PLS DO NOT ACCEPT IF YOU ARE NOT FAMILIAR WITH MATERIAL.4 chapters on testChapter 6- sales revenue, receivables and cash ( concepts: Sales discounts, credit card sales Bad debt expense, receivables turnover ratio)Chapter 7: costs of goods sold ( inventory management and effect on Balance sheet and Income Statement, LIFO FIFO AVERAGE COST METHODS, NRV and holding losses)chapter 8- DEPRECIATION- (fixed asset turnover, capitlaztions vs expenditures, Net Book value, 3 ways to calculate deprection expense (1. straight line formula 2. units of production method, 3 double declining balance method ) asset impairmentchapter 11- stock holder equity test will be multiple choice, t charts, filling out balance sheets, etc.chapter
6
Reporting and Interpreting Sales
Revenue, Receivables, and Cash
Financial Accounting
10e
Libby • Libby • Hodge
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Learning Objectives
After studying this chapter, you should be able to:
6-1 Analyze the impact of credit card sales, sales discounts, sales returns,
and sales of bundled items on the amounts reported as net sales.
6-2 Estimate, report, and evaluate the effects of uncollectible accounts
receivable (bad debts) on financial statements.
6-3 Analyze and interpret the receivables turnover ratio and the effects of
accounts receivable on cash flows.
6-4 Report, control, and safeguard cash.
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6-2
Learning Objective 6-1
6-1 Analyze the impact of credit card sales, sales discounts, sales returns,
and sales of bundled items on the amounts reported as net sales.
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6-3
Accounting for Net Sales Revenue (1 of 2)
The revenue recognition principle requires that
revenues be recorded:
1. when the company transfers goods and services
to customers.
2. in the amount the company expects to be
entitled to receive.
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6-4
Accounting for Net Sales Revenue (2 of 2)
For sellers of goods, sales revenue is recorded when
title and risks of ownership transfer to the buyer.
The point at which title changes hands is determined
by these shipping terms: FOB Destination and FOB
Shipping point.
❖ FOB Destination – the title of the goods changes
hands on delivery.
❖ FOB Shipping point – the title of the goods
changes hands at the shipping date.
FOB = free on board
Service companies most often record sales revenue
when they have provided services to the buyer.
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6-5
Summary of Significant Accounting Policies
Here is an example of a financial statement footnote that
discloses the revenue recognition rule:
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6-6
Motivating Sales and Collections
Companies use a variety of methods to motivate businesses and consumers
to buy their products and make payments for their purchases,
including:
1) Allowing consumers to use credit cards to pay for purchases.
2) Providing business customers direct credit and discounts for early
payment.
3) Allowing returns from all customers under certain circumstances.
These methods affect the way companies compute net sales revenue.
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6-7
Credit Card Sales to Consumers
Retailers accept credit cards for several reasons:
1. To increase customer traffic.
2. To avoid the costs of providing credit directly to customers.
3. To lower risks due to bad checks.
4. To avoid losses due to fraudulent credit card sales.
5. To receive payment quicker.
When credit card sales are made, the company must pay the credit
card company a fee for the service it provides. This fee is called a
Credit Card Discount.
Sales revenue
Less: Credit card discounts (0.03 × 3,000)
Net sales (reported on the income statement)
$3,000
90
$2,910
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6-8
Sales Discounts to Businesses
Companies often sell to other businesses on open account (without a
formal written promissory note).
Companies may offer a sales discount as an early payment incentive.
Early Payment Incentive
Number of days
In discount period
Discount
percentage
Net (total sales
less returns)
2/10, n/30
Maximum
credit period
Read as: “Two ten, net thirty”
Sales discounts encourage prompt payment from customers, reducing the
need for the company to borrow money to meet operating needs. Also,
customers often pay bills providing discounts first.
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6-9
To Take or Not to Take the Discount, That Is
the Question
FINANCIAL ANALYSIS
With discount terms of 2/10, n/30, a customer
saves $2 on a $100 purchase by paying
on the 10th day instead of the 30th day.
$$$
This amounts to substantial savings!
Amount Saved
Amount Paid
$2
$98
= Interest Rate for 20 Days
= 2.04% savings for 20 Days
365 Days
× 2.04% = 37.23% annual interest rate
20 Days
As long as the bank’s interest rate is less than the annual interest rate the
customer will save by taking the cash discount.
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6-10
Sales Returns and Allowances
Customers have a right to return unsatisfactory or damaged
merchandise and receive a refund or an adjustment to their bill.
These returns are accumulated in a separate account called Sales
Returns and Allowances.
Sales revenue
Less: Sales returns and allowances (10 pairs × $50)
Net sales (reported on the income statement)
$2,000
500
$1,500
Cost of goods sold related to the returned sale would also be
reduced.
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6-11
Reporting Net Sales
Companies record credit card discounts, sales discounts, and sales
returns and allowances separately to allow management to monitor
the magnitude of these transactions.
Sales revenue
Less: Credit card discounts (a contra-revenue)
Sales discounts (a contra-revenue)
Sales returns and allowances (a contra-revenue)
Net sales (the first line of the income statement)
$6,000
90
20
500
$5,390
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6-12
Exhibit 6.1
Net Sales on the Income Statement
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6-13
Volume Discounts/Rebates and
Earnings Misstatements
In 2016, the SEC found that
Monsanto had materially
misstated company revenue and
earnings by improperly accounting
for volume discounts and rebates
offered to retailers and distributers
of its product Roundup.
Monsanto delayed
recording rebates until
the following year,
overstating net sales
and earnings before
taxes by $44.5 million
and $48 million,
respectively, over two
years
Question of Ethics
$$$
Sales revenue should be
recorded “in the amount
the company expects to be
entitled to receive”. This
rule requires Monsanto to
reduce the amount of
reported net sales by the
expected rebates in the
year of the sale.
Monsanto also improperly
accounted for additional rebates as
expense instead of a reduction in
net sales. This practice overstated
gross profit, an important measure
used by analysts, but did not affect
income before tax.
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6-14
Revenue Recognition for Bundled Goods and Services:
A Five Step Process
Assume Apple sells an iPad for $500, (1) $450 of which relates to the hardware with
essential software and (2) $50 of which relates to future software upgrades that
would be provided over five years.
Step 1: Identify the contract
between the company and the
customer.
Bundled: iPad and related future
upgrade services
Step 2: Identify the performance
obligations (promised goods and
services).
#1 Hardware with essential software
#2 Future software upgrades
Step 3: Determine the transaction
price.
$500 total
Step 4: Allocate the transaction
price to the performance
obligations.
#1 Hardware with software
#2 Future software upgrades
$450
$50
Step 5: Recognize revenue when
each performance obligation is
satisfied (or over time if a service is
provided over time).
#1 Hardware with software
year 1
#2 Future software upgrades
= $10 each year for 5 years
$450 in
$50/5
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6-15
Measuring and Reporting Receivables
Receivables may be classified in three common ways:
Accounts receivable
(created by a credit sale on an
open account)
Trade receivable
(created in the normal course of
business when a credit sale of
merchandise or services occurs)
Current
(short-term)
or
or
or
Notes receivable
(a written promise to pay
principal and interest at one
or more future dates)
Nontrade receivables
(arise from transactions
other than the normal sale
of merchandise or services)
Noncurrent
(long-term)
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6-16
Foreign Currency Receivables
International Perspective
Export (international) sales
are a growing part of the U.S.
economy. Most export sales
to businesses are on credit.
$$$
When a buyer agrees to
pay in its local currency,
the resulting accounts
receivable is denominated
in a foreign currency. This
amount cannot be added
to other U.S. dollar
accounts receivable.
Companies must convert
the amount to U.S. dollars
using the end-of-period
exchange rate between
the two currencies.
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6-17
Learning Objective 6-2
6-2 Estimate, report, and evaluate the effects of uncollectible accounts
receivable (bad debts) on financial statements.
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6-18
Accounting for Bad Debts
Companies keep a separate accounts receivable account for each customer
(called a subsidiary account). The amount on the balance sheet represents
the total of these individual customer accounts.
Bad debts result from credit customers who will not pay the amount they
owe, regardless of collection efforts.
The Expense Recognition Principle requires recording of bad debt expense in
the same accounting period in which the related sales are made.
Problem – Company may not learn which particular customers
will not pay until the next accounting period.
Therefore, companies use the allowance method to measure bad debt
expense. The allowance method is based on estimates of the expected
amount of bad debts with two steps:
1) Make end-of-period adjusting entry to record bad debt expense.
2) Write off specific accounts determined to be uncollectible during the
period.
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6-19
Recording Bad Debt Expense Estimates
An adjusting journal entry at the end of the accounting period records the
bad debt estimate.
Example: Skechers estimated bad debt expense for 2017 to be $18,398 (in
thousands) and made the following adjusting entry:
Contra-asset account
subtracted from the asset
Accounts Receivable on the
balance sheet.
Bad debt expense is the expense
associated with estimated uncollectible
accounts receivable. It is included in the
category “General and Administrative”
expense on the income statement.
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6-20
Writing Off Specific Uncollectible Accounts
Throughout the year, when it is determined that a customer will not pay its
debts (e.g., due to bankruptcy), the write-off of that individual bad debt is
recorded through a journal entry.
Skechers’ total write-offs for 2017 were $8,865.
Notice that this journal entry did not affect any income statement accounts.
It also did not change the net book value of accounts receivable.
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6-21
Bad Debt Recoveries
FINANCIAL ANALYSIS
When a company receives a payment on an account
that has already been written off, the journal entry to
write off the account is reversed to put the receivable
back on the books and then the collection of cash is
recorded.
$$$
For example, if the previously written-off amount was
$677, the following two entries are made:
Note that these entries, like the original write-off, do not affect total
assets or net income. Only the estimate of bad debts affects these
amounts.
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6-22
Summary of the Accounting Process (1 of 2)
Accounting for bad debts is a two-step process.
Step
Timing
Financial
Accounts Affected Statement Effects
1. Record
estimated
bad debts
adjustment
End of period in Bad Debt Expense (E)
which sales are
made
Allowance for Doubtful
Accounts (XA)
Net Income
2. Identify and
write off
actual bad
debts
Throughout
period as bad
debts become
known
Accounts Receivable (A)
Net Income
Allowance for Doubtful
Accounts (XA)
Assets (Accounts
Receivable, Net)
Assets (Accounts
Receivable, Net)
No effect
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6-23
Summary of the Accounting Process (2 of 2)
Accounts Receivable (Gross)(A)
Beginning balance
Sales on account
Ending balance
368,491 Collections on account
4,164,160 Write-offs
4,066,685
8,865
457,101
Allowance for Doubtful Accounts (XA)
Write-offs
8,865
Beginning balance
Bad debt expense
adjustment
Ending balance
41,647
18,398
51,180
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6-24
Exhibit 6.2
Reporting Accounts Receivable and Bad Debts
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6-25
Exhibit 6.3
Accounts Receivable Valuation Schedule (Form 10-K)
Publicly traded companies report the amount of bad debt expense and
accounts receivable written off for the period if the amounts are material.
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6-26
Estimating Bad Debt Expense
The bad debt expense amount recorded in the end-of-period
adjusting entry often is estimated based on either:
(1) A percentage of total credit sales for the period or
(2) An aging of accounts receivable.
Both methods are acceptable under GAAP and are widely used.
The percentage of credit sales method is simpler to apply, but
the aging method is generally more accurate.
Many companies use the simpler method on a weekly or
monthly basis and use the more accurate method on a monthly
or quarterly basis to check the accuracy of the earlier estimates.
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6-27
Estimating Bad Debts—Percentage of Credit Sales Method
The percentage of credit sales method bases bad debt expense on the
historical percentage of credit sales that result in bad debts.
Credit sales
× Bad debt loss rate (1.0%)
Bad debt expense
$1,500,000
× 0.01
$ 15,000
This amount would be directly recorded as Bad Debt Expense (and an increase
in Allowance for Doubtful Accounts) in the current year. Our beginning balance
in the Allowance for Doubtful Accounts for 2018 would be the ending balance
for 2017. Assuming write-offs during 2018 of $17,420, the ending balance is
computed as follows:
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6-28
Estimating Bad Debts—Aging of Accounts Receivable
The Aging method estimates uncollectible accounts based on the age of
each accounts receivable.
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6-29
Estimating Bad Debts—Comparison of the Two Methods
Percentage of credit sales: Directly compute the amount of Bad Debt
Expense on the income statement for the period.
Aging of Accounts Receivable: Compute the estimated ending balance in
the Allowance for Doubtful Accounts on the balance sheet after making
the necessary adjusting entry. The difference between the current balance
in the account and the estimated balance is recorded as the adjusting
entry for Bad Debt Expense.
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6-30
Actual Write-offs Compared with Estimates
If uncollectible accounts actually written off differ from the estimated
amount previously recorded, a higher or lower amount of bad debt
expense is recorded in the next period to make up for the previous
period’s error in estimate.
When estimates are found to be incorrect, financial statement values for
prior annual accounting periods are not corrected.
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6-31
Control over Accounts Receivable
Practices That Can Help Minimize Bad Debts
Require approval of
customers’ credit history
by a person independent
of the sales and
collections functions.
Age accounts
receivable periodically
and contact customers
with overdue
payments.
Reward both sales and
collections personnel
for speedy collections
so they work as a team.
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6-32
Learning Objective 6-3
6-3 Analyze and interpret the receivables turnover ratio and the effects of
accounts receivable on cash flows.
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6-33
Receivables Turnover Ratio
The receivables turnover ratio measures how many
times average trade receivables are recorded and
collected for the year.
KEY RATIO
ANALYSIS
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6-34
Accounts Receivable
FOCUS ON CASH FLOWS
$$$
Add any decrease in
Accounts Receivable
Cash collections
from customers
Sales
Revenue
Subtract any increase in
Accounts Receivable
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6-35
Learning Objective 6-4
6-4 Report, control, and safeguard cash.
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6-36
Cash and Cash Equivalents
Money
Checks
Cash
Money Orders
Bank Drafts
Cash Equivalents
(investments with
original maturities of
3 months or less)
Certificates of Deposit
issued by banks
Treasury Bills issued by
the U.S. government
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6-37
Cash Management
Cash Management Procedures
Accurate accounting so
that reports of cash flows
and balances may be
prepared.
Controls to ensure
that enough cash is
available to meet current
operating needs, maturing
liabilities, and unexpected
emergencies.
Prevention of the
accumulation of excess
amounts of idle cash.
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6-38
Internal Control of Cash
“Internal controls” refers to the process by which a company:
Safeguards its
assets
Provides reasonable assurance regarding:
• The reliability of the company’s financial reporting
• The effectiveness and efficiency of its operations
• Compliance with laws and regulations
Controls are designed to prevent inadvertent errors and outright fraud.
Internal control is reviewed by the outside independent auditor.
Internal control procedures should extend to all assets (cash, receivables,
investments, plant and equipment, and so on) but cash is the asset most
vulnerable to theft and fraud.
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6-39
Effective Internal Control of Cash
Separate jobs of receiving cash and disbursing cash.
Separation
of Duties
Separate procedures of accounting for cash receipts
and cash disbursements.
Separate the physical handling of cash and all phases
of the accounting function.
Require that all cash receipts be deposited in a bank
daily. Keep cash on hand under strict control.
Prescribed Policies
and Procedures
Require separate approval of the purchases and the
actual cash payments.
Assign responsibilities for cash payment approval and
check-signing to different individuals.
Require monthly reconciliation of bank accounts with
the cash accounts on the company’s books.
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6-40
Ethics and the Need for Internal Control
Question of Ethics
All well-run
companies should
have strong internal
control procedures
Convicted
felons stole
from their
employers
because it was
easy and no
one cared.
$$$
Although the vast
majority of employees
are trustworthy,
employee theft costs
businesses billions of
dollars each year.
Many
companies
have a formal
code of ethics
requiring high
standards of
behavior.
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6-41
Exhibit 6.4
Example of a Bank Statement
Electronic Funds
Transfer (EFT)
Interest Earned
(INT)
Not Sufficient
Funds (NSF)
Service Charge
(SC)
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6-42
Need for Reconciliation
A bank reconciliation explains the differences between the ending cash
balance reported on the bank statement and the ending cash balance in
the company’s records. Differences exist for two possible reasons:
1) Transactions affecting cash were recorded on the books of the
company (the accounting records) or the bank statement, but not both.
2) Errors in recording transactions.
Errors by the
Bank or the
Company
Outstanding
Checks
Bank Service
Charges
Deposits in
Transit
Interest
Earned
NSF Checks
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6-43
Bank Reconciliation
A bank reconciliation accomplishes two major objectives:
1. It checks the accuracy of the bank balance and the company cash records,
which involves developing the correct cash balance to be reported on the
balance sheet.
2. It identifies any previously unrecorded transactions or changes that are
necessary to cause the company’s Cash account(s) to show the correct cash
balance. Any transactions or changes on the company’s books side of the
bank reconciliation need journal entries.
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6-44
Bank Reconciliation Illustrated (1 of 3)
General Format of a Bank Reconciliation
Ending cash balance per books
+Interest paid by bank
−NSF check/Service charges
±Company errors
Ending correct cash balance
$xxx
xx
xx
xx
$xxx
Ending cash balance per bank statement
+Deposits in transit
−Outstanding checks
±Bank errors
Ending correct cash balance
$xxx
xx
xx
xx
$xxx
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6-45
Exhibit 6.5
Bank Reconciliation Illustrated (2 of 3)
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6-46
Bank Reconciliation Illustrated (3 of 3)
Any transactions or changes on the company’s books side of the bank
reconciliation need journal entries.
Here are the journal entries necessary for Row.com:
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6-47
Chapter Supplement: Recording Discounts and Returns (1 of 3)
Credit card discounts and cash discounts must be recorded as contrarevenues that reduce reported net sales.
For example, if the credit card company is charging a 3 percent fee for its
service and Skechers’ online credit card sales are $3,000 for January 2,
Skechers will record the following:
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6-48
Chapter Supplement: Recording Discounts and Returns (2 of 3)
If credit sales of $1,000 are recorded with terms 2/10, n/30 record the
following:
Record the payment made within the discount period ($1,000 × 0.98 = $980):
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6-49
Chapter Supplement: Recording Discounts and Returns (3 of 3)
Sales returns and allowances should always be treated as a contra-revenue
that reduces net sales.
Assume that Dick’s Sporting Goods, buys 40 pairs of shoes from Skechers for
$2,000 on account. On the date of sale, Skechers makes the following journal
entry:
Before paying for the shoes, however, Fontana’s discovers that 10 pairs of
shoes are not the color ordered and returns them to Skechers. On that date
Skechers records:
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6-50
chapter
11
Reporting and Interpreting
Stockholders’ Equity
Financial Accounting
10e
Libby • Libby • Hodge
Learning Objectives
After studying this chapter, you should be able to:
11-1
11-2
11-3
11-4
11-5
11-6
11-7
11-8
11-9
Explain the role of stock in the capital structure of a corporation.
Compute and analyze the earnings per share ratio.
Describe the characteristics of common stock and report
common stock transactions.
Discuss and report dividends.
Compute and analyze the dividend yield ratio.
Discuss and report stock dividends and stock splits.
Describe the information reported on the statement of
stockholders’ equity.
Describe the characteristics of preferred stock and report
preferred stock transactions.
Discuss the impact of stock transactions on cash flows.
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11-2
Advantages of a Corporation
The corporate form of business has the primary advantage of ease
of participation in ownership, as compared to a sole proprietorship
or a partnership. Ease of ownership exists in three forms.
+
+
+
Shares of stock may be purchased in small amounts.
Ownership interests can be transferred easily through the
sale of shares on established markets.
Stock ownership provides investors with limited liability.
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11-3
Ownership of a Corporation
Corporations enjoy a continuous existence separate and apart from
its owners. A corporation can . . .
Own assets
Incur liabilities
Sue others and be sued
Expand and contract in size
Enter into contracts
independently of its
owners
Corporations are created by application to a state government (not the
federal government). Corporations are governed by a board of directors
elected by the stockholders.
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11-4
Learning Objective 11-1
11-1
Explain the role of stock in the capital structure of a corporation.
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11-5
Benefits of Stock Ownership
Owners of common stock (known as stockholders or
shareholders) receive a number of benefits:
A voice in management.
Dividends: Proportional share of
the distribution of profits.
Residual claim: Proportional share
of the distribution of remaining assets
upon the liquidation of the company.
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11-6
Authorized, Issued, and Outstanding Shares (1 of 3)
The authorized number of shares is the maximum number of shares
of stock a corporation can issue as specified in its charter.
Issued
shares are
the total
number of
shares sold
to the public.
Unissued
shares are the
shares that
have never
been sold.
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11-7
Authorized, Issued, and Outstanding Shares (2 of 3)
Outstanding
Shares (owned by
stockholders)
Issued
Shares
Unissued
Shares
Treasury Shares
(reacquired by the
corporation)
Authorized number of shares is the
maximum number of shares of stock
a corporation can issue.
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11-8
Authorized, Issued, and Outstanding Shares (3 of 3)
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11-9
Learning Objective 11-2
11-2
Compute and analyze the earnings per share ratio.
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11-10
Earnings per Share (EPS) (1 of 2)
KEY RATIO ANALYSIS
EPS =
Net Income*
Weighted Average Number of Common
Shares Outstanding
$$$
* Preferred dividends, if any, should be subtracted from net income.
Companies are required to report EPS on their income statements.
IBM’s income for 2017 was $5,753 million, and the average number of
shares outstanding was 932.8 million.
EPS =
$5,753 million
932,828,295 shares
=
$6.17 per share
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11-11
Earnings per Share (EPS) (2 of 2)
KEY RATIO ANALYSIS
$$$
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11-12
Learning Objective 11-3
11-3
Describe the characteristics of common stock and report
common stock transactions.
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11-13
Common Stock Transactions (1 of 2)
Common stock is held by investors who are the owners of a corporation.
Stockholders have the right to:
• Vote
• Share in profits of the business
• Elect the board of directors who hire and monitor the executives who
manage a company’s activities on a day-to-day basis
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11-14
Common Stock Transactions (2 of 2)
Par value is the nominal value per share, established in the
corporate charter.*
Par Value
Market Value
Legal capital is the amount of capital, required by the state,
that must remain invested in the business.
*Some states do not require a par value to be
stated in the charter.
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11-15
Initial Sale of Stock
An initial public offering, or IPO, involves the very first sale of a company’s
stock to the public (i.e., when the company first “goes public”).
Additional sales of new stock to the public are called seasoned offerings.
Assume IBM sold 100,000 shares of its $0.20 par value common stock for
$150 per share. The company would record the following journal entry:
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11-16
Sale of Stock in Secondary Markets
• When a company sells stock to the public, the transaction is
between the issuing corporation and the investor.
• Subsequent to the initial sale, investors can sell shares to other
investors without directly affecting the corporation.
• The corporation is not a part of the transaction and therefore
does not receive or pay anything.
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11-17
Stock Issued for Employee Compensation
• Managers may be offered stock options, a common form of
compensation, which permit them to buy stock at a fixed price.
• Options specify that shares may be bought at the then-current
market price.
• If the stock price increases, you can exercise your option at the low
grant price and sell the stock at the higher price for a profit.
• If you hold a stock option and the stock price declines, you have
lost nothing. They are a risk-free investment.
• Companies must estimate and report compensation expense
associated with stock options.
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11-18
Repurchase of Stock
• A corporation repurchase its stock from existing stockholders for a number
of reasons:
• When employee bonus plans provide workers with shares of
company’s stock, the company can give employees repurchased shares
rather than issue new ones.
• If a company were to pay bonuses with newly issued shares each
period, it would increase the number of shares in the market,
which would decrease the company’s stock price.
• Increasing the number of shares also would dilute existing
stockholders’ investments, as each share of stock they own would
be worth less.
• By repurchasing shares to fulfill bonus obligations, companies
avoid this dilutive effect.
• Stock that has been repurchased and is held by the issuing corporation is
called treasury stock.
• Treasury shares have no voting, dividend, or other stockholder rights while
they are held as treasury stock.
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11-19
Repurchase and Reissuance of Stock (1 of 2)
IBM reacquired 100,000 shares of its
common stock when it was selling for $140 per share.
Treasury Stock is a contra-equity account, not an asset!
IBM reissued 10,000 shares
of treasury stock at $150 per share.
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11-20
Repurchase and Reissuance of Stock (2 of 2)
IBM reissued 10,000 shares
of treasury stock at $130 per share.
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11-21
Learning Objective 11-4
11-4
Discuss and report dividends.
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11-22
Dividends on Common Stock
•
The return from investing in a company’s common stock can come from
two sources: stock price appreciation and dividends.
•
Some investors prefer to buy stocks that pay little or no dividends.
•
•
Companies that reinvest the majority of their earnings back into
their operations tend to increase their future earnings potential
and their stock price.
•
Wealthy investors in high tax brackets prefer to receive their return
in the form of higher stock prices because capital gains may be
taxed at a lower rate than dividend income.
Other investors, such as retired people who need a steady income,
prefer to receive their return in the form of dividends.
•
•
Retirees seek stocks that will pay relatively high dividends, such as
utility stocks.
Analysts compute the dividend yield ratio to evaluate a company’s
dividend policy.
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11-23
Key Dividend Dates
Date of Declaration: Date on which the board of directors approves the
dividend. Assume IBM declared a $1,387 million dividend on 10/31.
Date of Record: Stockholders who own shares on this date will receive the
dividend. (No journal entry)
Date of Payment: The date the cash is disbursed to stockholders.
Note: The corporation must have sufficient retained earnings and
cash to cover the amount of the dividend.
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11-24
Learning Objective 11-5
11-5
Compute and analyze the dividend yield ratio.
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11-25
Dividend Yield
KEY RATIO ANALYSIS
Dividend
Yield
=
$$$
Dividends per Share
Market Price per Share
In 2017, IBM paid a dividend of $5.90 per share, and the
market price of a share of IBM stock was $153.42.
Dividend
=
Yield
$5.90 per share
$153.42 per share
= 3.85%
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11-26
Impact of Dividends on Stock Price
FINANCIAL ANALYSIS
• The ex-dividend date is the date two days before
the date of record. This date is established by the
stock exchanges to account for the fact that it
takes time (typically three days) to officially
transfer stock from a seller to a buyer.
$$$
• If someone buys stock before the ex-dividend date, they will be
listed as the owner and receive the dividend. If someone buys
stock on or after the ex-dividend date, the previous owner will be
listed as the owner of the dividend.
• Stock prices often fall on the ex-dividend date since the stock no
longer includes the right to receive the next dividend.
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11-27
Learning Objective 11-6
11-6
Discuss and report stock dividends and stock splits.
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11-28
Nature of Stock Dividends (1 of 2)
• Stock dividends represent a distribution of additional shares of
stock to shareholders.
• Stock is distributed pro rata; stockholders retain the same
percentage ownership after stock dividends are distributed.
• A stock dividend has no economic value!
• Stock dividends do not change the stock’s par value or total
stockholders’ equity.
• The stock market reacts immediately when a stock dividend is
issued.
• The stock price falls.
• The lower market price may make the stock more attractive
to new investors.
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11-29
Nature of Stock Dividends (2 of 2)
Small
Large
Stock dividend < 20–25%
Stock dividend > 20–25%
Record at current market value
of stock.
Record at par value
of stock.
The entry for a stock dividend is a transfer from the Retained
Earnings account to the Common Stock account (and Additional
Paid-in Capital account for small stock dividends).
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11-30
Stock Dividends
Large Stock Dividend: Assume IBM issued 50 million shares of its $0.20 par
value stock. On the date of declaration the following journal entry is made:
Small Stock Dividend: Assume IBM issued 5 million shares of its $0.20 par
value stock when it was trading for $150 per share.
On the date of declaration the following journal entry is made:
NOTE: Regardless of whether a stock dividend is classified as large or
small, there is no change in the total amount of stockholders’ equity
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11-31
Stock Splits
Unlike stock dividends, companies do not make journal entries to record
stock splits. Stock splits change the par value per share, but the total par
value is unchanged. Assume that a corporation had 3,000 shares of $2
par value common stock outstanding before a two-for-one stock split.
Before
Split
Common Stock Shares
After Split
3,000
6,000
Increase
Par Value per Share
$
0.02
$
0.01
Decrease
Total Par Value
$
60
$
60
No Change
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11-32
Learning Objective 11-7
11-7
Describe the information reported on the statement of
stockholders’ equity.
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11-33
Exhibit 11.2
Excerpt from Statement of Shareholders’ Equity for IBM
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11-34
Learning Objective 11-8
11-8
Describe the characteristics of preferred stock and report
preferred stock transactions.
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11-35
Preferred Stock Transactions
Less risky because of
preference over common
stock
Typically does not have
voting rights
Typically has a fixed
dividend rate
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11-36
What’s in a Name?
International
Perspective
U.S. GAAP and IFRS use different
words to describe the same
stockholders’ equity accounts.
IBM (U.S.) GAAP
Common stock
Additional paid-in capital
ASOS (UK) IFRS
=
=
Share capital
Share premium
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11-37
Dividends on Preferred Stock (1 of 2)
Preferred stock offers a dividend preference:
Current dividend preference: Requires a company to pay current
dividends to preferred stockholders before paying dividends to common
stockholders. After this is met then dividends can be paid to common
stockholders.
Cumulative dividend preference: Requires any unpaid dividends on
preferred stock to accumulate. This amount, called dividends in arrears,
must be paid before common dividends are paid.
If preferred stock is noncumulative, any dividends not declared in previous
years are permanently lost and will never be paid.
Note: Dividends in arrears are disclosed in the notes to the financial
statements. They are not a liability until the board of directors declares
them.
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11-38
Dividends on Preferred Stock (2 of 2)
Wally Company has the following stock outstanding:
Preferred stock: 6%, $20 par value, 2,000 shares outstanding. Assume
current dividend preference
Common stock: $10 par value, 5,000 shares outstanding
(1) If Wally issues a $3,000 current dividend, the dividends would be
allocated as follows:
Preferred: $20 par value × 6% × 2,000 shares = $2,400
Common: $3,000 − $2,400 = $600
(2) If Wally issues a $30,000 dividend and the dividends were in arrears
for two years (assume cumulative dividend preference) the allocation
would be as follows:
Preferred: $2,400 current + ($2,400 in arrears × 2 years) = $7,200
Common: $30,000 − $7,200 = $22,800
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11-39
Preferred Stock and Limited Voting Rights
FINANCIAL ANALYSIS
Although not typical, some preferred stock has
special voting rights. For example, the excerpt below
is from Public Storage’s 2017 Annual Report:
$$$
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11-40
Learning Objective 11-9
11-9
Discuss the impact of stock transactions on cash flows.
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11-41
Financing Activities
FOCUS ON CASH FLOWS
Transactions involving stock have a direct impact on
the capital structure of a business. The cash inflows
and outflows associated with these transactions are
reported in the Financing Activities section of the
statement of cash flows.
$$$
Effect on Cash Flows
Financing activities
Issuance of common or preferred stock
Purchase of treasury stock
Sale of treasury stock
Payment of cash dividends
+
—
+
—
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11-42
Chapter Supplement: Accounting for the Equity of Sole
Proprietorships
Owners’ Equity for a Sole Proprietorship
A sole proprietorship is an unincorporated
business owned by one person.
Two equity accounts
Capital account
Drawing (or withdrawal) account
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11-43
Exhibit 11.4: Accounting for Owner’s Equity for a Sole
Proprietorship (1 of 2)
Hans Solo started an aviation business by investing $150,000 of
personal savings. The journal entry to record this business formation is:
Each month, Hans Solo withdrew $1,000 cash from the business
for personal living expenses.
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11-44
Exhibit 11.4: Accounting for Owner’s Equity for a Sole
Proprietorship (2 of 2)
At the end of Year 1, $418,000 of revenues and $400,000
of expenses were closed to the owner’s capital account as follows:
The drawing account was closed as follows:
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11-45
Exhibit 11.4
Accounting for Owner’s Equity for a Sole Proprietorship
HANS SOLO AVIATION
Statement of Owner’s Equity
For the Year Ended December 31, Year 1
Owner’s Equity
Hans Solo, capital, January 1, Year 1
Add: Additional investments during Year 1
Add: Net income for Year 1
Total
Less: Drawings for Year 1
Hans Solo, capital, December 31, Year 1
$
0
150,000
18,000
168,000
(12,000)
$156,000
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11-46
Owners’ Equity for a Partnership (1 of 3)
❑ A partnership is owned by two or more individuals. The partnership
agreement specifies the division of income, management
responsibilities, transfer or sale of partnership interests, disposition of
assets upon liquidation, and procedures to be followed in case of the
death of a partner.
❑ Separate capital and drawing accounts are maintained for each partner.
❑ Partnership income is divided among the partners according to the
partnership agreement.
❑ Advantages of a partnership include:
• Ease of formation
• Complete control by partners
• No income taxes on business itself
❑ The primary disadvantage of a partnership is unlimited liability of each
partner for the partnership’s debts.
❑ Partners must report their share of the partnership profits on their
individual tax returns.
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11-47
Owners’ Equity for a Partnership (2 of 3)
Hannah and Bob formed a partnership. Hannah contributed $60,000 cash.
Bob contributed $40,000 cash. The partners agreed to divide partnership
income in the ratio of their contributions (60:40).
The journal entry to record this business formation is:
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11-48
Owners’ Equity for a Partnership (3 of 3)
The partners agreed that each month, Hannah would withdraw
$1,000 and Bob would withdraw $650. The monthly
journal entry to record the withdrawal is:
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11-49
Exhibit 11.5
Accounting for Owners’ Equity for a Partnership
A separate statement of owners’ equity, similar to the following, is
customarily prepared to supplement the balance sheet:
MIRROR IMAGE PARTNERS
Statement of Owners’ Equity
For the Year Ended December 31, Year 1
Hannah
Investment, January 1, Year 1
Add: Additional investments during Year 1
Add: Net income for Year 1
Totals
Less: Drawings during Year 1
Owners’ equity, December 31, Year 1
$
Bob
0 $
0
60,000 40,000
18,000 12,000
78,000 52,000
(12,000) (7,800)
$66,000 $44,200
Total
$
0
100,000
30,000
130,000
(19,800)
$110,200
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11-50
chapter
7
Reporting and Interpreting Cost
of Goods Sold and Inventory
Financial Accounting
10e
Libby • Libby • Hodge
Learning Objectives
After studying this chapter, you should be able to:
7-1 Apply the cost principle to identify the amounts that should be
included in inventory and the cost of goods sold for typical retailers,
wholesalers, and manufacturers.
7-2 Report inventory and cost of goods sold using the four inventory
costing methods.
7-3 Decide when the use of different inventory costing methods is
beneficial to a company.
7-4 Report inventory at the lower of cost or net realizable value.
7-5 Evaluate inventory management using the inventory turnover ratio.
7-6 Compare companies that use different inventory costing methods.
7-7 Understand methods for controlling inventory, analyze the effects of
inventory errors on financial statements, and analyze the effects of
inventory on cash flows.
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7-2
Understanding the Business
Primary Goals of
Inventory
Management
To have sufficient
quantities of highquality inventory
available to serve
customers’ needs
To minimize the costs of
carrying inventory
(production, storage,
obsolescence, and
financing)
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7-3
Exhibit 7.1
Income Statement and Balance Sheet Excerpts
HARLEY-DAVIDSON, INC.
Consolidated Statements of Income
(In thousands)*
Years Ended December 31, 2017
2016
Net Sales
Cost of Goods Sold
Gross Profit
$5,647,224
3,261,683
$2,385,541
$5,996,458
3,419,710
$2,576,748
2015
$5,995,402
3,356,284
$2,639,118
HARLEY-DAVIDSON, INC.
Consolidated Balance Sheets
(In thousands)*
2017
Assets
Current Assets
Cash and cash equivalents
Marketable securities
Accounts receivable, net
Finance receivables, net
Inventories
Other current assets
Total current assets
$ 687,521
329,986
2,105,662
538,202
223,371
$3,884,742
2016
$ 759,984
5,519
285,106
2,076,261
499,917
227,065
$3,853,852
* Harley-Davidson’s statements have been simplified for purposes of our discussion.
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7-4
Learning Objective 7-1
7-1 Apply the cost principle to identify the amounts that should be
included in inventory and the cost of goods sold for typical retailers,
wholesalers, and manufacturers.
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7-5
Items Included in Inventory
Merchandisers
Manufacturers
Merchandise
Inventory
Raw
Materials
Inventory
Work in
Process
Inventory
Finished
Goods
Inventory
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7-6
Costs Included in Inventory Purchases
Inventory is initially recorded at cost.
Inventory cost includes the costs to bring an article to
usable or salable condition and location.
+ Invoice price
+ Freight-In (freight charges to deliver items to company warehouse)
+ Inspection costs
+ Preparation costs
– Purchase returns and allowances
– Purchase discounts
= Total inventory cost
Company should cease accumulating purchase costs when the
raw materials are ready for use or when the merchandise
inventory is ready for shipment.
Costs related to selling the inventory should be included in
selling, general, and administrative expenses.
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7-7
Applying the Materiality Constraint in Practice
FINANCIAL ANALYSIS
Incidental costs, such as inspection and preparation
costs, do not have to be assigned to the inventory cost
if they are not material. Therefore, many companies
record inspection and preparation costs as an expense.
$$$
Most companies report inventory cost as:
Invoice Price
Less Returns
Less Discounts
Total Inventory Cost
XX
– XX
– XX
XX
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7-8
Exhibit 7.2
Flow of Inventory Costs
STAGE 1: PURCHASING/
PRODUCTION ACTIVITIES
A. MERCHANDISER
STAGE 3: SALESTAGE 2: ADDITIONS TO INVENTORY
COST
OF GOODS SOLD
ON THE BALANCE SHEET
ON INCOME STATEMENT
Merchandise
purchased
Cost of
goods sold
Merchandise
inventory
B. MANUFACTURER
Raw
materials
purchased
Raw
materials
inventory
Work in
process
inventory
Finished
goods
inventory
Cost of
goods sold
Direct
labor
incurred
Factory
overhead
incurred
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7-9
Exhibit 7.3 (1 of 2)
Cost of Goods Sold for Merchandise Inventory
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7-10
Exhibit 7.3 (2 of 2)
Calculating Cost of Goods Sold
+
–
Beginning inventory
Purchases of merchandise during the year
Goods available for sale
Ending inventory
Cost of goods sold
Cost of goods sold equation: BI + P − EI = CGS
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7-11
Perpetual and Periodic Inventory Systems
The amount of cost of goods sold and ending inventory can be determined
by using one of two different inventory systems: perpetual or periodic.
Perpetual
Periodic
Purchase transactions are
recorded directly in an
inventory account.
No up-to-date record of
inventory is maintained
during the year.
Sales require two entries to
record: (1) the sale and (2)
the cost of goods sold.
Sales require one entry to
record the sale. Cost of
goods sold is calculated at
the end of each period.
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7-12
Learning Objective 7-2
7-2 Report inventory and cost of goods sold using the four inventory
costing methods.
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7-13
Inventory Costing Methods
Total Dollar Amount of Goods Available
for Sale
Inventory Costing
Method
Ending Inventory
1.
2.
3.
4.
Cost of Goods Sold
Inventory Costing Methods
Specific identification
First-in, first-out (FIFO)
Last-in, first-out (LIFO)
Average cost
The four inventory costing methods are alternative ways to
assign the total dollar amount of goods available for sale
between ending inventory and cost of goods sold.
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7-14
Cost Flow Assumptions
The choice of an inventory costing method is not based on the
physical flow of goods on and off the shelves.
That is why they are called cost flow assumptions.
FIFO
LIFO
Average Cost
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7-15
Inventory example
Assume that a Harley-Davidson dealer had the indicated inventory on hand
and transactions during January as follows:
Jan. 1
Jan. 12
Jan. 14
Jan. 15
Had beginning inventory of two units of a Model A leather jacket
at $70 each.
Purchased four units of the Model A leather jacket at $80 each.
Purchased one unit of the Model A leather jacket at $100.
Sold four units of the Model A leather jacket for $120 each.
Note: Three units remain in ending inventory at the end of the period
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7-16
Exhibit 7.4
FIFO Inventory Flows
A. FIFO
Step 2: Sell
Merchandise
Step 1: Purchase
Merchandise
Units
purchased
$100
$100
Purchases
$420
Beginning
inventory
$140
$80
$80
$80
$80
$70
$70
$80
Ending
inventory
$260
$80
Goods
available
for sale
$560
Units
sold
$80
$80
$70
$70
Cost of
goods sold
$300
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7-17
First-In, First-Out Method (1 of 2)
This chart provides
information about
purchases for the Model A
leather jacket inventory for
Harley-Davidson. We will
use these data throughout
our inventory examples so
we can compare our results
at the end.
Additional Information:
✓During the period, Harley-Davidson sold four units
✓Three units remain in ending inventory at the end of the period
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7-18
First-In, First-Out Method (2 of 2)
Cost of Goods Sold Calculation (FIFO)
(2 units at $70 each)
Beginning inventory
(4 units at $80 each)
+ Purchases
(1 unit at $100)
Goods available for sale
(2 units at $80 each and 1 unit at $100)
− Ending inventory
(2 units at $70 each and 2 units at $80
Cost of goods sold
each)
$140
320
100
560
260
$300
Cost of Goods Available for Sale
$560
Ending Inventory
$260
Cost of Goods Sold
$300
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7-19
Exhibit 7.4
LIFO Inventory Flows
B. LIFO
Step 1: Purchase Merchandise
Step 2: Sell Merchandise
Units
purchased
$100
$80
$100
Purchases
$420
Beginning
inventory
$140
$80
$80
$80
$80
$70
$70
Cost of
goods sold
$340
$80
$80
Goods
available
for sale
$560
Units
sold
Ending
inventory
$220
$80
$70
$70
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7-20
Last-In, First-Out Method (1 of 2)
This chart provides
information about
purchases for the Model A
leather jacket inventory for
Harley-Davidson. We will
use these data throughout
our inventory examples so
we can compare our results
at the end.
Additional Information:
✓During the period, Harley-Davidson sold four units
✓Three units remain in ending inventory at the end of the period
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7-21
Last-In, First-Out Method (2 of 2)
Cost of Goods Sold Calculation (LIFO)
(2 units at $70 each)
$140
Beginning inventory
(4 units at $80 each)
320
+ Purchases
(1 unit at $100)
100
560
Goods available for sale
(2 units at $70 each and 1 unit at $80)
220
− Ending inventory
(3 units at $80 each and 1 unit at $100) $340
Cost of goods sold
Cost of Goods Available for Sale
$560
Ending Inventory
$220
Cost of Goods Sold
$340
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7-22
Average Cost Method (1 of 2)
This chart provides
information about
purchases for the Model A
leather jacket inventory for
Harley-Davidson. We will
use these data throughout
our inventory examples so
we can compare our results
at the end.
Additional Information:
✓During the period, Harley-Davidson sold four units
✓Three units remain in ending inventory at the end of the period
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7-23
Average Cost Method (2 of 2)
Cost of Goods Sold Calculation (Average Cost)
Beginning inventory
(2 units at $70 each)
+ Purchases
(4 units at $80 each)
(1 unit at $100)
Goods available for sale (7 units at $80 average cost each)
− Ending inventory
(3 units at $80 average cost each)
Cost of goods sold
(4 units at $80 average cost each)
$140
320
100
560
240
$320
Cost of Goods Available for Sale
$560
Ending Inventory
$240
Cost of Goods Sold
$320
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7-24
Perpetual Inventory Systems and Cost Flow Assumptions in
Practice
FIFO inventory and cost of goods sold are the same
whether computed on a perpetual or periodic basis.
Accounting systems that keep track of the costs of individual items
normally do so on a FIFO or average cost basis, regardless of the
cost flow assumption used for financial reporting.
As a consequence, companies that wish to report under LIFO
convert the outputs of their perpetual inventory system to
LIFO with an adjusting entry at the end of each period.
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7-25
LIFO and International Comparisons
International
Perspective
While U.S. GAAP allows companies to choose among FIFO,
LIFO, and weighted average inventory methods,
International Financial Reporting Standards (IFRS) currently
prohibit the use of LIFO.
GAAP also allows different
inventory accounting methods to
be used for different types of
inventory items.
IFRS requires that the same method
be used for all inventory items that
have a similar nature and use.
These differences can create comparability problems when one attempts to
compare companies across international borders.
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7-26
Exhibit 7.5 (1 of 2)
Financial Statement Effects of Inventory Costing Methods
FIFO
LIFO
Effect on the Income Statement
$480
Sales
300
Cost of goods sold
180
Gross profit
80
Other expenses
100
Income before income taxes
25
Income tax expense (25%)
$ 75
Net income
$480
340
140
80
60
15
$ 45
$480
320
160
80
80
20
$ 60
Effect on the Balance Sheet
Inventory
$220
$240
$260
Average Cost
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7-27
Exhibit 7.5 (2 of 2)
Financial Statement Effects of Inventory Costing Methods
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7-28
Learning Objective 7-3
7-3 Decide when the use of different inventory costing methods is
beneficial to a company.
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7-29
Managers’ Choice of Inventory Methods (1 of 2)
What motivates companies to choose different inventory costing methods?
Most managers choose accounting methods based on two factors:
Net Income Effects
Managers prefer to
report higher
earnings for their
companies.
Income Tax Effects
Managers prefer to
pay the least
amount of taxes
allowed by law as
late as possible.
Any conflict between the two motives is normally resolved
by choosing one accounting method for external financial
statements and a different method for preparing tax returns.
HOWEVER: If last-in, first-out is used to compute taxable
income, it must also be used to calculate inventory and cost
of goods sold for financial statements. This is called the
LIFO Conformity Rule.
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7-30
Managers’ Choice of Inventory Methods (2 of 2)
Increasing Cost Inventories
LIFO is used on the tax
return because it normally
results in lower income taxes
For inventory located in
countries that do not allow
LIFO for tax purposes, or do
not have a LIFO conformity
rule, companies most often
use FIFO or average cost to
report higher income on the
income statement
Decreasing Cost Inventories
FIFO is most often used for
both the tax return and
financial statements. FIFO
produces the lowest tax
payments for companies
with decreasing cost
inventories.
REMINDER: Regardless of the physical flow of goods, a company can use
any of the inventory costing methods. Also, companies are not required to
use the same costing method for all inventory items. However, they must
apply the accounting method consistently from year to year.
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7-31
LIFO and Conflicts between
Managers’ and Owners’ Interests
QUESTION OF ETHICS
The selection of an inventory method can have significant
effects on the financial statements. Company managers
may have an incentive to select a method that is not
consistent with the owners’ objectives.
$$$
For example, during a period of rising prices, using LIFO
may be in the best interest of the owners (reduce tax
liability), however managers may prefer FIFO (typically
higher profits) if their compensation is tied to profits.
A well designed
compensation plan
should reward
managers for acting
in the best interest
of the owners.
A manager who selects an
accounting method that is
not optimal for the company
solely to increase his or her
compensation is engaging in
questionable ethical
behavior.
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7-32
Learning Objective 7-4
7-4 Report inventory at the lower of cost or net realizable value.
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7-33
Valuation at Lower of Cost or Net Realizable Value
Inventories should be measured initially at their purchase cost. When the
net realizable value of goods in ending inventory falls below cost, these
goods must be assigned a unit cost equal to their net realizable value.
This rule is known as measuring inventories at the lower of cost or net
realizable value (lower of cost or market).
Net realizable value (NRV) = sales price less costs to sell
Lower of Cost or Net Realizable Value is based on the
conservatism constraint, which requires companies to avoid
overstating assets and income.
This is particularly important for two types of companies:
1) High-technology companies
2) Companies that sell seasonal goods
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7-34
Net Realizable Value
Under lower of cost or net realizable value, companies recognize a
“holding” loss in the period in which the net realizable value of an item
drops below original cost, rather than recording the loss in the period
the item is sold.
If the net realizable value of the inventory is lower than original cost,
the company would make a “write-down” entry to reduce the
inventory balance to net realizable value.
No write-down is necessary if the net realizable value is higher than the
original cost. Recognition of holding gains on inventory is not permitted
by GAAP
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7-35
Valuation at Lower of Cost or Net Realizable Value
Assume that HP had the following items in the current period ending
inventory:
The 1,000 Intel chips should be recorded in the ending inventory at the
current net realizable value ($200) because it is lower than the cost ($250).
HP makes the following journal entry to record the write-down:
Because the net realizable value of the disk drives ($110) is higher than the
original cost ($100), no write-down is necessary. The drives remain on the
books at their cost of $100 per unit ($40,000 in total).
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7-36
Effects of Lower of Cost or NRV Write-Down
The write-down of the Intel chips to market produces the following
effects on the income statement and balance sheet:
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7-37
Learning Objective 7-5
7-5 Evaluate inventory management using the inventory turnover ratio.
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7-38
Inventory Turnover
How efficient are inventory
management activities?
KEY RATIO ANALYSIS
Cost of Goods Sold
Inventory Turnover =
Average Inventory
$$$
Average Inventory is
(Beginning Inventory + Ending Inventory) ÷ 2
The ratio reflects how many times average inventory was
produced and sold during the period. A higher ratio indicates that
inventory moves more quickly through the production process to
the customer, thus reducing storage and obsolescence costs.
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7-39
Average Days to Sell Inventory
KEY RATIO ANALYSIS
Average Days to Sell Inventory =
365
Inventory Turnover
$$$
This ratio reflects the average time in days it takes a
company to produce and deliver inventory to its customers.
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7-40
Exhibit 7.6
Financial Statement Effects of Inventory Costing Methods
HARLEY-DAVIDSON, INC.
Notes to Consolidated Financial Statements
2. ADDITIONAL BALANCE SHEET AND CASH FLOWS INFORMATION
Inventories, net (In thousands)
December 31,
2017
Inventories:
…
Inventory at FIFO
Excess of FIFO over LIFO cost
Inventory at LIFO
2016
HARLEY-DAVIDSON, INC.
REAL WORLD EXCERPT:
Annual Report
$590,557
(52,355)
$538,202
$548,184
(48,267)
$499,917
LIFO reserve
Inventory reported
on the balance sheet
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7-41
LIFO and Inventory Turnover Ratio
FINANCIAL ANALYSIS
Consider Deere & Co., manufacturer of John Deere farm,
lawn, and construction equipment.
$$$
Its inventory note lists the following values:
DEERE & COMPANY
Notes to Consolidated Financial Statements
(dollars in millions)
2017
2016
Inventories:
Total FIFO value
Adjustment to LIFO basis
Inventories
$5,365
1,461
$3,904
$4,798
1,457
$3,341
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7-42
LIFO and Inventory Turnover
FINANCIAL ANALYSIS
John Deere’s cost of goods sold for 2017 was $19,933.5
million. If the ratio were computed using the reported LIFO
inventory values for the ratio, it would be
Inventory Turnover Ratio =
$19,933.5
$$$
= 5.5
($3,904 + $3,341)/2
Converting cost of goods sold (the numerator) to a FIFO basis and using the
more current FIFO inventory values in the denominator, it would be
Inventory Turnover Ratio =
$19,933.5 – 4
($5,365 + $4,798)/2
= 3.9
Note that the major difference between the two ratios is in the denominator.
FIFO inventory values are roughly 40 percent higher than the LIFO values. The
LIFO beginning and ending inventory numbers are artificially small because
they reflect older lower costs.
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7-43
Learning Objective 7-7
7-7 Understand methods for controlling inventory, analyze the effects of
inventory errors on financial statements, and analyze the effects of
inventory on cash flows.
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7-44
Internal Control of Inventory
Separation of
responsibilities for
inventory accounting and
physical handling of
inventory.
Storage of inventory in a
manner that protects it
from theft and damage.
Maintaining perpetual
inventory records.
Comparing perpetual
inventory records to
periodic physical counts of
inventory.
Limiting access to
inventory to authorized
employees.
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7-45
Errors in Measuring Ending Inventory
You can compute the effects of inventory errors on both the current
year’s and the next year’s income before taxes using the cost of goods
sold equation.
Assume that ending inventory was overstated by $10,000 due to a
clerical error that was not discovered. This would effect the current
year and next year.
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7-46
chapter
8
Reporting and Interpreting
Property, Plant, and Equipment;
Intangibles; and Natural
Resources
Financial Accounting
10e
Libby • Libby • Hodge
Learning Objective 8-1
8-1 Define, classify, and explain the nature of long-lived productive
assets and interpret the fixed asset turnover ratio.
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8-2
2
Classifying Long-Lived Assets
Tangible
Intangible
Physical
Substance
No Physical
Substance
◼
Land
◼
Buildings, fixtures, and equipment
◼
Natural resources
▪ Patents
▪ Copyrights
▪ Franchises
▪ Licenses
▪ Trademarks
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8-3
3
Exhibit 8.1
Southwest Airline’s Asset Section of the Balance Sheet
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8-4
4
Fixed Asset Turnover
KEY RATIO ANALYSIS
Fixed Asset
Turnover
=
Net Sales (or Operating Revenues)
Average Net Fixed Assets
$$$
This ratio measures the sales dollars generated
by each dollar of fixed assets used.
A high rate suggests effective management.
The 2017 ratio for Southwest is (dollars in millions):
Operating Revenues $21,171
($17,044 + $18,539) ÷ 2
= 1.19 times
COMPARISONS OVER TIME
Southwest Airlines
COMPARISONS WITH COMPETITORS
Delta
United Continental Holdings
2017
1.19
2017
1.62
2016
1.25
2015
1.33
2017
1.64
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8-5
5
Learning Objective 8-2
8-2 Apply the cost principle to measure the acquisition and
maintenance of property, plant, and equipment.
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8-6
6
Measuring and Recording Acquisition Cost (2 of 3)
Acquisition for Cash – Southwest Airlines paid cash for the aircraft and
transportation and preparation costs.
Debit
Flight equipment (+A)
Credit
120
Cash (-A)
120
Acquisition for Debt – Southwest Airlines signed a note payable for the aircraft
and paid cash for the transportation and preparation costs.
Debit
Flight equipment (+A)
Cash (-A)
Note Payable (+L)
Credit
120
2
118
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8-7
7
Repairs, Maintenance, and Improvements (1 of 3)
Type of
Expenditure
Identifying Characteristics
1. Maintains the productive capacity of the asset
Ordinary
during the current acounting period only
repairs and 2. Recurring in nature
maintenance 3. Involve small amounts
4. Do not increase the productive life, operating
efficiency, or capacity of the asset
1. Increase the productive life, operating efficiency,
Improvements or capacity of the asset
2. Occur infrequently
3. Involve large amounts of money
Accounting
Treatment
Expense
in the
period
incurred
Add to
asset
account
(Capitalize)
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8-8
8
Repairs, Maintenance, and Improvements (2 of 3)
To avoid spending too much time classifying additions and improvements
and repair expenses, some companies record all expenditures below a
certain dollar amount as expenses.
Such policies are acceptable because immaterial amounts will not affect
users’ decisions when analyzing financial statements.
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8-9
9
Repairs, Maintenance, and Improvements (3 of 3)
Southwest paid $1 billion for aircraft maintenance and repairs. This amount
was reported as an expense on its income statement.
Debit
Maintenance and repairs expense (+E, -SE)
Credit
1,000
Cash (-A)
1.000
Southwest spent $300 million to modify the exterior of its aircraft to
reduce fuel consumption, resulting in 9 percent greater fuel efficiency and
lower operating costs. These expenditures would have been recorded by
Southwest, as capital expenditures:
Debit
Flight equipment (+A)
Cash (-A)
Credit
300
300
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8-10
10
WorldCom: Hiding Billions in Expenses through
Capitalization
FINANCIAL ANALYSIS
• When expenditures that should be recorded as
current period expenses are improperly capitalized as
part of the cost of the asset, the effects on the
financial statements can be enormous.
$$$
• In one of the largest accounting frauds in history, WorldCom (now
part of Verizon) inflated its income and cash flows from operations
by billions of dollars. This fraud turned WorldCom’s actual losses into
large profits.
• Over five quarters in 2001 and 2002, the company initially announced
that it had capitalized $3.8 billion that should have been recorded as
operating expenses. By early 2004, auditors had discovered $74.4
billion in necessary restatements (reductions to previously reported
pretax income) for 2000 and 2001.
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8-11
11
Learning Objective 8-3
8-3 Apply various cost allocation methods as assets are held and used
over time.
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8-12
12
Depreciation Concepts (1 of 2)
Depreciation is the process of allocating the cost
of buildings and equipment over their productive lives
using a systematic and rational method.
Balance Sheet
Acquisition Cost
Income Statement
Cost Allocation
(Unused)
Depreciation
Expense
Accumulated
Depreciation
Expense
(Used)
Depreciation
(current year)
Total depreciation
(to date)
Income
Statement
Balance
Sheet
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8-13
13
Key Depreciation Concepts
❖ Depreciation is a process of cost allocation, not a process of
determining market value.
❖ The remaining balance sheet amount probably does not represent
the asset’s current market value.
❖ The undepreciated cost is not measured on a market or fair value
basis.
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8-14
14
Adjusting for Depreciation
An adjusting journal entry is needed at the end of each
period to reflect the use of buildings and equipment for
the period.
Debit
Depreciation expense (+E, -SE)
x,xxx
Accumulated depreciation (+XA, -A)
Cost
– Accumulated Depreciation
Net Book Value
Credit
x,xxx
XX
– XX
XX
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8-15
15
Book Value as an Approximation of
Remaining Life
FINANCIAL ANALYSIS
Some analysts compare the book value of assets to their
original cost as an approximation of their remaining life.
Example:
❑ If book value of an asset is 100 percent of its cost,
it is a new asset.
❑ If book value of an asset is 25 percent of its cost, it
only has around 25 percent of its life remaining.
$$$
Book Value as a Percentage of Original Cost
Southwest
United Continental
66%
69%
JetBlue
75%
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8-16
16
Depreciation Concepts (2 of 2)
To calculate depreciation expense, three pieces of information
are required for each asset:
Acquisition cost
Estimated useful life
Estimated residual (or salvage) value at the end of the
assets’ useful life
Alternative depreciation methods:
Straight-line
Units-of-production
Declining-balance
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8-17
17
Exhibit 8.2
Data for Illustrating the Computation of Depreciation
SOUTHWEST AIRLINES CO.
Acquisition of a New Service Vehicle
Cost, purchased on January 1, 2019
Estimated residual value
Estimated useful life
Actual miles driven in:
$62,500
$ 2,500
3 Years OR 100,000 miles
Year 2019
30,000 miles
Year 2020
50,000 miles
Year 2021
20,000 miles
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8-18
18
Straight-Line Method (1 of 2)
Notice that:
❖ Depreciation expense is a constant amount
each year.
❖ Accumulated depreciation increases by an
equal amount each year.
❖ Net book value decreases by the same
amount each year until it equals the
estimated residual value.
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8-19
19
Straight-Line Method (2 of 2)
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8-20
20
Units-of-Production Method (1 of 2)
Southwest purchased ground equipment for $62,500 cash. The
equipment has an estimated useful life of 100,000 miles and an estimated
residual value of $2,500.
If the equipment is used 30,000 miles in the first year, what is the amount
of depreciation expense?
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8-21
21
Units-of-Production Method (2 of 2)
Note – the ending Net Book
Value is equal to the
estimated residual value at
the end of the useful life
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8-22
22
Double Declining-Balance Method (1 of 2)
At the beginning of the year, Southwest purchased equipment for
$62,500 cash. The equipment has an estimated useful life of three
years and an estimated residual value of $2,500.
Note – Accumulated Depreciation
increases over time
Annual computation ignores residual value.
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8-23
23
Double Declining-Balance Method (2 of 2)
Depreciation expense is limited to the amount that
reduces book value to the estimated residual value.
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8-24
24
Summary of the three depreciation methods
Method
Formula
Deprecation Expense
Straight-line
(Cost − Residual
Value) × 1/Useful Life
Equal amounts each
year
[(Cost − Residual
Value)/Estimated
Total Production] ×
Annual Production
Varying amounts
based on production
level
Units-of-production
Double-decliningbalance
(Cost − Accumulated
Depreciation) ×
2/Useful Life
Declining amounts
over time
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8-25
25
Impact of Alternative Depreciation Methods
FINANCIAL ANALYSIS
• Accelerated depreciation methods report higher
depreciation and, therefore, lower net income during
the early years of an asset’s life. As the age of the asset
increases, this effect reverses.
$$$
• The graph shown
illustrates the
relationship
between the
double-decliningbalance method
and the straightline method of
depreciation.
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