Chapter 1 Review

PRINCIPLES OF ACCOUNTING
LO1: IDENTIFY THE ACTIVITIES AND USERS ASSOCIATED WITH ACCOUNTING

Accounting: The information system that identifies, records, and communicates the
economic events of an organization to interested users.

Two Main Types of Users:

1. Internal Users: Managers who plan, organize, and run a business.

Examples: Marketing managers, production supervisors, finance directors, and company officers.

2. External Users: Includes investors who use accounting information to make

decisions to buy, hold, or sell stock and creditors who use the accounting
information to evaluate the risks of selling on credit or lending money.

Other Examples: Taxing Authorities (Ex: IRS), customers, labor unions, and regulatory
agencies (Ex: Securities and Exchange Commission (SEC)).

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LO2: EXPLAIN THE BULDING BLOCKS OF ACCOUNTING: ETHICS,

PRINCIPLES, AND ASSUMPTIONS
Ethics In Financial Reporting
Sarbanes-Oxley Act (SOX): Passed by congress to reduce unethical corporate behavior and decrease the
likelihood of future corporate scandals. As a result of SOX….
1. Top management must now certify the accuracy of financial information.
2. Penalties for fraudulent financial activity are much more severe.
3. The independence of the outside auditors who review the accuracy of
corporate financial statements and the oversight role of the board of directors
has increased.

Standard-Setting Environment
1. GAAP: (Generally Accepted Accounting Principles) rules and concepts that
govern financial accounting. It attempts to make information RELEVANT, RELIABLE,
and COMPARABLE.

Standard-setting bodies that determine these guidelines:

• SEC (Securities and Exchange Commission): oversees the U.S. financial markets and
accounting standard-setting bodies.
• FASB (Financial Accounting Standards Board): The primary accounting standard-
setting body in the United States.
• IASB (International Accounting Standards Board): The primary accounting
standard-setting body for countries outside the united States that use
International Financial Reporting Standards (IFRS).

2. Characteristics of Financial Information: Financial information needs to be USEFUL to

investors and creditors for making decisions about providing capital. Useful information
possesses two important qualities…
1. RELEVANCE: Has the potential to impact decision making. Information is relevant if it has…
• Predictive Value: helps provide accurate expectations about the future.
• Confirmatory Value: confirms or corrects prior expectations.
• Materiality: when its size makes it likely to influence the decision of an
investor or creditor.

2. FAITHFUL REPRESENTATION: The information accurately reflects an entity’s

economic activity or condition. To provide a faithful representation,
information must be…
• Complete: nothing important has been omitted.
• Neutral: is not biased toward one position or another.
• Free from Error: no errors or omissions in amounts and process
used to report amounts.

3. Accounting Principles: MEASUREMENT PRINCIPALS

• Historical Cost Principle: Accounting information is based on actual cost. Cost is
measured on a cash or equal to cash basis. (Ex: Bob bought equipment for
$15,000 so the equipment should be valued at $15,000). In generally, most
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assets have to be valued using the historical cost principle.

• Fair Value Principle: Indicates that assets and liabilities should be reported at fair
value (the price received to sell an asset or settle a liability). Only in situations
where assets are actively traded, such as investment securities, is the fair value
principle applied.

4. 2 Main Assumptions in the Accounting Process

• MONETARY UNIT ASSUMPTION: stable monetary unit of measure used in
U.S. financial statements such as the U.S. dollar.
• ECONOMIC ENTITY ASSUMPTION: business is accounted for separately from
other business entities, including its owner.

TYPES OF BUSINESS ENTITIES

1. Sole Proprietorship: business owned by ONE PERSON and that person and company are
viewed as ONE entity for tax and liability purposes. For example, if a customer sues Bill
who owns the proprietorship, the court can order Bill to sell his personal belongings
including his house to settle the debt.
• Simple to establish
• Owner controlled
• Tax advantages

2. Partnership: owned by TWO OR MORE PEOPLE who are JOINTLY liable for tax and other
obligations. Like a proprietorship, partnerships are NOT LEGALLY SEPARTE from owners.
Each partner’s share of profits is reported and taxed on that partner’s tax return.
• Simple to establish
• Shared control
• Broader skills and resources
• Tax advantages

3. Corporation: a business legally separate from its owner or owners, meaning it is

responsible for its own acts and its own debts. A corporation is owned by shareholders
who are NOT personally liable for corporate acts and debts. A corporation acts through
its managers.
• Easier to transfer ownership
• Easier to raise funds
• No personal liability
• A major disadvantage is that corporations face double taxation (The corporation
is taxed as a separate entity and the owner’s (stockholders) are taxed on any
earnings distributed to them from the corporation.

Attribute Present Proprietorship Partnership Corporation

One owner allowed YES NO YES
Business taxed NO NO YES
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Limited liability NO* NO* YES

Business entity YES YES YES
Legal entity NO NO YES
Unlimited life NO NO YES

*A proprietorship or partnership that is set up as an LLC (Limited Liability Corporation)

has limited liability. (LLCs are talked about more in business law courses)

LO 3: STATE THE ACCOUNTING EQUATION, AND DEFINE IT COMPONENTS

The two basic elements of a business are what it owns and what it owes. Assets are the
resources a business owns.

Liabilities and stockholders’ equity are the rights or claims against these resources.

The Basic Accounting Equation: Assets = Liabilities + Owners’

Equity
This relationship is the basic accounting equation. Assets must equal the sum of liabilities and
owners’ equity. The equation provides the underlying framework for recording and summarizing
economic events
Assets - resources a business owns. The business uses its assets in carrying out such
activities as production and sales.

Liabilities -claims against assets—existing debts and obligations. Businesses of all sizes
usually borrow money and purchase merchandise on credit. These economic activities
result in payables of various sorts.

Owners’ Equity - The ownership claim on total assets is owner’s equity. It is equal to total assets minus
total liabilities
1. Increase in Owner’s Equity:
• Investment by Owner - are the assets the owner puts into the business. These investments increase
owner’s equity. They are recorded in a category called owner’s capital.
• Revenues - are the gross increase in owner’s equity resulting from business activities entered into
for the purpose of earning income.
2. Decrese in Owner’s Equity:
• Drawings - an owner may withdraw cash or other assets for personal use. Drawings decrease
owner’s equity. They are recorded in a category called owner’s drawings.
• Expenses - are the cost of assets consumed or services used in the process of earning revenue.
They are decreases in owner’s equity that result from operating the business.

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Expanded Accounting Equation:

LO 4: ANALYZE THE EFFECT OF BUSINESS TRANSACTIONS ON THE BASIC

ACCOUNTING EQUATION
THE ACCOUNTING INFORMATION SYSTEM
• Accounting Information System: system of collecting, processing transaction data, and
communicating financial information to decision makers.
o Rely on the accounting process.
1. Analyze business transactions
2. Journalize
3. Post
4. Trial Balance
5. Adjusting Entries
6. Adjusted Trial Balance
7. Financial Statements
8. Closing Entries
9. Post-Closing Trial Balance

• Transactions: economic events that require recording in the financial statements.

o Assets, liabilities, or stockholders’ equity items change as a result of some economic event.
o Dual effect on the accounting equation (Assets = Liabilities + Owners’ Equity)
o Not all activities represent transactions.
o Ex: The payment of rent, purchase of a building, and sale of goods all
represented transactions that need to be recorded.

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ANALYZING TRANSACTIONS

When analyzing transactions keep in mind.

• The accounting equation MUST ALWAYS BALANCE.

• The cause of each change in Owners’ equity must be indicated.
Example Business Transactions (From Softbyte.):
Keep A = L + OE in Balance

TRANSACTION 1. INVESTMENT BY OWNER Ray Neal decides to start a smartphone app

development company which he names Softbyte. On September 1, 2017, he invests $15,000 cash in
the business. This transaction results in an equal increase in assets and owner’s equity.
TRANSACTION 2. PURCHASE OF EQUIPMENT FOR CASH Softbyte Inc. purchases computer
equipment for $7,000 cash.
TRANSACTION 3. PURCHASE OF SUPPLIES ON CREDIT Softbyte Inc. purchases for $1,600 headsets
and other accessories expected to last several months. The supplier allows Softbyte to pay this bill in
October.
TRANSACTION 4. SERVICES PERFORMED FOR CASH Softbyte Inc. receives $1,200 cash from
customers for app development services it has performed.
TRANSACTION 5. PURCHASE OF ADVERTISING ON CREDIT Softbyte Inc. receives a bill for $250
from the Daily News for advertising on its online website but postpones payment until a later date.
TRANSACTION 6. SERVICES PERFORMED FOR CASH AND CREDIT. Softbyte performs $3,500 of
services. The company receives cash of $1,500 from customers, and it bills the balance of $2,000 on
account.
TRANSACTION 7. PAYMENT OF EXPENSES Softbyte Inc. pays the following expenses in cash for
September: office rent $600, salaries and wages of employees $900, and utilities $200.
TRANSACTION 8. PAYMENT OF ACCOUNTS PAYABLE Softbyte Inc. pays its $250 Daily News bill in
cash. The company previously (in Transaction 5) recorded the bill as an increase in Accounts Payable.
TRANSACTION 9. RECEIPT OF CASH ON ACCOUNT Softbyte Inc. receives $600 in cash from
customers who had been billed for services (in Transaction 6).
TRANSACTION 10. WITHDRAWAL OF CASH BY OWNER Ray Neal withdraws $1,300 in cash in cash
from the business for his personal use.
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LO 5: DESCRIBE THE FOUR FINANCIAL STATEMENTS AND HOW THEY

ARE PREPARED
1. Income Statement
2. Retained Earnings Statement
3. Balance Sheet
Income Statement
• Describes a company’s revenues and expenses which result in net income (revenues exceed expenses)
or a net loss (expenses exceed revenues) over a specific period of time due to earnings activities.

Statement of Owner’s Equity

• Explains changes in owner’s equity from net income, net loss, and drawings over a specific period of
time. (Same time period as covered by the income statement)

• Balance Sheet
• Describes a company’s financial position (types and amounts of assets, liabilities, and equity) at a
point in time.

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• Basic Accounting Equation: ASSETS = LIABILITIES + OWNERS’EQUITY

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Summary of Accounts

Category/
Name Financial Quick Definition
Statement
Includes money and any medium of exchange that bank has for deposit (coins,
Cash Asset/Balance Sheet
checks, money orders, checking account balances.)

Held by the SELLER. Promises of future payment to seller from buyer.

Accounts Receivable Asset/Balance Sheet
(RECEIVE money later)

A written promissory note that gives a business the right to receive cash in the
Notes Receivable Asset/Balance Sheet
future. The receipt of cash includes the original amount (principal) and interest.

Inventory Asset/Balance Sheet Goods a company owns and expects to sell in its normal operations.

Assets that represent payments of FUTURE expenses such as Prepaid Insurance

Prepaid Accounts Asset/Balance Sheet
(pay for it ahead of the time you are going to use the insurance.)

Assets such as paper, toner, and pens that become expenses when they are used
Supplies Accounts Asset/Balance Sheet
up.

Incudes land, buildings, and equipment. Equipment and building accounts get
Property, Plant, and
Asset/Balance Sheet expensed by allocating their cost over the periods benefited by them. Land
Equipment Accounts
accounts DO NOT get expensed over their life.

Liability/Balance
Accounts Payable Promise by the BUYER to pay the seller at a later date.
Sheet

Liability/Balance
Notes Payable A formal promise that includes signing a promissory note to pay a future amount.
Sheet

Liability that is going to be settled in the future when a company delivers its
Unearned Revenue Liability/Balance products or services. (Ex: Jim’s neighbor gave him $50 now to mow their lawn
Accounts Sheet while they are on vacation. Jim has an obligation to mow his neighbor’s lawn in
the future.)

Liability/Balance
Accrued Liabilities Amounts owed that are not yet paid.
Sheet

Stockholders’
Common Stock Amount that shareholders (owners) invest in the company.
Equity/Balance Sheet

Stockholders’ Equity Distribution of assets such as cash to the shareholders of the company. It
Dividends
/Retained Earnings REDUCES retained earnings. (NOT AN EXPENSE)

Revenue (Ex: Sales,

Revenue/Income INCREASE retained earnings and are resources generating by a company’s
Professional Service, and
Statement earning activities.
Rent Revenue.)

Expenses (Ex: Advertising,

Expenses/Income DECREASE retained earnings and are the cost of assets or services used to earn
Store Supplies, Rent, and
Statement revenues.
Utilities Expense)

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THE RECORDING PROCESS

LO1: Explain how accounts, debits, and credits are used to record business
transactions.
• Account: an individual accounting record of increases and decreases in a specific asset, liability,
owner’s equity, revenue, or expense item.
o Has 3 Parts: 1) Title of an account 2) A left or debit side 3) A right or credit side
• Accountants use “T accounts” to analyze transactions. A “T account” consists of a vertical line
and a horizontal line that resembles the letter T. “T accounts” are helpful when analyzing
transactions.
• Accounts used in recording transactions have a normal DEBIT or CREDIT balance.

*Debit means Left and Credit means Right

• Normal Balance: The increase side of the account.

* An account with a normal DEBIT balance means that we INCREASE that account with a DEBIT. (and
decrease the account with the opposite…a credit.)
An account with a normal CREDIT balance means that we INCREASE that account with a CREDIT. (and
decrease the account with the opposite…a debit)
• An account balance is the difference between the amounts recorded on the two sides of an
account.

• If Debits are GREATER than Credits, the account will have a DEBIT BALANCE.
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• If Credits are GREATER than Debits, the account will have a CREDIT BALANCE.
• The Cash T-Account above has a debit balance of $83,000.

Extended Accounting Equation

The equation must be in balance after every transaction. Total Debits must equal total Credits.

Double-Entry Accounting
• At least 2 accounts are involved, with at least one debit and one credit.
• DEBITS MUST EQUAL CREDITS.
• The accounting equation must NOT be violated. (Assets = Liabilities + Owner’s Equity)

LO 2: Indicate how a journal is used in the recording process.

The Recording Process

The Journal
• Transactions recorded in chronological order in a journal before they are transferred to the
accounts.
Contributions to the recording process:
1. Discloses the complete effects of a transaction.
2. Provides a chronological record of transactions.
3. Helps to prevent or locate errors because the debit and credit amounts can be easily compared.
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• A complete journal entry consists of

1. The date of a transaction.
2. The accounts and amounts to be debited and credited.
3. A brief explanation of the transaction.

• Example: Entering transaction data into a journal.

Kate Browne engaged in the following activities in establishing her salon, Hair It Is:
1. Opened a bank account in the name of Hair It Is and deposited $20,000 of her own money in this
account as her initial investment.
Cash 20,000
Owner’s Capital 20,000

2. Purchased equipment on account (to be paid in 30 days) for a total cost of $4,800.

Equipment 4,800
Accounts Payable 4,800

3. Interviewed three persons for the position of hair stylist. – No Entry

LO 3: Explain a ledger and posting help in the recording process.

• Ledger: comprised of the entire group of accounts maintained by a company.
• General Ledger: contains all the asset, liability, owner’s equity, revenue, and expense
accounts.

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• Standard form of Accounts:

• Posting: the process of transferring journal entry amounts to ledger accounts. Think about the
ledger accounts as individual “T-accounts” that keep track of the current balance for each account
listed in a company’s chart of accounts.

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• Chart of Accounts:

• Examples:

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LO 4: Prepare a trial balance.

• Trial Balance: list of accounts
and their balances at a given
time.
1. Accounts are listed in
the order in which they
appear in the ledger.
 Assets
 Liabilities
 Owner’s Equity
 Revenues
 Expenses
2. Purpose is to PROVE
DEBITS = CREDITS.
3. Can be used to uncover
errors in journalizing and
posting.
4. Useful in preparation of financial statements.

Limitations of a Trial Balance

The trial balance may balance even when

1. A transaction is not journalized,.

2. A correct journal entry is not posted.
3. A journal entry is posted twice.
4. Incorrect accounts are used in journalizing or posting.
5. Offsetting errors are made in recording the amount of a transaction.

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ACCRUAL ACCOUNTING CONCEPTS

LO 1: Explain the accrual basis of accounting and the reasons for adjusting
entries.
• Periodicity Assumption: Accounting divides the economic life of a business into artificial time
periods (ex: month, quarter, or year)
o Fiscal Year: an accounting time period that is one year long.
• Revenue Recognition Principle: requires that companies recognize revenue in the accounting
period in which the performance obligation is satisfied (when the money is EARNED, not collected.)

Ex: John mowed Danny’s lawn for $40 on May 15. Danny didn’t have the money to pay John until May
26. What are the journal entries for George on May 15 and May 26?

• Expense Recognition (Matching) Principle: requires that companies match expenses with revenues
in the period when the company makes efforts to generate those revenues. (when the expense has
been INCURRED, not paid.)
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ACCRUAL VERSUS CASH BASIS OF ACCOUNTING

Accrual-Basis Accounting

• Transactions recorded in the periods in which the events occur.

• Revenues are recognized when services performed, even if cash was not received.
• Expenses are recognized when incurred, even if cash was not paid.

Cash-Basis Accounting

• Revenues are recognized only when cash is received.

• Expenses are recognized only when cash is paid.
• Not in accordance with generally accepted accounting principles (GAAP).

Ex: Suppose that P Company paints a large office building in 20 YR 1. In 20 YR 1, it incurs and pays total
expenses (salaries and paint costs) of $30,000. It bills the customer $50,000, but does not receive
payment until 20 YR 2.
Accrual Basis Cash Basis
Revenue $ 50,000 Revenue $ -
20 YR 1 Expenses $ 30,000 20 YR 1 Expenses $ 30,000
Net Income $ 20,000 Net Income $ (30,000)

20 YR 2 Revenue $ - 20 YR 2 Revenue $ 50,000

Expenses $ - Expenses $ -
Net Income $ - ADJUSTING Net Income $ 50,000 ENTRIES
• Ensure that the revenue recognition and expense recognition principles are followed.
• Required every time a company prepares financial statements.
• Includes one income statement account and one balance sheet account.

Types of Adjusting Entries

Deferrals:

1. Prepaid expenses: Expenses paid in cash and recorded as assets before they are used or consumed.

2. Unearned revenues: Cash received before service are performed.

Accruals:

1. Accrued revenues: Revenues for services performed but not yet received in cash or recorded.

2. Accrued expenses: Expenses incurred but not yet paid in cash or recorded.

*ADJUSTING ENTRIES NEVER INVOLVE CASH

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LO 2: Prepare adjusting entries for deferrals.

DEFERRALS
1. PREPAID EXPENSES: Cash payment BEFORE expense is recorded.
• Costs that expire either with the passage of time or through use.
• Adjusting entry results in an increase (a debit) to an expense account and a decrease (a credit)
to an asset account.

Examples of Prepaid Expenses (Assets): Supplies, Prepaid insurance, Prepaid Advertising, Prepaid Rent,
Equipment, and Buildings.
*Adjusted because they have been USED or CONSUMED in the business operations.

Ex (Prepaid Insurance): Jones Co. pays $5,000 for Insurance for 24 months on January 1. What is the
journal entry on January 1 and the adjusting entry at the END of the year when 12 months of the
insurance is USED UP?

INSURANCE EXPENSE
Dec. 31 $2,500

Balance $2,500

PREPAID INSURANCE
Jan. 1 $5,000 Dec. 31 $2,500

Balance $2,500

($5,000/24 months) * 12 months

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Depreciation: the process of allocating the cost of an asset to expense (depreciation) over its useful life.

• Buildings, equipment, and motor vehicles (long-lived assets) are recorded as assets, rather than an
expense, in the year acquired.
• Depreciation does not attempt to report the actual change in the value of an asset.

• “Using Up” of these long-lived fixed assets is debited to depreciation expense and the account that is
credited is the accumulated depreciation account which is a contra-asset
(Normal Balance is a CREDIT….opposite of an asset.)

• For journal entry think of the term DEAD to help you remember.

Ex: Bob’s office equipment depreciated by $300 during the year. The journal entry to record
depreciation on December 31 is

• The difference between the original cost of the office equipment and the balance in the
accumulated depreciation—office equipment account is called the BOOK VALUE OF THE ASSET
(or net book value).

• It is computed as follows:

Book Value of Asset = Cost of the Asset – Accumulated Depreciation of Asset

Ex: Cost of Equipment= $50,000 (on balance sheet)

Accumulated Depreciation-Equipment= $40,000
Book Value = $50,000 - $40,000
Book Value= $10,000

SUMMARY
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2. UNEARNED REVENUES: Cash receipt BEFORE revenue is recorded.

• Adjusting entry is made to record the revenue for services performed during the period and to show
the liability that remains.
• Adjusting entry results in a decrease (a debit) to a liability account and an increase (a credit) to a
revenue account.

Examples of Unearned Revenue (Liability): Unearned Rent, Unearned Ticket Revenue, Unearned
Subscription Revenue, Unearned Service Revenue, and Customer Deposits.
*Adjusted because originally when cash is received services weren’t provided so a liability was recorded.
By the end of the accounting period some services were provided to the customer.

Ex: Tom receives $50 from his neighbor Dave before mowing the lawn on August 25 because Dave is
going on vacation. Tom mows Dave’s lawn on September 5. Prepare the journal entries for Tom for both
days.
Service Revenue
Sept. 5 $50

Balance $50

Unearned Service Revenue

Sept. 5 $50 Aug. 25 $50

Balance $0

SUMMARY
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LO 3: Prepare adjusting entries for accruals.

ACCRUALS
3. ACCRUED REVENUES: Revenue recorded BEFORE cash receipt.
• An adjusting entry serves 2 purposes:
1. Shows the receivable that exists.
2. Records the revenues for services performed.

Examples of Accrued Revenue: Rent Revenue, Interest Revenue, and Service Revenue.
*Adjusted because services have been provided to the customer, but have not been billed or recorded.
Interest has been earned, but has not been received or recorded.

Ex: George shoveled Kim’s driveway for $30 on December 20. Kim didn’t have the money to pay George
until December 28. What are the journal entries for George on December 20 and December 28?

SUMMARY
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4. ACCRUED EXPENSES: Expenses recorded BEFORE cash payment.

• An adjusting entry serves 2 purposes:
1. Records the obligations (payable).
2. Recognizes the expenses.

Examples of Accrued Expenses: Interest, Taxes, Utilities, and Salaries.

*Adjusted because expenses were incurred but have not been paid or recorded.

Ex (Salaries and Wages): Employees of Lincoln Co. are paid $5,000 every 2 weeks. If December 31 occurs
at the end of the 1st week of the pay period what journal entry is made? When the payment for the 2
week pay period actually happens January 7 what is the journal entry?

($5,000/ 2 weeks)

Salaries and Wages Expense- Current Year Salaries and Wages Payable- Current Year
Dec. 31 $2,500 Dec. 31 $2,500

Balance $2,500 Balance $2,500

Labor occurred in the current year

(last week of December)
Labor occurred next year
(first week of January)

Salaries and Wages Expense- Next Year Salaries and Wages Payable- Current Year
Jan. 7 $2,500 Jan. 7 $2,500 Dec. 31 $2,500
Balance $2,500
*Expenses are closed out at YEAR END Balance $0
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Ex (Interest): M Corporation signed a three-month note payable in the amount of $8,000 on

November 1. The note requires M Corporation to pay interest at an annual rate of 10%. What is the
adjusting entry to record the accrual of interest in November?

Face Value of Note × Annual Interest Rate × Time in Terms of One Year = Interest
$8,000 x 10% x (1/12) = 66.67 ≈ $67

SUMMARY

LO 4: Prepare an Adjusted Trial Balance

• Adjusted Trial Balance: Prepared after

all adjusting entries are journalized
and posted to the ledger accounts.
o Purpose is to prove the
EQUALITY of debit
balances and credit
balances in the ledger.
o The primary basis for the
preparation of the financial
statements.

• Order the financial statements are

prepared from the adjusted trial
balance.
1. Income Statement
2. Owner’s Equity Statement
3. Balance Sheet
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Companies can prepare financial statements directly from the adjusted trial balance.
Illustrations below present the interrelationships of data in the adjusted trial balance
and the financial statements.

1. Preparation of the Income Statement and Owner’s Equity statement from the
adjusted trial balance
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2. Preparation of the Balance Sheet from the adjusted trial balance

 Chapter 4 Review

Chpt 4: Completing the Accounting Cycle

LO 1 Prepare a worksheet
Below is a table demonstrating the basic form of a worksheet and the five steps for preparing it. Each
step is performed in sequence – see steps 1 – 5 in graph below. The use of a worksheet is optional.

A worksheet is not a journal, and it cannot be used as a basis for posting to ledger
accounts.
To adjust the accounts, the company must journalize the adjustments and post them to the
ledger.
The adjusting entries are prepared from the adjustments columns of the
worksheet.

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Chpt 4: Completing the Accounting Cycle

LO 2: Prepare closing entries and post close trial balance

CLOSING THE BOOKS

*CLOSE (ZERO OUT) TEMPORARY ACCOUNTS SUCH AS REVENUES, EXPENSES, AND DRAWINGS.

*PERMANENT ACCOUNTS (BALANCE SHEET ACCOUNTS) ARE NOT CLOSED AT THE END OF THE PERIOD
AND ARE CARRIED FORWARD FROM YEAR TO YEAR.

Think “RED” when trying to remember which accounts are temporary which means they get
“Closed Out.”

• Revenue
• Expenses
• Drawings

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Chpt 4: Completing the Accounting Cycle

STEPS TO CLOSING THE BOOKS
STEP 1: Close credit balances in revenue accounts to INCOME SUMMARY. Debit each revenue account
for its balance and credit Income Summary for the total revenue.

STEP 2: Close debit balances in expense accounts to INCOME SUMMARY. Credit each expense account
for its balance and debit Income Summary for the total expenses.

STEP 3: Close Income Summary to OWNER’S CAPITAL

When a company has Net Income: Debit Income Summary for its balance (net income) and credit the
owner’s capital account.

When a company has Net Loss: Credit Income Summary for the amount of its balance and debit the
owner’s capital account for the amount of the net loss.

INCOME SUMMARY

STEP 4: Close drawings account to OWNER’S CAPITAL ACCOUNT. Debit the owner’s capital account
for the balance of the drawings account and credit the drawings account.

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Chpt 4: Completing the Accounting Cycle

***After the closing entries are posted, ALL OF THE TEMPORARY ACCOUNTS HAVE ZERO BALANCES
and they ARE NOT SHOWN ON THE POST-CLOSING TRIAL BALANCE.

• Income Summary: temporary account that is ONLY used during the closing process.

o After the closing entries are posted, ALL OF THE TEMPORARY ACCOUNTS HAVE ZERO
BALANCES.

o During the closing process, revenue and expense accounts are cleared by debiting or
crediting Income Summary for their amounts.

Post-Closing Trial Balance

• Proves the equality of the permanent account balances that the company carries forward into the
next accounting period
• All temporary accounts will have zero balances.

Post-closing trial balance

• Pioneer prepares the post-closing trial balance from the permanent accounts in
the ledger. The example above shows the permanent accounts in Pioneer’s
general ledger.

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Chpt 4: Completing the Accounting Cycle

LO 3: Explain the steps in the accounting cycle and how to prepare correcting
entries.
Summary of the Accounting Cycle

Correcting Entries
Errors that occur in recording transactions should be corrected as soon as they are discovered
by preparing correcting entries. Correcting entries:
a. are unnecessary if the records are free of errors.
b. are journalized and posted whenever an error is discovered.
c. may involve any combination of balance sheet and income statement accounts.

Adjusting entries always affect at least one balance sheet account and one income statement
account. In contrast, correcting entries may involve any combination of accounts
in need of correction.
Correcting entries must be posted before closing entries.
To determine the correcting entry
1. Compare the incorrect entry with the correct entry
2. Then make a correcting entry

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Chpt 4: Completing the Accounting Cycle

Example: On July 4th, Harper Co. journalized and posted a $150 cash collection on
account from a customer as a debit to Cash $150 and a credit to Service Revenue $150
(see below).

The company discovered the error on July 31, when the customer paid the remaining
balance in full.

1. Comparison of entries
Incorrect Entry (July 4) Correct Entry (July 31)

Cash 150 Cash 150

Service Revenue 150 Accounts Receivable 150

Comparison of the incorrect entry with the correct entry reveals that the debit to Cash
$150 is correct.

However, the $150 credit to Service Revenue should have been credited to
Accounts Receivable.

As a result, both Service Revenue and Accounts Receivable are overstated in the ledger.
Harper makes the correcting entry.

2. Correcting Entry Necessary

Correcting entry
July 31 Dr Service Revenue 150
Cr Accounts Receivable 150
(To correct entry of July 4)

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 Chapter 4 Review

Chpt 4: Completing the Accounting Cycle

***Notice that Assets = Liabilities + Owner’ Equity. Everything is balanced.

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 Chapter 4 Review

Chpt 4: Completing the Accounting Cycle

ACCOUNT EXAMPLES DEFINITION

CLASSIFICATION
1. Cash
“Cash and other resources that are expected to be
2. Accounts Receivable
sold, collected, or used WITHIN one year or company’s
3. Inventory
Current Assets 4. Prepaids
operating cycle, whichever is longer.” Companies list
current asset accounts in the order they expect to
5. Supplies
convert them into cash.
6. Investments (short-term).
1. Investments in stocks and bonds of other
corporations that are held for more than one year.
2. Long-term assets such as land or buildings that a “Notes receivable and investments in stocks and bonds
Long-Term company is not currently using in its operating that the company intends to hold onto for MORE THAN
Investments activities. the longer of one year or operating cycle.” Also, they
3. Long-term notes receivable. ARE NOT used in the company’s operating activities.

“Tangible assets that are both long-lived and used in

operating the business.”
1. Equipment
Plant Assets 2. Machinery
All plant assets (EXCLUDING Land) depreciate over their
(Property, 3. Buildings useful lives.
Plant, and 4. Land
• Depreciation: allocating the cost of assets to a
5. Delivery Vehicles
Equipment) 6. Furniture.
number of years.
• Accumulated Depreciation: total amount of
depreciation expensed thus far in the asset’s life.
1. Trademarks
2. Patents
Intangible 3. Copyrights “Long-term resources that lack a physical form (not
Assets 4. Franchises touchable) and benefit business operations.”
5. Goodwill

1. Accounts Payable
2. Salaries and Wages Payable
Current 3. Income Taxes Payable “Obligations due to be paid or settled WITHIN one
Liabilities 4. Interest Payable year or the operating cycle, whichever is longer.”
5. Notes Payable (1 year or less).
6. Current maturities of long-term obligations
1. Bonds Payable
Long-Term 2. Notes Payable (more than 1 year)
“Obligations NOT DUE within one year or the
3. Mortgage Payable.
Liabilities 4. Lease Liabilities
operating cycle, whichever is longer.”
5. Pension Liabilities
1. Common stock
2. Preferred Stock
Equity 3. Paid-in Capital “The owner’s claim on assets.”
4. Retained Earnings ( income retained for use in
the business)

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 Chapter 5 Review

MERCHANDISING OPERATIONS AND THE MULTI-STEP

INCOME STATEMENT
LO 1: Describe merchandising operations and inventory systems.
• Primary source of revenue for merchandisers like Walmart that buy and sell goods is referred to as
sales revenue.
• Cost of goods sold is the total cost of merchandise sold during the period.
o It is an EXPENSE that is directly related to the revenue recognized from the sale of goods.

Ex: Company C, a retailer, bought chairs from a wholesaler for $15 each. Company C then sold the
chairs to their customers for $20 each.

• The $20 represents Company C’s sales revenue for each chair.
• The $15 that Company C spent on each chair represents Company C’s cost of goods sold and
is recognized when each chair is sold to customers.

***Key Formula: Sales Revenue – Cost of Goods Sold = Gross Profit

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FLOW OF COSTS
• Companies use either a perpetual inventory system or a periodic inventory system to account for
inventory.

1. Perpetual: CONTINUOUSLY updates accounting records for merchandising transactions –

SPECIFICALLY reduction of inventory and increasing cost of goods sold.

• Advantages of perpetual inventory system.

1. Traditionally used for merchandise with high unit values.
2. Shows the quantity and cost of the inventory that should be on hand at any time.
3. Provides better control over inventories than a periodic system.

2. Periodic: updates the accounting records for merchandise transactions at the END OF A PERIOD.

• Cost of goods sold determined by count at the end of the accounting period.

***Key Formula… Cost of Goods Sold = Beginning Inventory + Net Purchases – Ending Inventory

Beginning Inventory $ 200,000

Add: Purchases, net $ 900,000
Goods available for sale $ 1,100,000
Less: Ending Inventory $ 400,000
Cost of Goods Sold $ 700,000

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 Chapter 5 Review

LO 2: Record purchases under a perpetual inventory system.

FREIGHT COSTS

Shipping Terms Ownership Transfers when goods passed to Freight cost paid by

1. FOB (Free on Board) 1. BUYER

Shipping Point: GOODS 1. CARRIER
Inventory xxx
ARE BUYERS AS SOON AS
Cash xxx
CARRIER GETS THEM.

2. FOB (Free on Board) 2. SELLER

Destination: GOODS ARE 2. BUYER
SELLERS UNTIL THEY REACH Freight-Out xxx
BUYER. Cash xxx

Del

PURCHASE DISCOUNTS
• Buyer receives a cash discount for prompt payment.
• Saves the buyer money and helps the seller collect money faster.

What does this mean?

*The buyer can deduct 2% of the invoice amount if
payment is made within 10 days of the invoice
date, otherwise full payment is due within a
30-day credit period.
*Simply…The buyer gets a 2% discount if they pay
within 10 days, otherwise the full amount is due in
30 days.

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 Chapter 5 Review

PURCHASE DISCOUNTS (Cont.)

1% discount if paid within first 10 days of next month.

Net amount due within the first 10 days of the next month.

PURCHASE RETURNS AND ALLOWANCES

• Purchase Returns: Return goods for credit if the sale was made on credit, or for a cash refund if the
purchase was for cash.
• Purchase Allowances: May choose to keep the merchandise if the seller will grant a reduction of
the purchase price.

Summary of Purchasing Journal Entries- Perpetual

DEBIT CREDIT
Inventory xxx
1. Purchase inventory ON ACCOUNT.
Accounts Payable xxx

Inventory xxx
2. Purchase inventory for CASH.
B Cash xxx

Inventory xxx
U 3. Paying freight costs on purchases (FOB Shipping Point) Cash xxx

Y Accounts Payable xxx

4. Paying WITHIN discount period. Inventory (For purchase discount) xxx
E Cash xxx

R 5. Paying OUTSIDE discount period.

Accounts Payable
Cash
xxx
xxx

Cash or Accounts Payable xxx

6. Recording Purchase Returns and Allowances. Inventory xxx

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Example Journal Entries

Jay Company bought inventory from Z Company on January 1 for $10,000 under the credit terms 3/15,
n/60. On January 10, Jay Company returned goods costing $1,000 to Z Company. Jay Company paid Z
Company for the remaining goods on Jan. 12.

What are the journal entries that need to be recorded in January for Jay Company?

Date Debit Credit

Inventory Jan. 1 10,000
Accounts Payable- Z Company 10,000

Accounts Payable- Z Company Jan. 10 1,000

Inventory 1,000

Accounts Payable- Z Company (10,000 – 1,000) Jan. 12 9,000

Inventory (9,000 × 3% = $270) 270
Cash 8,730

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 Chapter 5 Review

LO 3: Record sales under a perpetual inventory system.

SALES RETURNS AND ALLOWANCES

• Used when the seller either accepts goods back from a purchaser (a return) or grants a reduction in
the purchase price (an allowance) so that the buyer will keep the goods.
• Contra-revenue account on the income statement and has a Debit balance.

SALES DISCOUNTS
• Issued by the seller to obtain their money from the customer faster.
• Contra-revenue account on the income statement and has a Debit balance.

Sales Revenue – Sales Returns and Allowances – Sales Discounts = Net Sales

Net Sales – Cost of Goods Sold = Gross Profit

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Example Journal Entries

• Jay Company sold goods costing $6,000 to X Company for $10,000 on March 1 under the terms
2/10, net 30. On March 5, X Company returned goods to Jay Company with a selling price of $3,000
and a cost of $1,800. On March 10, Jay Company received payment from X Company for the
remainder of the goods.

What are the journal entries that need to be recorded on in March for Jay Company?

Date Debit Credit

Accounts Receivable- X Company Mar. 1 10,000
Sales Revenue 10,000

Cost of Goods Sold Mar. 1 6,000

Inventory 6,000

Sales Returns and Allowances Mar. 5 3,000

Accounts Receivable- X Company 3,000

Inventory Mar. 5 1,800

Cost of Goods Sold 1,800

Cash Mar. 10 6,860

Sales Discounts (7,000 × 2% = $140) 140
Accounts Receivable- X Company (10,000 -3,000) 7,000

LO 5: Apply the steps in the accounting cycle to a merchandising company.

Each of the required steps described in Chapter 4 for service companies applies to
merchandising companies.
Adjusting Entries
A merchandising company generally has the same types of adjusting entries as a service
company. However, a merchandiser using a perpetual system will require one additional
adjustment to make the records agree with the actual inventory on hand. Here’s why: At the end
of each period, for control purposes, a merchandising company that uses a perpetual system will
take a physical count of its goods on hand.
The company’s unadjusted balance in Inventory usually does not agree with the actual amount of
inventory on hand. The perpetual inventory records may be incorrect due to recording errors,
theft, or waste. Thus, the company needs to adjust the perpetual records to make the recorded
inventory amount agree with the inventory on hand.

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• This adjustment impacts Inventory and Cost of Goods Sold.

For example, suppose that PW Audio Supply, Inc. has an unadjusted balance of $40,500 in
Inventory.
Through a physical count, PW Audio Supply determines that its actual merchandise inventory at
December 31 is $40,000. The company would make an adjusting entry as follows.

Dec. 31 Cost of Goods Sold 500

Inventory ($40,500 – $40,000) 500
(To adjust inventory to physical count)

Closing Entries
A merchandising company, like a service company, closes to Income Summary all accounts that
affect net income. In journalizing, the company credits all temporary accounts with debit
balances, and debits all temporary accounts with credit balances. It also closes both Income
Summary and Dividends to Retained Earnings. (Hint – R.E.D – temporary accounts are
Revenue, Expense, and Dividends)

The following are the closing entries for PW Audio Supply using assumed amounts from its
year-end adjusted trial balance.
• Cost of Goods Sold is an expense account with a normal debit balance,
• Sales Returns and Allowances and Sales Discounts are contra revenue accounts with
normal debit balances

The easiest way to prepare the first two closing entries is to identify the temporary
accounts by their balances and then prepare one entry for the credits and one for the
debits.
Dec.31 Sales Revenue 480,000
Income Summary 480,000
(To close income statement accounts with credit
balances)
31 Income Summary 450,000
Sales Returns and Allowances 12,000
Sales Discounts 8,000
Cost of Goods Sold 316,000
Salaries and Wages Expense 64,000
Freight-Out 7,000
Advertising Expense 16,000

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 Chapter 5 Review

Utilities Expense 17,000

Depreciation Expense 8,000
Insurance Expense 2,000
(To close income statement accounts with debit
balances)
31 Income Summary 30,000
Retained Earnings 30,000
(To close net income to retained earnings)
31 Retained Earnings 15,000
Dividends 15,000
(To close dividends to retained earnings)
After PW Audio Supply has posted the closing entries, all temporary accounts have zero
balances. Also, Retained Earnings has a balance that is carried over to the next period

LO 5: Prepare a multi-step income statement

SINGLE-STEP INCOME STATEMENT
• Subtract total expenses from total revenues
• Two reasons for using the single-step format:
1. Company does not realize any type of profit or income until total revenues exceed total
expenses.
2. Form is simple and easy to read.

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 Chapter 5 Review

MULTI-STEP INCOME STATEMENT

• Highlights the components of net income.
• Three important line items:
1. Gross profit
2. Income from Operations
3. Net Income

•
***ALL OF THESE ITEMS ARE PART OF NONOPERATING
ACTIVITIES AND ARE ADDED OR DEDUCTED FROM INCOME
FROM OPERATIONS TO GET INCOME BEFORE TAXES.

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 Chapter 6 Review

REPORTING AND ANALYZING INVENTORY

LO 1: Discuss how to classify and determine inventory.
• Inventory: “Assets a company intends to sell in the normal course of business, has in production for
future sale, or uses currently in the production of goods to be sold.”
1. Inventory--ON BALANCE SHEET: “represents the cost of inventory STILL ON HAND.”
2. Cost of Goods Sold---ON INCOME STATEMENT: “represents the cost of inventory SOLD
DURING THE PERIOD.”

• Merchandising companies have ONE type of inventory: Merchandise Inventory

• Manufacturing companies have THREE types of inventory:
1. Raw Materials
2. Work in Process
3. Finished Goods

DETERMINING INVENTORY QUANTITIES

• Physical inventory is taken for 2 reasons:
o Perpetual System
1. Check accuracy of inventory records.
2. Determine amount of inventory lost due to wasted raw materials, shoplifting, or
employee theft.

o Periodic System
1. Determine the inventory on hand.
2. Determine the cost of goods sold for the period.

• One challenge in determining inventory quantities is making sure a company owns the inventory.
o Goods in transit: purchased goods not yet received and sold goods not yet delivered.
• FOB (Free on Board) Shipping Point: Ownership of the goods passes to the buyer
when the public carrier accepts the goods from the seller.
• If goods are in transit they are the BUYERS.

• FOB (Free on Board) Destination: Ownership of the goods remains with the seller
until the goods reach the buyer.
• If goods are in transit they are the SELLERS.

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o Consigned Goods: Goods held for other parties to see if they can sell the goods for the
other party. The company holding the goods charges a fee and does not take ownership of
the goods.
• Consignor: goods shipped by the owner.
• Consignee: sell goods for the owner.
**At end of the year GOODS NOT SOLD BELONG AS PART OF CONSIGNOR’S (OWNER’S)
INVENTORY.

Ex: Auto Alex owns a used car lot. Nick has a used car that he wants to sell. He goes to Auto Alex
and the dealer agrees to put Nick’s car on the lot for a fee. Auto Alex does not take ownership of
the car.

Consignor: Nick (Car is INCLUDED in inventory.)

Consignee: Auto Alex (Used car is NOT INCLUDED in inventory.)

LO 2: Apply inventory cost flow methods and discuss their financial effects.
• Inventory is accounted for at cost.
o Cost includes all expenditures necessary to acquire goods and place them in a condition
ready for sale.
o Unit costs are applied to quantities to determine the total cost of the inventory and the cost
of goods sold using the following costing methods:
1. Specific identification
2. First-in, first-out (FIFO)
3. Last-in, first-out (LIFO)
4. Average-cost

o There is NO REQUIREMENT that the cost flow assumption has to be consistent with the
physical movement of goods.

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1. SPECIFIC IDENTIFICATION (PERPETUAL)

• Cost attached to a specific item. (Ex: When selling jewelry.)

Ex: Laker Company ending inventory consists of 200 units, where 180 are from January 24 purchase, 5 are
from January 6 purchase and 15 are from the beginning inventory.

Date Explanation Units Unit Cost Total

Cost
Jan. 1 Beginning Inventory 140 $ 6.00 $ 840.00
Jan.6 Purchase 60 $ 5.00 $ 300.00
Jan. 24 Purchase 180 $ 4.50 $ 810.00
Total 380 $ 1,950

Step 1: Calculate Cost of Goods Sold Step 2: Calculate Ending Inventory

Date Units Unit Cost Total Cost Cost of Goods Available for sale $ 1,950
Beg. Inv. 125 $ 6.00 $ 750 Less: Cost of Goods Sold $ (1,025)
Jan. 6 55 $ 5.00 $ 275 Ending Inventory $ 925.00
Jan. 24 0 $ 4.50 $ 0
Total 180 $ 1,025 OR
Step 2: Calculate Ending Inventory
Date Units Unit Cost Total Cost
Beg. Inv. 15 $ 6.00 $ 90
Jan. 6 5 $ 5.00 25
Jan. 24 180 $ 4.50 $ 810
Total 200 $ 925

2. FIRST-IN, FIRST-OUT (FIFO) (PERPETUAL)

• Assumes OLDEST ITEMS SOLD FIRST (Ex: Grocery stores sell oldest fruit or dairy
products like milk first before newest.)
• Costs of the earliest goods purchased are the first to be recognized in determining
cost of goods sold. (Resembles the actual physical flow of merchandise)
• Example:

[Grab your
reader’s
 Chapter 6 Review

NEWEST UNITS REMAIN IN ENDING INVENTORY.

3. LAST-IN, FIRST-OUT (LIFO) (PERPETUAL)

• Assumes NEWEST ITEMS SOLD FIRST (Ex: When new technology items came out.)
• Costs of the latest goods purchased are the first to be recognized in determining cost
of goods sold.
• Seldom coincides with actual physical flow of merchandise.

• OLDEST UNITS REMAIN IN ENDING INVENTORY.

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4. MOVING AVERAGE (PERPETUAL)

When a unit is sold, the average cost of each unit in inventory is assigned to cost of goods sold.

INCOME STATEMENT EFFECTS

• In periods of changing prices, the cost flow assumption can have significant impacts both on income
and on evaluations of income, such as the following.

1. In a period of inflation (prices are RISING), FIFO produces a higher net income because lower
unit costs of the first units purchased are matched against revenue.

2. In a period of inflation (prices are RISING), LIFO produces a lower net income because higher
unit costs of the last goods purchased are matched against revenue.

3. If prices are falling, the results from the use of FIFO and LIFO are reversed. FIFO will report the
lowest net income and LIFO the highest.

4. Regardless of whether prices are rising or falling, average-cost produces net income between
FIFO and LIFO.
During Times of Rising Prices:
(Jan. 1 $20, Feb. 1 $30, Mar. 1 $40

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• Each of the three cost flow assumptions are acceptable under GAAP.
• Method should be used consistently, enhances comparability.
• Although consistency is preferred, a company may change its inventory costing method.

LO 3: Indicate the effects of inventory errors on financial statements.

• INCOME STATEMENT EFFECTS

• BALANCE SHEET EFFECTS

Accounting Equation: ASSETS = LIABILITIES + STOCKHOLDERS’ EQUITY

LO 4: Explain the statement presentation and analysis of inventory.

• Inventory is classified in the BALANCE SHEET as a CURRENT ASSET immediately below receivables.
• In a multiple-step income statement, cost of goods sold is subtracted from net sales.
• There also should be disclosure of
1. The major inventory classifications
2. The basis of accounting (cost, or lower-of-cost-or-market)
3. The cost method (FIFO, LIFO, or average-cost).

LOWER-OF-COST-OR-MARKET
• Applied to items in inventory after the company has used one of the cost flow methods (
specific identification, FIFO, LIFO, or average-cost) to determine cost.
• Companies can “write down” the inventory to its market value in the period in which the price
decline occurs.

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• Market value = Replacement Cost

• Example of conservatism.
• Inventory is valued at the LOWER of
its COST or MARKET VALUE.

ANALYSIS
1. Inventory Turnover Ratio

• Average Inventory= (Inventory Beginning of Year + Inventory End of Year) ÷ 2

• Used to measure a company’s ability to manage its inventory effectively.
• A company that has an inventory turnover of 4 indicates that it sells and replaces their inventory 4
times per year.

2. Days in Inventory

• Indicates the average number of days’ inventory is held.

• Shorter the number of days’ in inventory, the better, but it depends on industry. For example,
grocery stores will have a much shorter amount of days then jewelry stores.
• A company has 100 days’ in inventory. Therefore, it takes it 100 days to purchase, sell, and replace
their inventory.

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REPORTING AND ACCOUNTS RECEIVABLE

LO 1: Explain how companies recognize accounts receivable.
RECEIVABLES
• “Amounts due from individuals and companies that are expected to be collected in cash.”
1. Accounts Receivable: Amounts customers owe on account that result from the sale of
goods and services. Companies generally expect to collect accounts receivable within 30
to 60 days.

2. Notes Receivable: Written promise (formal instrument) for amount to be received. Also
called trade receivables. They include interest and extend for time periods of 60 to 90
days or longer.

3. Other Receivables: Nontrade receivables such as interest, loans to officers, advances to

employees, and income taxes refundable.

• Service organization records a receivable when it performs service ON ACCOUNT.

• Merchandiser records accounts receivable at the point of sale of merchandise ON ACCOUNT.

***Below are examples of journal entries that would be made with accounts receivables.
Many of these journal entries were explained in Chapter 5.

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Example: Prepare journal entries to record the following transactions entered into by the Castagno
Company:

Nov. 1 Sold merchandise on account to Mercer, Inc., for $18,000, terms 2/10, n/30.
Nov. 5 Mercer, Inc., returned merchandise worth $1,000.
Nov. 9 Received payment in full from Mercer, Inc.

Date Debit Credit

Accounts Receivable- Mercer, Inc. Nov. 1 18,000
Sales Revenue 18,000

Sales Returns and Allowances Nov. 5 1,000

Accounts Receivable- Mercer, Inc. 1,000

Cash Nov. 9 16,660

Sales Discounts ($17,000 x 0.02) 340
Accounts Receivable- Mercer, Inc. 17,000

***Remember: 2/10, n/30 means that the buyer (Mercer) will get a 2% discount
on the selling price if they pay Castagno within 10 days, otherwise the full
amount is due in 30 days with no discount.

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LO 2: Describe how companies value accounts receivable and record their

disposition.
VALUING ACCOUNTS RECEIVABLE
• Current asset on the balance sheet.
• Valuation (net realizable value). (The amount of accounts receivable that the company actually
expects to collect.)
• Bad Debt Expense: Losses that the seller records as a result from extending credit and not being
able to collect the money.

• Two methods used in accounting for uncollectible accounts are:

1. Direct Write-Off Method
• Records bad debt expense only when an account is determined to be worthless.
• Used by SMALL companies and companies with a FEW receivables.
• No matching.
• Receivable is not stated at net realizable value.
• Not acceptable for financial reporting.
• If an accounts receivable that has been written off is later collected, then 2 journal
entries have to be made. One to reinstate the accounts receivable and the other one
to collect the cash.

2. Allowance Method
• Records bad debt expense by estimating uncollectible accounts at the end of the
accounting period.
• Generally accepted accounting principles (GAAP) require companies with a large
amount of receivables to use the allowance method.
• When an estimation of bad debts is made the account “ALLOWANCE FOR
DOUBTFUL ACCOUNTS” gets credited (Has a normal CREDIT balance after the end
of period adjusting journal entry). It is a contra-asset.
o Allowance for Doubtful accounts has a DEBIT balance when:
the write-offs during the period EXCEED than the beginning balance.
o Allowance for Doubtful accounts has a CREDIT balance when:
write-offs during the period are LESS than the beginning balance.

Cash (Net) Realizable Value of Receivables= Accounts Receivable Balance – Allowance for Doubtful Accounts

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Example: On November 15, it was determined that Mr. Sanders account of $3,000 would be
uncollectible. On December 20, after Mr. Sanders account was written off he paid Company M $3,000 in
full. On December 31, Company M estimated that $10,000 of their remaining credit sales will prove
uncollectible.

a) Prepare the journal entries for November 15, December 20, and December 31 under the direct write-
off method.

Date Debit Credit

Bad Debt Expense Nov. 15 3,000
Accounts Receivable- Mr. Sanders 3,000

Accounts Receivable- Mr. Sanders Dec. 20 3,000

Bad Debt Expense 1,000

Cash Dec. 20 3,000

Accounts Receivable- Mr. Sanders 3,000

NO JOURNAL ENTRY Dec. 31

b) Prepare the journal entries for November 15, December 20, and December 31 under the allowance
method.

Date Debit Credit

Allowance for Doubtful Accounts Nov. 15 3,000
Accounts Receivable- Mr. Sanders 3,000

Accounts Receivable- Mr. Sanders Dec. 20 3,000

Allowance for Doubtful Accounts 1,000

Cash Dec. 20 3,000

Accounts Receivable- Mr. Sanders 3,000

Bad Debt Expense Dec. 31 10,000

Allowance for Doubtful Accounts 10,000

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PRESENTATION OF ACCOUNTS RECIEVABLE ON THE BALANCE SHEET UNDER THE

ALLOWANCE METHOD

• Cash (Net) Realizable Value = Accounts Receivable – Allowance for Doubtful Accounts
• For Hampson Furniture, of the $200,000 in Accounts Receivable, they only expect to collect
$188,000. They do not expect to collect $12,000.

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2 Methods for Estimating Uncollectible Accounts under the Allowance Method

1. Balance Sheet Approach (Percent of Ending Accounts Receivable Method)

Allowance for Doubtful Accounts
% of End Accounts Receivable as Uncollectible as a decimal x End A/R = Y

BEG Balance

*X--- WE NEED TO
JOURNAL ENTRY
FIGURE THE
ADJUSTMENT FROM Bad Debt Expense X
THE BEG TO END
BALANCE
Allowance for Doubtful Accounts X

Y- END BALANCE
RULES
1. IF BEGINNING ALLOWANCE FOR DOUBTFUL ACCOUNTS IS A CREDIT THEN
END BALANCE – BEGINNING BALANCE = X

2. IF BEGINNING ALLOWANCE FOR DOUBTFUL ACCOUNTS IS A DEBIT THEN

END BALANCE + BEGINNING BALANCE = X

Ex: 1 Smith Inc. estimates that 1% of their $100,000 accounts receivable balance as of December
31 will be uncollectible. What Journal entry would be made on December 31 if the beginning
balance for the Allowance for Doubtful Accounts was a $600 CREDIT balance?

Bad Debt Expense 400 $1,000 (END) - $600 (BEG)

Allowance for Doubtful Accounts 400 $1,000 (END) - $600 (BEG)

Allowance for Doubtful Accounts

$600 Beginning Balance
$400 $1,000 (END) - $600 (BEG) = $400

$1,000 0.01 X $100,000 = $1,000

Ending Balance

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Ex: 2 Smith Inc. estimates that 1% of their $100,000 accounts receivable balance as of December
31 will be uncollectible. What Journal entry would be made on December 31 if the beginning
balance for the Allowance for Doubtful Accounts was a $600 DEBIT balance?

Bad Debt Expense 1,600 $1,000 (END) + $600 (BEG)

Allowance for Doubtful Accounts 1,600 $1,000 (END) + $600 (BEG)

Allowance for Doubtful Accounts

BEG: $600 $1,600 $1,000 (END) + $600 (BEG) = $1,600

End: $1,000 0.01 X $100,000 = $1,000

2. Balance Sheet Approach (Aging the Accounts Receivables Method)

Totals Not Yet Due 1-30 days Past Due 31-60 days Past Due 61-90 days Past Due 90 + Days Past Due
John Smith $2,000 $1,000 $1,000
Sue $3,000 $1,000 $1,000 $1,000
Aging of Jim $10,000 $5,000 $2,000 $1,000 $2,000
Recievables Total Recievables $15,000 $6,000 $2,000 $3,000 $2,000 $2,000
Method Percent Uncollectible 2% 5% 10% 25% 40%
ESTIMATED UNCOLLECTIBLE $1,820.00 $120 $100 $300 $500 $800

Ending Balance of Allowance for Doubtful Accounts

*If Allowance for Doubtful Accounts had an unadjusted $500 credit balance then…..

Ending Balance – Beginning Balance = Adjustment

$1,820 - $500 = $1,320

Bad Debt Expense 1,320

Allowance for Doubtful Accounts 1,320

*The amount of the adjusting entry is the amount that will yield an adjusted balance for
Allowance for Doubtful Accounts equal to that estimated by the aging schedule. In this case the
adjusted entry which CREDITS Allowance for Doubtful Accounts by $1,320 leads to the ending
adjusted balance of the Allowance for Doubtful Accounts to have a CREDIT balance of $1,820.

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DISPOSING OF ACCOUNTS RECEIVABLE

Sale of Receivables to a Factor

• A factor is a finance company or bank.

o Buys receivables from businesses and then collects the payments directly from the
customers.
o Typically charges a commission to the company that is selling the receivables.
o Fee ranges from 1% to 3% of the receivables purchased.

Ex: Assume that Hendredon Furniture factors $600,000 of receivables to Federal Factors on Nov. 15.
Federal Factors assesses a service charge of 2% of the amount of receivables sold. The journal entry to
record the sale by Hendredon Furniture is as follows:

Date Debit Credit

Cash Nov. 15 588,000
Service Charge Expense ($600,000 x 2%) 12,000
Accounts Receivable 600,000

National Credit Card Sales (Customers that use Visa, Mastercard, or other credit card)

• A retailer’s acceptance of a national credit card is another form of selling (factoring) the receivables
by the retailer.
o Retailer pays card issuer a fee of 2 to 4% of the invoice price for its services.
o Recorded the same as cash sales.

o Advantages to retailer:
 Issuer does credit investigation of customer.
 Issuer maintains customer accounts.
 Issuer undertakes collection and absorbs losses.
 Receives cash more quickly.

Ex: Chef Louie purchases $2,000 worth of food and ingredients for his restaurant from Frank’s Fresh
Market store, and he charges this amount on his MasterCard. The service fee that MasterCard charges
Frank’s Fresh Market is 4%. Frank’s Fresh Market would record this transaction on March 28 as follows:

Date Debit Credit

Cash Mar. 28 1,920
Service Charge Expense ($2,000 x 4%) 80
Sales Revenue 2,000

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LO 3: Explain how companies recognize, value, and dispose of Notes Receivable.

Promissory Note: “written promise to pay a specified amount of money on demand or at a definite
time.”
• Promissory notes may be used when
1. Individuals and companies lend or borrow money.
2. Amount of transaction and credit period exceed normal limits.
3. In settlement of accounts receivable.
• Used for a credit period of more than 60 days. If it is going to be collected WITHIN ONE YEAR, it is
classified as a current asset on the balance sheet. If it is going to be collected AFTER MORE THAN A
YEAR, then it is classified as a noncurrent asset as an investment on the balance sheet.
• Report short-term notes receivable at their cash (net) realizable value.
• Estimation of cash realizable value and recording bad debt expense and related allowance are
similar to accounts receivable.

EXAMPLE used for terms below: A NOTE DATED JUNE 20, 20XX FOR RON TO PAY CAM $1,000 ON
OCTOBER 20, 20XX WITH AN INTEREST RATE OF 10%.

1. Face Value of a Note (Principal): specified amount of money at a definite future date.
(Ex: $1,000)

2. Maker of the Note: the person who signed the note and promised to pay it at maturity. (Ex: RON)
• The maker of the note recognizes a note payable.

3. Payee of the Note: the person to whom the note is payable. (Ex: CAM)
• The payee of the note recognizes a note receivable.

4. Issuance Date: the date the note is issued. (Ex: JUNE 20, 20XX)

5. Maturity date of the Note: the date the note must be repaid. (Ex: OCTOBER 20, 20XX)
• May be stated on demand, on a stated date, or at the end of a stated period of time.
• Note terms are expressed in months and days.

*When months or years are used, the note matures and is payable in the month of its maturity on the
same day of the month as its original date. For example, a 9-month note dated September 28 would be
payable on June 28.

*If days, then have to count days in the month. DON’T INCLUDE DATE OF NOTE AS PART OF NUMBER OF
DAYS. For example, if note issued March 16 the amount of days note is outstanding in
March is 31 days – 16 = 15 days.

Term of Note 90 days

March (31-16) 15 days
April 30 days
May 31 days 76
June 14
(Maturity Date)

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6. Term of Note: amount of time between the issuance and due dates. (About 122 days—Time
between June 20, 20XX and October 20, 20XX)

7. Interest Computation:

Time in Terms of One Year

Days: # of days ÷ 360
Months: # of months ÷ 12
Years: # of years ÷ 1

Ex: The total interest for a $1,000, 90-day, and 10% note would be computed as follows:
$1,000 X 10% X (90/360) = $25

Current Example: 122 day note between Ron and Cam.

$1,000 x 10% x (122/360) = $33.89 Interest

8. Maturity Value: Amount that must be paid at the due date of the note. It is the sum of the
face amount and interest. In our example Ron has to pay Cam $1,033.89 ($1,000 Face Amount
+ $33.89 Interest) when note is due on October 20, 2017.

Another Note Example

with Terms

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Journal Entries for Notes Receivable

1. Recognizing Notes Receivable (Tropical Breeze-Payee point of view)

Tropical Breeze Inc. received a $2,000, 90-day, 10% promissory note from Paradise Sand to settle their
overdue open account.

2. Recording an Honored Note (Tropical Breeze-Payee point of view)

After 90 days, Tropical Breeze Inc. receives $2,050 from Paradise Sand ($2,000 to repay the note and
$50 in interest.) Interest = (2,000 x 10% x (90/360))= $50

3. Recording a Dishonored Note (Tropical Breeze-Payee point of view)

After 90 days, Paradise Sand is unable and refuses to pay Tropical Breeze Inc. $2,050 ($2,000 to repay
the note and $50 in interest.)

4. Recording End-of-Period Interest Adjustment (Tropical Breeze-Payee point of view)

If Tropical Breeze Inc. receives a $2,000, 90-day, 10% promissory note from Paradise Sand on
December 1, then on December 31 Tropical Breeze Inc. would need to recognize 30 days of interest.

$2,000 X 10% X (30/360) = $16.67

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LO 4: Describe the statement presentation of receivables and the principles of

receivables management.

• Companies need to identify in the balance sheet or in notes to the financial statements each of the
major types of receivables.
• Companies report both the gross amount of receivables and the allowance for doubtful accounts.

MANAGING RECEIVABLES
Managing accounts receivable involves five steps:
1. Determine to whom to extend credit.

2. Establish a payment period.

3. Monitor collections.
• Companies should prepare an accounts receivable aging schedule at least monthly.
• Helps managers estimate the timing of future cash inflows.
• Provides information about the collection experience of the company and
identifies problem accounts.

4. Evaluate the liquidity of receivables.

• Accounts Receivable Turnover: Measure the number of times, on average, a

company collects receivables during the period.

• Average Collection Period: Used to assess the effectiveness of credit and collection
polices. This period SHOULD NOT EXCEED credit term period.

5. Accelerate cash receipts from receivables when necessary.

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Plant Assets, Natural Resources, and Intangible Assets

LO 1: Explain the accounting for Plant Asset Expenditures.
• Plant Assets (Also known as Property, Plant, and Equipment/ Fixed Assets): resources that have
• physical substance (a definite size and shape).
• are used in the operations of a business.
• are not intended for sale to customers.
• are expected to provide service to the company for a number of years.

• Cost of Plant Assets: Historical cost principle requires that companies record plant assets at COST.
• Consists of all expenditures necessary to acquire an asset and make it ready for its
intended use.
• Cost is measured by the cash paid in a cash transaction or the cash equivalent price paid.
• Cash equivalent price is the
• fair value of the asset given up or fair value of the asset received, whichever is
more clearly determinable.

1. Revenue Expenditure: costs incurred to acquire a plant asset that are EXPENSED
IMMEDIATELY.
• Include the cost of ordinary repairs, which are expenditures to maintain operating
efficiency and expected productive life of the unit.
• “Expenditures that produce benefits ONLY IN THE CURRENT PERIOD.” They are
EXPENSED in the current period.
• Ex: Engine tune-up for delivery truck. It allows the truck to continue its productive
activity but DOES NOT INCREASE FUTURE BENEFITS. This is an example of a
maintenance cost.

Ex: Aug. 1: $500 was paid for a tune-up of a delivery truck. The journal entry would be
recorded as
Date Debit Credit
Maintenance and Repairs Expense Aug. 1 500
Cash 500

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2. Capital Expenditure: costs INCLUDED IN A PLANT ASSET ACCOUNT.

• Include the cost of additions and improvements, which are costs incurred
to increase the operating efficiency, productive capacity, or expected useful
life of a plant asset.
• Costs that are CAPITALIZED NOW and expensed later.
• “Expenditures that produce future benefits.” They are recorded as an ASSET
and EXPENSED IN FUTURE PERIODS.
• Ex: Major improvement on a truck that EXTENDS its useful life.
• The accounting varies depending on the nature of the expenditure.

Ex: July 1: The engine of a forklift near the end of its useful life is overhauled (taken apart to be
repaired) at a cost of $5,000 which extends its useful life by 6 years. The journal entry to record this
expenditure is

Date Debit Credit

(1) Forklift July 1 5,000
Cash 5,000

COST OF PLANT ASSETS

1. Land: All necessary costs incurred in making land ready for its intended use increase (debit) the
Land account. Costs typically include:
• Cash purchase price.
• Closing costs such as title and attorney’s fees.
• Real estate brokers’ commissions.
• Accrued property taxes and other liens on the land assumed by the purchaser.

2. Land Improvements: Includes all expenditures necessary to make the improvements ready for
their intended use. They have limited useful lives and they are expensed (depreciated) over their useful
lives. Costs typically include:
• Driveways.
• Parking lots.
• Fences.
• Landscaping.
• Underground sprinklers.

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3. Buildings: Includes all costs related directly to purchase or construction.

Purchase costs typically include:
• Purchase price, closing costs (attorney’s fees, title insurance, etc.) and real estate broker’s
commission.
• Remodeling and replacing or repairing the roof, floors, electrical wiring, and plumbing.
Construction costs typically include:
• Contract price plus payments for architects’ fees, building permits, and excavation costs.
• Interest costs to finance a construction project which are limited to interest costs incurred
during the construction period.

4. Equipment: Include all costs incurred in acquiring the equipment and preparing it for use.
Costs typically include:
• Cash purchase price.
• Sales taxes.
• Freight charges.
• Insurance during transit paid by the purchaser.
• Expenditures required in assembling, installing, and testing the unit.

LO 2: Apply Depreciation Methods to Plant Assets

Depreciation: “Process of allocating to expense the cost of a plant asset over its useful life in a rational
and systematic manner.”

IMPORTANT FACTS ABOUT DEPRECIATION

• Process of cost allocation, not asset valuation.
• Applies to land improvements, buildings, and equipment, NOT LAND.
o LAND DOES NOT DEPRECIATE.
• Depreciable, because the revenue-producing ability of asset will decline over the asset’s useful life.

FACTORS IN COMPUTING DEPRECIATION

1. Cost: All expenditures necessary to acquire the asset and make it ready for intended use.

2. Useful Life: Estimate of the expected productive (service) life of the asset for its owner. It may be
expressed in terms of time, units of activity (such as machine hours), or units of output.

3. Salvage Value (Residual Value): Estimate of the asset’s value at the end of it useful life.
An asset cannot be depreciated past its salvage value.

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DEPRECIATION METHODS
1. STRAIGHT-LINE METHOD: equal amount of depreciation is taken out each year.
*Depreciable Cost (amount that gets depreciated) = Cost – Salvage Value

Depreciation Expense = Cost – Salvage Value

Useful Life in Periods

Ex: Smith Inc. bought a machine for $20,000 to use in his business. The machine’s useful life is 5 years.
What is the depreciation expense per year and what journal entry would be made at the end of the
year?

A) Depreciation Expense = ($20,000 - $0) ÷ 5 years = $4,000 per year

***Another way to compute depreciation expense would be to do depreciable cost × straight-line rate.
Straight-Line Rate= 100% ÷ Useful Life in Years ........ 100% ÷ 5 years = 20%
Depreciable Cost = Cost – Salvage Value………$20,000 - $0 = $20,000
Depreciation Expense = $20,000 x 20% = $4,000 per year

B) End of the year journal entry on December 31 to record depreciation expense.

Date Debit Credit

Depreciation Expense Dec. 31 4,000
Accumulated Depreciation- Machinery 4,000

End Book Value = Cost of Asset – Accumulated Depreciation

OR Beginning Book Value of the Current Year – Depreciation Expense

Beginning Book Value = Cost for the first year AND the End book value from the previous year for all
other years

Accumulated Depreciation: Balance in Accumulated Depreciation from previous year + Current year’s
depreciation expense

• As you can see, after year 5, the machine has fully depreciated and reached its salvage value of $0.

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2. DECLINING BALANCE METHOD: type of an accelerated depreciation method which yields larger
depreciation expenses in the early years of an asset’s life and less depreciation in the later years. It uses
a multiple of the straight-line rate and applies it to the asset’s beginning period book value.

STEP 1: Straight Line Rate = 100% ÷ Useful Life in Years

STEP 2: If Double Declining…Straight-Line Rate x 2
If 1.5 Declining….. Straight-Line Rate x 1.5

Ex: Holiday Company purchased a machine for $600,000. The company expects the service life of the
machine to be five years. The anticipated residual value is $40,000. Holiday Company uses the double
declining method.
100% ÷ 5 years = 20% x 2 =40% Double Declining Rate

STEP 3:
Use table to keep track of depreciation per year.

Depreciation Expense = Beginning Book Value X Depreciation Rate

End Book Value = Cost of Asset – Accumulated Depreciation

OR Beginning Book Value of the Current Year – Depreciation Expense

B) What journal entry would Holiday Company have to record on December 31 of the 1st year the
company had the machine to adjust for depreciation?

Date Debit Credit

Depreciation Expense Dec. 31 240,000
Accumulated Depreciation- Machinery 240,000

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3. UNITS OF ACTIVITY METHOD: charges a varying amount to expense for each period of an asset’s
useful life depending on its USAGE. May also be called the units-of-production method or units-of-
output method. The usage can be in hours, miles driven, or quantity produced.

Depreciation Cost Cost – Salvage Value

STEP 1: =
per Unit Total Units of Activity

STEP 2: Depreciation Expense = Depreciation per unit X Units of Activity for Period

Ex: Clark Company bought an airplane for $500,000 that had a total useful life of 3,000,000 miles. The
salvage value of the plane at the end of its useful life is $50,000. Year 1, the airplane flew 500,000 miles.

A) What is the depreciation expense and journal entry for the end of the 1st year?

Step 1: Depreciation Cost per Unit = ($500,000 - $50,000) ÷ 3,000,000 miles = $0.15 per mile
Step 2: Depreciation Expense = $0.15 per mile X 500,000 miles = $75,000

Date Debit Credit

Depreciation Expense Dec. 31 75,000
Accumulated Depreciation- Airplane 75,000

B) If the airplane flew 800,000 in year 2, 900,000 in year 3, and 400,000 miles in years 4 and 5, what
would the depreciation expense be in each of those years?

***Depreciation Expense = Depreciation Cost per unit X Units of Activity for Period

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PARTIAL YEAR DEPRECIATION

Annual Depreciation X Fraction of the Year that Company Has Fixed Asset
• Assets placed in service during the first half of a month are normally treated as having been
purchased on the FIRST DAY OF THAT MONTH.
• Asset purchases during the second half of a month are treated as having been purchased
on the FIRST DAY OF THE NEXT MONTH.

Ex) Smith Inc. bought a machine for $20,000 on October 1 to use in his business. The machine’s useful
life is 10 years. What is the depreciation expense for the current year and what journal entry would be
made at the end of the year?

STRAIGHT LINE
A) Depreciation Expense = ($20,000 - $0) ÷ 10 years = $2,000 per year X 3/12 months = $500

B) End of the year journal entry on December 31 to record depreciation expense.

Date Debit Credit

Depreciation Expense Dec. 31 500
Accumulated Depreciation- Machinery 500

DECLINING BALANCE METHOD

A) Depreciation Expense for Year 1….
Step 1: Double Declining Rate= 1/10 = 10% x 2 = 20%
Step 2: First-Year Annual Depreciation - $20,000 x 20% = $4,000
Step 3: First-Year Partial Depreciation (For 3 months) = $4,000 x (3/12) = $1,000

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Depreciation Expense for Year 2….

Step 1: Book Value After Year 1 = $20,000 - $1,000 Depreciation= $19,000
Step 2: Second-Year Annual Depreciation - $19,000 x 20% = $3,800

B) End of the year journal entry on December 31 of Year 1 and 2 to record depreciation expense.

Date Debit Credit

Depreciation Expense Dec. 31 1,000
Accumulated Depreciation- Machinery Year 1 1,000

Depreciation Expense Dec. 31 3,800

Accumulated Depreciation- Machinery Year 2 3,800

REVISING PERIODIC DEPRECIATION

• Accounted for in the period of change and future periods (Change in Estimate).
• Not handled retrospectively.
• Not considered error.

Ex) Nanki Corporation purchased equipment on January 1, Year 1 for $650,000. Years 1, 2, and 3 Nanki
depreciated the asset on a straight-line basis with an estimated useful life of eight years and a $10,000
salvage value. In Year 4, due to changes in technology, Nanki revised the useful life to a total of six years
with no salvage value. What depreciation would Nanki record for the Year 4 on this equipment?

1. Find original depreciation expense per year. ($650,000 - $10,000) ÷ 8 years = $80,000 per year

2. Find book value at start of Year 4 (when the change in estimate occurred)
Book Value = Cost – Accumulated Depreciation = $650,000 - $240,000 [$80,000 X 3 years] =
$410,000

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3. Revised Salvage Value = $0

4. Revised Remaining Useful Life= Total Life in Number of Years – Number of Years Used

*If useful life is extended then ADD Number of Years Extended to above formula.
*If useful life is decreased then DEDUCT Number of Years Decreased to above formula.

Revised Useful Life = 6 years – 3 years Used = 3 years remaining

New Depreciation per Year = ($410,000 - $0) ÷ 3 years ≈ $136,667 a year starting in Year 4

Date Debit Credit

Depreciation Expense Dec. 31 136,667
Accumulated Depreciation- Equipment Year 4 136,667

LO 3: Explain how to account for the Disposal of Plant Assets.

DISCARDING (RETIRING) A FIXED ASSET

• No cash is received.
• Decrease (debit) Accumulated Depreciation for the full amount of depreciation taken over the life of
the asset.
• Decrease (credit) the asset account for the original cost of the asset.

Ex: Machinery acquired at a cost of $50,000 is now fully depreciated. On October 31, the machinery is
discarded. The entry to record the discard (retirement) is

Date Debit Credit

Accumulated Depreciation-Machinery Oct. 31 50,000
Machinery 50,000

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Ex: Machinery acquired at a cost of $50,000 is discarded on October 31. However, the Machinery only
had an accumulated depreciation balance of $48,000 on October 31. The entry to record the discard is

Date Debit Credit

Accumulated Depreciation-Machinery Oct. 31 48,000
Loss on Disposal of Machinery 2,000
Machinery 50,000

SELLING AN ASSET

Step 1: Find Book Value = Cost – Accumulated Depreciation

Step 2: Proceeds Received from Sale – Book Value of Asset

If POSITIVE --- Proceeds Received from Sale > Book Value of Asset then there is a GAIN ON SALE.
If NEGATIVE --- Proceeds Received from Sale < Book Value of Asset then there is a LOSS ON SALE.

Ex: Paradise Corporation sold equipment that cost $100,000 and had accumulated depreciation of
$60,000 for $45,000. Compute the gain or loss on sale and record the journal entry for the sale of
equipment.

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Step 1: Find Book Value = $100,000 – $60,000 = $40,000

Step 2: Cash Received from Sale – Book Value of Asset = $45,000 - $40,000 = $5,000 GAIN

LO 4: Describe how to account for Natural Resources and Intangible Assets.

Natural resources: consist of standing timber and underground deposits of oil, gas, and minerals
(see Helpful Hint). These long-lived productive assets have two distinguishing characteristics: (1) they
are physically extracted in operations (such as mining, cutting, or pumping), and (2) they are replaceable
only by an act of nature.

The acquisition cost of a natural resource is the price needed to acquire the resource and prepare it for
its intended use.

Depletion of Natural Resources

The allocation of the cost of natural resources in a rational and systematic manner over the resource’s
useful life is called depletion. Companies generally use the units-of-activity method to compute
depletion. The reason is that depletion generally is a function of the units extracted during the year.
Under the units-of-activity method, companies divide the total cost of the natural resource minus
salvage value by the number of units estimated to be in the resource. The result is a depletion cost per
unit. To compute depletion, the cost per unit is then multiplied by the number of units extracted.
Example: Lane Coal Company invests $5 million in a mine estimated to have 1 million tons of coal and
no salvage value>

Step 1. Computation of Depletion Cost per unit

Total Cost−Salvage Value/ Total Estimated Units Available=Depletion Cost per Unit
($5,000,000−$0)/1,000,000 tons=$5.00 per ton

Step 2: Compute Depletion Extracted

If Lane extracts 250,000 tons in the first year, then the depletion for the year is $1,250,000 (250,000
tons × $5). It records the depletion as follows.

Inventory (coal) 1,250,000

Accumulated Depletion 1,250,000
(To record depletion of coal mine)

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Accumulated Depletion is a contra asset similar to Accumulated Depreciation. Lane credits Inventory
when it sells the inventory and debits Cost of Goods Sold. The amount not sold remains in inventory and
is reported in the current assets section of the balance sheet.

Intangible Assets: are rights, privileges, and competitive advantages that result from ownership of long-
lived assets that do not possess physical substance.

• Limited life or an indefinite life.

• Common types include: patents, copyrights, franchises or licenses, trademarks, trade names,
and goodwill.

ACCOUNTING FOR INTANGIBLES

Limited-Life Intangibles
• Amortize to expense.
• Credit asset account (used more often) or accumulated amortization.
• Amortization: USING up intangible assets. It results from the passage of time or a decline in
usefulness of the intangible asset. (Like depreciation for plant assets.)

Indefinite-Life Intangibles
• No foreseeable limit on time the asset is expected to provide cash flows.
• No amortization.

TYPES OF INTANGIBLE ASSETS

1. Patents: “Exclusive right to manufacture, sell, or otherwise control an invention for a period of 20
years from the date of the grant.”

• Capitalize costs of purchasing a patent and amortize over its 20-year life or its useful
life, whichever is shorter.
• Expense any research and development costs in developing a patent.
• Legal fees incurred successfully defending a patent are capitalized to Patent account.
• Journal entry to record amortization of patents would be…..

2. Research and Development Costs: “Expenditures that may lead to patents, copyrights, new
processes, and new products.”

• NOT intangible costs.

• All research and development costs are expensed when incurred.

3. Copyrights: “Give the owner the exclusive right to reproduce and sell an artistic or published work.”

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• Granted for the life of the creator plus 70 years.

• Capitalize costs of acquiring and defending it.
• Amortized to expense over useful life.

4. Trademarks and Trade Names: “Word, phrase, jingle, or symbol that distinguishes or identifies a
particular enterprise or product.” Examples include Wheaties, Monopoly, Sunkist, Kleenex, Coca-Cola,
Big Mac, and Jeep.

• Legal protection for indefinite number of 20 year renewal periods.

• Capitalize acquisition costs.
• No amortization.

5. Franchises: “Contractual arrangement between a franchisor and a franchisee.” Examples include

Toyota, Shell, Subway, and Marriott.

• When a company incurs costs in connection with the acquisition of the franchise or license,
it should recognize an intangible asset.
• Franchise (or license) with a limited life should be amortized to expense over the life of the
franchise.
• Franchise with an indefinite life should be carried at cost and not amortized.

6. Goodwill: EXCESS of the purchase price that a company pays OVER the fair market value of
another company’s identifiable net assets (assets – liabilities) that it acquires.
• Includes exceptional management, desirable location, good customer relations, skilled
employees, high-quality products, etc.
• Only recorded when an entire business is purchased.
• Internally created goodwill should not be capitalized.

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LO 5: Discuss how Plant Assets, Natural Resources, and Intangible Assets are
Reported and Analyzed.

• Either within the balance sheet or the notes, companies should disclose the balances of the major
classes of assets, such as land, buildings, and equipment, and of accumulated depreciation by major
classes or in total.
• The depreciation and amortization methods used and the amount of depreciation and amortization
expense for the period should also be disclosed.

ANALYSIS
Asset Turnover: indicates how efficiently a company uses its assets to generate sales.

Ex: A asset turnover ratio of 1.4 indicates that a company generated $1.40 of sales from every $1
invested in average total assets.

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COST CLASSIFICATION
LO 1: Understand the difference in managerial and financial accounting:
Financial Managerial
External Users Internal Users
Quarterly/Annual Financial Statement Internal Reports
General Purpose Reports Special Purpose Reports
GAAP - Audited Used for Decision Making Purposes

Understand Management Responsibilities and Structure

Responsibilities:
Planning: looking ahead to establish objectives that add value to the business
Directing: coordinating company’s activities and human resources to operate effectively
Controlling: keeping all the activities on track to accomplish objectives
Structure:

MANUFACTURING COSTS
Terms
Direct Materials Manufacturing Overhead
Indirect Materials Product Cost
Direct Labor Period Cost
Indirect Labor

Manufacturing consists of activities and processes that convert raw materials into finished
goods.

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Raw Materials: Basic material and parts used in the manufacturing process

Work in Process: Product costs associated with partially completed units

Finished Goods: Completed units that are unsold

PRODUCT COSTS: Manufacturing Costs PERIOD COSTS: Nonmanufacturing Costs

Direct Materials Selling Expenses
Direct Labor Administrative Expenses
Manufacturing Overhead (all indirect costs)

Practice #1
Indicate how a manager would assign the following costs to the various categories for a
motorcycle company.

Product Costs
Direct Materials Direct Labor Manufacturing Period Cost
Overhead
Engines
Labor costs
Factory
Equipment
Depreciation
Electricity to run
factory
equipment
Advertising
Salary of Plant
Manager
Shipping of
finished product
Salary of CFO
Lubricant for
tightening screws
Motorcycle seat

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FINANCIAL STATEMENTS
Terms
Cost of Goods Sold Raw Materials
Cost of Goods Manufactured Work in Process Inventory
Total Manufacturing Costs Finished Goods Inventory

Cost of Goods Manufactured

1) Start with the Beginning Work in Process
2) Find Direct Materials Used
3) Find Total Manufacturing Costs
4) Find Cost of Goods Manufactured

 Use this basic equation:

beginning balance + additions – deductions = ending balance

1) Find Beginning Work in Process

2) Find Direct Materials Used

Raw Materials Beginning Inventory
+ Raw Materials Purchased
= Raw Materials Available for Use
- Raw Materials Ending Inventory
= Direct Materials Used

3) Find Total Manufacturing Costs

Direct Materials Used (Step 2)
+ Direct Labor
+Total Manufacturing Overhead
=Total Manufacturing Costs

4) Find Cost of Goods Manufactured

Work in Process Beginning Inventory (Step 1)
+Total Manufacturing Costs (Step 3)
= Total Cost of Work in Process
- Work in Process Ending Inventory
= Cost of Goods Manufactured

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Beginning Total
Work in Total Cost of Ending Work Cost of
Process Manufacturing Work in in Process Goods
Inventory + Costs = Process - Inventory = Manufactured

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Cost of Goods Sold on the Income Statement

Beginning Finished Cost of Goods Ending Finished Cost of Goods

Goods Inventory + Manufactured - Goods Inventory = Sold

Inventory on the Balance Sheet

 Manufacturing companies have three inventory accounts: raw materials inventory,
work-in-process inventory and finished goods inventory.
 Raw Materials inventory includes all the direct and indirect materials purchased
but not yet used in the manufacturing or production process.
 Work-In-Process Inventory includes all the direct materials, direct labor and
manufacturing overhead costs that have been added to the manufacturing
process but for which production has not been completed.
 Finished Goods Inventory includes all manufacturing costs for products that have
been completed but not sold.

Raw Materials Work in Process Finished Goods

Direct Materials Cost of Goods

Used Manufactured

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Practice #2

T Company has provided the following data for the month of July:

Beginning Ending
Work-in-process inventory $23,000 $21,000
Finished goods inventory 26,000 35,000

July Activity
Direct materials used $56,000
Direct labor incurred 91,000
Manufacturing overhead 61,000

Required: a) Determine total manufacturing costs, cost of goods manufactured

and cost of goods sold for July.

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TRENDS
Terms
Value Chain Balanced Scorecard
Just in Time Inventory Sarbanes-Oxley Act
Total Quality Management Corporate Social Responsibility
Theory of Constraints Triple Bottom Line
Activity Based Costing

Solution #1
Indicate how a manager would assign the
following costs to the various categories for a
motorcycle company.

Product Costs
Direct Direct Manufacturing Period
Materials Labor Overhead Cost
Engines X
Labor costs X
Factory
Equipment X
Depreciation
Electricity
to run
X
factory
equipment
Advertising X
Salary of
Plant X
Manager
Shipping of
finished X
product
Salary of
X
CFO
Lubricant
for
X
tightening
screws
Motorcycle
X
seat

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Solution #2 Chapter 19 Review

a)
Direct materials used $56,000
Direct labor incurred 91,000
Manufacturing overhead 61,000
Total manufacturing cost $208,000

Beginning work-in-process $23,000

Total manufacturing cost 208,000
Ending work-in-process 21,000
Cost of goods manufactured $210,000

Beginning finished goods $26,000

Cost of goods manufactured 210,000
Ending finished goods 35,000
Cost of goods sold $201,000

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 Chapter 22 Review

Cost Volume Profit

Types of Costs
Terms
Variable Costs
Fixed Costs
Relevant Range
Mixed Costs

In Total Per Unit Examples

Variable Change in proportion Remain the same Direct materials
to activity level: if Direct labor
volume increases then Cost of goods sold
total cost will increase,
if volume decreases
then total cost will
decrease
Fixed Remain the same Have an inverse Taxes
relationship with activity Insurance
level: if volume Rent
increases then per unit Supervisor salary
cost will decrease, if Depreciation
volume decreases then
per unit cost will
increase

The above data is consistent as long as level of activity remains within the relevant range.

Mixed Costs: Have an element of both variable and fixed costs. Therefore, costs
change in total, but not in proportion with activity level changes. Example: The total cost
of a cell phone contract which charges a fixed amount for a certain number of minutes
per month and then an additional amount per minute for additional minutes used in the
month is a mixed cost.

High-Low Method
 Mixed costs must be separated into their variable and fixed elements so that their
behavior can be predicted when the activity level changes.

Step 1: Determine variable cost per unit

 Pick out the highest and lowest levels of activity in given data set
 Note the total cost that is given with each level of activity
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 Chapter 22 Review

 Put into the following equation to determine variable cost per unit
Change in Total Costs / Change in Activity = Variable Cost per Unit

(Cost of high level Divided (High level of activity-low Equals Variable Cost per Unit
activity – Cost of low by level of activity)
level activity)

Step 2: Determine Fixed Costs

 Pick the high or low level used
 Multiply the variable cost per unit determine is step 1 by the activity level to get total
variable cost
 Take total cost and subtract total variable cost to equal fixed cost

Total Cost – Total Variable Cost = Fixed Cost

Total cost from data point - Variable Cost per unit (step 1) * = Fixed Cost
selected activity level from data point selected

Practice # 1

T Company employed several maintenance engineers to keep the equipment running in

peak condition. Over the past eight months, Travis incurred the following maintenance
cost for these engineers. Plant activity is best measured by direct labor hours.

Month Direct Labor Hours Maintenance Cost

January 1,700 $14,300
February 1,900 $15,200
March 1,800 $16,700
April 1,600 $14,000
May 1,500 $14,300
June 1,300 $13,000
July 1,100 $12,800
August 1,400 $14,200

Required: Using the high-low method, determine the fixed and variable
components of the maintenance costs.

Cost-Volume-Profit
Terms
Cost-Volume-Profit Analysis Unit Contribution Margin
Cost-Volume-Profit Income Statement Breakeven Point
Contribution Margin Contribution Margin Ratio

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CVP is a critical planning piece for decision-making. The following assumptions must be
made:
1. Behavior of costs and revenues is within relevant range
2. Costs can be classified as variable or fixed
3. Changes in activity are the only factors affecting cost
4. All units produced are sold
5. Sales mix is constant when more than one product is sold

CVP income statement

 Distinguishes costs between variable and fixed
 Shows contribution margin, usually both in total and for a per unit basis
Sales – Variable Expenses = Contribution Margin
Sales per unit – Variable cost per unit = contribution margin per unit

Contribution Margin
 Unit contribution margin shows how much every unit sold will increase net income
 Determines how many units will need to be sold to cover fixed costs (break-even)

Contribution Margin Ratio

 Contribution Margin presented as a percentage of sales
 Contribution margin divided sales by OR Unit contribution margin divided by unit
selling price
 Shows how much a company earns for each dollar of sales

Example:
Total Per Unit Ratio
Sales $500,000 $500 100%
Variable Costs -200,000 200 40%
Contribution Margin 300,000 300 60%
Fixed Costs -125,000
Net Income $175,000

Sales – Variable Expenses = Contribution Margin

500,000-200,000=300,000
Sales per unit – Variable cost per unit = contribution margin per unit
500-200=300
Unit contribution margin divided by unit selling price
300/500=60%

Breakeven
At the breakeven point:
 Operating Income = 0
 Total revenue = total expenses
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 Fixed Expenses = Contribution Margin

1) Mathematical Equation:
 Sales – Variable Costs – Fixed Costs = Net Income
o At Breakeven, net income = zero
 In units: (Sales price per unit * Q)- (Variable cost per unit* Q)- Fixed Cost =
Zero
o Solve for Quantity (Q) to determine number of units needed to sell to
break even
o Use Break-even Quantity (Q) multiplied by sales price per unit to
determine sales dollars to breakeven
2) Contribution Margin Technique
 To Determine Breakeven in units:
Fixed Costs divided by Unit Contribution Margin= Breakeven in units
 To Determine Breakeven in Sales Dollars:
Fixed Costs divided by Contribution Margin Ratio= Breakeven in dollars
3) Graphic Presentation

Where the Total Cost Line (Red) meets

the Total Sales Line (Yellow), this is
the breakeven point. Follow this point
down to determine breakeven in units,
and follow across to determine
breakeven in sales dollars.

Any area above the breakeven point

reflects a profit. Any area below the
breakeven point reflects a loss.

Practice #2

W Company sells only one product with a selling price of $200 and a variable cost of $80
per unit. The company’s monthly fixed expense is $60,000.

Required: Determine the contribution margin per unit and contribution margin
ratio Determine breakeven point in units sold and sales dollars
using each of the three methods.

Determining Required Sales

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Terms
Target Net Income
Margin of Safety

Target Net Income

 Rather than setting operating income = 0, target profit calculations assume a
certain operating income and calculate the sales dollars and units sold necessary
to achieve it.
 The same equations are used as to calculate the breakeven point, except that a
non-zero operating income term is included.
1) Mathematical Equation:
 Required Sales – Variable Costs – Fixed Costs = Target Net Income
 In units: (Required Sales price per unit * Q)- (Variable cost per unit* Q)-
Fixed Cost = Target Net Income
o Solve for Quantity (Q) to determine number of units needed to sell to
break even
o Use Break-even Quantity (Q) multiplied by sales price per unit to
determine sales dollars to breakeven
2) Contribution Margin Technique
a. To Determine Breakeven in units:
(Fixed Costs + Target Net Income) divided by Unit Contribution Margin=
Breakeven in units
b. To Determine Breakeven in Sales Dollars:
(Fixed Costs+ Target Net Income) divided by Contribution Margin Ratio=
Breakeven in dollars
3) Graphic Presentation
a. Find target profit on graph and corresponding units to meet that profit

Margin of Safety
 The margin of safety is the excess of budgeted or actual sales over the breakeven
volume of sales. It is expressed as both the dollar amount of the difference and as
a percent of budgeted or actual sales.
1) In Dollars
a. Actual (expected) Sales – Break-even Sales = Margin of Safety in Dollars
2) As a Ratio
a. Margin of Safety in Dollars / Actual (expected) Sales = Margin of Safety
Ratio
i. The higher the percentage, the greater the margin of safety

Practice #3
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 Chapter 22 Review

S Company sells pillows for $90 per unit. The variable expenses are $63 per pillow and
the fixed costs are $135,000 per month. The company sells 8,000 pillows per month.

Required: A) Prepare contribution margin income statements for current

operating conditions showing contribution margin ratio.
B) Compute Breakeven using both the equation method and
the contribution margin technique
C) What is the margin of safety?
D) If the company wants a target profit of $200,000, how many
units must they sell, and what is the dollar sales?

Solution #1

(Cost of high level Divided (High level of activity-low Equals Variable Cost per Unit
activity – Cost of low by level of activity)
level activity)
(15,200-12,800) / (1,900-1,100) = $3.00

Change in Cost $2,400

= = $3.00 variable cost/unit
Change in Activity 800

Using either the high point or low point, total fixed cost is calculated next:

Total cost from data point - Variable Cost per unit (step 1) * = Fixed Cost
selected activity level from data point selected
Using High Point
15,200 - ($3*1,900)= $5,700 = $9,500
Using Low Point
12,800 - ($3*1,100)= $3,300 = $9,500
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* The high and low points are chosen by activity, not by cost.
* It doesn’t matter which point you pick, fixed costs equal the same amount

Solution #2

contribution margin per unit Sales-Variable Cost= 200-80=120

CM
contribution margin ratio CM/Sales 120/200=60%
Math Equation Contribution Margin
breakeven point in units sold Sales price per unit * Fixed Costs divided by
Q)- (Variable cost per Unit Contribution
unit* Q)- Fixed Cost = Margin= Breakeven in
Zero units

200Q-80Q-60,000=0 60,000/120= 500 units

120Q-60,000=0
120Q=60,000
Divide each side by 120
Q= 500 units

breakeven point in sales Use Break-even Fixed Costs divided by

dollars Quantity (Q) multiplied Contribution Margin
by sales price per unit to Ratio= Breakeven in
determine sales dollars dollars
to breakeven

Q= 500 units 60,000/ 60%= $100,000

500* 200 = $100,000

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Solution #3

Present
Per Unit % Total
A)
Sales $90 100.0 $720,000
Variable expenses 63 70.0 504,000
Contribution Margin 27 30.0 216,000
Fixed expenses 135,000
Operating income $81,000

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Present Breakeve
n
Per Unit % Total Total
Units 1 8,000 5,000 $450,000/$90
Sales $90 100.0 $720,000 $450,000 $135,000/30%
Variable expenses 63 70.0 504,000 315,000 $450,000x70%
Contribution Margin 27 30.0 216,000 135,000 fixed + OI
Fixed expenses 135,000 135,000 stays the same
Operating income $81,000 $0 Always $0

B)
Breakeven Dollars using Contribution Margin: 135,000/30%= 450,000
Breakeven Units using Contribution Margin per unit: 135,000/27=5,000

Equation:
90Q-63Q-135,000=0
27Q=135,000
Q=5,000

5,000 * $90= $450,000

C) Margin of Safety = $720,000 - $450,000 = $270,000 or 37.5%

D) Target Profit
Target Profit Dollars using Contribution Margin: 135,000+200,000/30%= $1,116,667
Target Profit Units using Contribution Margin per unit: 135,000+200,000/27=12,407

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Cost-Volume-Profit

Apply Concepts
Review Terms
Cost-Volume-Profit Analysis
Cost-Volume-Profit Income Statement
Contribution Margin
Unit Contribution Margin
Breakeven Point
Contribution Margin Ratio

CVP income statement

 Basic CVP income statement shows contribution margin, usually both in total and
for a per unit basis
Sales – Variable Expenses = Contribution Margin
Sales per unit – Variable cost per unit = contribution margin per unit
 Detailed CVP income statement shows types of variable and fixed costs

Breakeven
 To Determine Breakeven in units:
Fixed Costs divided by Unit Contribution Margin= Breakeven in units
 To Determine Breakeven in Sales Dollars:
Fixed Costs divided by Contribution Margin Ratio= Breakeven in dollars
Target Net Income
 To Determine Breakeven in units:
(Fixed Costs + Target Net Income) divided by Unit Contribution Margin=
Breakeven in units
 To Determine Breakeven in Sales Dollars:
(Fixed Costs+ Target Net Income) divided by Contribution Margin Ratio=
Breakeven in dollars
Margin of Safety
1. In Dollars:
Actual (expected) Sales – Break-even Sales = Margin of Safety in Dollars
2. As a Ratio:
Margin of Safety in Dollars / Actual (expected) Sales = Margin of Safety
Ratio
CVP Analysis
Uses the above equations to study the effects of changes in cost and volume on a
company’s profit

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Practice #1

S Company sells pillows for $90 per unit. The variable expenses are $63 per pillow and
the fixed costs are $135,000 per month. The company sells 8,000 pillows per month.
The sales manager is proposing a 10% reduction in selling price, which he believes will
produce a 25% increase in the number of pillows, sold each month.

Required: A) What is the current and proposed break-even points in

units? Will the proposed break-even point be supported by
the 25% increase in pillows?
B) What is the current and proposed margin of safety?
C) Based on A and B, should the company make the proposed
changes?
D) If the company makes the proposed change, but also
increase advertising expenses by $10,000, how many units
must they sell to have a net income of $315,800? What is
the dollar sales?

Sales Mix
The sales mix is the relative percentage in which a company sells its multiple products
and is used to determine breakeven for the company as a whole.

Follow the following steps to determine breakeven in sales dollars or units. To

determine sales dollars, use contribution margin ratios and sales mix for sales. To
determine units, use contribution margin per unit and sales mix for units.

Step 1: Find sales mix percentage for each product.

Unit
Product 1 unit sales / total unit sales = Product 1 sales mix percentage for units
Product 2 unit sales / total unit sales= Product 2 sales mix percentage for units

Sales
Product 1 total sales dollars / total dollar sales= Product 1 sales mix percentage for sales
Product 2 total sales dollars / total dollar sales= Product 2 sales mix percentage for sales

Note: total unit sales= Product 1 unit sales + Product 2 unit sales

Step 2: Find Weighted Average Unit Contribution Margin

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(Contribution Margin Product 1 * Sales Mix Percentage )

+ (Contribution Margin Product 2 * Sales Mix Percentage )
Weighted Average contribution margin

Step 3: Determine Breakeven

Fixed Costs / weighted average contribution margin = Breakeven point

Step 4: Determine individual product amounts

Breakeven point * Sales mix Product 1 = Dollar or units of Product 1 to breakeven

Breakeven point * Sales mix Product 2 = Dollar or units of Product 2 to breakeven

Practice #2

Z Company sells two models of doghouses, the Puppy Palace and the Canine Castle.
Fixed costs are $742,875.

Puppy Canine
Palace Castle
Sales price per unit $50 $75
Variable cost per unit 30 30
Unit Sales 37,500 12,500

Determine the company’s breakeven point in sales units and dollars.

Limited Resources
Terms
Theory of constraints

Limited resource decisions: Management must determine which products will maximize net
income in multiple produce utilize the same resource. They can do this by determining the
contribution margin per unit of the limited resource.

Unit contribution margin / Limited resource = Contribution margin per

requirement per unit unit of limited resource

1. Calculate contribution margin per unit

2. Apply above formula to get contribution margin per unit of limited resource

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 Chapter 22 Review

3. Produce product with highest contribution margin per unit of limited resource to
meet demand, then produce other products in order of contribution margin per unit
of limited resource from highest to lowest.

Practice #3

Management has limited machine hours to produce three different products. Below is the
information management has gathered. Which order should they produce the products?

Product A Product B Product C

Sales per unit $10 $20 $25
Variable Cost per unit 5 8 11
Machine Hours .2 .4 .6
Required per unit

Operating Leverage
Terms
Cost structure
Operating leverage
Degree of operating leverage

 Operating leverage quantifies, at a given level of sales, the percent change in

operating income caused by a percent change in sales.
 Leverage calculations are a two-step process:
o calculate the Degree of Operating Leverage
Degree of Operating Contribution Margin
=
Leverage Net Income
o Step 2: calculate the percent change in operating income:
Percent change Degree of Leverage x Operating Income
in operating =
income

Practice #4

P Company sells pillows for $90 per unit. The variable expenses are $63 per pillow and
the fixed costs are $135,000 per month. The company sells 8,000 pillows per month.

Required: Compute the current degree of operating leverage. Management

expected sales to increase 10% if variable costs decreased $10
per unit and increasing fixed costs by $109,600. Calculate the new
degree of operating leverage. Which produces a better degree of
operating leverage?
Solution #1

A)
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 Chapter 22 Review

Current Proposed
Sales 90 81
Variable Cost 63 63
Contribution Margin 27 18
Fixed Costs 135,000 135,000
Breakeven in units 5,000 7,500

Sales- Variable costs= Contribution margin

Fixed costs/contribution margin= breakeven in units

The proposed breakeven point will require an increase in sales of 50%.

B) Current: (8,000*90)-(5,000*90)= 270,000

Proposed: ((8,000*1.25)*81)-(7,500*81)=
(10,000 *81)-(7,500*81)=202,500
C) No, margin of safety is reduced and break-even sales increase by more than 25%
D) 135,000+10,000= 145,000 in fixed costs
(145,000+315,800)/18= 25,600
(145,000+315,800)/22%= $2,073,600

Solution #2

Step 1:
Unit Sales
Puppy Palace 37,500/50,000= 75% Puppy Palace (37,500*50)/2,812,500= 67%
Canine Castle 12,500/50,000= 25% Canine Castle (12,500*75)/2,812,500= 33%

Step 2:
Puppy Palace 50-30=20 per unit or 40%
Canine Castle 75-30=45 per unit or 60%

Puppy Palace Canine Castle Company Total

Weighted Average 20 * 75% + 45 * 25% 26.25 per unit
Contribution
Margin per Unit
Weighted Average 40% * 67% + 60%* 33% 46.6%
Contribution
Margin Ratio

Step 3:
$742,875/ 26.25= 28,300 units
$742,875/ 46.6%= $1,594,152

Step 4:
Puppy Palace 28,300* 75%= 21,225
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 Chapter 22 Review

Canine Castle 28,300*25%= 7,075

Puppy Palace $1,594,152* 66.7%=1,063,300
Canine Castle $1,594,152*33.3%= 530,852

Note: Some rounding causes breakeven units * selling price to not exactly equal breakeven in
sales dollars

Solution #3

Product A Product B Product C

Sales per unit $10 $20 $25
Variable Cost per unit 5 8 11
Contribution Margin 5 12 14
Machine Hours .2 .4 .6
Required per unit
Contribution margin $25 $30 $23.33
per limited resource
Produce in the following order: B,A,C

Solution #4

Present Proposed
Per Unit % Total Total
Units 1 8,000 8,800
Sales $90 100.0 $720,000 $792,000
Variable expenses 63 70.0 504,000 466,400
Contribution Margin 27 30.0 216,000 325,600
Fixed expenses 135,000 244,600
Operating income $81,000 $81,000

Degree of leverage 2.67 4.02

The changes would produce a better degree of operating leverage because switching the cost
structure to higher fixed costs, increases the operating leverage and with a percent change in
sales would produce a higher percent change in net income.

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 Chapter 23 Review

Budgeting
Terms
Budget
Sales forecast Long-range planning
Budget committee Master budget
Participative budgeting Operating budget
Budgetary slack Financial budget

Benefits of Budgeting:
 Planning for formalization of goals on a recurring basis
 Defines objectives for performance
 Creates a warning system for potential problems
 Facilitates coordination of activities within the business
 Management has greater overall awareness of operations
 Motivates personnel to meet objectives

Essential Elements of Budgeting:

 Having a sound organizational structure where responsibility for operations are defined
 Including research and analysis produce more realistic goals
 Acceptance by all level of management

Other Budgeting Information:

 Can be prepared for any length of time, and many companies use a continuous 12-month
budget
 Budgeting begins with the sales forecast
 A budget may be reviewed by a budget committee
 A bottom-to-top approach to budgeting is a participative budget. Lower level
management, who are well informed of day-to-day activities can more accurately create
the budget and feel more involved in the process. It is then reviewed by higher
management.
 As a budget is essential for evaluating performance, top management must completely
support it and must carefully review for budgetary slack

Master Budget:
 Includes a number of separate but interdependent budgets that formally report the
company’s sales, production, and financial goals.
 The starting point of the master budget is the sales budget and includes all other
operating budgets.
 The ending point of the master budget is the budgeted financial statements.
 Since the budgeted financial statements include both an income statement and balance
sheet, each step in the master budget has both an income statement and balance sheet
component. Sometimes they are presented in the same budget and other times they are
presented as separate budgets.

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Sales, Production and Direct Materials Budget

Terms
Sales budget
Production budget
Direct materials budget

Sales:
 The foundation and starting point for the master budget.
 Determines the anticipated unit and dollar sales for the budgeted income statement.

Expected Unit Sales * Unit Selling Price = Total Sales

Production:
 Determines the number of units of finished goods that must be produced each budget
period to satisfy expected sales needs (from the sales budget) and to provide for the
desired finished ending inventory.
 A realistic ending inventory is essential to production requirements. A “cushion” above
expected is used for budgeting purposes

Desired
Beginning
Budgeted Ending
+ - Finished = Required Production Units
Sales Units Finished
Goods Units
Goods Units

Direct Materials:

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 Chapter 23 Review
 Determines the quantity of direct raw materials that must be purchased each period to
meet anticipated production needs (from the production budget) and to provide for
adequate levels of direct raw materials inventories
 The desired ending inventory is again a key component in the budgeting process for
direct materials. A “cushion” above expected is used for budgeting purposes.
 The final step in the direct materials budget to to determine the cost of the direct
materials purchased by multiplying the quantity to be purchased by the purchase price
per unit.

Direct Material Desired Beginning

Required Direct Material
Units Required + Ending Direct - Direct Material =
Units to be Purchased
for Production Material Units Units

Required Direct * Unit Selling Price = Total Cost of Direct

Material Units to be Materials Purchased
Purchased

Practice #1

F Company has budgeted sales of its innovative mobile phone for next four months as follows:
Sales Budget in Units
July 30,000
August 45,000
September 60,000
October 50,000

The company is now in the process of preparing a production budget for the third quarter.
Ending inventory level must equal 10% of the next month’s sales.

a) Calculate the ending inventory as of June 30.

b) Prepare a production budget for the third quarter showing the number of
units to be produced each month and for the quarter in total

c) Prepare a direct materials budget for the third quarter. Each mobile
phone requires 3 data chips to operate. Each data chip cost $50 to
purchase. The current beginning inventory at July 1 of data chips is
10,000. The desired ending inventory for September is 32,300. The
company requires of 20% the next quarter production requirements in
ending inventory.

Direct Labor, Manufacturing Overhead, Selling and

Administrative, and Income Statement Budgets

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Terms
Direct Labor Budget
Manufacturing overhead budget
Selling and administrative expense budget
Budgeted income statement

Direct Labor:
 Determines the direct labor hours and direct labor dollars required each period to meet
anticipated production needs (from the production budget).

Direct Labor
Units to be Direct Labor
x Hours per X = Total Direct Labor Cost
Produced Cost per Hour
unit

Practice #2

The production department of the Company B has submitted the following forecast of units to be
produced by quarter for the upcoming fiscal year:

First Second Third Fourth

Units to be produced 10,000 8,000 8,500 9,000

Each unit requires 0.6 direct labor-hours and at a cost of $15.00 per direct labor hour. The
workforce can be adjusted each quarter for the expected production level

Required: Prepare the company’s direct labor budget for the next fiscal year.

Manufacturing Overhead:

 The manufacturing overhead budget has two components – variable and fixed overhead.
 Budgeted variable overhead expenses depend on the number of units produced from the
production budget and a budgeted variable overhead cost per unit.
 Budgeted fixed overhead expenses depend on the total cost expected to be incurred for
each type of fixed overhead cost.
 To determine an overhead rate to apply use total manufacturing overhead determined
and divide by the direct labor budgeted hours

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 Practice #3 Chapter 23 Review

Y Company’s variable manufacturing overhead rate is $2.00 per direct labor-hour and the
company’s fixed manufacturing overhead is $40,250 per quarter.

The budgeted direct labor-hours for each quarter are as followed:

First Second Third Fourth

Budgeted direct labor hours 5,000 6,500 6,000 5,500

Required: a) Construct company’s manufacturing overhead budget for the year.

b) Compute the company’s total manufacturing overhead rates for the
year.

Selling and Administrative:

 Selling and Administrative (S&A) expense budget is similar to the manufacturing

overhead budget as it includes variable and fixed expenses.
 Budgeted variable S&A expenses depend on the number of units sold or sales dollars
from the sales budget.
 Budgeted fixed S&A expenses depend on the total cost expected to be incurred for each
type of fixed S&A cost.

Income Statement:

 Budgeted income statements are prepared from other operating budgets

 They serve as a benchmark against which subsequent actual company performance can
be measured

Sales Total From Sales Budget

-Cost of Goods Sold Per unit cost calculated from
direct material, direct labor,
and manufacturing overhead
budget
=Gross Profit Calculate
-Selling and Administrative Total From Selling and
Administrative Budget
=Income from Operations Calculate
-Interest Expense Given
=Income before Income Tax Calculate
-Income Tax Expense Given
= Net Income Calculate

Cash Budget and Budgeted Balance Sheet

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 Chapter 23 Review
Terms
Cash budget
Budgeted balance sheet

Cash Budget:

 Cash budget is composed of four major sections:

o Cash Receipts
o Cash Disbursements
o Cash Excess or Deficiency
o Financing
 The cash budget uses information from all of the other budgets: cash receipts from the
sales budget, cash disbursements from direct materials budget, cash disbursements from
the direct labor, manufacturing overhead and selling administrative expense budget.
o Amounts from cash receipts and disbursements are calculated with a schedule of
expected collections/disbursements based on percentages expected to be
received or paid
 Amounts taken from manufacturing overhead budget and selling and
administrative budgets must be adjusted for depreciation- which is a non-cash
expense and requires to be subtracted from amounts determined in these budgets.
 It may also include other sources of cash receipts such as proceeds from the sale of
plant assets, issuance of stock or issuance of bonds.
 It may also include other sources of cash disbursements such as the purchase of plant
assets and the payment of cash dividends.
 The company may also have to meet a minimum balance requirement for its cash
account that is imposed by the bank. If the cash balance falls short of the minimum
required, the company will have to borrow money to increase the cash balance to the
minimum. If the company has cash in excess of the minimum balance required, it is
obligated to pay off any outstanding borrowings and the related interest payable. After
the borrowings and interest have been paid off, the company may leave the “excess”
cash in the cash account.

Practice #4

W Company wants to prepare a cash budget. The cash balance on July 1 is $10,400. Cash
receipts other than for loans received for July, August and September are Forecasted as
$24,000, $32,000 and $40,000, respectively. Payments other than for loan or interest
payments for the same periods are planned as $28,000, $30,000 and $32,000, respectively.
These payments, taken from the manufacturing overhead and selling and administrative
budgets include $2,000 related to depreciation each month.

W Company requires a $10,000 minimum cash balance. If necessary, loans are borrowed to
meet this requirement at a cost of 10% annual interest at the beginning of the quarter. If the
ending cash balance exceeds the $10,000 minimum, repaying any outstanding loan balance
will be done at the end of each quarter. At July 1, there are no outstanding loans.

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Required: Chapter 23 Review
Prepare the company’s cash budget by month and in total for the three
months.
Practice #5

P Company produces calculators. Each calculator requires three chips costing $2.00 each,
purchased from an overseas supplier. Texas Products has prepared a production budget for the
calculator by quarters for Year 2 and for the first quarter of Year 3:

Year 2 Year 3
First Second Third Fourth First
Budgeted productions, in
calculators 60,000 90,000 150,000 100,000 80,000

The inventory of the chips at the end of a quarter must be equal to 20% of the following
quarter’s production needs. There will be 36,000 chips on hand to start Year 2. Purchases are
paid for 50% in the quarter of purchase and 50% in the following quarter.

Required: a) Prepare the direct materials budget for the chips by quarter and in total
for year 2.
b) Prepare the cash disbursements budget for the chips by quarter and in
total for year 2.
c) Determine the accounts payable balance at the end of Year 2.

Balance Sheet:

 Budgeted balance sheets are prepared from other budgets to project financial position
 The budgeted balance sheet includes the following accounts taken from various budgets.
All other data is given

Cash Cash Budget

Accounts receivable Schedule of cash collections
Finished goods inventory Production budget
Raw materials inventory Direct materials budget
Property, plant, equipment Previous balance + purchases
shown on cash budget
Accumulated Depreciation Previous balance + amounts
for depreciation expense
shown on manufacturing
overhead and selling and
administrative budgets
Accounts Payable Schedule of cash
disbursements
Common Stock Previous balance + receipts
shown on cash budget
Retained Earnings Previous balance + net

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 Chapter 23 Review
income shown on budgeted
income statement

Budgeting for Nonmanufacturing Companies

Terms
Merchandise purchases budget

Merchandisers:
 uses a merchandise purchases budget instead of a production budget
 does not use manufacturing budgets (direct materials, direct labor, manufacturing
overhead)

Desired
Beginning
Budgeted cost ending Required merchandise
+ - merchandise =
of goods sold merchandise purchases
inventory
inventory

Service Companies:
 direct labor budgets are important as labor costs are high
 revenue can be budgeted based on expected output an input

Not for Profit Organizations:

 budget based on cash flows instead of revenue and expenses

Solution #1

a) Ending inventory:
Since the ending inventory level must equal 10% of the next month’s sales, the
ending inventory for the month of June must be 10% of July’s sales of 30,000 or 3,000
units.

b) Production Budget
Quarter
July August September Total October
Budgeted sales in units 30,000 45,000 60,000 135,000 50,000
+ ending inventory 4,500 6,000 5,000 5,000
= Total required units 34,500 51,000 65,000 140,000
- beginning inventory 3,000 4,500 6,000 3,000 5,000
= Required production 31,500 46,500 59,000 137,000
July Ending Inventory= 45,000*10%
August Ending Inventory= 60,000*10%
c) Direct Materials budget
July August September Quarter Total
Required production 31,500 46,500 59,000 137,000
Direct material per unit 3 3 3 3
Total materials needed 94,500 139,500 177,000 411,000
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 Chapter 23 Review
+ ending inventory 27,900 35,400 32,300 32,300
Total material required 122,400 174,900 209,300 443,300
- beginning inventory 10,000 27,900 35,400 10,000
Direct material to
112,400 147,000 173,900 433,300
purchase
Cost per direct material $50 $50 $50 $50
Total Cost of purchases $5,620,000 $7,350,000 $8,695,000 $21,665,000

July Ending Inventory= 139,500*20%

August Ending Inventory= 177,000*20%

Solution #2
First Second Third Fourth
Required production – units 10,000 8,000 8,500 9,000
X Direct labor hours per unit 0.6 0.6 0.6 0.6
= Total direct labor-hours needed 6,000 4,800 5,100 5,400
X Direct labor cost per hour $15.00 $15.00 $15.00 $15.00
= Total direct labor cost $90,000 $72,000 $76,500 $81,000

Solution #3

a) Overhead budget
First Second Third Fourth Year
Budgeted direct labor-hours 5,000 6,500 6,000 5,500 23,000
X Variable overhead rate $2.00 $2.00 $2.00 $2.00 $2.00
= Variable overhead $10,000 $13,000 $12,000 $11,000 $46,000
+ Fixed overhead 40,250 40,250 40,250 40,250 161,000
= Total overhead $50,250 $53,250 $52,250 $51,250 $207,000
/Total Direct Labor Hours 5,000 6,500 6,000 5,500 23,000
= Overhead Rate per DLH $9

Solution #4

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 Chapter 23 Review
July August September Quarter
Cash Balance:
Beginning Balance $10,400 $10,000 $14,000 $10,400
Add: Cash Receipts 24,000 32,000 40,000 94,000
Total Available Cash 34,400 42,000 54,000 104,400
Cash Disbursements (26,000) (28,000) (30,000) (84,000)
Excess (Deficiency) of available
cash over cash disbursements $6,400 $14,000 $24,000 $20,400
Borrowings 3,600 0 0 3,600
Repayments 0 0 (3,690) (3,690)
Ending Balance $10,000 $14,000 $20,310 $20,310

Interest: 3,600*10%*3/12=90

Solution #5

Year 2 Year 3
First Second Third Fourth First
Calculators produced 60,000 90,000 150,000 100,000 80,000
X Chips per calculator 3 3 3 3 3
= Production needs - chips 180,000 270,000 450,000 300,000 240,000
+ Ending inventory - chips 54,000 90,000 60,000 48,000 48,000
= Total needs - chips 234,000 360,000 510,000 348,000 1,248,000
- Beginning inventory - chips 36,000 54,000 90,000 60,000 36,000
= Required purchases - chips 198,000 306,000 420,000 288,000 1,212,000
X Purchase cost per chip $2.00 $2.00 $2.00 $2.00 $2.00
= Total purchase cost $396,000 $612,000 $840,000 $576,000 $2,424,000

Cash Disbursements:
Fourth Quarter, Year 1
purchases
36,000 chips x $2.00 x 50% $36,000 $36,000
First Quarter purchases 198,000 $198,000 $396,000
Second Quarter purchases 306,000 $306,000 $612,000
Third Quarter purchases 420,000 $420,000 $840,000
Fourth Quarter purchases 288,000 $288,000
$234,000 $504,000 $726,000 $708,000 $2,172,000

Accounts payable at the end of Year 2 is the unpaid

balance of the fourth quarter purchases $288,000

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