charged

back to divisions at a charge rate of $9.00 per invoice: Action Sports Division,

32,000 sales invoices; Team Sports Division, 12,500 sales invoices.

  1. Warehouse expense—charged back to divisions on the basis of floor space

used in storing division products: Action Sports Division, 120,000 square feet;

Team Sports Division, 80,000 square feet.

Prepare divisional income statements with two column headings: Action Sports

Division and Team Sports Division. Provide supporting schedules for determining

service department charges.

E14-10 Rate of return on investment

The income from operations and the amount of invested assets in each division

of Gantt Industries are as follows:

Income from Operations Invested Assets

Sporting Goods Division $270,000 $1,500,000

Health Club Division 220,000 1,100,000

School Division 227,500 1,750,000

  1. Compute the rate of return on investment for each division.
  2. Which division is the most profitable per dollar invested?

E14-11 Residual income

Based on the data in Exercise 14-10, assume that management has established a

10% minimum acceptable rate of return for invested assets.

  1. Determine the residual income for each division.
  2. Which division has the most residual income?

E14-12 Determining missing items in rate of return computation

One item is omitted from each of the following computations of the rate of

return

on investment:

Rate of Return on Investment 5 Profit Margin 3 Investment Turnover

12% 5 8% 3 (a)

(b) 5 16% 3 1.25

24% 5 (c) 3 1.20

15% 5 10% 3 (d)

(e) 5 10% 3 1.70

Determine the missing items, identifying each by the appropriate letter.

E14-13 Profit margin, investment turnover, and rate of return on investment

The condensed income statement for the International Division of Mingledorff

Inc. is as follows (assuming no service department charges):

Sales $14,400,000

Cost of goods sold 10,600,000

Gross profit $ 3,800,000

Administrative expenses 1,352,000

Income from operations $ 2,448,000

The manager of the International Division is considering ways to increase the

rate of return on investment.

  1. Using the DuPont formula for rate of return on investment, determine the

profit margin, investment turnover, and rate of return on investment of the

International Division, assuming that $16,000,000 of assets have been invested

in the International Division.

  1. If expenses could be reduced by $144,000 without decreasing sales, what

would be the impact on the profit margin, investment turnover, and rate of

return on investment for the International Division?

E14-14 Rate of return on investment

The Walt Disney Company has four major sectors, described as follows:

  • Media Networks: The ABC television and radio network, Disney channel,

ESPN, A&E, E!, and Disney.com.

  • Parks and Resorts: Walt Disney World Resort, Disneyland, Disney Cruise

Line, and other resort properties.

  • Studio Entertainment: Walt Disney Pictures, Touchstone Pictures, Hollywood

Pictures, Miramax Films, and Buena Vista Theatrical Productions.

  • Consumer Products: Character merchandising, Disney stores, books, and

magazines.

Disney recently reported sector income from operations, revenue, and invested

assets (in millions) as follows:

Income from

Operations Revenue

Invested

Assets

Media Networks $4,285 $15,046 $27,692

Parks and Resorts 1,710 10,626 16,311

Studio Entertainment 1,201 7,491 10,812

Consumer Products 631 2,347 1,553

  1. Use the DuPont formula to determine the rate of return on investment for the

four Disney sectors. Round profit margin to one decimal place and investment

turnover to two decimal places.

  1. How do the four sectors differ in their profit margin, investment turnover, and

return on investment?

E14-15 Determining missing items in rate of return and residual income

computations

Data are presented in the following table of rates of return on investment and

residual incomes:

Invested

Assets

Income

from

Operations

Rate of

Return on

Investment

Minimum

Rate of

Return

Minimum

Acceptable

Income from

Operations

Residual

Income

$ 1,250,000 $ 225,000 (a) 13% (b) (c)

2,400,000 (d) (e) (f ) $216,000 $144,000

5,000,000 (g) 19% (h) $550,000 (i)

18,000,000 $2,520,000 (j) 8% (k) (l)

Determine the missing items, identifying each item by the appropriate letter.

E14-16 Determining missing items from computations

Data for the California, Midwest, Northwest, and Texas divisions of Firefly

Industries

are as follows:

Sales

Income

from

Operations

Invested

Assets

Rate of

Return on

Investment

Profit

Margin

Investment

Turnover

California $ 6,000,000 (a) (b) 16% 20% (c)

Midwest (d) $1,512,000 (e) (f ) 12% 1.4

Northwest 13,750,000 (g) $11,000,000 17.5% (h) (i)

Texas 5,250,000 840,000 3,500,000 (j) (k) (l)

  1. Determine the missing items, identifying each by the letters (a) through (l). Round

profit margin to one decimal place and investment turnover to two decimal places.

  1. Determine the residual income for each division, assuming that the minimum

acceptable rate of return established by management is 10%.

  1. Which division is the most profitable in terms of (1) return on investment and

(2) residual income?

E14-17 Rate of return on investment, residual income

Marriott International, Inc., provides lodging services around the world. The company

is organized into the following five segments:

  • North American—Full Service: Marriott and Renaissance Hotels.
  • North American—Limited Service: Courtyard, Fairfield, SpringHill Suites, and

Residence Hotels.

  • International: Hotels outside of North America.
  • Luxury: The Ritz-Carlton, Bulgari, and Edition Hotels.
  • Timeshare: Marriott Vacation Club, The Ritz-Carlton Destination and The Ritz-

Carlton Residences.

Financial information for each segment taken from a recent annual report is as

follows (in millions):

North American—

Full Service

North American—

Limited Service International Luxury Timeshare

Revenues $5,108 $2,149 $1,245 $1,563 $1,546

Income from operations 318 298 169 77 121

Total assets 1,203 464 841 871 3,310

  1. Use the DuPont formula to determine the return on investment for each of

the Marriott business divisions. Round profit margin to one decimal place and

investment turnover to two decimal places.

  1. Determine the residual income for each division, assuming a minimum

acceptable

income of 10% of total assets. Round minimal acceptable return to

the nearest million dollars.

  1. Interpret your results.

E14-18 Balanced scorecard

American Express Company is a major financial services company, noted for its American

Express® card. Below are some of the performance measures used by the

company in its balanced scorecard.

Average cardmember spending Number of merchant signings

Cards in force Number of card choices

Earnings growth Number of new card launches

Hours of credit consultant training Return on equity

Investment in information technology Revenue growth

Number of Internet features

For each measure, identify whether the measure best fits the innovation, customer,

internal process, or financial dimension of the balanced scorecard.

E14-19 Balanced scorecard

Several years ago, United Parcel Service (UPS) believed that the Internet was going

to change the parcel delivery market and would require UPS to become a more

nimble and customer-focused organization. As a result, UPS replaced its old measurement

system, which was 90% oriented toward financial performance, with a

balanced scorecard. The scorecard emphasized four “point of arrival” measures,

which were:

  1. Customer satisfaction index—a measure of customer satisfaction.
  2. Employee relations index—a measure of employee sentiment and morale.
  3. Competitive position—delivery performance relative to competition.
  4. Time in transit—the time from order entry to delivery.
  5. Why did UPS introduce a balanced scorecard and nonfinancial measures in

its new performance measurement system?

  1. Why do you think UPS included a factor measuring employee sentiment?

E14-20 Decision on transfer pricing

Wiring used by the Aircraft Division of Retina Manufacturing is currently purchased

from outside suppliers at a cost of $75 per unit. However, the same

materials are available from the Electronic Division. The Electronic Division has

unused capacity and can produce the materials needed by the Aircraft Division

at a variable cost of $66 per unit.

  1. If a transfer price of $70 per unit is established and 25,000 units of materials

are transferred, with no reduction in the Electronic Division’s current

sales, how much would Retina Manufacturing’s total income from operations

increase?

  1. How much would the Aircraft Division’s income from operations increase?
  2. How much would the Electronic Division’s income from operations increase?

E14-21 Decision on transfer pricing

Based on Retina Manufacturing’s data in Exercise 14-20, assume that a transfer

price of $72 has been established and that 25,000 units of materials are transferred,

with no reduction in the Electronic Division’s current sales.

  1. How much would Retina Manufacturing’s total income from operations

increase?

  1. How much would the Aircraft Division’s income from operations increase?
  2. How much would the Electronic Division’s income from operations increase?
  3. If the negotiated price approach is used, what would be the range of acceptable

transfer prices and why?

 

Problems

P14-1 Budget performance report for a cost center

Sneed Industries Company sells vehicle parts to manufacturers of heavy construction

equipment. The Crane Division is organized as a cost center. The budget

for the Crane Division for the month ended August 31, 2012, is as follows (in

thousands):

Customer service salaries $ 250,000

Insurance and property taxes 50,000

Distribution salaries 475,000

Marketing salaries 300,000

Engineer salaries 740,000

Warehouse wages 280,000

Equipment depreciation 155,000

Total $2,250,000

During August, the costs incurred in the Crane Division were as follows:

Customer service salaries $ 368,000

Insurance and property taxes 49,100

Distribution salaries 469,500

Marketing salaries 371,000

Engineer salaries 738,250

Warehouse wages 274,900

Equipment depreciation 155,000

Total $2,425,750

Instructions

  1. Prepare a budget performance report for the director of the Crane Division

for the month of August.

  1. For which costs might the director be expected to request supplemental reports?

P14-2 Profit center responsibility reporting

A-One Freight Inc. has three regional divisions organized as profit centers. The

chief executive officer (CEO) evaluates divisional performance, using income

from operations as a percent of revenues. The following quarterly income and

expense accounts were provided from the trial balance as of December 31, 2012.

Revenues—Air Division $5,000,000

Revenues—Rail Division 6,000,000

Revenues—Truck Division 9,000,000

Operating Expenses—Air Division 4,100,000

Operating Expenses—Rail Division 4,900,000

Operating Expenses—Truck Division 7,555,000

Corporate Expenses—Shareholder Relations 220,000

Corporate Expenses—Customer Support 990,000

Corporate Expenses—Legal 880,000

General Corporate Officers’ Salaries 500,000

The company operates three service departments: Shareholder Relations, Customer

Support, and Legal. The Shareholder Relations Department conducts a

variety of services for shareholders of the company. The Customer Support Department

is the company’s point of contact for new service, complaints, and requests

for repair. The department believes that the number of customer contacts is an

activity base for this work. The Legal Department provides legal services for division

management. The department believes that the number of hours billed is an

activity base for this work. The following additional information has been gathered:

Air Rail Truck

Number of customer contacts 1,500 4,500 16,000

Number of hours billed 900 2,400 6,700

Instructions

  1. Prepare quarterly income statements showing income from operations for the

three divisions. Use three column headings: Air, Rail, and Truck.

  1. Identify the most successful division according to the profit margin. Round to

one decimal place.

  1. Provide a recommendation to the CEO for a better method for evaluating the

performance of the divisions. In your recommendation, identify the major

weakness of the present method.

P14-3 Divisional income statements and rate of return on investment analysis

Pastry Inc. is a diversified food products company with three operating divisions

organized as investment centers. Condensed data taken from the records of the

three divisions for the year ended April 30, 2012, are as follows:

Breakfast

Division

Cookies

Division

Frozen Desserts

Division

Sales $19,800,000 $8, 550,000 $33,300,000

Cost of goods sold 14,850,000 6,400,000 25,100,000

Operating expenses 1,782,000 1,124,000 2,206,000

Invested assets 18,000,000 9,000,000 27,750,000

The management of Pastry Inc. is evaluating each division as a basis for planning

a future expansion of operations.

Instructions

  1. Prepare condensed divisional income statements for the three divisions, assuming

that there were no service department charges.

  1. Using the DuPont formula for rate of return on investment, compute the profit

margin, investment turnover, and rate of return on investment for each division.

  1. If available funds permit the expansion of operations of only one division,

which of the divisions would you recommend for expansion, based on parts

(1) and (2)? Explain.

P14-4 Effect of proposals on divisional performance

A condensed income statement for the Jet Ski Division of Amazing Rides Inc. for

the year ended December 31, 2012, is as follows:

Sales $12,000,000

Cost of goods sold 7,200,000

Gross profit $ 4,800,000

Operating expenses 3,120,000

Income from operations $ 1,680,000

Invested assets $15,000,000

Assume that the Jet Ski Division received no charges from service departments.

The president of Amazing Rides has indicated that the division’s rate of return

on a $15,000,000 investment must be increased to at least 12% by the end of

the next year if operations are to continue. The division manager is considering

the following three proposals:

Proposal 1: Transfer equipment with a book value of $3,000,000 to other divisions

at no gain or loss and lease similar equipment. The annual lease payments would

exceed the amount of depreciation expense on the old equipment by $264,000

This increase in expense would be included as part of the cost of goods sold.

Sales would remain unchanged.

Proposal 2: Purchase new and more efficient machining equipment and thereby

reduce the cost of goods sold by $480,000. Sales would remain unchanged, and

the old equipment, which has no remaining book value, would be scrapped at

no gain or loss. The new equipment would increase invested assets by an additional

$1,000,000 for the year.

Proposal 3: Reduce invested assets by discontinuing the tandem jet ski line. This

action would eliminate sales of $2,280,000, cost of goods sold of $1,400,000, and

operating expenses of $463,600. Assets of $4,200,000 would be transferred to

other divisions at no gain or loss.

Instructions

  1. Using the DuPont formula for rate of return on investment, determine the

profit margin, investment turnover, and rate of return on investment for the

Jet Ski Division for the past year.

  1. Prepare condensed estimated income statements and compute the invested

assets for each proposal.

  1. Using the DuPont formula for rate of return on investment, determine the

profit margin, investment turnover, and rate of return on investment for each

proposal.

  1. Which of the three proposals would meet the required 12% rate of return on

investment?

  1. If the Jet Ski Division were in an industry where the profit margin could not

be increased, how much would the investment turnover have to increase to

meet the president’s required 12% rate of return on investment?

P14-5 Divisional performance analysis and evaluation

The vice president of operations of Montana Bike Company is evaluating the performance

of two divisions organized as investment centers. Invested assets and

condensed income statement data for the past year for each division are as follows:

On-Road Bike Division Off-Road Bike Division

Sales $10,500,000 $8,000,000

Cost of goods sold 6,300,000 5,600,000

Operating expenses 2,940,000 1,560,000

Invested assets 7,500,000 5,000,000

Instructions

  1. Prepare condensed divisional income statements for the year ended December

31, 2012, assuming that there were no service department charges.

  1. Using the DuPont formula for rate of return on investment, determine the

profit margin, investment turnover, and rate of return on investment for each

division.

  1. If management desires a minimum acceptable rate of return of 15%, determine

the residual income for each division.

  1. Discuss the evaluation of the two divisions, using the performance measures

determined in parts (1), (2), and (3).

P14-6 Transfer pricing

Pendray Scientific Inc. manufactures electronic products, with two operating divisions,

the GPS Systems and Communication Systems Divisions. Condensed divisional

income statements, which involve no intracompany transfers and which

include a breakdown of expenses into variable and fixed components, are as

follows:

Pendray Scientific, Inc.

Divisional Income Statements

For the Year Ended December 31, 2012

GPS

Systems

Division

Communication

Systems

Division Total

Sales:

75,000 units @ $60 per unit $4,500,000 $ 4,500,000

140,000 units @ $115 per unit $16,100,000 16,100,000

$4,500,000 $16,100,000 $20,600,000

Expenses:

Variable:

75,000 units @ $40 per unit $3,000,000 $ 3,000,000

140,000 units @ $90* per unit $12,600,000 12,600,000

Fixed 250,000 500,000 750,000

Total expenses $3,250,000 $13,100,000 $16,350,000

Income from operations $1,250,000 $ 3,000,000 $ 4,250,000

* $60 of the $90 per unit represents materials costs, and the remaining $30 per unit represents other variable conversion

expenses incurred within the Communication Systems Division.

The GPS Systems Division is presently producing 75,000 units out of a total

capacity of 100,000 units. Materials used in producing the Communication Systems

Division’s product are currently purchased from outside suppliers at a price of

$60 per unit. The GPS Systems Division is able to produce the materials used by

the Communication Systems Division. Except for the possible transfer of materials

between divisions, no changes are expected in sales and expenses.

Instructions

  1. Would the market price of $60 per unit be an appropriate transfer price for

Pendray Scientific Inc.? Explain.

  1. If the Communication Systems Division purchases 25,000 units from the GPS

Systems Division, rather than externally, at a negotiated transfer price of $52

per unit, how much would the income from operations of each division and

the total company income from operations increase?

  1. Prepare condensed divisional income statements for Pendray Scientific Inc.

based on the data in part (2).

  1. If a transfer price of $49 per unit is negotiated, how much would the income

from operations of each division and the total company income from operations

increase?

  1. a. What is the range of possible negotiated transfer prices that would be

acceptable

for Pendray Scientific Inc.?

  1. Assuming that the managers of the two divisions cannot agree on a transfer

price, what price would you suggest as the transfer price?

 

Activities

A14-1 Ethics and professional conduct in business

Sisel Company has two divisions, the Optic Lens Division and the Camera Division.

The Camera Division may purchase lenses from the Optic Lens Division or

from outside suppliers. The Optic Lens Division sells products both internally

and externally. The market price for lenses is $2,500 per carton (100). Newt Watt

is the controller of the Camera Division, and Tani Trudeau is the controller of

the Optic Lens Division. The following conversation took place between Newt

and Tani:

Newt: I hear you are having problems selling lenses out of your division. Maybe

I can help.

Tani: You’ve got that right. We’re producing and selling at about 75% of our

capacity to outsiders. Last year we were selling at capacity. Would it be possible

for your division to pick up some of our excess capacity? After all, we are part

of the same company.

Newt: What kind of price could you give me?

Tani: Well, you know as well as I that we are under strict profit responsibility

in our divisions, so I would expect to get market price, $2,500 per carton (100).

Newt: I’m not so sure we can swing that. I was expecting a price break from a

“sister” division.

Tani: Hey, I can only take this “sister” stuff so far. If I give you a price break,

our profits will fall from last year’s levels. I don’t think I could explain that. I’m

sorry, but I must remain firm—market price. After all, it’s only fair—that’s what

you would have to pay from an external supplier.

Newt: Fair or not, I think we’ll pass. Sorry we couldn’t have helped.

Was Newt behaving ethically by trying to force the Optic Lens Division into

a price break? Comment on Tani’s reactions.

A14-2 Service department charges

The Customer Service Department of Bragg Inc. asked the Publications Department

to prepare a brochure for its training program. The Publications Department

delivered the brochures and charged the Customer Service Department a rate

that was 15% higher than could be obtained from an outside printing company.

The policy of the company required the Customer Service Department to use the

internal publications group for brochures. The Publications Department claimed

that it had a drop in demand for its services during the fiscal year, so it had to

charge higher prices in order to recover its payroll and fixed costs.

Should the cost of the brochure be transferred to the Customer Service Department

in order to hold the department head accountable for the cost of the

brochure? What changes in policy would you recommend?

A14-3 Evaluating divisional performance

The three divisions of Dixie Foods are Cereal, Produce, and Snacks. The divisions

are structured as investment centers. The following responsibility reports were

prepared for the three divisions for the prior year:

Cereal Produce Snacks

Revenues $5,400,000 $16,000,000 $9,000,000

Operating expenses 4,200,000 12,800,000 6,300,000

Income from operations before service

department charges $1,200,000 $ 3,200,000 $2,700,000

Service department charges:

Promotion $ 500,000 $ 1,500,000 $1,200,000

Legal 268,000 740,000 420,000

$ 768,000 $ 2,240,000 $1,620,000

Income from operations $ 432,000 $ 960,000 $1,080,000

Invested assets $4,500,000 $ 8,000,000 $5,000,000

  1. Which division is making the best use of invested assets and thus should be

given priority for future capital investments?

  1. Assuming that the minimum acceptable rate of return on new projects is 10%,

would all investments that produce a return in excess of 10% be accepted by

the divisions?

  1. Determine the overall return on investment for Dixie Foods. Round to one

decimal place.

  1. Can you identify opportunities for improving Dixie Foods’ financial performance?

A14-4 Evaluating division performance over time

The Laser Division of FOX Technologies Inc. has been experiencing revenue and

profit growth during the years 2010–2012. The divisional income statements are

provided below.

FOX Technologies Inc.

Divisional Income Statements, Laser Division

For the Years Ended December 31, 2010–2012

2010 2011 2012

Sales $3,000,000 $4,500,000 $7,000,000

Cost of goods sold 1,800,000 2,625,000 3,800,000

Gross profit $1,200,000 $1,875,000 $3,200,000

Operating expenses 300,000 300,000 400,000

Income from operations $ 900,000 $1,575,000 $2,800,000

Assume that there are no charges from service departments. The vice president

of the division, Stacy Harper, is proud of her division’s performance over the last

three years. The president of FOX Technologies Inc., Hal Nelson, is discussing

the division’s performance with Stacy, as follows:

Stacy: As you can see, we’ve had a successful three years in the Laser Division.

Hal: I’m not too sure.

Stacy: What do you mean? Look at our results. Our income from operations has

more than tripled, while our profit margins are improving.

Hal: I am looking at your results. However, your income statements fail to include

one very important piece of information; namely, the invested assets. You

have been investing a great deal of assets into the division. You had $2,000,000

in invested assets in 2010, $4,500,000 in 2011, and $10,000,000 in 2012.

Stacy: You are right. I’ve needed the assets in order to upgrade our technologies

and expand our operations. The additional assets are one reason we have been

able to grow and improve our profit margins. I don’t see that this is a problem.

Hal: The problem is that we want to maintain a 30% rate of return on invested assets.

  1. Determine the profit margins for the Laser Division for 2010–2012.
  2. Compute the investment turnover for the Laser Division for 2010–2012.
  3. Compute the rate of return on investment for the Laser Division for 2010–2012.
  4. Evaluate the division’s performance over the 2010–2012 time period. Why was

Hal concerned about the performance?

A14-5 Evaluating division performance

Modern Living Inc. is a privately held diversified company with five separate divisions

organized as investment centers. A condensed income statement for the Patio

Division for the past year, assuming no service department charges, is as follows:

Modern Living Inc.— Patio Division

Income Statement

For the Year Ended December 31, 2011

Sales $18,000,000

Cost of goods sold 13,000,000

Gross profit $ 5,000,000

Operating expenses 1,400,000

Income from operations $ 3,600,000

Invested assets $15,000,000

The manager of the Patio Division was recently presented with the opportunity

to add an outdoor fireplace product line, which would require invested assets of

$4,500,000. A projected income statement for the new product line is as follows:

Outdoor Fireplace Line

Projected Income Statement

For the Year Ended December 31, 2012

Sales $4,050,000

Cost of goods sold 2,340,000

Gross profit $1,710,000

Operating expenses 900,000

Income from operations $ 810,000

The Patio Division currently has $15,000,000 in invested assets, and Modern Living

Inc.’s overall rate of return on investment, including all divisions, is 14%. Each

division manager is evaluated on the basis of divisional rate of return on investment,

and a bonus equal to $10,000 for each percentage point by which the division’s

rate of return on investment exceeds the company average is awarded each year.

The president is concerned that the manager of the Patio Division rejected the

addition of the new product line, when all estimates indicated that the product

line would be profitable and would increase overall company income. You have

been asked to analyze the possible reasons why the Patio Division manager rejected

the new product line.

  1. Determine the rate of return on investment for the Patio Division for the past year.
  2. Determine the Patio Division manager’s bonus for the past year.
  3. Determine the estimated rate of return on investment for the new product line.
  4. Determine the rate of return for the Patio Division if the Outdoor Fireplace

product line was added and the 2012 operating results were similar to those

of 2011. Round to one decimal place.

  1. Why might the manager of the Patio Division decide to reject the new product

line?

  1. Can you suggest an alternative performance measure for motivating division

managers to accept new investment opportunities that would increase the

overall company income and rate of return on investment?

A14-6 The balanced scorecard and EVA

Divide responsibilities between two groups, with one group going to the home

page of The Palladium Group at http://www.thepalladiumgroup.com, and the second

group going to the home page of Stern Stewart & Co. at http://www.eva.com.

The Palladium Group is a consulting firm that helped develop the balanced scorecard

concept. Stern Stewart & Co. is a consulting firm that developed the concept

of economic value added (EVA), another method of measuring corporate and

divisional performance, similar to residual income.

After reading about the balanced scorecard at the palladiumgroup.com site, prepare

a brief report describing the balanced scorecard and its claimed advantages.

In the Stern group, use links in the home page of Stern Stewart & Co. to learn

about EVA. After reading about EVA, prepare a brief report describing EVA and

its claimed advantages. After preparing these reports, both groups should discuss

their research and prepare a brief analysis comparing and contrasting these two

approaches to corporate and divisional performance measurement.

 

Answers to Self-Examination Questions

  1. B The manager of a profit center (answer B)

has responsibility for and authority over costs

and revenues. If the manager has responsibility

for only costs, the department is called a cost

center (answer A). If the responsibility and

authority extend to the investment in assets

as well as costs and revenues, it is called

an investment center (answer C). A service

department (answer D) provides services

to other departments. A service department

could be a cost center, a profit center, or an

investment center.

  1. C $600,000/150,000 5 $4 per payment.

Division A anticipates 60,000 payments or

$240,000 (60,000 3 $4) in service department

charges from the Accounts Payable

Department. Income from operations is thus

$900,000 2 $240,000, or $660,000. Answer

A assumes that all of the service department

overhead is assigned to Division A, which

would be incorrect, since Division A does

not use all of the accounts payable service.

Answer B incorrectly assumes that there are

no service department charges from Accounts

Payable. Answer D incorrectly determines the

accounts payable transfer rate from Division

A’s income from operations.

  1. A The rate of return on investment for Division

A is 20% (answer A), computed as follows:

Rate of Return on

Investment

(ROI) 5

Income from Operations

Invested Assets

ROI5

$350,000 2 $200,000 2 $30,000

5 20%

$600,000

  1. B The profit margin for Division L of Liddy

Co. is 15% (answer B), computed as follows:

Rate of Return on

Investment

(ROI) 5

Profit

Margin 3

Investment

Turnover

24% 5 Profit Margin 3 1.6

15% 5 Profit Margin

  1. C The market price approach (answer C) to

transfer pricing uses the price at which the

product or service transferred could be sold

to outside buyers. The cost price approach

(answer A) uses cost as the basis for setting

transfer prices. The negotiated price approach

(answer B) allows managers of decentralized

units to agree (negotiate) among themselves

as to the proper transfer price. The standard

cost approach (answer D) is a version of the

cost price approach that uses standard costs

in setting transfer prices.

 

 

 

Chapter 15 Capital Investment analysis

Class Discussion Questions

  1. What are the principal objections to the

use of the average rate of return method in

evaluating capital investment proposals?

  1. Discuss the principal limitations of the

cash payback method for evaluating capital

investment proposals.

  1. Why would the average rate of return differ

from the internal rate of return on the same

project?

  1. What information does the cash payback

period ignore that is included by the net

present value method?

  1. Your boss has suggested that a one-year

payback period is the same as a 100% average

rate of return. Do you agree?

  1. Why would the cash payback method

understate the value of a project with a large

residual value?

  1. Why might the use of the cash payback period

for analyzing the financial performance of

theatrical releases from a motion picture

production studio be used over the net

present value method?

  1. A net present value analysis used to evaluate

a proposed equipment acquisition indicated

a $115,000 net present value. What is the

meaning of the $115,000 as it relates to the

desirability of the proposal?

  1. Two projects have an identical net present

value of $360,000. Are both projects equal

in desirability?

  1. What are the major disadvantages of the use

of the net present value method of analyzing

capital investment proposals?

  1. What are the major disadvantages of the

use of the internal rate of return method of

analyzing capital investment proposals?

  1. What provision of the Internal Revenue

Code is especially important to consider in

analyzing capital investment proposals?

  1. What method can be used to place two

capital investment proposals with unequal

useful lives on a comparable basis?

  1. What are the major advantages of leasing a

fixed asset rather than purchasing it?

  1. Give an example of a qualitative factor that

should be considered in a capital investment

analysis related to acquiring automated

factory equipment.

  1. Monsanto Company, a large chemical and

fibers company, invested $37 million in

state-of-the-art systems to improve process

control, laboratory automation, and local

area network (LAN) communications. The

investment was not justified merely on cost

savings but was also justified on the basis

of qualitative considerations. Monsanto

management viewed the investment as a

critical element toward achieving its vision of

the future. What qualitative and quantitative

considerations do you believe Monsanto

would have considered in its strategic

evaluation of these investments?

 

Exercises

E15-1 Average rate of return

The following data are accumulated by Bio-Tech Inc. in evaluating two competing

capital investment proposals:

Testing

Equipment

Diagnostic

Software

Amount of investment $1,000,000 $760,000

Useful life 8 years 10 years

Estimated residual value 0 0

Estimated total income over the useful life $360,000 $456,000

Determine the expected average rate of return for each proposal.

E15-2 Average rate of return—cost savings

Espinosa Industries is considering an investment in equipment that will replace

direct labor. The equipment has a cost of $615,000 with a $75,000 residual value

and a 10-year life. The equipment will replace one employee who has an average

wage of $134,100 per year. In addition, the equipment will have operating and

energy costs of $18,000 per year.

Determine the average rate of return on the equipment, giving effect to straightline

depreciation on the investment.

E15-3 Average rate of return—new product

Arrowhead Inc. is considering an investment in new equipment that will be used

to manufacture a mobile communications product. The product is expected to

generate additional annual sales of 24,000 units at $400 per unit. The equipment

has a cost of $27,000,000, residual value of $1,800,000, and a 10-year life. The

equipment only can be used to manufacture the product. The cost to manufacture

the product is shown on the next page.

Cost per unit:

Direct labor $ 40.00

Direct materials 60.00

Factory overhead (including depreciation) 120.00

Total cost per unit $220.00

Determine the average rate of return on the equipment.

E15-4 Calculate cash flows

Daffodil Inc. is planning to invest in new manufacturing equipment to make a

new garden tool. The new garden tool is expected to generate additional annual

sales of 120,000 units at $9 each. The new manufacturing equipment will

cost $320,000, have a 10-year life, have a residual value of $20,000, and will be

depreciated using the straight-line method. Selling expenses related to the new

product are expected to be 15% of sales revenue. The cost to manufacture the

product includes the following on a per-unit basis:

Direct labor $1.00

Direct materials 3.40

Fixed factory overhead—depreciation 1.25

Variable factory overhead 0.35

Total $6.00

  1. Determine the net cash flows for the first year of the project, Years 2–9, and

for the last year of the project.

  1. Assume that the operating cash flows occur evenly throughout the year and

that the equipment is purchased on January 1, 2013. Determine when the cash

payback will occur by year, month, and day.

E15-5 Cash payback period

Platte Woodworks is evaluating two capital investment proposals for a retail outlet

store, each requiring an investment of $350,000 and each with an eight-year life

and expected total net cash flows of $560,000. Location 1 is expected to provide

equal annual net cash flows of $70,000, and Location 2 is expected to have the

following unequal annual net cash flows:

Year 1 $125,000

Year 2 85,000

Year 3 70,000

Year 4 70,000

Year 5 70,000

Year 6 60,000

Year 7 40,000

Year 8 40,000

Determine the cash payback period for both location proposals.

E15-6 Cash payback method

Charisma Beauty Products is considering an investment in one of two new product

lines. The investment required for either product line is $1,125,000. The net cash

flows associated with each product are shown on the next page:

Year Shampoo/Conditioner Body Wash

1 $ 450,000 $ 187,500

2 375,000 187,500

3 300,000 187,500

4 100,000 187,500

5 85,000 187,500

6 80,000 187,500

7 60,000 187,500

8 50,000 187,500

Total $1,500,000 $1,500,000

  1. Recommend a product offering to Charisma Beauty Products, based on the

cash payback period for each product line.

  1. Why is one product line preferred over the other, even though they both have

the same total net cash flows through eight periods?

  1. Assume that instead of $300,000 of cash flows in Year 3 and $100,000 in

Year 4, the Shampoo/Conditioner had cash flows of $250,000 in Year 3 and

$150,000 in Year 4. What would be the cash payback period assuming that

the cash flows occur uniformly throughout the year?

E15-7 Net present value method

The following data are accumulated by Lindquist Company in evaluating the

purchase of $100,000 of equipment, having a four-year useful life:

Net Income Net Cash Flow

Year 1 $65,000 $90,000

Year 2 60,000 85,000

Year 3 35,000 60,000

Year 4 10,000 35,000

  1. Assuming that the desired rate of return is 15%, determine the net present

value for the proposal. Use the table of the present value of $1 appearing in

Exhibit 1 of this chapter.

  1. Would management be likely to look with favor on the proposal? Explain.

E15-8 Net present value method

Speedy Delivery Inc. is considering the purchase of an additional delivery truck

for $110,000 on January 1, 2012. The truck is expected to have a five-year life

with an expected residual value of $15,000 at the end of five years. The expected

additional revenues from the added delivery capacity are anticipated to be $70,000

per year for each of the next five years. A driver will cost $40,000 in 2012, with

an expected annual salary increase of $1,000 for each year thereafter. The insurance

for the truck is estimated to cost $2,000 per year.

  1. Determine the expected annual net cash flows from the delivery truck investment

for 2012–2016.

  1. Calculate the net present value of the investment, assuming that the minimum

desired rate of return is 12%. Use the present value of $1 table appearing in

Exhibit 1 of this chapter.

  1. Is the additional truck a good investment based on your analysis?

E15-9 Net present value method—annuity

Model 99 Hotels is considering the construction of a new hotel for $80 million.

The expected life of the hotel is 20 years with no residual value. The hotel is

expected to earn revenues of $15 million per year. Total expenses, including

straight-line depreciation, are expected to be $6 million per year. Model 99 management

has set a minimum acceptable rate of return of 10%.

  1. Determine the equal annual net cash flows from operating the hotel.
  2. Calculate the net present value of the new hotel, using the present value factor

of an annuity of $1 at 10% for 20 periods of 8.5136. Round to the nearest

million dollars.

  1. Does your analysis support construction of the new hotel?

E15-10 Net present value method—annuity

Osborne Excavation Company is planning an investment of $315,000 for a bulldozer.

The bulldozer is expected to operate for 1,850 hours per year for five

years. Customers will be charged $140 per hour for bulldozer work. The bulldozer

operator costs $37 per hour in wages and benefits. The bulldozer is expected

to require annual maintenance costing $9,750. The bulldozer uses fuel that is

expected to cost $48 per hour of bulldozer operation.

  1. Determine the equal annual net cash flows from operating the bulldozer.
  2. Determine the net present value of the investment, assuming that the desired

rate of return is 10%. Use the table of present values of an annuity of $1 in

the chapter. Round to the nearest dollar.

  1. Should Osborne Excavation invest in the bulldozer, based on this analysis?

E15-11 Net present value method

Carnival Corporation has recently placed into service some of the largest cruise

ships in the world. One of these ships, the Carnival Dream, can hold up to

3,600 passengers and cost $750 million to build. Assume the following additional

information:

  • There will be 300 cruise days per year operated at a full capacity of 3,600

passengers.

  • The variable expenses per passenger are estimated to be $90 per cruise day.
  • The revenue per passenger is expected to be $450 per cruise day.
  • The fixed expenses for running the ship, other than depreciation, are estimated

to be $100,000,000 per year.

  • The ship has a service life of 10 years, with a residual value of $120,000,000

at the end of 10 years.

  1. Determine the annual net cash flows from operating the cruise ship.
  2. Determine the net present value of this investment, assuming a 12% minimum

rate of return. Use the present value tables provided in the chapter in determining

your answer.

E15-12 Present value index

Kaheka Hawaiian Grill has computed the net present value for capital expenditures

for the San Jose and Malibu locations using the net present value method.

Relevant data related to the computation are as follows:

San Jose Malibu

Total present value of net cash flow $8,086,900 $7,190,900

Amount to be invested 6,469,500 5,617,800

Net present value $1,617,400 $1,573,100

Determine the present value index for each proposal. Round to two decimal

places.

E15-13 Net present value method and present value index

Ball Sports Inc. is considering an investment in one of two machines. The stitching

machine will increase productivity from sewing 300 baseballs per hour to stitching

360 per hour. The contribution margin is $0.30 per baseball. Assume that any increased

production of baseballs can be sold. The second machine applies a synthetic

balata cover to golf balls. The golf ball machine will reduce labor cost. The labor

cost saved is equivalent to $40 per hour. The stitching machine will cost $484,600,

have an eight-year life, and will operate for 7,500 hours per year. The golf ball

machine will cost $897,400, have an eight-year life, and will operate for 6,000 hours

per year. Ball Sports Inc. seeks a minimum rate of return of 15% on its investments.

  1. Determine the net present value for the two machines. Use the table of present

values of an annuity of $1 in the chapter. Round to the nearest dollar.

  1. Determine the present value index for the two machines. Round to two decimal

places.

  1. If Ball Sports Inc. has sufficient funds for only one of the machines and qualitative

factors are equal between the two machines, in which machine should

it invest?

E15-14 Average rate of return, cash payback period, net present value method

Glacier Transportation Inc. is considering a distribution facility at a cost of

$8,000,000. The facility has an estimated life of 10 years and a $2,000,000 residual

value. It is expected to provide yearly net cash flows of $1,600,000. The

company’s minimum desired rate of return for net present value analysis is 10%.

Compute the following:

  1. The average rate of return, giving effect to straight-line depreciation on the

investment.

  1. The cash payback period.
  2. The net present value. Use the table of the present value of an annuity of $1

appearing in this chapter. Round to the nearest dollar.

E15-15 Payback period, net present value analysis, and qualitative considerations

The plant manager of Jurassic Industries is considering the purchase of new

automated assembly equipment. The new equipment will cost $3,437,500. The

manager believes that the new investment will result in direct labor savings of

$625,000 per year for 10 years.

  1. What is the payback period on this project?

 

  1. What is the net present value, assuming a 10% rate of return? Use the present

value tables appearing in this chapter.

  1. What else should the manager consider in the analysis?

E15-16 Internal rate of return method

The internal rate of return method is used by Premier Construction Co. in analyzing

a capital expenditure proposal that involves an investment of $41,575 and annual

net cash flows of $12,500 for each of the six years of its useful life.

  1. Determine a present value factor for an annuity of $1 which can be used in

determining the internal rate of return.

  1. Using the factor determined in part (a) and the present value of an annuity

of $1 table appearing in this chapter, determine the internal rate of return for

the proposal.

E15-17 Internal rate of return method

The Canyons Resort, a Utah ski resort, recently announced a $400 million expansion

of lodging properties, lifts, and terrain. Assume that this investment is estimated

to produce $79.7 million in equal annual cash flows for each of the first 10 years

of the project life.

Determine the expected internal rate of return of this project for 10 years, using

the present value of an annuity of $1 table found in Exhibit 2.

E15-18 Internal rate of return method—two projects

Strahn Foods Inc. is considering two possible investments: a delivery truck or a

bagging machine. The delivery truck would cost $65,970 and could be used to

deliver an additional 90,000 bags of taquitos chips per year. Each bag of chips

can be sold for a contribution margin of $0.35. The delivery truck operating

expenses, excluding depreciation, are $0.55 per mile for 24,000 miles per year.

The bagging machine would replace an old bagging machine, and its net investment

cost would be $35,890. The new machine would require 2.5 fewer hours

of direct labor per day. Direct labor is $20 per hour. There are 240 operating

days in the year. Both the truck and the bagging machine are estimated to have

five-year lives. The minimum rate of return is 14%. However, Strahn Foods has

funds to invest in only one of the projects.

  1. Compute the internal rate of return for each investment. Use the table of present

values of an annuity of $1 in the chapter.

  1. Provide a memo to management with a recommendation.

E15-19 Net present value method and internal rate of return method

Wisconsin Healthcare Corp. is proposing to spend $3,810,000 on a project that

has estimated net cash flows of $620,000 for each of the 10 years.

  1. Compute the net present value, using a rate of return of 12%. Use the table

of present values of an annuity of $1 in the chapter.

  1. Based on the analysis prepared in part (a), is the rate of return (1) more than

12%, (2) 12%, or (3) less than 12%? Explain.

  1. Determine the internal rate of return by computing a present value factor for

an annuity of $1 and using the table of the present value of an annuity of $1

presented in the text.

E15-20 Identify error in capital investment analysis calculations

Fireproofing Solutions Inc. is considering the purchase of automated machinery

that is expected to have a useful life of eight years and no residual value. The

average rate of return on the average investment has been computed to be 15%,

and the cash payback period was computed to be ten years.

Do you see any reason to question the validity of the data presented? Explain.

E15-21 Net present value—unequal lives

Healey Development Company has two competing projects: an office building and

a condominium complex. Both projects have an initial investment of $2,000,000.

The net cash flows estimated for the two projects are as follows:

Net Cash Flow

Year Office Building Condominium Complex

1 $950,000 $1,200,000

2 600,000 900,000

3 500,000 700,000

4 450,000 400,000

5 350,000

6 350,000

7 300,000

8 300,000

The estimated residual value of the office building at the end of Year 4 is

$900,000.

Determine which project should be favored, comparing the net present values

of the two projects and assuming a minimum rate of return of 15%. Use the table

of present values in the chapter.

E15-22 Net present value—unequal lives

Buscho Industries is considering one of two investment options. Option 1 is

a $45,000 investment in new blending equipment that is expected to produce

equal annual cash flows of $18,000 for each of eight years. Option 2 is a $17,000

investment in a new computer system that is expected to produce equal annual

cash flows (savings) of $10,000 for each of four years. The residual value of the

blending equipment at the end of the fourth year is estimated to be $5,000. The

computer system has no expected residual value at the end of the fourth year.

Assume there is sufficient capital to fund only one of the projects. Determine

which project should be selected, comparing the (a) net present values and

(b) present value indices of the two projects, assuming a minimum rate of return

of 12%. Round the present value index to two decimal places. Use the table of

present values in the chapter.

 

Problems

P15-1 Average rate of return method, net present value method, and analysis

The capital investment committee of Overnight Express Inc. is considering two

investment projects. The estimated income from operations and net cash flows

from each investment are as follows:

Distribution Center Expansion Internet Tracking Technology

Year

Income from

Operations

Net Cash

Flows

Income from

Operations

Net Cash

Flows

1 $ 66,000 $ 226,000 $200,000 $ 360,000

2 66,000 226,000 90,000 250,000

3 66,000 226,000 30,000 190,000

4 66,000 226,000 10,000 170,000

5 66,000 226,000 0 160,000

Total $330,000 $1,130,000 $330,000 $1,130,000

Each project requires an investment of $800,000. Straight-line depreciation will

be used, and no residual value is expected. The committee has selected a rate

of 15% for purposes of the net present value analysis.

Instructions

  1. Compute the following:
  2. The average rate of return for each investment.
  3. The net present value for each investment. Use the present value of $1

table appearing in this chapter.

  1. Prepare a brief report for the capital investment committee, advising it on the

relative merits of the two projects.

P15-2 Cash payback period, net present value method, and analysis

McMorris Publications Inc. is considering two new magazine products. The estimated

net cash flows from each product are as follows:

Year Canadian Cycling European Hiking

1 $220,000 $188,000

2 180,000 212,000

3 158,000 150,000

4 131,000 110,000

5 61,000 90,000

Total $750,000 $750,000

Each product requires an investment of $400,000. A rate of 10% has been

selected for the net present value analysis.

Instructions

  1. Compute the following for each product:
  2. Cash payback period.
  3. The net present value. Use the present value of $1 table appearing in this

chapter.

  1. Prepare a brief report advising management on the relative merits of each of

the two products.

P15-3 Net present value method, present value index, and analysis

Soares Industries Inc. wishes to evaluate three capital investment projects by

using the net present value method. Relevant data related to the projects are

summarized as follows:

Product Line

Expansion

Computer System

Upgrade

Internet

Bill-Pay

Amount to be invested $980,000 $665,000 $392,000

Annual net cash flows:

Year 1 490,000 350,000 224,000

Year 2 455,000 315,000 154,000

Year 3 420,000 280,000 112,000

Instructions

  1. Assuming that the desired rate of return is 15%, prepare a net present value analysis

for each project. Use the present value of $1 table appearing in this chapter.

  1. Determine a present value index for each project. Round to two decimal places.
  2. Which project offers the largest amount of present value per dollar of investment?

Explain.

P15-4 Net present value method, internal rate of return method, and analysis

The management of Heckel Communications Inc. is considering two capital investment

projects. The estimated net cash flows from each project are as follows:

Year Radio Station TV Station

1 $560,000 $1,120,000

2 560,000 1,120,000

3 560,000 1,120,000

4 560,000 1,120,000

The radio station requires an investment of $1,598,800, while the TV station requires

an investment of $3,401,440. No residual value is expected from either project.

Instructions

  1. Compute the following for each project:
  2. The net present value. Use a rate of 10% and the present value of an annuity

of $1 table appearing in this chapter.

  1. A present value index. Round to two decimal places.
  2. Determine the internal rate of return for each project by (a) computing a

present value factor for an annuity of $1 and (b) using the present value of

an annuity of $1 table appearing in this chapter.

  1. What advantage does the internal rate of return method have over the net

present value method in comparing projects?

P15-5 E valuate alternative capital investment decisions

The investment committee of Iron Skillet Restaurants Inc. is evaluating two restaurant

sites. The sites have different useful lives, but each requires an investment

of $1,000,000. The estimated net cash flows from each site are as follows:

Net Cash Flows

Year Site A Site B

1 $400,000 $500,000

2 400,000 500,000

3 400,000 500,000

4 400,000 500,000

5 400,000

6 400,000

The committee has selected a rate of 20% for purposes of net present value

analysis. It also estimates that the residual value at the end of each restaurant’s

useful life is $0, but at the end of the fourth year, Site A’s residual value would

be $300,000.

Instructions

  1. For each site, compute the net present value. Use the present value of an

annuity of $1 table appearing in this chapter. (Ignore the unequal lives of the

projects.)

  1. For each site, compute the net present value, assuming that Site A is adjusted

to a four-year life for purposes of analysis. Use the present value of $1 table

appearing in this chapter.

  1. Prepare a report to the investment committee, providing your advice on the

relative merits of the two sites.

P15-6 Capital rationing decision involving four proposals

Kopecky Industries Inc. is considering allocating a limited amount of capital

investment funds among four proposals. The amount of proposed investment,

estimated income from operations, and net cash flow for each proposal are as

follows:

Investment Year

Income from

Operations

Net Cash

Flow

Proposal Sierra: $850,000 1 $ 80,000 $ 250,000

2 80,000 250,000

3 80,000 250,000

4 30,000 200,000

5 (70,000) 100,000

$200,000 $ 1,050,000

Proposal Tango: $1,200,000 1 $320,000 $ 560,000

2 320,000 540,000

3 160,000 400,000

4 60,000 300,000

5 (40,000) 220,000

$820,000 $2,020,000

Proposal Uniform: $550,000 1 $ 90,000 $ 200,000

2 90,000 200,000

3 90,000 200,000

4 90,000 200,000

5 70,000 180,000

$430,000 $ 980,000

Proposal Victor: $380,000 1 $44,000 $ 120,000

2 44,000 120,000

3 44,000 120,000

4 4,000 80,000

5 4,000 80,000

$140,000 $ 520,000

The company’s capital rationing policy requires a maximum cash payback

period of three years. In addition, a minimum average rate of return of 12% is

required on all projects. If the preceding standards are met, the net present value

method and present value indexes are used to rank the remaining proposals.

Instructions

  1. Compute the cash payback period for each of the four proposals. Assume that

net cash flows are uniform throughout the year.

  1. Giving effect to straight-line depreciation on the investments and assuming no

estimated residual value, compute the average rate of return for each of the

four proposals. Round to one decimal place.

  1. Using the following format, summarize the results of your computations in

parts (1) and (2). By placing the calculated amounts in the first two columns

on the left and by placing a check mark in the appropriate column to the

right, indicate which proposals should be accepted for further analysis and

which should be rejected.

Cash Payback

Period

Average Rate

of Return

Accept for

Further Analysis

Proposal Reject

Sierra

Tango

Uniform

Victor

  1. For the proposals accepted for further analysis in part (3), compute the net

present value. Use a rate of 12% and the present value of $1 table appearing

in this chapter. Round to the nearest dollar.

  1. Compute the present value index for each of the proposals in part (4). Round

to two decimal places.

  1. Rank the proposals from most attractive to least attractive, based on the present

values of net cash flows computed in part (4).

  1. Rank the proposals from most attractive to least attractive, based on the present

value indexes computed in part (5). Round to two decimal places.

  1. Based on the analyses, comment on the relative attractiveness of the proposals

ranked in parts (6) and (7).

 

Activities

A15-1 E thics and professional conduct in business

Erin Haywood was recently hired as a cost analyst by Wind River Medical Supplies

Inc. One of Erin’s first assignments was to perform a net present value analysis

for a new warehouse. Erin performed the analysis and calculated a present value

index of 0.8. The plant manager, Zuhair Barbat, is very intent on purchasing the

warehouse because he believes that more storage space is needed. Zuhair asks

Erin into his office and the following conversation takes place:

Zuhair: Erin, you’re new here, aren’t you?

Erin: Yes, sir.

Zuhair: Well, Erin, let me tell you something. I’m not at all pleased with the

capital investment analysis that you performed on this new warehouse. I need

that warehouse for my production. If I don’t get it, where am I going to place

our output?

Erin: Hopefully with the customer, sir.

Zuhair: Now don’t get smart with me.

Erin: No, really, I was being serious. My analysis does not support constructing

a new warehouse. The numbers don’t lie; the warehouse does not meet our

investment return targets. In fact, it seems to me that purchasing a warehouse

does not add much value to the business. We need to be producing product to

satisfy customer orders, not to fill a warehouse.

Zuhair: Listen, you need to understand something. The headquarters people will

not allow me to build the warehouse if the numbers don’t add up. You know as

well as I that many assumptions go into your net present value analysis. Why don’t

you relax some of your assumptions so that the financial savings will offset the cost?

Erin: I’m willing to discuss my assumptions with you. Maybe I overlooked

something.

Zuhair: Good. Here’s what I want you to do. I see in your analysis that you

don’t project greater sales as a result of the warehouse. It seems to me, if we

can store more goods, then we will have more to sell. Thus, logically, a larger

warehouse translates into more sales. If you incorporate this into your analysis, I

think you’ll see that the numbers will work out. Why don’t you work it through

and come back with a new analysis? I’m really counting on you on this one.

Let’s get off to a good start together and see if we can get this project accepted.

What is your advice to Erin?

A15-2 Personal investment analysis

A Masters of Accountancy degree at Jalapeno University would cost $15,000 for

an additional fifth year of education beyond the bachelor’s degree. Assume that

all tuition is paid at the beginning of the year. A student considering this investment

must evaluate the present value of cash flows from possessing a graduate

degree versus holding only the undergraduate degree. Assume that the average

student with an undergraduate degree is expected to earn an annual salary of

$50,000 per year (assumed to be paid at the end of the year) for 10 years. Assume

that the average student with a graduate Masters of Accountancy degree

is expected to earn an annual salary of $65,000 per year (assumed to be paid

at the end of the year) for nine years after graduation. Assume a minimum rate

of return of 10%.

  1. Determine the net present value of cash flows from an undergraduate degree.

Use the present value tables provided in this chapter. Round to nearest dollar.

  1. Determine the net present value of cash flows from a Masters of Accountancy

degree, assuming no salary is earned during the graduate year of schooling.

Round to nearest dollar.

  1. What is the net advantage or disadvantage of pursuing a graduate degree

under these assumptions?

A15-3 Changing prices

World Electronics Inc. invested $16,000,000 to build a plant in a foreign country.

The labor and materials used in production are purchased locally. The plant

expansion was estimated to produce an internal rate of return of 20% in U.S.

dollar terms. Due to a currency crisis, the currency exchange rate between the

local currency and the U.S. dollar doubled from two local units per U.S. dollar

to four local units per U.S. dollar.

  1. Assume that the plant produced and sold product in the local economy. Explain

what impact this change in the currency exchange rate would have on

the project’s internal rate of return.

  1. Assume that the plant produced product in the local economy but exported the

product back to the United States for sale. Explain what impact the change in

the currency exchange rate would have on the project’s internal rate of return

under this assumption.

A15-4 Qualitative issues in investment analysis

The following are some selected quotes from senior executives:

CEO, Worthington Industries (a high technology steel company): “We try to find the

best technology, stay ahead of the competition, and serve the customer. . . . We’ll

make any investment that will pay back quickly . . . but if it is something that we

really see as a must down the road, payback is not going to be that important.”

Chairman of Amgen Inc. (a biotech company): “You cannot really run the

numbers, do net present value calculations, because the uncertainties are really

gigantic. . . . You decide on a project you want to run, and then you run the

numbers [as a reality check on your assumptions]. Success in a business like this is

much more dependent on tracking rather than on predicting, much more dependent

on seeing results over time, tracking and adjusting and readjusting, much

more dynamic, much more flexible.”

Chief Financial Officer of Merck & Co., Inc. (a pharmaceutical company): “ . . .

at the individual product level—the development of a successful new product

requires on the order of $230 million in R&D, spread over more than a decade—

discounted cash flow style analysis does not become a factor until development

is near the point of manufacturing scale-up effort. Prior to that point, given the

uncertainties associated with new product development, it would be lunacy in

our business to decide that we know exactly what’s going to happen to a product

once it gets out.”

Explain the role of capital investment analysis for these companies.

A15-5 Net present value method

Metro-Goldwyn-Mayer Studios Inc. (MGM) is a major producer and distributor of theatrical

and television filmed entertainment. Regarding theatrical films, MGM states,

“Our feature films are exploited through a series of sequential domestic and

international distribution channels, typically beginning with theatrical exhibition.

Thereafter, feature films are first made available for home video generally six

months after theatrical release; for pay television, one year after theatrical release;

and for syndication, approximately three to five years after theatrical release.”

Assume that MGM produces a film during early 2012 at a cost of $200 million,

and releases it halfway through the year. During the last half of 2012, the

film earns revenues of $240 million at the box office. The film requires $80

million of advertising during the release. One year later, by the end of 2013,

the film is expected to earn MGM net cash flows from home video sales of

$50 million. By the end of 2014, the film is expected to earn MGM $25 million

from pay TV; and by the end of 2015, the film is expected to earn $10 million

from syndication.

  1. Determine the net present value of the film as of the beginning of 2012 if the

desired rate of return is 20%. To simplify present value calculations, assume

all annual net cash flows occur at the end of each year. Use the table of the

present value of $1 appearing in Exhibit 1 of this chapter. Round to the nearest

whole million dollars.

  1. Under the assumptions provided here, is the film expected to be financially

successful?

A15-6 Capital investment analysis

In one group, find a local business, such as a copy shop, that charges for printing,

faxing, copying, and scanning documents. In the other group, determine

the price of a mid-range printer/copier/scanner/fax machine. Combine this information

from the two groups and perform a capital budgeting analysis. Assume

that one student will use the machine for 1,000 documents per semester for

the next three years. Also assume that the minimum rate of return is 10%. In

performing your analysis, use the present value factor for 5% compounded for

six semiannual periods of 5.08.

Does your analysis support the student purchasing the printer/copier/scanner/

fax machine?

 

Answers to Self-Examination Questions

  1. C Methods of evaluating capital investment

proposals that ignore the time value of money

are categorized as methods that ignore present

value. This category includes the average

rate of return method (answer A) and the cash

payback method (answer B).

  1. B The average rate of return is 24% (answer

B), determined by dividing the expected average

annual earnings by the average investment,

as follows:

$60,000 4 5

5 24%

($100,000 1 $0) 4 2

  1. B Of the four methods of analyzing proposals

for capital investments, the cash payback

period (answer B) refers to the expected

period

of time required to recover the

amount of cash to be invested. The average

rate of return (answer A) is a measure of the

anticipated

profitability of a proposal. The

net present value method (answer C) reduces

the expected future net cash flows originating

from a proposal to their present values.

The internal rate of return method (answer

  1. D) uses present value concepts to compute

the rate of return from the net cash flows

expected from the investment.

  1. B The net present value is determined as

follows:

Present value of $25,000 for 8 years

at 10% ($25,000 × 5.335) $133,375

Less: Project cost 120,000

Net present value $ 13,375

  1. C The internal rate of return for this project

is determined by solving for the present value

of an annuity factor that when multiplied by

$40,000 will equal $226,000. By division, the

factor is:

$226,000

5 5.65

$40,000

In Exhibit 2, scan along the n 5 10 years

row until finding the 5.65 factor. The column

for this factor is 12%.