ACCOUNTING FINAL EXAM STUDY GUIDE:

Chapter 6:

Net Sales Revenue:

1. Revenue recognition:
a. For sellers of goods and services, sales revenue is recorded when the title and
risk of ownership transfer to the buyer
b. The point at which the transfer occurs is determined by:
i. FOB Destination: Title changes hands on delivery
ii. FOB Shipping point: Title changes hands at the shipping date
iii. FOB: Free on board
2. Credit Card sales:
a. Retailers accept credit cards:
i. To increase consumer traffic
ii. To avoid costs of providing credit directly to customers
iii. To lower risks due to bad checks
iv. To avoid losses due to fraudulent credit card sales
v. To receive payment quicker
b. When credit card sales are made, the company must pay the credit card
company a fee for the service it provides: Credit card discount fee
i. Sales Revenue
ii. Less: Credit Card discounts
iii. Net Sales (reported on the income statement)
3. Sales discounts to businesses:
a. Companies often sell to other businesses on an open account
b. Companies may offer a sales discount as an early payment incentive
c. Early payment incentive
i. D/P,n/M
ii. D = Discount percentage
iii. P = Number of days in discount period
iv. n = Net (Total sales revenue less returns)
v. M = Maximum credit period
d. 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
e. Annual interest rate = (Days in a year/P)*(D/(100-D))
f. As long as the bank’s interest rate is less than the annual interest rate the
customer will save by taking the cash discount
4. Sales Returns and Allowances:
a. Customers have a right to return unsatisfactory or damaged merchandise and
receive a refund or an adjustment to their bill.
 b. These returns are accumulated in a separate account called Sales Returns and
Allowances
i. Sales Revenue
ii. Less: Sales returns and allowances
iii. Net sales (reported on the income statement)
c. Cost of goods sold related to the returned sale would also be reduced
5. Measuring and Reporting Receivables:
a. Receivables may be classified in three common ways
i. Accounts receivable or Notes receivable
1. Accounts receivable: Created by credit sale on an open account
2. Notes receivable: a written promise to pay principal and interest
at one or more future dates
ii. Trade receivable or Nontrade receivable
1. Trade receivable: created in the normal course of business when a
credit sale of merchandise or service occurs
2. Nontrade receivable: arise from transactions other than the
normal sale of merchandise or services
iii. Current or Noncurrent
1. Current: short-term
2. Noncurrent: Long-term
6. Accounting for Bad debts
a. 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
b. Bad debts result from credit customers who will not pay the amount they owe,
regardless of collection efforts
c. The expense recognition principle requires recording of bad debt expense in the
same accounting period in which the related sales are made
i. Problem: company may not learn which particular customers will not pay
until the next accounting period
d. Therefore, companies use the allowance method to measure bad expense. The
allowance method is based on estimates of the expected amount of bad debts
with two steps:
i. Make end-of-period adjusting entry to record bad debt expense
ii. Write off specific accounts determined to be uncollectible during the
period
7. Recording Bad Debt Expenses
a. An adjusting entry at the end of the accounting period records the bad debt
estimate
i. Bad Debt Expense (DEBIT) (+E, -SE)
ii. Allowance for doubtful accounts (CREDIT) (+XA, -A)
b. Contra-asset account subtracted from the assent account receivable on the
balance sheet
 c. 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.
8. Writing off Specific Uncollectible Accounts
a. 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
i. Allowance for doubtful accounts (DEBIT) (-XA, +A)
ii. Accounts receivable (CREDIT) (-A)
b. Notice that this journal entry did not affect any income statemen accounts. It
also did not change the net book value of accounts receivable
9. Bad Debt Recoveries
a. 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.
i. Accounts receivable (DEBIT) (+A)
ii. Allowance for doubtful accounts (CREDIT) (+XA, -A)
iii. Cash (DEBIT) (+A)
iv. Accounts receivable CREDIT (-A)
b. Note that these entries, like the original write-off, do not affect the total assets
or net income. Only the estimate of bad debts affects these amounts.
10. Estimating Bad Debt Expense
a. The bad debt expense amount recorded in the end-of-period adjusting entry
often is estimated based on either:
i. A percentage of total credit sales for the period
ii. An aging of accounts receivable
b. Both methods are acceptable under GAAP and are widely used
c. The percentage of credit sales method is simpler to apply, but the aging method
is generally more accurate.
d. 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 earlier estimates
11. Estimating Bad Debts – Percentage of Credit Sales Method:
a. The percentage of credit sales method bases bad debt expense on the historical
percentage of credit sales that result in bad debts
i. Credit Sales 1,500,000
ii. Bad Debt loss rate (1.0%)
iii. Bad Debt Expense 15,000
12. Estimating Dab Debts – Aging of Accounts Receivable:
a. The aging method estimates uncollectible accounts based on the age of each
accounts receivable
b. These values are estimated percentages of uncollectible accounts
13. Estimating Bad Debts – Comparison of the two methods
 a. Percentage of credit sales: Directly compute the amount of bad debt expense on
the income statement for the period
b. 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
14. Actual Write-offs Compared with Estimates:
a. If the 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
b. When estimates are found to be incorrect, financial statement values for prior
annual accounting periods are not corrected
15. Control over the accounts receivable
a. Practices that can help minimize bad debts
i. Require approval of customers’ credit history by a person independent of
the sales and collections functions
ii. Age accounts receivable periodically and contact customers with overdue
payments
iii. Rewards both sales and collections personnel for speedy collections so
they work as a team
16. Receivables Turnover Ratio
a. The receivable turnover ratio measures how many times average trade
receivables are recorded and collected for the year
b. Receivable turnover = Net Sales/ Average Net Trade Accounts Receivables
17. Accounts Receivable
a. Sales Revenue
i. Add any decrease in Accounts Receivable
ii. Subtract any increase in accounts receivable
b. Cash collections from customers
18. Cash and Cash Equivalents
a. Cash
i. Money
ii. Money Orders
iii. Checks
iv. Bank drafts
b. Cash equivalents
i. Certificates of deposit issued by banks
ii. Treasury Bills issued by the US Government
19. Cash Management
a. Cash management procedures
i. Accurate accounting so that reports of cash flows and balances may be
prepared
 ii. Controls to ensure that enough cash is available to meet current
operating needs, maturing liabilities, and unexpected emergencies
iii. Prevention of the accumulation of excess amounts of idle cash
20. Internal Control of Cash
a. Internal controls refers to the process by which a company:
i. Safeguards its assets
1. Provides reasonable assurance regarding:
a. The reliability of the company’s financial reporting
b. The effectiveness and efficiency of its operations
c. Compliance with laws and regulations
b. Controls are designed to prevent inadvertent errors and outright fraud internal
control is reviewed by the outside independent auditor
c. 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.
21. Effective Internal Control of Cash
a. Separation of duties
i. Separate jobs of receiving cash and disbursing cash
ii. Separate procedures for accounting for cash receipts and cash
disbursements
iii. Separate the physical handling of cash and all phases of the accounting
function
b. Prescribed Policies and Procedures
i. Require that all cash receipts be deposited in a bank daily. Keep cash on
hand under strict control
ii. Require separate approval of the purchases and the actual cash
payments
iii. Assign responsibilities for cash payment approval and check-signing to
different individuals
iv. Require monthly reconciliation of bank accounts with the cash accounts
on the company’s books
22. Chapter supplement: Recording Discounts and Returns
a. Credit card discounts and cash discounts must be recorded as contra-revenues
that reduce reported net sales
b. For example, if the credit card company is charging a 3 percent fee for its service
and Skechers’ online credit card sales are $3000 for January 2, Skechers will
record the following
i. Cash (+A) DEBIT 2910
ii. Credit Card Discount (+XR, -R, -SE) DEBIT 90
iii. Sales Revenue (+R, +SE) CREDIT 3000
c. If the credit sales of $1000 are recorded with terms 2/10,n/30, record the
following
i. Accounts receivable (+A) DEBIT 1000
ii. Sales revenue (+R, +SE) CREDIT 1000
 Record the payment made within the discount period (1000 * 0.98 = 980)
iii. Cash (+A) DEBIT 980
iv. Sales discounts (+XR, -R, -SE) DEBIT 20
v. Accounts receivable (-A) CREDIT 1000
d. Sales returns and allowances should always be treated as contra-revenue that
reduces net sales
e. Assume that Dick’s Sporting Goods, buys 40 pairs of shoes from Skechers for
$2000 on accounts. On the date of sale, Skechers makes the following journal
entry
i. Accounts Receivable (+A) DEBIT 2000
ii. Sales revenue (+R, +SE) CREDIT 2000
f. Before paying for the shows, however, Fontana’s discovers that 10 pairs of does
are not the color ordered and returns them to Skechers. On that date Skechers
records
i. Sales returns and allowances (+XR, -R, -SE) DEBIT 500
ii. Accounts Receivable (-A) CREDIT 500
Chapter 7:

1. Costs included in inventory:

a. Inventory is initially recorded at cost
b. Inventory cost includes the costs to bring an article to usable or salable condition
and location
c. TOTAL INVENTORY COST = INVOICE PRICE + FREIGHT-IN + INSPECTION COSTS +
PREPARATION COSTS – PURCHASE RETURNS AND ALLOWANCES – PURCHASE
DISCOUNTS
d. Company should cease accumulating purchase costs when the raw materials are
ready for use or when the merchandise inventory is ready for shipment
e. Costs related to selling the inventory should be included in selling, general, and
administrative expenses
2. Applying the materiality constraint in practice
a. 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
i. Most companies report inventory cost as:
1. Invoice Price
2. Less Returns
3. Less Discounts
4. = Total Inventory Costs
3. Calculating costs of goods sold
a. Beginning inventory + purchases of merchandise during the year = Goods
available for sale
b. Goods available for sale – ending inventory = costs of goods sold
c. COGS = BI + P – EI
4. Perpetual and Periodic inventory systems
a. Perpetual
i. Purchase transactions are recorded directly in an inventory account
ii. Sales require two entries to record
1. The sale
2. The cost of goods sold
b. Periodic
i. No up-to-date record of inventory is maintained during the year
ii. Sales require one entry to record the sale
iii. Cost of goods sold is calculated at the end of each period
5. Inventory Costing methods
a. Specific Identification
b. First-in, first-out (FIFO)
c. Last-in, first-out (LIFO)
d. Average Cost
 e. 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
6. Cash Flow Assumptions
a. The choice of an inventory costing method is not based on the physical flow of
goods on and off the shelves
b. That is why they are called cost flow assumptions
i. FIFO
ii. LIFO
iii. Average Cost
7. FIFO Inventory flows
a. Step1: Purchase merchandise
i. Beginning inventory + purchases = goods available for sale
b. Step 2: Sell Merchandise
i. Goods available for sale – ending inventory = COGS
ii. Ending inventory – units sold = COGS
8. LIFO Inventory Flows
a. Step 1: Purchase Merchandise
i. Beginning inventory + purchases = goods available for sale
b. Step 2: Sell merchandise
i. Goods available for sale – ending inventory = COGS
ii. Ending inventory + units sold = COGS
9. Average Cost Method
a. Take the average cost of the units purchased and beginning inventory
i. E.g. BI 2 units at 70; Purchases 4 units at 80 and 1 unit at 100
ii. Gods available for sale = 7 Weighted average cost = (2*70 + 4*80 +
1*100)/7 = (140+320+100)/7 = 560/7 = 80
iii. Ending inventory = 3
iv. COGS = 560 – 3*80 = 560 – 240 = 320 (4 units at 80)
10. Perpetual inventory systems and Cost Flow Assumptions in Practice
a. FIFO inventory and cost of goods sold are the same whether computed on a
perpetual or periodic basis
b. 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
c. 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
11. Manager’s choice of inventory methods
a. What motivates companies to choose different inventory costing methods? Most
managers choose accounting methods based on two factors:
i. Net Income Effects: Managers prefer to report higher earnings for their
companies
 ii. Income tax Effects: Managers prefer to pay the least amount of taxes
allowed by law as late as possible.
b. 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, firs-out is used to compute taxable
income, it must be used to calculate inventory and cost of goods sold for
financial statements. This is called the LIFO conformity rule
c. Increasing cost inventories
i. LIFO is used on the tax return because it normally results in lower income
taxes
ii. 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
d. Decreasing cost Inventories
i. FIFO is most often used for both the tax return and financial statements.
ii. FIFO produces the lowest tax payments for companies with decreasing
cost inventories
e. 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.
12. LIFO and Conflicts between Manager’s and Owner’s interests
a. 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 owner’s objectives
b. A well-designed compensation plan should reward managers for acting in the
best interest of the owners
c. 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
13. Valuation at Lower Cost or Net Recognizable Value
a. Inventories should be measured initially at their purchase cost. When the net
recognizable value of goods in ending inventory falls below cost, these goods
must be assigned a unit cost equal to their net recognizable value
b. This rule is known as measuring inventories at the lower of cost or net
recognizable value (lower of cost or market)
c. Net recognizable value (NRV) = sales price less costs to sell
d. Lower of cost or net recognizable value is based on the conservatism constraint,
which requires companies to avoid overstating assets and income
e. This is particularly important for two types of companies:
i. High-technology companies
ii. Companies that sell seasonal goods
14. Net recognizable value
 a. Under lower of cost or net recognizable 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
b. If the net recognizable value of the inventory is lower than the original cost, the
company would make a “write-down” entry to reduce the inventory balance to
net realizable value
c. 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
15. Valuation at lower cost or net realizable value
a. COGS DEBIT (+E,-SE)
b. Inventory CREDIT (-A)
16. Effects of lower of cost or NRV write-down
a. COGS Increase in current period; Decrease if sold in the next period
b. Pretax income Decrease in current period by same value; increase by same value
if sold in the next period
c. Ending Inventory on balance sheet Decrease in the current period; Unaffected if
sold in the next period
17. Inventory turnover
a. Inventory turnover = COGS/Average Inventory
i. Average inventory = (Beginning inventory + Ending Inventory)/2
b. 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
18. Average Days to sell inventory
a. Average days to sell inventory = 365/Inventory turnover
b. This ratio reflects the average time in days it takes a company to produce and
deliver inventory to its customers
19. Internal Control of inventory
a. Separation of responsibilities for inventory accounting and physical handling of
inventory
b. Storage of inventory in a manner that protects it from theft and damage
c. Limiting access to inventory to authorized employees
d. Maintaining perpetual inventory records
e. Comparing perpetual inventory records to periodic physical counts of inventory
20. Inventory and Cash Flows
a. Net income
i. Add any:
1. Decrease in inventory
2. Increase in accounts payable
ii. Subtract any:
1. Increase in inventory
2. Decrease in accounts payable
b. Giving Cash flow from operations
Chapter 8
1. Classifying long-lived assets
a. Tangible: Physical substance
i. Land
ii. Buildings, fixtures, and equipment
iii. Natural resources
b. Intangible: No physical substance
i. Patents
ii. Copyrights
iii. Franchises
iv. Licenses
v. Trademarks
2. Fixed Asset Turnover
a. Fixed asset turnover = Net sales (or operating revenues)/Average net fixed assets
b. This ratio measures the sales dollars generated by each dollar of fixed assets
used. A high rate suggests effective management
3. Measuring and Recording Acquisition Cost
a. Acquisition cost includes the purchase price and all expenditures needed to
prepare the asset for its intended use. This does not include financing charges
associated with the purchase
b. Acquisition costs
i. Purchase price
ii. Sales taxes
iii. Legal Fees
iv. Transportation costs
v. Installation and preparation costs
c. Note we say that the expenditures are capitalized when they are recorded as an
asset
d. Acquisition for cash
i. Factor DEBIT (+A)
ii. Cash CREDIT (-A)
e. Acquisition for debt
i. Factor DEBIT (+A)
ii. Cash CREDIT (-A)
iii. Notes Payable CREDIT(+L)
f. Acquisition for Equity
i. Factor DEBIT (+A)
ii. Common Stock CREDIT (+SE)
iii. Additional Paid-in capital CREDIT (+SE)
iv. Cash CREDIT (-A)
g. Acquisition by construction
i. Asset cost includes:
1. Building
a. All materials and labor traceable to the construction
 b. A reasonable amount of overhead
c. Interest on debt incurred during the construction
ii. Building DEBIT (+A)
iii. Cash CREDIT (-A)
4. Repairs, Maintenance, and Improvements
a. Type of expenditure
i. Ordinary repairs and maintenance
1. Maintains the productive capacity of the asset during the current
accounting period only
2. Recurring in nature
3. Involves small amounts
4. Do not increase in the productive life, operating efficiency, or
capacity of the asset
5. ACCOUNTING TREATMENT: Expense in the period incurred
ii. Improvements
1. Increase the productive life, operating efficiency, or capacity of
the asset
2. Occur infrequently
3. Involve large amounts of money
4. ACCOUNTING TREATMENT: Add to asset account (capitalize)
b. Capitalize:
i. Balance sheet account debited
ii. Expense is deferred
iii. Current income will be higher
iv. Current taxes will be higher
c. Expense:
i. Income statement account debited
ii. Expense is currently recognized
iii. Current income will be lower
iv. Current taxes will be lower
d. 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
e. Such policies are acceptable because immaterial amounts will not affect user’s
decisions when analyzing financial statements
f. Record the journal entry as shown:
i. Maintenance and repairs expense DEBIT (+E, -SE)
ii. Cash CREDIT (-A)
5. Depreciation Concepts
a. Depreciation is the process of allocating the cost of buildings and equipment
over their productive lives using a systematic and rational method
b. Balance sheet
i. Acquisition cost (unused)
ii. Accumulated depreciation
 c. Income statement
i. Expense (used)
ii. Depreciation expense
d. Depreciation is a process of cost allocation, not a process of determining market
value
e. The remaining balance sheet amount probably does not represent the asset’s
current market value
f. The undepreciated cost is not measured on a market or fair value basis
g. To calculate depreciation expense, three pieces of information are required for
each asset:
i. Acquisition cost
ii. Estimated useful life
iii. Estimated residual (or salvage) value at the end of the assets’ useful life
h. Alternative depreciation methods:
i. Straight-line
ii. Units-of-production
iii. Declining-balance
6. Adjusting for depreciation
a. Depreciation expense DEBIT (+E, -SE)
b. Accumulated depreciation CREDIT (+XA, -A)
c. Cost – Accumulated depreciation = Net book value
7. Book value as an approximation of remaining life
a. Some analysts compare the book value of assets to their original cost as an
approximation of their remaining life
8. Straight-line method:
a. Straight line formula
i. (Cost – residual value) x 1/useful life = depreciation expense
b. Notice that
i. Depreciation expense is a constant amount each year
ii. Accumulated depreciation increases by an equal amount each year
iii. Net book value decreases by the same amount each year until it equals
the estimated residual value
9. Units-of-production Method:
a. [(Cost – residual value)/estimated total production] x actual production =
depreciation expense
10. Declining-balance method: An accelerated depreciation method:
a. If an asset is more efficient or productive when it is newer, managers might
choose the declining-balance depreciation method to match a higher
depreciation expense with higher revenues in the early years of an asset’s life
and a lower depreciation expense with lower revenues in the later years
b. Early years
i. Depreciation expense will be higher
ii. Revenues will be higher
c. Later years
 i. Depreciation expense will be low
ii. Revenues will be lower
11. Double declining-balance method:
a. (Cost – accumulated depreciation) x 2/useful life = depreciation expense
12. How managers choose
a. Financial reporting
i. Managers determine which depreciation method provides the best
matching of revenues and expenses
ii. Choose the straight-line method (the most common and easy to use) if
the asset provides benefits evenly over time. During the early years of an
asset’s life, the straight-line method reports higher income than the
accelerated methods do
iii. Choose an accelerated method if assets produce more revenue in their
early lives
b. Tax reporting (IRC)
i. When given a choice managers will apply the least and latest rule. All
taxpayers want to pay the lowest amount of tax that is legally permitted
and at the latest possible date
13. Measuring asset impairment
a. An asset’s book value is impaired when the asset is not expected to generate
sufficient cash flows (probably future benefits) at least equal to its book value
b. Step 1: Test for impairment:
i. Impairment occurs when events or changed circumstances cause the
estimated future cash flows (future benefits) of these assets to fall below
their book value
ii. If net book value > estimated future cash flows, then the asset is
impaired
c. Step 2: Computation of impairment loss:
i. For any asset considered to be impaired, companies recognize a loss for
the difference between the asset’s book value and its fair value (a market
concept). The asset is written down to fair value
ii. Impairment loss = net book value – fair value
14. Asset Impairment Illustration
a. Loss due to impairment DEBIT (E, -SE)
b. Factor CREDIT (-A)
15. Disposal of property, plant, and equipment
a. Update depreciation expense through the date of disposal
b. Record disposal by:
i. Recording cash received (debit) or paid (credit)
1. Writing off accumulated depreciation (debit)
ii. Recording a gain (credit) or loss (debit)
1. Writing off the asset cost (credit)
c. Recording the journal entry for depreciation
i. Depreciation expense DEBIT (+E, -SE)
 ii. Accumulated depreciation CREDIT (+XA, -A)
d. Recording the journal entry for sale of equipment
i. Cash DEBIT (+A)
ii. Accumulated Depreciation DEBIT (-XA, +A)
iii. Factor paid for CREDIT (-A)
iv. Gain on sale of assets CREDIT (+R, +SE)
v. Loss on sale of assets DEBIT (+L)
e. Nature of Intangible assets
i. Noncurrent assets without physical substance
ii. Has value because of certain rights and privileges conferred by law
iii. Usually evidenced by a legal document
iv. Most common types of intangible assets:
1. Goodwill (recognized in a business merger or acquisition)
2. Trademarks
3. Copyrights
4. Technology (computer software and website)
5. Patents
6. Franchises
7. Licenses and operating rights
8. Other (customer lists/relationships, noncompete covenants,
contracts and agreements)
v. Intangible assets are recorded at historical cost only if they have been
purchased. If these assets are developed internally by the company, they
are expensed when incurred.
16. Amortization of Intangible Assets
a. Upon acquisition of intangible assets, managers, determine whether they have
definite or indefinite lives:
i. Definite life
1. Amortized over the shorter of the asset’s economic life or legal
life
2. Straight-line method used
3. Most companies do not estimate a residual value
ii. Indefinite life
1. Not amortized
2. Reviewed at least annually for possible impairment of value. If
impaired, the carrying value is reduced to fair market value
17. Common Intangibles
a. Goodwill
i. Only recorded as an asset when one company buys another business
ii. Equals the purchase price of the company less the fair market value of
net assets (assets minus liabilities)
iii. Not amortized but reviewed annually for impairment
b. Trademarks
i. A special name, image or slogan identified with a product or company
 ii. Rarely seen on balance sheets because they are only recorded if
purchased
c. Copyrights
i. The exclusive right to publish, use, and sell a literary, musical, or artistic
work
ii. Legal life is the life of the creator plus 70 years
d. Technology
i. Website development: capitalize costs of acquiring a domain name and
developing graphics
ii. Software: capitalize the direct costs of developing software (coding and
testing) after the software is technologically feasible. Costs incurred
during the preliminary concept phase should be expensed. Amortize as a
general expense or as cost of goods sold if the software is to be sold to
the customers
e. Patents:
i. Exclusive right granted by the federal government for 20 years for
inventions and new processes
ii. Owner can use, manufacture, and sell both the subject of the patent and
the patent itself
iii. Only registration fees and legal costs are capitalized if developed
internally. Research and development costs are expensed
f. Franchises
i. Rights granted by the government or a company to provide a product or
service
ii. The investment made by the franchisee is accounted for as an intangible
asset
iii. The investment made by the franchisee is accounted for as an intangible
asset
iv. The life of the franchise agreement depends on the contract and can be
for a single year or indefinite period
g. Licenses and operating rights
i. These intangible assets are permissions to use a product or service
according to specific terms and conditions
18. Changes in depreciation estimates
a. Depreciation is based on two estimates
i. Estimated useful life
ii. Estimated residual value
b. If the estimates change, then the undepreciated asset balance (less any residual
value at the date of the change) should be depreciated over the remaining useful
life
c. If improvements are made that extend the assets useful life, the depreciation
must also be recalculated
d. To compute the new depreciation expense due to a change in estimate,
substitute the net book value for the original acquisition cost, the new residual
value for the original amount, and the estimated remaining life in place of the
original estimated life
Chapter 9:
1. Liabilities defined and classified
a. Defined as the probable future sacrifice of economic benefits that arise from
past transactions
b. Current liabilities: to be paid with current assets
i. Maturity = 1 year or less
c. Long-term liabilities
i. Maturity > 1 year
d. Liabilities are recorded at their current cash equivalent, which is the cash
amount a creditor would accept to settle the liability immediately
2. Current Liabilities
a. Operating activity  Current liabilities
i. Purchase inventory  accounts payable
ii. Purchase or rent land  Accrued rent (in accrued liabilities)
iii. Wages  Accrued wages (include in accrued liabilities)
iv. Payment that haven’t been made yet but to be paid by customers 
Deferred revenue (reported as “stored value card liability)
b. Accounts payable
i. Also called trade accounts payable
ii. Obligations to pay for goods and services used in the basic operating
activities of the business
c. Accrued liabilities
i. Also called accrued expenses
ii. Obligations related to expenses that have been incurred but have not
been paid at the end of the accounting period
d. Deferred revenues
i. Also called unearned revenues
ii. Obligations arising when cash is received prior to the related revenue
being earned
e. Notes payable
i. Obligations supported by a formal written contract
3. Payroll taxes
a. Gross payroll
i. Less
1. Employee portion of FICA tax (social security & medicare)
2. Federal income tax withheld
3. State and local income taxes withheld
b. = Net payroll paid to employees
c. Employers also pay FICA taxes and are charged unemployment taxes through the
Federal Unemployment Tax Act (FUTA) and State Unemployment Tax Acts
(SUTA)
4. Deferred Revenues
a. Deferred revenues are reported as a liability because cash has been collected but
the related revenue has not been earned by the end of the accounting period
5. Accounts payable turnover
a. Accounts payable turnover = COGS/Average accounts payable
b. Measures how quickly management is paying its suppliers
c. A high accounts payable turnover ratio normally suggests that a company is
paying its suppliers in a timely manner
d. Average days to pay payables = 365 / Accounts payable turnover ratio
6. Notes Payable
a. A note payable is a formal written contract that specifies:
i. The amount borrowed
ii. The repayment date
iii. The annual interest rate associated with the borrowing
b. To the lender, interest is a revenue
c. To the borrower, interest is an expense
d. Interest = Principal x Annual Interest rate x number of months/12
e. Interest is an expense incurred when companies borrow money
f. Companies record interest expense for a given accounting period, regardless of
when they actually pay the bank cash for interest
g. A journal entry is to be recorded as:
i. Cash DEBIT (+A)
ii. Notes Payable CREDIT (+L)

iii. Interest expense DEBIT (+E, -SE)

iv. Interest payable CREDIT (+L)

v. Interest payable DEBIT (-L)

vi. Cash CREDIT (-A)
7. Current portion of long-term debt
a. To provide accurate information on how much of its long-term debt is due in the
current year, a company must reclassify its long-term debt as a current liability
within a year of its maturity date
8. Contingent liabilities
a. A contingent liability is a potential liability that has arisen as the result of a past
event; it is not a definitive liability until some future event occurs
b. The probabilities of occurrence are defined in the following manner:
i. Probable – the future event or events are likely to occur
ii. Reasonably probably – the chance of the future event or events occurring
is more than remote but less than likely
iii. Remote – the chance of the future event or events occurring is slight
9. Working Capital Management
a. A company has liquidity if it has the ability to pay current obligations. Liquidity is
measured using the current ratio and the dollar amount of working capital
b. Working Capital = Current assets – current liabilities
i. Working capital has a significant impact on the health and profitability of
the company
 c. Changes in working capital accounts are important to managers and analysts
because they have a direct impact on the cash flows from operating activities
reported on the statement of cash flows
10. Long-term Liabilities
a. Long-term liabilities include all obligations not classified as current liabilities,
such as long-term notes payable and bonds payable
b. Secured debt: when creditors require the borrower to pledge specific assets as
security for long-term liabilities
c. Unsecured debt: when the lender relies on the borrower’s integrity and general
earning power to repay the loan
11. Long-term notes payable and bonds
a. Companies can raise capital from a number of financial service organizations in a
private placement (notes payable)
i. Banks
ii. Insurance companies
iii. Pension plans
b. If a company needs more capital than any single creditor can provide, the
company may issue publicly traded bonds to the public (bonds payable)
12. Lease liabilities
a. Companies often lease assets rather than purchase them
b. When a company leases as an asset, it enters into a contractual agreement with
the owner of the asset
c. For accounting purposes, a lessee can lease an asset by signing either a short-
term lease(12 months or less) or a long-term lease
i. Longer-term leases are more common and are classified as either finance
leases or operating leases depending on whether effective control of the
leased asset remains with the lessor or is transferred to the lease
d. Lessor: party that owns the asset
e. Lessee: Party that pays for the right to use the asset
f. We focus on accounting for leases from the lessee’s perspective
13. Classifying longer-term lease as finance lease or an operating lease
a. Classify as Finance Lease if lease meets any of the finance lease criteria. Effective
control has been transferred to the lessee
b. Classify as Operating Lease if none of the finance lease criteria are met. Lessor
maintains effective control of the asset
c. Finance lease criteria
i. The lease transfers ownership of the underlying asset to the lessee by the
end of the lease term
ii. The lease grants the lessee an option to purchase the underlying asset
that the lessee is reasonably certain to exercise
iii. The lease term is for the major part of the remaining economic life of the
underlying asset
 iv. The present value of the sum of the lease payments and any residual
value guaranteed by the lessee… equals or exceeds substantially all of the
fair value of the underlying asset
v. The underlying asset is of such a specialized nature that it is expected to
have no alternative use to the lessor at the end of the lease term
14. Accounting for leases differs depending on whether the lease is a short term or long
term lease
a. Long term leases (both Finance and Operating)
i. Require recognition of a lease asset and lease liability
ii. Amount recognized is the current cash equivalent of the required future
lease payments
iii. More details discussed in advanced accounting courses
iv. Journal Entry
1. Lease Asset DEBIT (+A)
2. Lease liability CREDIT (+L)
b. Short term leases
i. No lease asset or liability is recorded
ii. Lessee records lease expense over the life of the lease
iii. Journal entry
1. Lease Expense DEBIT (+E, -SE)
2. Cash CREDIT (-A)
15. Present value concepts: The value of money can grow over time because money can
earn interest
16. Future value of a single amount
a. Finding the future value using the present value
17. Present value of a single amount
a. Finding the present value using the future value
18. Present value of an annuity
a. An annuity is a series of consecutive payments
i. An equal dollar amount each period
ii. Interest periods of equal length
iii. The same interest rate each period
19. Accounting Applications of present values
a. Starbucks bought new delivery truck by signing a note and agreeing to pay
$200000 Dec. 31, 2020
b. This note is a “non-interest bearing-note” because no interest payments are
required over the life of the note. The interest is built into the final payment
c. Assume that the market value rate applicable to the note is 12%
i. Future value = $200000
ii. PV of $1 (i=12%, n=2) = 0.79719
iii. Present value = 200000 * 0.79719 = 159438
d. Record the purchase of the delivery trucks
i. Delivery trucks DEBIT (+A) 159438
ii. Note Payable CREDIT (+L) 159438
 e. At the end of each year, record the implied interest expense
i. Interest expense = 159438 * 12% = 19133
ii. Interest Expense DEBIT (+E, -SE) 19133
iii. Note payable CREDIT (+L) 19133
f. For both years,
i. Interest expense = (159438+19133) * 12% = 21429
ii. Interest expense DEBIT (+E, -SE) 21429
iii. Note Payable CREDIT (+L) 21429
g. Therefore
i. Initial loan balance = 159438
ii. Interest added 12/31/2019 = 19133
iii. Interest added 12/31/2020 = 21429
iv. Loan balance at the end of loan = 200000
h. Journal entry
i. Note Payable DEBIT (-L) 200000
ii. Cash CREDIT (-A) 200000
20. Computing the amount of a liability with an annuity
a. Starbucks purchased equipment with a note payable to be paid off in three end-
of-year payments of $163,685. Each payment includes principal plus interest on
any unpaid balance. The annual interest rate is 11%.
b. Annuity payment = 163685; i=11%; n=3
c. Using PVA of $1, PVA of 163685 with interest at 11% after 3 years
i. = 163686 * 2.44371 = $399,999
d. Recording the purchase of the espresso machines:
i. Espresso Machines DEBIT (+A) 399,999
ii. Note Payable CREDIT (+L) 399,999
e. Calculate interest expense for the first year
i. 399,999 note payable balance * 11% = 44,000 interest expense
ii. Journal entry for the first year
1. Note Payable DEBIT (-L) 119685
2. Interest expense DEBIT (+E, -SE) 44000
3. Cash CREDIT (-A) 163685
iii. The remaining balance after recording this entry is 280314
f. Calculate the interest expense for the second year
i. 280314 note payable balance * 11% annual interest rate = 30835
ii. Journal entry for second year
1. Note Payable DEBIT (-L) 132850
2. Interest expense (+E, -SE) 30835
3. Cash CREDIT (-A) 163685
iii. The remaining balance after recording this entry is 147464
g. Calculate the interest expense for the third year
i. 147464 note payable balance * 11% annual interest rate = 16221
ii. Journal entry for third year
1. Note Payable DEBIT (-L) 147464
 2. Interest expense DEBIT (+E, -SE) 16221
3. Cash CREDIT (-A) 163685
21. Present values involving both an annuity and a single payment
a. Starbucks bought new coffee roasting equipment and agreed to pay the supplier
$1000 per month for 20 months and an additional $40000 at the end of the 20
months. The supplier charges 12% interest per year or 1% per month
b. Step 1: Compute the present value of the annuity. The factor is 18.04555 given
that i=1% and n=20
i. 1000 * 18.04555 = 18046
c. Step 2: Compute the present value of the single payment. The factor is 0.89154
given i=1% and n=20
i. 40000 * 0.89154 = 32782
d. Add the two amounts to determine the present value of the total obligation
i. 18046 + 32782 = 50828
Chapter 10
1. Characteristics of bonds payable: Reasons why companies issue bonds
a. Advantages of bonds
i. Stockholders maintain control because bondholders do not vote or share
in any dividend payments
ii. A portion of interest expense is tax deductible which reduces the cost of
borrowing
iii. The return to shareholders can be positive if money is borrowed at a low
interest rate and invested in projects that earn a higher rate
b. Disadvantages of bonds
i. Risk of bankruptcy exists because the bond interest payments must be
paid each period whether the corporation earns income or incurs a loss
ii. Negative impact on cash flows because bonds must be repaid at a specific
time in the future. Company must be able to repay the debt or refinance
it
2. Bond Terminology
a. A bond usually requires the payment of intertest over its life with repayment of
principal on the maturity date
b. The bond principal is:
i. The amount a company must pay to bondholders at the maturity date
ii. The amount used to compute the bond’s periodic cash interest payments
c. Bond principal is also called face value, par value, or maturity value
d. All bonds have a face value. The face value is usually $1000, but it can be any
amount
e. The coupon rate is the interest rate specified on a bond, and the rate used to
compute the bond’s periodic cash interest payment
f. A bond always specifies the coupon rate and the frequency of periodic cash
interest payments
i. The coupon rate is called the stated rate, contract rate, or nominal rate
ii. The interest payments are sometimes called coupon payments
iii. A bond’s coupon rate is always stated in annual terms
1. If interest is paid annually, the periodic cash interest payment is
computed as the bond’s face value times its coupon rate
2. If the interest payment is made more frequently, computing the
cash interest payment requires that the coupon rate be converted
to a rate per interest period before it is multiplied by the bond’s
face value
3. Characteristics of different types of bonds
a. Unsecured bond (or debenture)
i. No assets are pledged as a guarantee of repayment at maturity
b. Secured bond
i. Specific assets are pledged as a guarantee of repayment at maturity
c. Callable bond
 i. Contains a call feature that allows the bond issuer the option of retiring
the bonds early
d. Convertible bond
i. Contains a conversion feature that allows the bonds to be converted into
shares of the issuer’s common stock
4. Relationship between coupon rate and market rate
a. The bond market determines the price of bonds by computing the present value
of the bonds using the market rate of interest on the day the company issues the
bonds
b. The relationship between the market interest rate and the bond’s coupon rate
determines whether the bond is issued at par, at a premium, or at a discount
c. Example: Bond contract: coupon rate is 10%
i. If the market rate is less than 10%, bond price is a premium
ii. If the market rate is exactly 10%, the bond price is at par
iii. If the market rate is greater than 10%, the bond price is at a discount
1. Important: REGARDLESS of whether a bond is issued at par, at a
discount, or at a premium, investors always will earn the market
rate of return
5. Bond Issued at par:
a. On January 1,2019, Amazon issues bonds with a coupon rate of 10 percent and a
face value of $100000. The bonds start accruing interest on January 1, 2019 and
will pay interest each June 30 and December 31. The bonds mature in two years
on December 2020
b. Investors are willing to pay $100,000 in cash for the bonds meaning the bonds
are sold at par
c. The amount of money a company receives when it sells bonds is the present
value of the future cash flows associated with the bonds
i. Amazon agrees to make two types of payments in the future: a single
payment of $100,000 when the bond matures in two years and an
annuity of $5000 (100000 * 10% *1/2 year) payable twice a year for two
years
d. We use the bond’s market interest rate per period (in this case 10%/2=5%) to
compute the bond’s present value as follows
i. Single Principal payment at maturity: 100000 * 0.82270 = 82270
ii. Add: Annuity cash interest payment: 5000 * 3.54595 = 17730
iii. Issue (sale) price of bonds = 100000
e. When the market rate of interest equals the coupon rate, the present value of
the future cash flows associated with a bond always equals the bond’s face value
amount
f. Remember a bond’s selling price is determined by the present value of its future
cash flows, not the face value
g. On the day Amazon issues the bonds, it records a bond liability equal to the
amount investors are willing to pay for the bonds
i. Cash DEBIT (+A) 100000
 ii. Bonds Payable CREDIT (+L) 100000
h. The amount of interest each period will be 5000 (100000 * 10% * ½ years)
i. Interest expense DEBIT (+E, -SE) 5000
ii. Cash CREDIT (-A) 5000
i. Reporting interest expense
i. Interest expense is reported on the income statement. Because interest
is related to financing activities rather than operating activities, it is
normally not included in operating expenses on the income statement
ii. Interest expense is typically reported just below “income from
operations” on the income statement
6. Times Interest earned
a. Times interest earned = (Net income + interest expense + income tax
expense)/Interest expense
b. This ratio shows whether a company is generating sufficient resources from its
profit-making operations to meet its current interest obligations
c. A high ratio indicates an extra margin of protection in case profitability
deteriorates
d. Failure to meet required interest payments could result in bankruptcy
7. Bond Issued at Discount
a. Jan. 1, 2019, Amazon issues bonds with a coupon rate of 10% and a face value of
$100,000. The bonds start accruing interest on Jan. 1 2019 and will pay interest
each June 30 and Dec. 31. The bonds mature in two years on Dec. 31 2020
b. Coupon rate less than market interest rate 12% (sold at a discount)
i. Single principal payment at maturity: 100000 * 0.79209 = 79209
ii. Add: Annuity cash interest payment: 5000 * 3.45611 = 17326
iii. Issue (sale) price of bonds = 96535
c. Journal entry
i. With discount
1. Cash DEBIT (+A) 96535
2. Bond Discount DEBIT (-L) 3465  Contra-liability account
3. Bonds payable CREDIT (+L) 100000
ii. Without discount
1. Cash DEBIT (+A) 96535
2. Bonds Payable CREDIT (+L) 96535
8. Reporting Interest expense on bonds issued at discount
a. Using effective-interest amortization (with discount account)
i. Under effective-interest amortization method a company computes
interest expense in a given period by multiplying the bonds payable book
value times the market rate of interest on the date of issuance
1. Step 1: Compute interest expense: Bonds payable book value x
market interest rate per period
2. Step 2: Compute cash owed for interest: Bond face value x
coupon rate per period
 3. Step 3: Compute amortization amount: Interest expense – Cash
owed for interest
ii. Journal entry:
1. Interest Expense DEBIT (+E, -SE)
2. Bond Discount CREDIT (+L)
3. Cash CREDIT (-A)
4. Cash + Bond Discount = Interest expense
9. Bond Issued at a Premium:
a. Jan 1, 2019, Amazon issues bonds with a coupon rate of 10 percent and a face
value of $100,000. The bonds start accruing interest on Jan 1, 2019 and will pay
interest each June 30 and December 31. The bonds mature in two years on Dec
31, 2020
b. The coupon rate is 10 percent. Market interest rate is 8 percent, thus it is issued
at a premium
i. Single principal payment at maturity: 100000 * 0.85480 = 85480
ii. Add Annuity cash interest payment: 5000 * 3.62990 = 18150
iii. Issue (sale) price of bonds = 103630
c. Journal entry:
i. With Premium account
1. Cash DEBIT (+A) 103630
2. Bond Premium CREDIT (+L) 3630
3. Bonds Payable CREDIT (+L) 100000
ii. Without premium account
1. Cash DEBIT (+A) 103630
2. Bonds Payable CREDIT (+L) 103630
10. Reporting expense on bonds issued at a premium
a. Using Effective-Interest Amortization (with premium account)
i. Under the effective-interest amortization method, a company computes
interest expense in a given period by multiplying the bonds payable book
value times the market rate of interest on the date of issuance
ii. Step 1: Compute interest expense
1. Bonds Payable book value x Market interest rate per period
iii. Step 2: Compute cash owed for interest
1. Bond face value x Coupon rate per period
iv. Step 3: Compute Amortization Amount
1. Interest expense – Cash owed for interest
v. Journal entry
1. Interest expense DEBIT (+E, -SE)
2. Bond Premium DEBIT (-L)
3. Cash CREDIT (-A)
11. Journal Entry to Retire the bonds at maturity:
a. Regardless of whether a company issues bonds at par, at a discount, or at a
premium, the company will enter the same journal entry when it retires the
bonds at maturity
 i. Bonds Payable DEBIT (-L) 100000
ii. Cash CREDIT (-A) 100000
12. Debt-to-Equity
a. Debt-to-equity = Total liabilities / total stockholders’ equity
b. This ratio shows the relationship between the amount of capital provided by
owners and the amount provided by creditors
c. In general, a high ratio indicates that a company relies heavily on debt financing
relative to equity financing. This increases the risk that company may not be able
to meet its contractual financial obligations during a business downturn
13. Early retirement of bonds
a. Some bonds have a call feature that allows the issuing company to call (retire)
the bonds early. A call feature most often requires the issuing company to pay
investors an amount greater than the bond’s face value to retire the bonds
before their maturity date. The amount often is stated as a percentage of the
bond’s face value
b. Book value > cash paid to retire bonds = gain
c. Book value < cash paid to retire bonds = loss
d. In some cases a company may elect to retire bonds early by purchasing them on
the open market, just as an investor would
14. Price of bonds versus market interest rates
a. Bond prices move in the opposite direction of interest rates: if interest rates go
up, bond prices fall, and vice versa
b. If interest rates go up enough, a company may decide that it makes good
economic sense to retire its bonds early by purchasing them on the open market
Chapter 11
1. Advantages of a corporation
a. 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
i. Shares of stock may be purchased in small amounts
ii. Ownership interests can be transferred easily through the sale of shares
on established markets
iii. Stock ownership provides investors with limited liability
2. Ownership of a corporation
a. Corporations enjoy a continuous existence separate and apart from its owners. A
corporation can:
i. Own assets
ii. Sue others and be sued
iii. Incur liabilities
iv. Expand and contract in size
v. Enter into contracts independently of its owners
b. Corporations are created by application to a state government (not federal
government). Corporations are governed by a board of directors elected by the
stockholders
3. Benefits of stock ownership
a. Owners of common stock (known as stockholders or shareholders) receive a
number of benefits:
i. A voice in management
ii. Dividends: proportional share of the distribution of profits
iii. Residual claim: proportional share of the distribution of remaining assets
upon the liquidation of the company
4. Authorized, Issued and Outstanding shares
a. The authorized number of shares is the maximum number of shares of stock a
corporation can issue as specified in its charter
i. Issued shares are the total number of shares sold to the public
ii. Unissued shares are the shares that have never been sold
b. Issued shares
i. Outstanding shares (owned by stockholders)
ii. Treasury shares (required by the corporation)
c. Authorized shares  issued shares  stock market where stockholders can
purchase shares (or issue shares) and the corporation can repurchase shares 
repurchased shares are held as treasury stock and may be reissued
5. Earnings per share (EPS)
a. EPS = Net income*/Weighted average number of common shares outstanding
i. *Preferred dividends, if any, should be subtracted from net income
b. Companies are required to report EPS on their income statements
6. Common stock transactions
a. Common stock is held by investors who are the owners of a corporation
 b. Stockholders have the right to:
i. Vote
ii. Share in profits of the business
iii. Elect the board of directors who hire and monitor the executives who
manage a company’s activities on a day-to-day basis
c. Par value is the nominal value per share, established in the corporate chapter
i. Par Value ≠ Market value
ii. Legal Capital is the amount of capital, required by the state, that must
remain invested in the business
7. Initial sale of stock
a. 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”)
b. Additional sales of new stock to the public are called seasoned offerings
c. Assume IBM sold 100,000 shares of its $0.20 par value common stock for $150
per share The following journal entry shows the record
i. Cash DEBIT (+A) (100,000 * 150) = 15,000,000
ii. Common stock (+SE) (100,000 * 0.20) = 20,000
iii. Additional paid-in capital (+SE) = 14,980,000
8. Sale of stock in secondary markets
a. When a company sells stock to the public, the transaction is between the issuing
corporation and the investor
b. Subsequent to the initial sale, investors can sell shares to other investors without
directly affecting the corporation
i. The corporation is not a part of the transaction and therefore does not
receive or pay anything
9. Stock issued for employee compensation
a. Managers may be offered stock options, a common form of compensation,
which permit them to buy stock at a fixed price
b. Options specify that shares may be bought at the then-current market price
c. 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
i. If you hold a stock option and the stock price declines, you have lost
nothing. They are a risk-free investment
d. Companies must estimate and report compensation expense associated with
stock options
10. Repurchase of stock
a. A corporation repurchase its stock from existing stockholders for a number of
reasons:
i. When employee bonus plans provide workers with shares of company’s
stock, the company can give employees repurchased shares rather than
issue new ones
1. 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
 2. Increasing the number of shares also would dilute existing
stockholders’ investments, as each share of stock they own would
be worth less
3. By repurchasing shares to fulfill bonus obligations, companies
avoid this dilutive effect
b. Stock that has been repurchased and is held by the issuing corporation is called
treasury stock
c. Treasury shares have no voting, dividend, or other stockholder rights while they
are held as treasury stock
11. Repurchase and reissuance of stock
a. IBM reacquired 100,000 of its common stock when it was selling for $140
i. Treasury stock DEBIT (+XSE, -SE) (100000 * 140) = 14000000
ii. Cash CREDIT (-A) 14,000,000
iii. Treasury stock is a contra-equity account not an asset
b. IBM reissued 10,000 shares of treasury stock at $150 per share
i. Cash DEBIT (+A) (10000 * 150) = 1,500,000
ii. Treasury stock CREDIT (-XSE, +SE) (10000 * 140) = 1,400,000
iii. Additional paid-in capital (+SE) 100,000
c. IBM reissued 10,000 shares of treasury stock at $130 per share
i. Cash DEBIT (+A) (10000 * 130) = 1,300,000
ii. Additional paid-in capital DEBIT (-SE) 100,000
iii. Treasury stock CREDIT (-XSE, +SE) (10000 * 140) = 1,400,000
12. Dividends on common stock
a. The return from investing in a company’s common stock can come from two
sources: stock price appreciation and dividends
b. Some investors prefer to buy stocks that pay little or no dividends
i. Companies that reinvest the majority of their earnings back into their
operations tend to increase their future earnings potential and their stock
price
ii. Wealthy investors in high tax brackets prefer to receive their return in
form of higher stock prices because capital gains may be taxed at a lower
rate than dividend income
c. Other investors, such as retired people who need a steady income, prefer to
receive their return in the form of dividends
i. Retirees seek stocks that will pay relatively high dividends, such as utility
stocks
d. Analysts compute the dividend yield ratio to evaluate a company’s dividend
policy
13. Key dividend dates
a. Date of declaration: date on which the board of directors approves the dividend
i. Journal entry
1. Retained Earnings DEBIT (-SE)
2. Dividends payable CREDIT (+L)
 b. Date of record: Stockholders who own shares on this date will receive the
dividend
c. Date of payment: The date the cash is disbursed to stockholders
i. Journal entry
1. Dividends payable DEBIT (-L)
2. Cash CREDIT (-A)
14. Dividend Yield
a. Dividend yield = dividends per share / market price per share
15. Impacts of dividends on stock price
a. 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
b. If someone buys stock before the ex-dividend date, they will be listed as the
owner and receive the dividend. If someone buys stock after the ex-dividend
date, the previous owner will be listed as the owner of the dividend
c. Stock prices often fall on the ex-dividend date since the stock no longer includes
the right to receive the next dividend
16. Nature of Stock Dividends
a. Stock dividends represent a distribution of additional shares of stock to
shareholders
i. Stock is distributed pro rata; stockholders retain the same percentage
ownership after stock dividends are distributed
ii. A stock dividend has no economic value
b. Stock dividends do not change the stocks’ par value or total stockholders’ equity
c. The stock market reacts immediately when a stock dividend is issued
i. The stock price falls
ii. The lower market price may make the stock more attractive to new
investors
d. Small Stock dividends
i. Stock dividend < 20-25 %
ii. Record at current market value of stock
e. Large stock dividends
i. Stock dividend > 20-25 %
ii. Record at par value of the stock
f. The entry for a stock dividend is a transfer from retained earnings account to
common stock account (and additional paid-in capital account for small stock
dividends)
i. Retained earnings DEBIT (-SE)
ii. Common Stock CREDIT (+SE)

iii. Retained earnings DEBIT (-SE)

iv. Common stock CREDIT (+SE)
v. Additional Paid-in capital CREDIT (+SE)
17. Stock dividends
 a. 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:
i. Retained Earnings DEBIT (-SE) (0.20 * 50,000,000) = 10,000,000
ii. Common stock CREDIT (+SE) (0.20 * 50,000,000) = 10,000,000
b. 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:
i. Retained earnings DEDIT (-SE) (150 * 5,000,000) = 750,000,000
ii. Common stock CREDIT (+SE) (0.20 * 5,000,000) = 1,000,000
iii. Additional paid-in capital CREDIT (+SE) (remainder) = 749,000,000
c. Note: regardless of whether a stock dividend is classified as a large or small,
there is no change in the total amount of stockholders’ equity
18. Stock Splits
a. 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
b. Common stock shares increase after split
c. Par value per share decreases after split
d. Total par value remains unchanged
19. Preferred stock transactions
a. Less risky because of preference over common stock
b. Typically does not have voting rights
c. Typically has a fixed dividend rate
20. Dividends on preferred stock
a. Preferred stock offers a dividend preference:
i. 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
ii. 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
iii. If preferred stock are noncumulative, any dividends not declared in
previous years are permanently lost and will never be paid
iv. 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
v. Wally company has the following stock outstanding:
1. Preferred stock: 6%, $20 par value, 2,000 shares outstanding.
Assume current dividend preference. Common stock: $10 par
value, 5,000 shares outstanding
2. If Wally issues a $3,000 current dividend, the dividends would be
allocated as follows:
 a. Preferred: $20 par value * 6% * 2,000 = 2,400
b. Common Stock: $3000 - $2400 = $600
3. 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:
a. Preferred: $2400 + (2400 in arrears * 2 years) = 7200
b. Common: $30000 - $7200 = $22800
Chapter 12
1. What is cash?
a. The definition of cash includes cash and cash equivalents
b. Cash equivalents are short-term, highly liquid investments that are both
i. Readily convertible into known amounts of cash
ii. So near to maturity there is little risk their value will change if interest
rates change
c. Generally, only investments with original maturities of three months or less
qualify as cash equivalents
2. Classifications of the statement of cash flows
a. Operating Activities
i. Cash inflows and outflows directly related to earnings from normal
operations
b. Investing activities
i. Cash inflows and outflows related to the acquisition or sale of productive
facilities investments in the securities of other companies
c. Financing activities
i. Cash inflows and outflows related to external sources of financing
(owners and creditors) for the enterprise
3. Direct method VS indirect method
a. Two formats for reporting cash flows from operating activities
i. Direct method
1. Reports the cash effects of each operating activity
ii. Indirect method
1. Starts with accrual net income and converts to cash flow from
operating activities
b. The cash flows from operating activities are always the same, regardless of
whether the direct or indirect method is used.
4. Cash flow from operating activities
a. Inflows:
i. Customers
ii. Dividends and interest on investments
b. Outflows:
i. Purchase of services and goods for resale
ii. Salaries and wages
iii. Income taxes
iv. Interest on liabilities
5. Cash flow from investing activities
a. Inflows:
i. Sale or disposal of property, plant, and equipment
ii. Sale or maturity of investments in securities
b. Outflows:
i. Purchase of property, plant, and equipment
ii. Purchase of investments in securities
6. Cash flow from financing activities
a. Inflows:
i. Borrowings on notes, mortgages, bonds, etc. from creditors
ii. Issuing stock to owners
b. Outflows:
i. Repayment of principal to creditors (excluding interest, which is an
operating activity)
ii. Repurchasing stock from owners
iii. Dividends to owners
7. Net Increase or Decrease in cash
a. The combination of net cash flows from operating, investing and financing
activities must equal the net increase or decrease in cash
8. Relationships to the balance sheet and income statement
a. Information needed to prepare a statement of cash flows
i. Comparative balance sheets
ii. A complete income statement
iii. Additional details concerning selected accounts
b. Preparation and understanding of the cash flow statement focuses on the
changes in the balance sheet accounts
i. Δ Cash = Δ Liabilities + Δ stockholders’ equity – Δ noncash assets
ii. Derives from…
1. Assets = Liabilities + Stockholders’ equity
9. Reporting and Interpreting Cash flows from operating activities
a. The indirect method adjusts net income by eliminating noncash items
b. Net income
i. + Noncash expenses such as depreciation and amortization
ii. +/- changes in current assets and current liabilities
iii. + Losses and – Gains
c. Giving Cash flows from operating activities
10. Adjustment for gains and losses
a. Cash received from the sale or disposal of long-term assets is classified as
investing cash flow. Gains/Losses on the income statement, if any, are
subtracted from/added to net income in order to compute cash flow from
operating activities
b. Gains must be subtracted from net income to avoid double counting the gain
c. Losses must be added to net income to avoid doble counting the loss
11. Schedule for Net Cash Flow from Operating Activities, Indirect method
a. Step 1: Adjust net income for depreciation and amortization expense and gains
and losses on sale of investing assets
b. Step 2: Adjust net income for change in current assets and current liabilities
i. Changes in accounts receivable
1. To convert to cash flow from operating activities, the amount of
the increase must be subtracted from net income
ii. Changes in inventory
 1. The increase must be subtracted from net income to convert to
cash flow from operating activities
iii. Changes in prepaid expenses
1. The increase must be subtracted from net income to convert to
cash flow from operating activities
iv. Changes in accounts payable
1. The increase must be added to net income to convert to cash flow
from operating activities
v. Changes in accrued expenses
1. The increase must be added to net income to convert to cash flow
from operating activities
12. Summary:

a.
13. Classification of interest on the cash flow statement
a. US GAAP and IFRS differ in the cash flow statement treatment of interest
received and interest paid
b. US GAAP
i. Interest Received: Operating
ii. Interest Paid: Operating
c. IFRS
i. Interest Received: Operating or Investing
ii. Interest Paid: Operating or Financing
14. Interpreting Cash flows from operating activities
a. A common rule of thumb followed by financial and credit analysts is to avoid
firms with rising net income but falling cash flow from operations
b. Investors will not invest in a company if they do not believe that cash generated
from operations will be available to pay them dividends or expand the company
c. Creditors will not lend money if they do not believe that cash generated from
operations will be available to pay back the loan
15. Quality of Income Ratio = Cash flow from operating activities/Net income
 a. In general, this ratio measures the portion of income that was generated in cash.
All other things equal, a higher quality of income ratio indicates greater ability to
finance operating and other cash needs from operating cash inflows
16. Reporting and Interpreting Cash Flows from investing activities

a.
17. We must report individually the cash used to purchase equipment and cash proceeds
received from the sale of equipment
18. Although short-term investments is a current asset, it is reported in the investing section
on the statement of cash flows.
19. Capital Acquisition Ratio
a. Capital Acquisitions ratio = Cash flow from operating activities/Cash paid for
property, plant, and equipment
b. In general, this ratio reflects the portion of purchases of property, plant, and
equipment financed from operating activities. A high ratio indicates less need for
outside financing for current and future expansions
c. A high ratio benefits the company because
i. It provides the company opportunities for strategic acquisitions
ii. It avoids the cost of additional debt
iii. It reduces the risk of bankruptcy that comes with additional leverage
20. Free Cash Flow
a. Managers and analysts calculate free cash flow as a measure of a firm’s ability to
pursue long-term investment opportunities
b. Free Cash Flow = Cash Flow from operating activities – dividends – Capital
expenditures
c. Any positive free cash flow is available for additional capital expenditures,
investments in other companies, and mergers and acquisitions without the need
for external financing or reductions in dividends to shareholders
21. Reporting Cash flows from financing activities

a.
b. Cash received from issuance of long-term debt
c. Cash received from issuing common stock
22. Interpreting Cash flows from financing activities
a. The long-term growth of a company is normally financed from three sources:
i. Internally generated funds (cash from operating activities)
ii. The issuance of stock
iii. Money borrowed on a long-term basis
b. The statement of cash flows shows how management has elected to fund its
growth. This information is used by analysts who wish to evaluate the capital
structure and growth potential of a business
23. Completing the statement and additional disclosures:

24.
25.