WGU Accounting II CZC1
ANALYSIS The net loss for the year was $15,000. Depreciation expense was $4,000. Merchandise Inventory decreased by $3,000. Accounts Receivable decreased by $5,000. Accounts Payable decreased by $2,500. Income Tax Payable decreased by $5,000. Calculate the net cash provided or used by operating activities for the year.
$10,500 used
Suppose that the equipment was purchased on September 5, 2019. Depreciation for the four months in 2019 would be a proportionate part of the depreciation for the first year of the asset's life, or $240 ($2,160 × 5/15 × 4/12). For 2020, depreciation consists of the total of two parts: the depreciation for the remaining eight months of the first year (12 months) of life and depreciation for four months of the second year of life.
$2,160 × 8/12 (8 months) × 5/15 (1st year fraction) $480 $2,160 × 4/12 (4 months) × 4/15 (2nd year fraction) 192 Depreciation for 2020 $672
On April 20, the board of directors of Auto Corporation declared a 15 percent stock dividend payable on June 1 to stockholders of record on May 15. The stock is expected to trade at $35 per share. On the declaration date, there are 4,000 shares outstanding. The par value of the shares is $30. What amount is credited to the Paid-in Capital in Excess of Par Value—Common Stock account?
$3,000 (600 shares × $5) 35-30=5.00
An asset with a cost of $60,000 and accumulated depreciation of $54,600 is retired and sold as junk for $1,600. How much gain or loss is recorded on the retirement?
$3,800 loss ($5,400 book value − $1,600 sales price).
An asset acquired on May 22, 2019, cost $50,000, has an estimated useful life of five years, and has a net salvage value of $10,000. What is the amount of depreciation expense for 2019 if the straight-line method is used?
$4,666.66
Ten-year bonds, dated January 1, 2019, with a face value of $100,000 are issued at 101 on January 1, 2019. How much premium will be amortized on the interest payment date, July 1, 2019?
$50 ($1,000/10 yrs. = $100/yr. or $50/payment date)
During the year, equipment was sold for $50,000, and a $5,000 gain was recorded. How is this transaction reported on the statement of cash flows?
$50,000—included as inflow from investing activities. $5,000 gain—deducted from net income.
ANALYSIS A truck that originally cost $40,000 was sold for $10,000 cash. Accumulated depreciation up to the date of the sale was $36,000. A $6,000 gain was reported on the income statement. What is the effect on the statement of cash flows?
$6,000 gain—subtracted from net income. $10,000—included as cash inflow from investing activities.
A corporation's taxable income for 2019 was $250,000. Using the corporate tax rates shown under "Federal Income Tax Rates," compute the total federal income tax expense for the year.
$80,750
Assuming a five-year life, a cost of $40,000, and an estimated net salvage value of $8,000, what would be the depreciation for the second year of the life of an asset if the double-declining-balance method is used?
$9,600.
Federal income tax rules basically replace the depreciation rules of generally accepted accounting principles with the Modified Accelerated Cost Recovery System (MACRS), which applies to all assets purchased after December 31, 1986.
(If appropriate, however, the taxpayer can use the units-of-production depreciation method instead of MACRS.)
Number of Times Bond Interest Earned
(Income before bond interest and income taxes)/(Bond interest cash requirement)
Maturity of discounted interest-bearing note receivable
*Contingent liability is removed from the books
Bank draft
- A bank orders another bank to pay the stated amount to a specific party - It is more readily accepted than a business or personal check
Appropriation of retained earnings
- A formal declaration of an intention to restrict dividends - Corporation restrict dividend payments in order to reinvest in plant assets or working capital
Sum-of-the-years'-digits-method
- Accelerated method of depriciation - The denominator is sum of the useful life years added together. (If the useful life is 5 years, then denominator is 15 (1+2+3+4+5)) - The numerator is the number of years remaining in the useful life of the asset Year 1 - 5/15 Year 2 - 4/15 Year 5 - 1/15 - The fraction is multiplied by the acquisition cost less the net salvage value
Participating preferred stock Has right to receive preference dividend each year before any dividend can be paid on common stock
- After common shareholders have received specified amount, preferred and common stock share in further dividends
What are the financial accounting rules for trade-ins of similar assets?
- Allow a loss to be recognized on the trade-in of a similar asset - Gains are not recognized unless it is on a non-similar asset. Otherwise, it only reduces the expense of the new asset
Declining-balance method
- Also referred to as the 200 percent declining - balance method - Book value of an asset at the beginning of the year is multiplied by a percentage to determine depriciation for the year - Accelerated method of depreciation - Ignores salvage value - Twice the straight-line rate - Last year only depriciate up to the salvage value of asset
First in, first out method (FIFO)
- Assumes that merchanges sell oldest items first - The merchandise on hand is usually the most recently purchased items - The cost of ending inventory is computed by referring to the cost of the latest purchases. - Inventory valuation on the balance sheet will reflect the most recent price levels - Many accountants consider this method less conservative and less realistic
Last in, first out method (LIFO)
- Assumes that merchants sell the items that were most recently purchased. - The value assigned to the ending inventory is the cost of the oldest merchandise on hand during the period - In a period of rising prises, the relatively lower inventory value tends to increase costs of goods, and decrease reported net income - Lower net income = lower income tax liability - Most conservative method
Internal control of property, plant, and equipment
- Authorize and justify the purchase of assets - Assign identification number to each asset - Maintain an asset register listing - Assign responsibility for safekeeping, maintaining, and operating each asset to a specific person - Take a physical inventory count periodically - Establish procedures to authorize asset retirement, sale, or other disposition
Periodic inventory
- Based on a periodic count of goods on hand - Requires a physical inventory (count)
Perpetual Inventory
- Based on a running total of number of units - Uses point-of-sale cash registers and scanners
Methods of disposition
- Businesses routinely sell or dispose of plant assets that are no longer useful to the business - When assets are disposed of, the business often incurs a gain or loss *Scrapping or discarding *Sale *Trade-in for a similar asset
Units-of-output method
- Calculates depreciation at the same rate for each unit produced - Unit of production can be measured by: -Physical quantities of production -Number of hours the asset is used -Other measures
Capital stock on the balance sheet
- Capital stock represents the equity in a corporation - Common stock and preferred stock are reported separately - Since the owners of a corporation are stockholders, the equity section of the balance sheet is titled "Stockholders' Equity"
Interest expense
- Classified as a nonoperating expense - Listed in the other income and expenses section of the income statement.
Disadvantages of a corporation
- Corporate income tax - Governmental regulation
Treasury stock
- Corporations purchase their own stock - Extra cash to invest - Offered as incentive plans for officers - Desire to increase the demand for the stock, thus increasing its market value - Can be purchased from stockholders needing cash or want to retire
Characteristics of a corporation
- Created by corporate charter issued by state government - Can enter into contracts and own property - Can have few or many owners - Can be privately held or publicly held - Has shareholders who own the shares of stock - They are the owners of the corporation
Dividend rights on preferred stock
- Cumulative - Noncomulative - Nonparticipating - Participating
Depletion for federal income tax purposes
- Depletion for federal income tax purposes is the LARGER of cost depletion or percentage depletion - Formula for percentage depletion: Gross income from sale of resource X a percentage
Depletion for financial statement purposes
- Depletion of natural resources for financial statement preparation is called cost depletion - Formula for cost depletion : Cost of natural resource ---------------------------- = Depletion per unit Estimated units of resource
Calculating the discount and the proceeds
- Determine the maturity value of the note - Calculate the number of days in the discount period - Compute the discount charged by the bank - Calculate the proceeds
Calculating the maturity date of a note
- Determine the number of days remaining in the month of issue. - Determine the number of days in each full month of the note. - Determine the number of days in the last month of the note. Add the days together to confirm they equal the period of the note.
Nonparticipating preferred stock Has right to receive preference dividend each year before any dividend can be paid on common stock
- Does not have the right to any dividend in excess of the preference dividend
Horizontal analysis
- Evaluates financial statements for two or more periods - Compares items in each line to determine the change in dollar amounts - Uses the same method for both the income statement and the balance sheet
Vertical analysis
- Every item on the income statement is divided by the net sales figure - Expressed as a percentage of total assets, or total liabilities plus stockholders' equity
Cost of tangible personal property
- Gross purchase price less discounts - Transportation costs - Installation costs - Costs of adjustments or modifications needed to prepare the asset for use
Cumulative preferred stock Has right to receive preference dividend each year before any dividend can be paid on common stock
- If dividend is passed (not paid) in one year, the amount not paid carries over and must be fully paid in a subsequent year before any dividend can be paid on common stock.
Bond premium
- If the face rate on the bond exceeds the market rate of interest at the time the bonds are issued - The premium will decrease the total cost of borrowing funs over the life of the bond - Issuing corporation must write off (amortize) the premium over the period from date of issue of the bonds until maturity
Statement of Cash Flows (to prepare)
- Income statement - Schedule of operating expenses - Statement of retained earnings - Comparative balance sheet (two methods of preparing : direct or inderect)
Financing activities - sources of cash
- Issuance of common stock - Issuance of preferred stock - Issuance of bonds payable - Borrowing through signing a note payable - Resale of treasury stock
Subchapter S Corporation
- Known as S Corporation - Meets Subchapter S requirements of Internal Revenue Code to be treated as a partnership * does not pay income taxes * Shareholders include their share of corporate profits on their individual tax returns
Advantages of a corporation
- Limited liability - Restricted agency - Continous existence - Transferability of ownership rights - Ease of raising capital
Depreciation
- Long term assets are depreciated because they have a limited life and get used up over time - Refers to the loss of usefullness, and not necessarily to a decrease in the market value - The account "depreciation expense" is debited, and the account "accumulated depreciation" is credited to record the depriciation for a period
Acid-test ratio
- Measures immediate liquidity - Formula: Quick assets / current liabilities = Acid-test ratio *Quick assets are cash, receivables, and market securities
Inventory turnover
- Measures the number of times the inventory is replaced during the period - Formula: Cost of goods sold / Average inventory = Inventory turnover
Accounts receivable turnover
- Measures the speed with which sales on account are collected - Formula : Net credit sales / Avg receivables = A/R turnover
MACRS
- Modified accelerated cost recovery system - A different set of rules is used for depreciation for income tax purposes - Results in higher depreciation expense in early years which results in tax savings - Not acceptable for financial statement preparation
UCC Requirements for Negotiability
- Must be in writing and signed by the maker - Must contain an unconditional promise to pay a definite amount of money. - Must be payable either on demand or at a future time that is fixed or that can be determined. - Must be payable to the order of a specific person or to the bearer. - Must clearly name or identify the drawee if addressed to a drawee.
Inventory costing method guidelines
- Once a firm adopts a method, it should use that method from one period to the next - A firm can generally use one inventory costing method for financial accounting purposes, and one for federal income tax purposes *Exception* - The firm must use the LIFO method for financial accounting if that method is adopted for tax purposes
Commercial draft
- One party orders another party to pay a specified amount on a specified date - It is used for special shipment and collection situations
Cash inflows and outflows - classifications
- Operating activities - Investing activities - Financing activities In order to prepare a statement of cash flows, you must be able to distinguish between these activities
LLC
- Owners have limited liability - Owners choose to have profits taxed at the company level, or on their individual income tax return - Profits and losses can be allocated other than in proportion to ownership interest - Transfers of ownership must be approved by owners
LLP
- Partners are responsible and have liability for their own actions and actions of those they control or supervise - Partners are not liable for the actions or malfeasance of another partner
Types of intangible assets
- Patent - Copyright - Franchises - Trademarks, trade names, brand names - Computer software - Goodwill
Financing activities - uses of cash
- Pay cash dividends on common stock - Pay cash dividends on preferred stock - Repay bond indebtedness - Repay notes payable or other borrowing - Purchase treasury stock
Operating activities - uses of cash
- Pay for merchandise - Pay taxes - Pay salaries and wages - Pay interest expense - Pay for other expenses
Investing activities - uses of cash
- Pay for purchase of land, buildings, or equipment - Pay for the purchase of investments in bonds or other securities
Cost of real property
- Purchase price - Legal costs - Other costs related to the acquisition
Ratios measuring Profitability, Operating Results, and Efficiency
- Rate of return on sales - Rate of return on common stockholders' equity - Earnings per share (EPS) on common stock - Price-earnings ratio - Yield on common stock - Rate of return on total assets - Asset turnover
What is the income tax method?
- Records the trade-in of an asset according to income tax rules - Income tax rules do not recognize gain or loss on a trade-in 1. Remove the cost of the old asset 2. Remove the accumulated depreciation for the old asset 3. Record the payment 4. Determine and record the cost of the new asset Formula for new asset - Book value of the old asset + payment for new asset = Cost of new asset
Statement of cash flows
- Reviewed by creditors to determine how the firm will pay principal and interest on debts - Reviewed by investors to determine if the corporation will have the cash to pay dividends - Reviewed by management for information about cash to pay employees, suppliers, and other obligations. - Addresses cash equivalents, which are classified as assets that are easily convertible into into known amounts of cash (CDs, money market funds, and T-bills, etc)
Investing activities - sources of cash
- Sale of land, buildings, or equipment - Principal payments collected on receivable for long-term assets - Sale of investment in bonds or other securities
Operating activities - sources of cash
- Sale of merchandise - Sale of services - Interest income - Dividend income - Miscellaneous income
Types of bonds
- Secured or unsecured - Registered or unregistered - Single-maturity or serial-maturity
Comparative statement
- Show amounts and percentages for two consecutive years
Four methods for computing inventory costs
- Specific identification method - Average cost method - FIFO Method - LIFO Method
Noncumulative preferred stock as right to receive preference dividend each year before any dividend can be paid on common stock
- Stockholders have no rights to dividend for years in which none were declared
Depreciation methods
- Straight-line - Declining-balance - Sum-of-the-years'-digits - Units-of-output
"Hybrid" business entities
- Subchapter S corporation - Limited liability partnerships (LLPs) - Limited liability corporations (LLCs) *Have characteristics of partnerships and corporations
Reporting contingent liabilities
- The contingent liability can appear as a separate item on the balance sheet: Notes receivable $7,400 Notes receivable-discounted $(3,000) ------------------------------------------------ Net notes receivable $4,400 - Another way to report contingent liabilities is to present net notes receivable on the balance sheet and to include a footnote with information about the discounted notes receivable.
Contigent liability for a discounted note
- The note holder endorses the discounted note receivable - If the maker of the note dishonors the note, the bank can obtain payment from the endorser - The endorser has a contingent liability
Indirect method
- Treats net income as the primary source of cash from operating activities and adjusts net income for changes in noncash items
Disposal by scrapping or discarding
- When an asset is worn out, often it is simply discarded - If the discarded asset is no fully depreciated, depreciation is recorded up to the date of disposal
Specific identification method
- a method of inventory costing based on the actual cost of each piece of merchandise - used by auto dealers, or merchants who deal with large unit costs, or one of a kind items
Average cost method (definition)
- a method of inventory costing when inventory is composed of many similar items - the average cost of all similar items is used to value the ending inventory.
Extraordinary, nonrecurring items
- are highly unusual - are clearly unrelated to routine operations - do not frequently occur shown on INCOME STATEMENT in a separate section titled "term"
Retained earnings
- does not represent a cash fund - are invested in: *Inventory *Plant and equipment *Various other types of assets - may be distributed to stockholders - appear in "Stockholders' Equity" section of the balance sheet
Capital stock records for a corporation
- meeting minutes - corporate bylaws - stock certificate books - stock ledgers - stock transfer records
Stock split
- occurs when a corporation issues two or more shares of new stock to replace each share outstanding without making changes to the capital accounts - declared when stock is difficult to sell because of high market price - does not change the capital account balances - requires only a memorandum notation in the general journal
Book value
- represents the total equity applicable to the class of stock divided by the number of shares outstanding - remains the same before and after a stock dividend, but each shareholder owns more shares of stock with proportionately lower book value per share For each class of stock, book value per share = equity/shares outstanding
Ratios measuring liquidity
- working capital - current ratio - acid-test ratio - inventory turnover - accounts receivable turnover
The average collection period is determined by dividing:
. 365 days by the accounts receivable turnover
Cruz Corporation decides to accumulate $30,000 per year in the bond sinking fund for each of the last five years that the bonds are outstanding. The net earnings of the fund will reduce the amount that the corporation has to add each year. Suppose that the bond sinking fund investment account is started on April 1, 2024, by making a $30,000 cash deposit. The $30,000 is immediately invested. The following journal entries are for the first transfer of cash to the fund, net earnings for the first year, second transfer of cash to the fund, and retirement of the bonds at the end of the fifth year:
1
Average cost method (steps)
1. Add the total number of units purchased plus the beginning inventory. 2. Calculate the total cost by adding the cost of beginning inventory plus purchases. 3. Divide the total cost by the number of units to determine the average cost of each item. $20,600 (total cost) ---------------------- = $20.60 avg cost of each item 1000 (# of units)
Phases of statement analysis
1. Computation phase - Vertical analysis - Horizontal analysis - Ratio analysis 2. Interpretation phase : Comparison of ratios - Budgeted ratios - Industry averages
Disposal by sale
1. Record depreciation to the date of disposition 2. Remove the cost of the asset 3. Remove the accumulated depreciation 4. Record the proceeds 5. Determine and record the gain or loss, if any
Disposal by trade-in
1. Record the depreciation up to the date of trade-in 2. Record the trade-in of the old asset and the purchase of the new asset. Use either: - the financial accounting rules OR - the income tax rules
Determining if an asset is impaired
1. Review circumstances that suggest impairment may have occured 2. Apply the recoverability test (a comparison of of estimated net cash flow from future use of the asset with the book value of the asset) 3. Compute the amount of the impairment
During the year, $1,800 is earned on the sinking fund investments. Expenses of $40 are incurred in operating the bond sinking fund.
2
Total selling expenses for 2018 and 2019 were $725,000 and $875,000, respectively. Net sales for 2018 and 2019 were $3,300,000 and $3,700,000, respectively. For each year, what are total selling expenses as a percentage of net sales? What is the percentage of increase or decrease of total selling expenses?
2018: 22.0 percent 2019: 23.6 percent $150,000 increase; 20.7 percent
Net earnings for the year are $1,760. The following year only $28,240 ($30,000 − $1,760) needs to be added to the fund.
3
The accounts receivable turnover can be used to determine the average collection period of accounts receivable, or number of days' sales in receivables. The average collection period is computed as follows:
365 DAYS/ACCOUNTS RECEIVABLE TURNOVER
Average collection period
365 days/Accounts receivable turnover Average number of days required to collect sales on account
This procedure is repeated each year, so that at the end of the fifth year the fund will have the $150,000 needed to retire the bonds.
4
If current assets are $200,000 and total assets are $500,000, the percentage of current assets to total assets is:
40 percent.
Under MACRS, property is separated into defined classes. For tangible personal property, there are six classes of property. However, almost all personal property falls in three of those classes. Those three are
5-year class—automobiles, lightweight trucks, computers, and certain special-purpose property. 7-year class—office furniture and fixtures and most manufacturing equipment. 10-year class—special purpose property, such as equipment used in the manufacture of food and tobacco products.
What is the denominator of the fraction used in the calculation of annual depreciation using the sum-of-the-years'-digits method of depreciation for an asset with a useful life of 10 years?
55 (10 + 9 + 8 + 7 + 6 + 5 + 4 + 3 + 2 + 1).
Bankers year
A 360-day time period used to calculate interest on a note.
The balance of an appropriated retained earnings account is reduced:
A board resolution is necessary to reduce appropriated retained earnings.
SECURED AND UNSECURED BONDS Secured bonds have property pledged to secure the claims of the bondholders. Collateral trust bonds involve the pledge of securities, such as stocks or bonds of other companies.
A bond contract, known as a bond indenture, is prepared. A trustee, frequently an investment banker, is named to protect the bondholders' interests. If the bonds are not paid when due, the trustee takes legal steps to sell the pledged property and pay off the bonds.
Why would a corporation purchase its own stock as treasury stock?
A common reason is that the corporation's board decides the corporation has excess cash and concludes that its own stock represents the best available investment. Sometimes stock is repurchased to reduce the number of shares outstanding with the expectation of increasing net income per share and/or dividends per share for remaining shareholders.The cost of treasury stock should not be shown as an asset on the balance sheet of the issuing corporation. It represents a deduction from the total of the corporation's other stockholders' equity accounts.
What is a convertible bond?
A convertible bond is one that may be converted into common stock, under specified conditions, at the option of the owner.
Ease of Raising Capital.
A corporation can have an unlimited number of shareholders. Some corporations have more than a million shareholders, making available a vast pool of capital.
Describe special "hybrid" organizations that have some characteristics of partnerships and some characteristics of corporations.
A corporation formed as an S corporation is taxed as a partnership. The limited liability partnership and limited liability company avoid federal corporate income tax and also provide limited liability.
Trade acceptance
A draft used in recording transactions involving the sale of goods Original transaction --> Recorded as a sale on credit Trade acceptance --> Accounted for as a promissory note
Negotiable Instrument
A financial document containing a promise or order to pay, that meets all the UCC requirements to be transferrable to another party.
Compute the proceeds from a discounted note receivable, and record transactions related to discounting of notes receivable.
A firm with an immediate need for cash can discount a note receivable. Debit Cash for the proceeds, credit Notes Receivable—Discounted for the face value, and either debit Interest Expense (if the proceeds are less than the principal) or credit Interest Income (if the proceeds exceed the principal). Notes Receivable—Discounted represents a contingent liability. If the note's maker fails to pay at maturity, the business must pay the bank.
Most corporations pay out only a portion of retained earnings as dividends. They restrict dividend payments in order to reinvest in plant assets or working capital. Sometimes dividends are restricted by contract, such as the requirements of a bond issue.
A footnote to the financial statements can be used to indicate how management's plans or contractual obligations will affect (restrict) the dividends. A more formal way for the board of directors to show an intention to restrict dividends is to make an appropriation of retained earnings by resolution. Dividends cannot be declared from appropriated retained earnings.
Bond sinking fund
A fund established to accumulate assets to pay off bonds when they mature
What is a bond sinking fund investment?
A fund used to accumulate assets to pay off bonds when they mature.
How does the general journal entry for a stock split differ from one for a stock dividend?
A general journal entry is made to reflect a reduction of Retained Earnings for the value of a stock dividend. No entry is made in the accounts to record a stock split, except memorandum entries to note the board's action when the split is authorized and again on the date the additional shares are issued.
In general, would it be preferable in a retail store to have a higher or lower inventory turnover? Explain.
A higher inventory turnover number would probably indicate that assets are being used more effectively in generating sales in a retail business.
Note payable
A liability that represents a written promise by the debtor to pay the creditor a specified amount at a specified future date.
Liquidation Preferences on Preferred Stock In case of liquidation, preferred stockholders have a claim on assets before that of common stockholders.
A liquidation value (usually par value or an amount higher than par value) is assigned to the preferred stock. After the creditors are paid, the preferred stockholders are paid the liquidation value for each share of preferred stock before any assets are distributed to common stockholders. The liquidation value of preferred stock includes any cumulative dividends that have not been paid. (Cumulative dividends are explained later in this chapter.) The liquidation preference on preferred stock is disclosed in the Stockholders' Equity section of the balance sheet.
To record cash dividends (Record date:)
A list is made of the stockholders and the number of shares owned by each
Stockholders' Equity
A low ratio of stockholders' equity to total liabilities can be risky. The corporation might not be able to make interest and principal payments on its debts.
Record stock issued at a premium and stock with no par value.
A premium on stock is recorded in a Paid-in Capital in Excess of Par Value account. Stock without a par value is called no-par-value stock. A few states require it to be assigned a stated value, similar to par value for accounting purposes.
Schedule of operating expenses
A schedule that supplements the income statement
Restricted Agency.
A shareholder has no right to act on behalf of the business. Instead, the board of directors controls the corporation, and the corporate officers are in direct charge of operations. For example, a person who owns 10,000 shares of Microsoft CorporationPage 707 has no greater power to act on behalf of Microsoft than a person who has no ownership interest at all.
Stated value
A value assigned to no-par stock by the board of directors for accounting and legal purposes. (Treated the same as par value)
Which account(s) will be debited and which will be credited when an interest-bearing note receivable that has been discounted is dishonored at the time of maturity?
Accounts debited and credited: Notes Receivable—Discounted will be debited and Notes Receivable will be credited. Also, Accounts Receivable and the customer's account in the subsidiary ledger will be debited and Cash will be credited.
Cost Basis Principle
Accounts reflect historical costs, not current market values. This must be considered when analyzing financial statements. Book value rarely reflects fair market value.
Decrease in current asset
Add to Net Income
Increase in current liability
Add to Net Income
At what point in preparing the corporate end-of-year worksheet does the accountant enter the adjustment for income taxes?
After the balances of income and expense accounts—other than income taxes—have been extended to the Income Statement of the worksheet, the Debit column and Credit column are totaled. The difference is the income before taxes. The taxes are computed on that income and entered as an adjustment and carried forward to the Debit column of the income statement section.
An oil company paid a landowner $30,000 for the mineral rights underlying his property. The well was drilled and equipped at a cost of $900,000. It is estimated that 300,000 barrels of oil will be produced from the property. Describe the method that should be used to measure and record depletion of the cost of the mineral rights as the oil is produced. How should depreciation of the costs of drilling and equipping the well be measured and recorded?
All of these costs should be transferred to expense (depletion for the mineral rights and depreciation for drilling equipment) on the unit-of-production basis as the oil is produced.
RealTime Company has outstanding 10,000 shares of 8 percent, $50 par-value, cumulative, preferred stock and 20,000 shares of $25 par-value common stock. There are no dividends in arrears on the preferred stock. In 2019, the corporation distributed dividends of $100,000. How much will be distributed to common stockholders and to preferred stockholders?
Allocation is $40,000 to preferred and $60,000 to common, computed in following order: 8% of $50.00 is $4.00 per share Step 1: To preferred: 10,000 shares × $4 per share dividend = $40,000. Step 2: To common: All dividend distributions remaining after preferred dividends ($100,000 − $40,000) = $60,000.
Note receivable
An asset representing a written promise by the debtor to pay the creditor a specified amount at a specified future date.
What is the straight-line method for amortizing bond discount or premium?
An equal amount of discount or premium is amortized each month from the issue date to the maturity date.
During the year, the notes payable account increased is this reflected when computing net income from operations?
An increase in notes payable does not affect cash flow from operations, unless the notes were credited when merchandise inventory or other operating assets were purchased.
Contingent liability
An item that can become a liability if certain future events happen.
Federal Income Tax Requirements for "Cost Recovery" (Depreciation) of Property, Plant, and Equipment
Apply the Modified Accelerated Cost Recovery System (MACRS) for federal income tax purposes.
REPORTING INCOME TAX EXPENSE ON THE INCOME STATEMENT There are two ways to show income tax expense on the income statement:
As a deduction at the bottom of the income statement, after Net Income Before Income Tax. To see this presentation, refer to Figure 21.3. As an operating expense, to emphasize that taxes represent a cost of doing business.
On the statement of cash flows, how is the payment of a cash dividend reported?
As cash used in financing activities.
Natural resources such as iron ore, oil, gold, and coal are physically removed from the land in the production process. Businesses must know how to allocate the cost of natural resources as they are taken from their source.
As the resources are extracted, part of their cost is charged to expense.
Assets that are used for more than one year are capitalized.
Asset account names are descriptive, for example, Office Equipment, Store Equipment, Vehicles, or Buildings.
Worksheet
Asset, liability, and equity accounts are extended to the Balance Sheet columns. Revenue and expense accounts are extended to the Income Statement columns.
Cash equivalents
Assets that are easily convertible into known amounts of cash are easily convertible into known amounts of cash. They include certificates of deposit (CDs), U.S. Treasury bills, and money market funds.
What is the gross profit method?
Assumes that the rate of gross profit on sales and the ratio of cost of goods sold to net sales are relatively constant from period to period. 1. Estimate the cost of goods sold. (sales X ratio of cost of goods sold to net goods) 2. Determine the cost of goods available for sale. (beginning inventory plus purchases) 3. Compute the ending (destroyed) inventory. (Cost of goods available for sale less estimated cost of goods sold)
Mountain Supplies, Inc., estimated its tax liability for 2019 to be $20,000. During the year, it made four tax deposits of $5,000 ($20,000 ÷ 4). The journal entry to record the first deposit (April 15) is as follows:
At the end of the year, the Income Tax Expense account has a balance of $20,000.
Understand how to use bank drafts and trade acceptances and how to record transactions related to those instruments.
Bank drafts, commercial drafts, and trade acceptances are negotiable instruments used in business. Bank drafts are checks written by a bank ordering another bank in which it has funds to pay the indicated amount to a specific person or business. Businesses issue commercial drafts to order a person or firm to pay a sum of money at a specific time. Trade acceptances arise from the sale of goods. The original transaction is recorded in the same way as a sale on credit. When the draft has been accepted, it is accounted for as a promissory note.
Bonds payable are debt. When the bonds fall due, the debt must be repaid.
Because the bonds represent debt, they are classified as long-term liabilities. Interest must be paid on the bonds. Interest is deducted in arriving at the taxable income Interest rates on bonds are slightly lower than dividends on preferred stock.
Book value for each share of stock is the total equity applicable to the class of stock divided by the number of shares outstanding. The total book value is the same before and after a stock dividend, but each shareholder owns more shares of stock with a proportionately smaller book value per share.
Before the stock dividend, Fee owned 400 shares, or 10 percent (400 ÷ 4,000 shares), of the stock of the corporation. After the stock dividend, Fee still owned 10 percent (440 ÷ 4,400 shares) of the corporation's stock:
Cost of Goods Sold The formula for cost of goods sold is
Beginning inventory + Purchases − Ending inventory = Cost of goods sold
Bond issue costs are costs incurred in issuing bonds, including items such as legal and accounting fees and printing costs.
Bond issue costs reduce the proceeds of borrowing. These costs should be shown as a deferred charge in the long-term asset category of the balance sheet. That cost would be allocated over the life of the bonds.
Why is amortization of a bond premium offset against interest expense?
Bond premium is a device to adjust the face amount of interest to the market interest rate at the date of issuance. Thus, the premium is directly related to interest expense.
The entry to record retirement of a bond includes a debit to:
Bonds Payable.
Serial-maturity
Bonds are payable over a period of years
Bonds are classified by the following characteristics:
Bonds can be secured by collateral, or they can be unsecured. Bonds can be registered or unregistered. Bonds can all mature on the same date, or portions can mature over a period of several years. Mature means to fall due or to become payable.
Single-maturity
Bonds mature on the same day
Why would a corporation purchase its own bonds and retire them?
Bonds may be retired prior to maturity because management has surplus cash, it wants to save interest costs, or it expects interest costs to decrease.
What factor would cause bonds to be sold at a premium?
Bonds sell at a premium when the face interest rate is greater than the market rate of interest on similar investments on the date of the sale.
If it is determined that an asset is impaired, how is the amount of impairment to be charged to expense computed?
By comparing its fair value to its book value. There may be no ready indication, such as a ready market price, of an asset's fair value. A common approach is to estimate the future cash flows from the asset's use on a year-by-year basis and to discount these future cash flows to their current value.
double-declining-balance (DDB).
Calculate the straight-line rate. 100 percentUseful life=100 percent5 years=20 percent
Bonds are frequently callable. Callable bonds allow the issuing corporation to require the holders to surrender the bonds for payment before their maturity date.
Call provisions are clearly stated on the bond. The call price is the amount the corporation must pay for the bond when it is called. Usually the call price is slightly above the face value. If the market interest rate declines below the face interest rate on the bonds, or if the corporation has excess cash, it might call all or part of the bonds and retire them.
YIELD ON COMMON STOCK For a publicly held corporation, the relationship between the dividends received by the stockholders and the market value of each share is important. The yield on common stock is computed as follows:
Cash dividend per share/Market price per share
Sources of cash
Cash inflows
Cash Flows from Financing Activities. Financing activities involve transactions that provide cash to the business to carry on its activities.
Cash inflows from financing activities include issuing bonds and capital stock for cash, borrowing cash by signing notes payable, and reselling treasury stock.
Uses of cash
Cash outflows
A considerable period of time might be necessary to sell the inventory and convert it into cash in the normal course of business. The acid-test ratio measures immediate liquidity. This ratio uses quick assets, which are cash, receivables, and marketable securities.
Cash+Receivables+Marketable securities/Current liabilities =Acid-test ratio
a comparative balance sheet for Your Products, Inc., with the vertical analysis results. The pair of columns on the right shows each item as a percentage of total assets for each year. The more recent year is on the left. On December 31, 2019, the cash balance was $115,231 and the total assets were $555,711. Thus, the cash balance is 20.7 percent of total assets in 2019:
CashTotal/assets=$115,231/$555,711 =0.2074=20.7 percent
Closing entries
Close revenue --> Income summary Close expenses --> Income summary Close income summary (net income or loss) --> Retained earnings
DIVIDENDS ON COMMON STOCK
Common stock dividends are paid only after preferred dividend requirements have been met. The fewer the dividend privileges enjoyed by preferred stockholders, the higher the dividends that common stockholders can receive, especially in prosperous years.
Book value per share measures the financial strength underlying each share of stock. It is frequently reported in financial publications. It represents the amount that each share would receive in case of liquidation if the assets were sold for book value.
Common stockholders' equity/Number of common shares outstanding =Book value per share of common stock
Trend analysis
Compares selected ratios and percentages over a period of time *time period is often 5 years
Compute the number of shares of common stock to be issued on the conversion of convertible preferred stock.
Convertible preferred stock gives its owners the right to convert their shares into common stock after a specified date by using the stated conversion ratio.
the corporate form of operation also has certain disadvantages:
Corporate Income Tax State and local governments can also levy income taxes on corporations Governmental Regulation.
Corporate Income Tax.
Corporate profits are subject to federal income tax. Profits distributed to shareholders in the form of dividends are taxed a second time as part of the personal income of the stockholder. The taxation of profits at the corporate level and at the shareholder level is known as double taxation.
Describe the capital stock records for a corporation.
Corporate records must include minute books, stockholders' ledgers, stock certificate books, and stock transfer records.
Governmental Regulation.
Corporations are subject to laws and regulations imposed by the state. In general, the state regulatory bodies exercise closer supervision and control over corporations than they do over sole proprietorships or partnerships. State laws may prohibit corporations from entering into particular types of transactions or from owning specific types of property. Special reports are frequently required of corporations.
Inventory turnover measures the number of times the inventory is replaced during the period. The higher the turnover, the shorter the time between the purchase and sale of the inventory. Inventory turnover is computed as follows:
Cost of goods sold/Average merchandise inventory =Inventory turnover
What is the formula for the cost ratio used in the retail method of estimating inventory?
Cost ratio = Cost of merchandise available for sale/Retail sales price of merchandise available for sale.
If there had been no bond sinking fund,
Cruz Corporation would have recorded the retirement on the maturity date by debiting 10% Bonds Payable, 2029, and crediting Cash.
Working capital
Current assets - current liabilities = working capital
Current ratio
Current assets / current liabilities = Current ratio *the higher the ratios the better *in retail and manufacturing, desired guideline is 2 to 1
Working capital is a very important measure of liquidity. The current ratio is another way to evaluate liquidity. The current ratio measures the ability of a business to pay its current debts using current assets. The current ratio is computed as follows:
Current assets/Current liabilities =Current ratio
Working capital is a measure of the ability of a company to meet its current obligations. It represents the margin of security afforded short-term creditors. Working capital, sometimes called net working capital, is computed as follows:
Current assets−Current liabilities=Working capital
GAIN
DR -DECREASE CR + INCREASE
Record entry to close income summaY FOR A NET LOSS
DR RETAINED EARNINGS CR INCOME SUMMARY
Loss
DR+INCREASE CR-DECREASE
What account is debited and what account is credited in the journal entry to record depreciation for the year
Debit Depreciation Expense; credit Accumulated Depreciation.
What is the entry to record $300,000 of bonds that were retired at maturity? Retained earnings were appropriated for $300,000 for bond retirement. There was no bond sinking fund.
Debit Retained Earnings Appropriated for Bond Retirement for $300,000; credit Retained Earnings for $300,000. Debit Bonds Payable for $300,000 and credit Cash for $300,000.
Decrease in current liability
Deduct from Net Income
Increase in current asset
Deduct from Net Income
Discounting
Deducting the interest from the principle of a note in advance.
The income statement shows depreciation expense of $25,000. How is the expense handled when computing net cash provided by operating activities?
Depreciation expense does not reflect a cash outlay, so it must be added back to net income.
ANALYSIS How are depreciation, depletion, and amortization different? How are they similar
Depreciation is the allocation of cost of personal and real tangible property to expense over the property's useful life. Depletion is the allocation of cost of mineral rights. Amortization is the allocation costs of intangibles with estimated useful lives. All refer to the charging of the costs of assets to expense over their useful lives, but apply to different types of long-term assets.
What is depreciation?
Depreciation is the allocation of the cost of a long-term asset to expense during its useful life.
Depreciation Expense The acquisition of property, plant, and equipment is reported in the Cash Flows from Investing Activities section of the statement of cash flows in the year acquired. .
Depreciation, depletion, and amortization of assets do not involve a cash outlay in the year the expense is recorded. Instead, these expenses represent a reduction in the net asset value shows depreciation expense of $7,680 (sum of $7,180 recorded as selling expenses and $500 recorded as general and administrative expenses). The depreciation expense was recorded as follows:
Name several factors that may cause misleading results when comparing percentage figures of a specific company to industry averages.
Different accounting methods, different types of entities, different ages of assets, and different financing methods can impair comparability.
Recognize shortcomings in financial statement analysis.
Different accounting policies and procedures make it difficult to compare financial results across companies. financial statements are prepared assuming that the dollar is a stable monetary unit; this is far from correct difficult to compare financial results of businesses that use different financing methods, classify expenses differently, have different policies for paying owner-employees, and operate as different types of business entities.
During the year, a corporation issued $100,000 of bonds payable in return for land with a fair market value of $100,000. How is this reported on the statement of cash flows?
Disclosed in footnotes to the statement.
How are bond discounts shown on the balance sheet?
Discount on bonds payable is shown on the balance sheet as a deduction from the face value of the bonds.
What does it mean to dishonor a note?
Dishonor of a note means that the maker of the note does not pay it when it is due.
Dividends
Distribution of profits of a corporation to its shareholders = par value of preferred stock X dividend rate
How does donated capital arise?
Donated capital arises when an asset or assets are contributed or donated to the corporation as an incentive to locate a new facility on the land.
What is meant by "donated capital"?
Donated capital represents the value of assets that have been donated to, or contributed to, the corporation. Usually such contributions are to be used for some specified purpose.
On the worksheet, column totals in the Income Statement section are debit, $192,000, and credit, $242,000. Assuming income and deductions for tax purposes are the same as those for financial accounting purposes and that the corporation had paid estimated taxes of $8,000, what is the adjusting entry for income taxes based on the income tax rates presented under "Federal Income Tax Rates"?
Dr. Income Tax Refund Receivable (or a similar account), $500. Credit Federal Income Tax Expense, $500. ($8,000 estimate paid, minus $7,500 actual tax for the year.)
To record stock dividends (Distribution date)
Dr: Common stock dividend distributable Cr: Common stock
To record cash dividends (Payment date:)
Dr: Dividends payable (common or preferred) Cr: Cash
To record cash dividends (Declaration date:)
Dr: Retained earning Cr: Dividends payable (Common or preferred)
To record stock dividends (Declaraction date)
Dr: Retained earnings Cr: Common stock dividend distributable Cr: Paid-in capital in excess of par--Common
Which of the following is true of vertical analysis?
Each item in the income statement is divided by net sales.
What is the retail method?
Estimates inventory cost by applying the ratio of cost to selling price in the current accounting period to the retail price of the inventory. 1. List the beginning inventory at both cost and retail 2. When merchandise is purchased, record it at cost and determine its retail value 3. Compute merchandise available for sale at cost and at retail 4. Determine net sales at retail
Remember the following important points about inventory valuation methods:
Except for specific identification, the physical flow of inventory and the costs assigned to inventory are not specifically matched. Average, FIFO, and LIFO cost methods assign costs to inventory but do not track the cost to the specific inventory item. Businesses can use separate inventory valuation methods for different classes of inventory. Following the consistency principle, once a business adopts an inventory valuation method, it uses that method consistently from one period to the next. A business cannot change its inventory valuation method at will, although a one-time change is acceptable. A business can use one inventory costing method for financial accounting purposes and another for federal income tax, with the exception of LIFO costing. A taxpayer who adopts LIFO for federal tax purposes must also adopt it for financial accounting purposes. FIFO focuses on the balance sheet. The most current costs are in ending inventory. LIFO focuses on the income statement and the matching principle. The most recent costs are matched with revenue. LIFO is considered the most conservative costing method in a period of rising prices.
A 90-day note, dated February 15, 2019, with a face value of $14,000, bearing interest at 9 percent. (Use 360 days a year. Round your answers to 2 decimal places.) A six-month note, dated March 10, 2019, with a face value of $7,200, bearing interest at 10 percent.
Explanation 1. MV = P + I = $14,000 + ($14,000 × 0.09 × 90/360) = $14,000+ $315 = $14,315 2. MV = P + I = $7,200 + ($7,200 × 0.10 × 6/12) = $7,200 + $360 = $7,560
Under FIFO costing, which costs are assigned to the goods sold during the period?
FIFO assumes that merchandise is sold in the order it is received. In this way, the oldest costs identified with merchandise are charged to cost of goods sold.
Market interest rate refers to the interest rate a corporation is willing to pay and investors are willing to accept at the current time.
Face interest rate refers to the contractual interest rate specified on the bond. Market interest rate changes constantly. Face interest rate of a bond does not change.
Accrual net income
Figure for non-cash expenses like depreciation and amortization which did not use cash
The second step in statement analysis, the interpretation phase, is the more difficult and important step.
Financial statement interpretation requires an understanding of financial statements and knowledge of the operations of the business and the industry. In the interpretation phase, the analyst develops an understanding of the significance of the percentages and ratios computed. Analysts compare the ratios for the current year to prior years' ratios, budgeted ratios, and industry averages.
Name some financing activities.
Financing activities are transactions that provide or use cash through selling stock, issuing bonds, or paying cash dividends.
Partial collection of a note
First applied to interest and then to principle
When is Interest Expense debited if an interest-bearing note payable is issued? If a note payable is discounted?
For an interest-bearing note issued, Interest Expense is debited when the note matures. The interest on a note payable discounted is recorded at the date of the discounting.
SINGLE-MATURITY AND SERIAL-MATURITY BONDS Most bonds in an issue mature on the same day. However, serial bonds are payable over a period of years.
For example, a corporation might issue serial bonds totaling $10 million, dated January 1, 2019, with $2,000,000 maturing each year for five years, beginning on January 1, 2029. The corporation might find it easier to retire bonds on a serial basis rather than to have all $10 million due on the same date.
Convertible bonds give the owner the right to convert the bonds into common stock under specified conditions.
For example, an indenture can give the holder of a 20-year, $1,000 bond the right to convert the bond into 50 shares of the corporation's common stock at any time. When the price of the stock reaches $20 or more ($1,000 bond ÷ 50 shares of stock), the bondholder is likely to convert it into stock.
A variety of costs are incurred when a business is incorporated, including legal fees, attorneys' fees, charter fees paid to the state, and the cost of the organizational meeting of the directors. Organization costs are incurred to provide benefit over the entire life of the corporation because they are necessary in order for the entity to exist and carry on business.
For this reason, in past years, organization costs have been capitalized and amortized over an arbitrary period (typically the period from the U.S. tax code). Some corporations, however, simply record the costs as an intangible asset and do not amortize the costs for financial accounting purposes.
Straight-line method
Formula: Depreciation exp = Cost - salvage value ----------------------- Estimated useful life - The same dollar amount of depreciation is taken each year as an expense
Financial statements for a corporation
Four total statements prepared: - Income statement - Statement of retained earnings - Balance sheet - Statement of cash flows
Strategic Innovations Company spent $80 million in 2019 on research and development costs (R&D). Some work was general research seeking basic knowledge about products. Other work was getting several projects started to look into ways to develop and improve a line of drugs manufactured by the company. Other costs were incurred in the final stages of perfecting new products. How should these costs be accounted for by Strategic Innovations?
GAAP requires that "research and development costs" must be charged to expense when incurred. There are a few specified exceptions to this rule, but the costs incurred by Strategic Innovations do not fall within these exceptions.
How often should a physical inventory be taken?
Generally, inventory is taken once a year. If there is a history of thefts, breakage, overstocking or understocking, or other operational problems, it may be necessary to make physical counts more often.
Transferability of Ownership Rights.
Generally, shareholders can sell their stock without consulting or obtaining the consent of the other owners. Shareholders are free to shift their investments at any time, provided they can find buyers for their stock. Organized stock markets, such as the New York Stock Exchange, make it easy to sell or buy interests in corporations whose stocks are traded.
Ratio analysis
Has three different classifications: - Profitability, operating results, and efficiency - Financial strength - Liquidity
Suppose that the new truck Howard acquired has an agreed-on price of $42,000, which is also its fair value. The dealer granted Howard a trade-in allowance of $7,800 and Howard paid cash of $34,200. As a result, Howard is deemed to have received $7,800 for the old truck. The implicit gain on the trade-in is $800 ($7,800 trade-in allowance, minus $7,000 book value of the old truck.) In this situation, the cost of the new asset is recorded at its fair market value and the difference between the trade-in allowance and book value of $800 is recorded as a gain.
Here are the steps to record the trade-in if there is a gain on the transaction: Step 1. Remove the cost of the old asset ($40,000). Step 2. Remove the accumulated depreciation for the old asset ($33,000). Step 3. Record the payment ($34,200). Step 4. Record the new asset at its fair market value ($42,000). Step 5. Determine and record the gain ($800). The journal entry to record the transaction would be:
APPLYING THE FINANCIAL ACCOUNTING RULES FOR TRADE-INS
Howard received a trade-in allowance of $7,800 on the old asset with a book value of $7,000, there is an implicit gain of $800. On the other hand, if the trade-in allowance is only $6,700 on an asset with a book value of $7,000, there is an implicit loss of $300.
In order to protect creditors, some states require that retained earnings be appropriated in an amount equal to the cost of treasury stock.
If a corporation does not have retained earnings with a value higher than the purchase price, it cannot purchase treasury stock.
Describe the different types of stock.
If a corporation issues only one type of stock, it is called common stock. Common stockholders vote on corporate matters and receive dividends as declared by the board of directors. Corporations can issue a second class of stock that carries special preferences, called preferred stock. Preferred stockholders are often given priority in the distribution of dividends. Liquidation value is often assigned to preferred stock; this stock class may be convertible to common stock.
Why do businesses sometimes accept notes receivable from customers?
If a customer is unable to pay a currently due account receivable, it is wise to have a note receivable signed. The note receivable provides greater legal protection to its holder than does an account receivable claim.
Why is it useful to know the inventory turnover for a company?
If inventory turnover is too low, compared to industry standards, it suggests that the amounts tied up in the inventory are excessive for the sales volume being generated.
Depletion for federal income tax purposes is the larger of cost depletion or percentage depletion. Cost depletion for tax purposes is computed in the same way as it is for financial statement preparation. However, the amount of cost depletion may be different because the cost (the numerator) for financial purposes may be different than the cost for tax purposes.
If percentage depletion is taken on the tax return, the amount taken in any year will reduce the cost on which cost depletion is based in future years.
Proceeds of Short-Term and Long-Term Borrowing shows that Your Products, Inc., did not seek additional cash from short-term or long-term note payable during 2019.
If the company had obtained cash from borrowing, it would have been reported in the financing activities section of the cash flow statement
Explain the test used to determine whether an asset is impaired.
If the expected future cash flows from the asset are less than its book value, the asset is impaired.
Bond Prices
If the face interest rate on bonds is higher than the market interest rate, the bonds will sell at a premium. If the face interest rate on bonds is lower than the market interest rate, the bonds will sell at a discount.
EFFECT OF NET LOSS ON CASH FLOWS FROM OPERATIONS
If the income statement reflects a net loss, the first line of the statement of cash flows is the net loss. All adjustments for changes in current assets and current liabilities are made to the net loss figure.
Various disclosures are added to the statement of cash flows.
If the indirect method of presentation is used, the amount of interest and income taxes paid during the period are reported in notes accompanying the statement. The note at the bottom of Figure 24.5 shows that cash payments were $23,813 for income taxes and $11,355 for interest.
Discounting a note receivable
If the noteholder wants cash before the maturity date, the note can be discounted (sold) at the bank. The bank pays the proceeds to the noteholder. Principle + Interest - Discount --------------- = Proceeds
Common stock
If there is only one class of stock, common stock is issued. Each share carries the same rights and priveleges as every other share.
In what ways, if any, may common stock be preferable to preferred stock?
If things go well, and large dividends are paid, common shares usually benefit from the large distribution while preferred shares do not. Participating preferred stock may be issued that provides that preferred shares participate in the higher dividends.
ANALYSIS Net sales for 2018 and 2019 are $1,200,000 and $1,000,000. Net income after income taxes for 2018 and 2019 are $60,000 and $30,000. Compute the percentage of net income after taxes (based on net sales) for 2018 and 2019.
In 2018, the percentage of net income after taxes was 5 percent. In 2019, the percentage was 3 percent.
Where on the statement of cash flows should a payment of interest expense be shown?
In a note to the statement of cash flows.
State and local governments can also levy income taxes on corporations.
In addition, most states require corporations to pay an annual franchise tax for the privilege of carrying on business in the state. In some states, especially those that have no corporate income tax, the franchise tax can be quite burdensome.
Percentages
In common-size statements, percentages (of net sales on the income statement and of total assets on the balance sheet) are shown instead of dollar amounts.
Adding It Up
In horizontal analysis, the amounts in the Increase or Decrease columns can be added or subtracted vertically, but the percentages cannot be.
Using borrowed funds to earn a profit higher than the interest that must be paid on the borrowing is called trading on the equity, or leveraging.
In lean years, such financing can be dangerous from the stockholders' standpoint. The bond interest expense might leave little or nothing for dividends to the stockholders. Moreover, even when the firm operates at a loss, the interest must be paid in full to the bondholders. In addition, the principal amount of the debt must also be paid when the bonds mature.
Decrease in Prepaid Expenses shows that Prepaid Expenses decreased by $300. This means that more was charged to expenses than was paid for prepaid expenses in arriving at net income for the year.
In other words, net income reflects the use of prepaid expenses. To obtain cash flows from operating activities, the decrease in prepaid expenses is added to net income.
Why would a corporation issue callable bonds?
In the event of a decrease in the market interest rate, or if the corporation has extra cash, the corporation can redeem the bonds if they are callable.
Where on the statement of cash flows should a loss on the sale of equipment be shown?
In the operating activities section as an addition to net income.
Property, plant, & equipment
Includes REAL property (land and land improvements) and tangible personal property (machinery, furniture, computers, vehicles) which is currently being used in the business.
A corporation's bondholders and stockholders want to know if net income is sufficient to cover the required bond interest payments. Times bond interest earned measures this. It is computed as follows:
Income before bond interest and income taxes/Bond interest cash requirement
Rate of return on total assets
Income before interest expense and income taxes / total assets = Rate of return on total assets
The rate of return on total assets measures the rate of return on the assets used by a company. This rate helps the analyst to judge managerial performance, measure the effectiveness of the assets used, and evaluate proposed capital expenditures. The rate is computed as follows:
Income before interest expense and income taxes/ Total assets
DEFERRED INCOME TAXES Usually net income reported on the financial statements does not match taxable income reported on the tax return because tax laws do not always follow generally accepted accounting principles.
Income can be included in taxable income this year and appear on the financial statements in later years, or vice versa. Income can be included on the financial statements but never appear in taxable income. Expenses can be included in taxable income this year and appear on the financial statements in later years, or vice versa. Expenses can be included on the financial statements and never be deducted from taxable income.
The entry to record income earned by a bond sinking fund investment includes a credit to:
Income from Sinking Fund Investment.
Where does the corporate income tax appear in the income statement?
Income tax expense is usually shown as a deduction at the bottom of the income statement, after Net Income Before Tax, but is sometimes shown as an Operating Expense to emphasize that taxes are a cost of doing business.
Increases in Current Assets Current assets include accounts receivable, merchandise inventory, and prepaid expenses. Look at the following examples. T
Increases in current assets are deducted from net income to arrive at cash flows from operating activities.
Increases in Current Liabilities Current liabilities include accounts payable, sales tax payable, payroll taxes payable, and interest payable.
Increases in current liabilities are added to net income to obtain the cash flows from operating activities.
What is the interest due on a note for $12,000 at 8 percent for 75 days?
Interest = $12,000 × .08 × 75/360 = $200
Calculating Interest on a Note
Interest = Principle x Rate x Time
important!
Inventory Costing and Net Income Gross profit on sales and net income are affected by the inventory costing method.
Investing Activities
Investing Activities Investing activities are transactions that involve the acquisition or disposal of assets that will not be used up or consumed in routine operations in a short time.
Cash Flows from Investing Activities.
Investing activities involve the acquisition (cash outflow) or disposal (cash inflow) of long-term assets, including land, buildings, equipment, and investments in bonds and other securities.
Financing Activities SOURCES OF CASH
Issuance of common stock Insurance of preferred stock Issuance of bonds payable Borrowing through signing a note payable Resale of treasury stock
Registered bond
Issued to a specific purchaser listed in the corporation's records
What is a common-size statement?
It is a financial statement with items expressed as a percentage of a base rather than in dollar amounts.
In horizontal analysis of the balance sheet, how is the percentage of change determined?
It is determined by first subtracting the current year's amount from the base year amount for the account being analyzed, and then dividing the difference (increase or decrease) by the base year amount.
Depletion of the cost of natural resources for financial statement preparation is called cost depletion.
It is similar to the units-of-output method of depreciation. The formula is: cost of natural resource --------------------------- estimated units of the resource equals DEPLETION PER UNIT
The sale of the equipment is not a part of the routine operating activities of the business. The gain of $4,000 is a part of the $8,000 in cash received from the asset sale. As we see, the entire $8,000 was included in cash inflows from investing activities.
It is therefore necessary to remove (deduct) the $4,000 of gain on sale A loss on sale of long-term assets would be added to net income.
How is gain or loss on early retirement of bonds shown on the income statement?
It is typically shown as Other Income or Other Expense.
Name three ways by which the lower of cost or net realizable value rule might be applied. Which will give the lowest ending inventory valuation?
It may be applied: (a) item by item, (b) by groups of items, or (c) by total cost and total net realizable value for the entire inventory. Application on an item-by-item basis will yield the lowest inventory value.
What does the current ratio tell you?
It tells you the general ability of a business to pay its short-term debts on time. It is computed by dividing current assets by current liabilities.
The statement of cash flows reconciles the beginning and ending cash balances.
It ties together the income statement and the changes in the noncash items on the balance sheet and on the statement of retained earnings.
Assuming that the same bonds remain outstanding during all of the second year, 2020, the following entries would be required. Cruz utilizes reversing entries:
January 1: Reverse the accrued interest payable entry for $1,250 made on December 31: Debit Bond Interest Payable for $1,250. Credit Bond Interest Expense for $1,250. April 1: Record the payment of interest for six months: Debit Bond Interest Expense for $2,500. Credit Cash for $2,500. October 1: Record the payment of interest for six months: Debit Bond Interest Expense for $2,500. Credit Cash for $2,500. December 31: Record accrued interest for three months: Debit Bond Interest Expense for $1,250. Credit Bond Interest Payable for $1,250.
Is it possible to apply the LIFO inventory method if items in the inventory cannot be identified as having been received as parts of specific purchases? Explain.
LIFO (or FIFO) may be used regardless of actual physical flow of merchandise.
In a period of RISING PRICES
LIFO method results in a higher reported cost of goods sold and a lower reported net income than FIFO or average cost method
In a period of FALLING PRICES
LIFO method results in a lower reported cost of goods sold and a higher reported net income than the FIFO or average cost method
In a period of rising prices, which inventory method (LIFO, FIFO, average cost) results in the lowest reported net income?
LIFO pricing will produce the highest cost of goods sold and the lowest net income in a period of rising prices.
What does LIFO mean, and what is the LIFO cost flow method?
LIFO stands for last-in, first-out. This method computes the cost of the inventory on hand as though the last merchandise received is the first to be sold. This is done so that the most current costs are matched with revenue.
Land is not depreciated.
Land has an indefinite life. Land does not deteriorate or get used up.
Managing Cash
Large companies actively manage their own corporate cash. Smaller businesses often place their cash in money market funds or "sweep accounts" by their banker, due to the limited time and resources available for cash management.
Distinguish between the legal life and the economic life of an intangible asset. Which is used in computing amortization if amortization is appropriate?
Legal life is the time period over which the business or individual has legal rights to utilize whatever rights can be derived from the intangible asset. Intangibles such as copyrights, patents, and most franchises may be used exclusively only for a limited period. t the economic life is the period over which the intangible will provide economic benefits to the holder of the right. For example, a patent owned by a business may provide exclusive right to produce a product for another 15 years. This is the legal life. However, new processes being developed may make the existing patent obsolete within three years. Three years is the economic life. Economic life is used in computing amortization.
Before declaring a dividend, the board of directors considers two issues: legality and financial feasibility.
Legality. State laws differ, but in general the corporation must have retained earnings in order to declare dividends. These laws are intended to protect the corporation's creditors. The restriction prevents an impairment of capital. Capital is impaired when dividends are paid that reduce total stockholders' equity to less than the paid-in capital accounts, which may result from paying excessive dividends. Financial Feasibility. The corporation must have the cash to pay the dividend. The board of directors does not declare dividends that lead to a cash shortage or other financial difficulties, even though there may be a large balance in Retained Earnings.
A corporation may have retained earnings but be short of cash and unable to pay a cash dividend. Or the board of directors may want to transfer part of retained earnings to a paid-in capital account. In these cases, the board of directors may declare a stock dividend. A stock dividend is a distribution of the corporation's own stock on a pro rata basis that results in conversion of a portion of the firm's retained earnings to permanent capital.
Let's see how the declaration of a stock dividend is recorded:
The corporate form offers some major advantages:
Limited Liability Restricted Agency. Continuous Existence Transferability of Ownership Rights Ease of Raising Capital the right of first refusal
Bonds payable
Long-term debt instruments that are written promises to repay the principal at a future date.
It is also important to keep in mind that
MACRS is not acceptable under GAAP.
Price-earnings Ratio
Market price per share / Earnings per share = Price-earningss ratio
The price-earnings ratio compares the market value of common stock with the earnings per share of that stock. It is computed as follows:
Market price per share of common stock/Earnings per share of common stock
Market Value.
Market value is the price per share at which stock is bought and sold. After the corporation issues stock, it can be resold for any price that can be agreed on between the shareholder and purchaser. Usually a stock's market value has little relation to its par or stated value.
Depletion
Matches an asset's costs with the benefits derived from its use Natural resources: Oil Gold Coal
How is maturity value of a note computed?
Maturity value of the note is the sum of (a) the principal amount of the note and (b) interest on the principal amount at the rate specified, computed from the date the note is dated until the maturity date.
What does book value per share measure?
Measures the amount each common stockholder would receive if assets were sold for their book value and the corporation liquidated.
Different Depreciation Methods Use
Most businesses use straight-line depreciation when preparing financial statements and MACRS when preparing tax returns.
The accounts receivable turnover is a measure of the reasonableness of the accounts outstanding. This measurement uses net credit sales, which includes notes receivable from sales transactions. The accounts receivable turnover is computed as follows:
Net credit sales/Average receivables =Accounts receivable turnover
Cash flows from operating activities (Indirect method)
Net income (or net loss) + or - Adjustments for noncash items on income statement + Decreases in current assets - Increases in current assets + Increases in current liabilities - Decreases in current liabilities -------------------------------------------------------- = Net cash provided by operating activities
Rate of return on sales
Net income / Net Sales THE HIGHER THE RATE THE BETTER
Rate of Return on Sales The rate of return on sales measures what part of each sales dollar remains as net income. It measures operating efficiency and profitability.
Net income after taxes/Net sales
Increase in Supplies shows that Supplies increased by $250. This means that more supplies were paid for than were used.
Net income does not reflect all cash paid for supplies. To obtain cash flows from operating activities, the increase in supplies is subtracted from net income.
Decrease in Merchandise Inventory shows that Merchandise Inventory decreased by $20,000. This means that more inventory was sold than was purchased. The sale of the inventory was reflected in net income as cost of goods sold, but cash was not paid to replace the inventory.
Net income reflects higher costs than actual cash outflows. To obtain cash flows from operating activities, a decrease in inventory is added to net income.
The accrual basis of accounting is used when recording transactions and preparing the balance sheet and the income statement.
Net income shown on the income statement includes both cash and noncash transactions. On the statement of cash flows, net income is adjusted for the noncash items.
Note that the depreciation expense did not involve a cash outflow. .
Net income was reduced by a noncash expense. To obtain cash flows from operating activities, the depreciation expense is added back to net income
Asset turnover
Net sales / total assets = Asset turnover *The higher the asset turnover, the more effectively the assets of the company are being used
The ratio of net sales to total assets measures the effective use of assets in making sales. This ratio is usually called asset turnover. It is computed as follows:
Net sales/Total assets
Does an appropriation of retained earnings include a transfer of cash to a restricted account? Explain.
No cash is involved in an appropriation of retained earnings. Cash is involved only if a separate fund is established to pay for the object of the appropriation.
What are the advantages of issuing no-par-value stock?
No-par stock makes financing more flexible. State laws prevent or discourage stock from being issued for less than par value. Having no-par stock eliminates this problem.
ANALYSIS When an interest-bearing note receivable is accepted, instead of cash at the time of sale, does the interest on the note increase the amount reported as sales? Explain.
No. Sales are recorded at the principal amount of the note. The interest is reported as Interest Income.
What type of account is Notes Receivable—Discounted? How should the Notes Receivable—Discounted account be shown on the balance sheet?
Notes Receivable—Discounted is a contra asset account. This means that it is deducted from Notes Receivable on the balance sheet.
Record routine notes receivable transactions.
Notes receivable can be noninterest- or interest-bearing. Most firms charge interest. If the note receivable is issued at the time of a sale, record the transaction by debiting Notes Receivable and crediting Sales. If the note receivable results from a customer's failure to pay an account receivable, debit Notes Receivable and credit Accounts Receivable. The recipient credits Interest Income for interest received when the note is paid.
On October 1, 2021, Cruz records the semiannual interest on the $100,000 of bonds outstanding. The bond interest paid is $5,000 ($100,000 × 0.10 × 6/12). Cruz also records amortization of the premium received on $50,000 of the bonds. The amortization is $150 each payment date.
Notice how the amortization of the Premium on Bonds Payable reduces the amount of Bond Interest Expense:
On October 1, 2022, Cruz Corporation records the semiannual interest on the $150,000 of bonds outstanding. The bond interest paid is $7,500 ($150,000 × 0.10 × 6/12). The company records the amortization of the premium for six months ($150). It records the amortization of the discount for six months ($80). The bond interest expense is $7,430, the interest paid ($7,500) less the amortized premium ($150) plus the amortized discount ($80).
Notice how the discount increases the actual cost of borrowing. The journal entry to record the interest payment and the amortization of the premium and the discount follows:
What is the numerator and what is the denominator to be used in computing depreciation for the third year of use of an asset with a life of seven years if the sum-of-the-years'-digits method is used?
Numerator = 5; denominator = 28.
Bonds issued at face value - record example
On April 1, 2013, Charbo Corporation sells $50,000 ($1,000 x 50) of its 10-year bonds at face value for cash Apr 1 Dr. $50,000 Cash 10% Bonds Payable, 2023 CR $50,000 Issued bonds at face value
Bonds - payment of interest
On Oct 1, the interest for six months at 10 percent becomes due on the $50,000 of bonds issued. ($50,000 x 10% x 6/12 = $2,500) Oct 1 Dr. $2,500 Bond interest expense Cr. $2,500 Cash Pd. Semiannual bond interest
How is treasury stock shown on the balance sheet?
On the balance sheet, treasury stock is deducted from the total of all other stockholders' equity.
Theoretically, the market price will decrease to one-third of the original market value, or to $100 per share ($300 × 1/3). If the price per share does not decrease to its theoretical level, the total market value of a stockholder's shares will be higher.
On the date of declaration of the stock split, a memorandum notation is made in the general journal of Lamp Corporation:
Cash Flows from Operating Activities. .
Operating activities are routine business operations. Cash inflows from operating activities include the sale of merchandise or services for cash, collection of accounts receivable created by the sale of merchandise or services, and miscellaneous sources, such as interest income
What are the three types of activities for which cash flows must be shown in a statement of cash flows?
Operating, investing, and financing activities are shown in a statement of cash flows.
Record organization costs.
Organization costs are charged to expense when incurred.
What are organization costs? How are they accounted for?
Organization costs are costs in getting the corporation into existence. They include such things as fees charged by the state, legal fees related to the incorporation, and costs of printing stock certificates. Organization costs are generally charged to expense in the year the corporation commences business.
When a corporation issues stock, the stock is sold (transferred to stockholders).
Outstanding stock is stock that has been issued and is still in circulation, meaning it is still in the hands of stockholders.
Convertible preferred stock
Owners have the right to convert their shares into common stock after a specified date.
Explain the characteristics of a corporation. A corporation is organized under state law to carry on activities permitted by its charter:
Ownership is indicated by shares of stock. Stockholders owning voting stock elect a board of directors. The board selects officers to run the business. The corporate charter specifies the types and amounts of capital stock authorized. The bylaws guide the firm's general operation, which must be consistent with charter provisions. The corporation is subject to federal income tax.
Registered bonds are bonds issued to a party whose name is listed in the corporation's records.
Ownership is transferred by completing an assignment form and having the change of ownership entered in the corporation's records. Interest is paid by check to each registered bondholder.
There are three terms commonly used to describe stock values.
Par Value. Stated Value. Market Value
Par Value.
Par value is an amount assigned by the corporate charter to each share of stock for accounting purposes. It may be any designated amount; it can be $25, $5, or even less than $1 per share. Stock can be issued for more than par value. State laws prohibit the issuance of par-value stock for less than the par value.
How do stated value and par value of stock differ?
Par value is established in the articles of incorporation. Stated value is set by the directors of the corporation.
How does "participating" preferred stock differ from "cumulative" preferred stock?
Participating preferred stock shares with common stock a part of increased dividends in excess of the preferred stock's rate of return. The degree of participation depends on the terms of the stock issue and is beyond the scope of this text. Cumulative preferred stock does not have this right.
Financing Activities USES OF CASH
Pay cash dividends on common stock Pay cash dividends on preferred stock Repay bond indebtedness Repay notes payable or other borrowing Purchase treasury stock
Operating Activities USES OF CASH
Pay for merchandise Pay taxes Pay salaries and wages Pay interest expense Pay for other expenses
Investing Activities USES OF CASH
Pay for purchase of land, buildings, or equipment Pay for the purchase of investments in bonds or other securities
EXERCISES Court Company has outstanding 10,000 shares of 10 percent, $50 par-value, cumulative, nonparticipating preferred stock and 25,000 shares of $20 par-value common stock. No dividends were declared in 2019. In 2020, the directors voted to distribute dividends of $48,000. What amount of dividends, if any, will be distributed to holders of preferred stock? What amount, if any, will be distributed to holders of common stock?
Preferred shareholders will receive the entire $48,000 in 2020. There is a carryover of $52,000 that preferred must receive in addition to future preferred dividend requirements before any dividends can be paid to common stockholders. Common shareholders will receive nothing in 2020.
DIVIDENDS ON PREFERRED STOCK Special dividend rights can improve the market demand for preferred shares of stock:
Preferred stock has a priority with respect to dividends. The priority is specified in the corporate charter. Preferred stock bears a basic or stated dividend rate, called the preference dividend, that must be paid before dividends can be paid on common stock. The dividend rate is expressed in dollars-per-share per year or as a percentage. When the dividend is expressed as a percentage, the dividend amount is par value of the stock multiplied by the percentage. For example, the annual dividend on 8 percent preferred stock with a par value of $50 is $4 per share ($50 × 0.08).
Why is preferred stock called "preferred"?
Preferred stock is entitled to a dividend before a dividend is paid on common stock. It may also have certain preferences over distribution of assets in the case of liquidation. In addition, there is a reasonable assurance of a constant and predictable income from dividends.
How much cash will the borrower receive for a $12,000, 75-day, noninterest-bearing note discounted at 8 percent?
Proceeds = Face amount − Discount Discount = $12,000 × .08 × 75/360 = $200 Proceeds = $12,000 − $200 = $11,800
A note receivable with a maturity value of $6,200 is discounted at 10 percent with 90 days remaining until the maturity date. What are the proceeds from discounting the note?
Proceeds = Maturity value − Discount Discount = $6,200 × .10 × 90/360 = $155 Proceeds = $6,200 − $155 = $6,045
Method of Disposition FORMULA
Proceeds−Book value=Gain or loss
Financial ratios have three classifications:
Profitability, operating results, and efficiency Financial strength Liquidity
The balance sheet shows a long-term asset's cost minus its accumulated depreciation. The difference is its book value, also known as its net book value. Book value is rarely the same as fair market value, which is the asset's price on the open market. After two years of depreciation, the balance sheet presentation for the building is as follows:
Property, Plant, and Equipment Building $500,000.00 Less Accumulated Depreciation 25,000.00 Net Book Value $475,000.00
Name three measurements often used in evaluating profitability.
Rate of return on net sales, rate of return on total assets, and earnings per share of common stock are all common measures of profitability.
Ratio analysis is used to assess a company's profitability, financial strength, and liquidity.
Ratio analysis investigates a relationship between two items either as a ratio (2 to 1 or 2:1) or as a rate (percentage).
How does real property differ from personal property?
Real property comprises land and other assets that are affixed permanently to the land. It includes land, land improvements, buildings, and other structures attached to the land. Personal property comprises those assets that are not affixed to the land and are relatively moveable—such as furniture, equipment, and vehicles.
What is the difference between registered bonds and coupon bonds?
Registered bonds are bonds whose owners are registered in the records of the corporation. Interest is paid each payment date to the registered owner. Coupon bonds are not registered. The corporation does not know the names of owners of the bonds. To collect interest, the bondholder clips a coupon from the bond and presents it to the bank.
Yield to common stock
Relationship between the dividends received by the stockholders and the market value of each share Dividend per share / Market price per share. = yld on common stk
The balance sheet presentation shows appropriated and unappropriated retained earnings. Assume that Retained Earnings had a balance of $154,600 before the first appropriation. The following is the balance sheet presentation immediately after the appropriation. Notice that total retained earnings stays the same, but it now has two parts:
Retained Earnings Appropriated Appropriated for Retail Center Construction $ 50,000 Unappropriated 104,600 Total Retained Earnings $154,600
What does the account Retained Earnings represent?
Retained earnings represent the cumulative profits and losses of the corporation that have not been distributed as dividends or transferred to Paid-in Capital through cash dividends, stock dividends, or stock splits.
RATIO OF STOCKHOLDERS' EQUITY TO TOTAL EQUITIES
STOCKHOLDER'S EQUITY/TOTAL EQUITIES
RATIO OF STOCKHOLDERS' EQUITY TO TOTAL LIABILITIES
STOCKHOLDER'SEQUITY/TOTAL LIABILITIES
Investing Activities SOURCES OF CASH
Sale of land, buildings, or equipment Principal payments collected on receivable(s) for long-term assets Sale of investment in bonds or other securities
Operating Activities SOURCES OF CASH
Sale of merchandise Sale of services Interest income Dividend income Miscellaneous income
Each MACRS class has a table of percentages. To determine the cost recovery (depreciation) under MACRS, multiply the asset's cost by the MACRS percentage.
Salvage value is ignored.
Generally, would an investor want secured bonds or debenture bonds? Why?
Secured bonds are bonds that have specific assets pledged as security. If the corporation does not pay the principal and interest, the bondholders may take possession of the assets. Debenture bonds have no specific assets pledged to secure payment. So, the secured bond is a more attractive investment.
Organization costs
Separate expense account - including but not limited to the following: Payment of legal fees, charter fee, cost of printing stock certificates, and cost of the organizational meeting with the directors
What are cash equivalents?
Short-term liquid investments that are easily convertible into cash.
On the balance sheet, the bonds payable appear as long-term liabilities. (Bonds that mature within one year from the balance sheet date appear as current liabilities.) There are three ways to report bonds on the balance sheet.
Show the face value of the bonds authorized, unissued, and issued: Long-Term Liabilities 10% Bonds Payable, Due April 1, 2029 Authorized $300,000 Less Unissued 250,000 Issued $ 50,000 Show the face value of the bonds authorized as a parenthetical note: Long-Term Liabilities 10% Bonds Payable, Due April 1, 2029 $50,000 (Bonds with a face value of $300,000 are authorized, of which $250,000 are unissued) Show the face value of the bonds issued. Provide details about the bonds in a note to the financial statements.
Bond
Similar to a loan
Limited Liability.
Sole proprietors and general partners have unlimited liability; they are personally liable for all debts of the business. Shareholders have no personal liability for the corporation's debts. The corporation's creditors must look to the assets of the business to satisfy their claims, not to the owners' personal property, even in the event of liquidation. It is not unusual, however, for major shareholders of small corporations to give personal guarantees to repay its loans.
VARIATIONS IN INCOME STATEMENT PRESENTATION
Some corporations include cost of goods sold with the operating expenses. They do not show gross profit on sales. This text uses the traditional income statement with a separate Gross Profit section. Some corporations show income tax expense as an operating expense rather than as a deduction from net income before income tax. This presentation can be used to emphasize that income taxes are a cost of doing business like any other expense.
Four methods are commonly used to value inventory.
Specific identification method average cost method FIRST-IN, FIRST-OUT METHOD LAST-IN, FIRST-OUT METHOD
Name four commonly used methods or assumptions for determining the cost of an inventory.
Specific identification, average costing, FIFO, and LIFO.
Par value
Specified in the corporate charter and assigned to each share of stock for accounting purposes
Which level of government is responsible for issuing charters for most corporations?
State governments issue a vast majority of corporate charters.
Stated Value.
State laws permit stock to be issued without par value. This type of stock is called no-par-value stock. The value that can be assigned to no-par-value stock by a board of directors for accounting purposes is called the stated value.
When bonds are retired prior to maturity, the bondholders are paid the agreed-upon price for the bonds plus the accrued interest to the date of purchase. There are two steps to record the retirement of bonds:
Step 1. Amortize the discount or premium on the bonds up to the date of retirement. Step 2. Remove the book value, and record the gain or loss. Remove the book value of the bonds. Record interest up to the date of retirement. Record the cash payment for the repurchase price and interest. Record the gain or loss (book value minus the repurchase price).
Sometimes useful assets are sold so the company can purchase better assets or because the assets are no longer needed. When an asset is sold, follow these steps to record the transaction:
Step 1. Record depreciation to the date of disposition. Step 2. Remove the cost of the asset. Step 3. Remove the accumulated depreciation. Step 4. Record the proceeds. Step 5. Determine and record the gain or loss, if any.
Trade-in transactions are recorded in two steps:
Step 1. Record the depreciation up to the date of trade-in. Step 2. Record the trade-in of the old asset and the purchase of the new asset.
Here are the steps to record the trade-in if there is a gain on the transaction:
Step 1. Remove the cost of the old asset ($40,000). Step 2. Remove the accumulated depreciation for the old asset ($33,000). Step 3. Record the payment ($34,200). Step 4. Record the new asset at its fair market value ($42,000). Step 5. Determine and record the gain ($800).
Here are the steps to record the trade-in if there is a LOSS on the transaction:
Step 1. Remove the cost of the old asset ($40,000). Step 2. Remove the accumulated depreciation for the old asset ($33,000). Step 3. Record the payment ($35,300). Step 4. Record the new asset at its fair market value ($42,000). Step 5. Determine and record the loss ($300).
Suppose the amount allowed Howard as a trade-in value of the old asset had been $6,700, instead of $7,800, and Howard paid cash of $35,300 ($42,000 − $6,700). As a result, there would be a realized loss of $300 on the trade-in ($7,000 book value minus $6,700 received as trade-in allowance). Remember that for financial accounting purposes, losses are recognized. To record a trade-in under the financial accounting rules when there is a loss on the transaction, follow these steps:
Step 1. Remove the cost of the old asset ($40,000). Step 2. Remove the accumulated depreciation for the old asset ($33,000). Step 3. Record the payment ($35,300). Step 4. Record the new asset at its fair market value ($42,000). Step 5. Determine and record the loss ($300). Here is the entry required to record the trade-in of the truck by Howard:
APPLYING THE INCOME TAX RULES FOR TRADE-INS The federal income tax method for trade-in transactions is easier than that for financial accounting because neither gain nor loss is recognized for tax purposes.
Step 1. Remove the cost of the old asset. Step 2. Remove the accumulated depreciation for the old asset. Step 3. Record the cash payment. Step 4. Record the new asset at the sum of the book value of the old asset and the cash paid.
APPLYING THE INCOME TAX RULES FOR TRADE-INS The federal income tax method for trade-in transactions is easier than that for financial accounting because neither gain nor loss is recognized for tax purposes. The steps in applying the tax rules are:
Step 1. Remove the cost of the old asset. Step 2. Remove the accumulated depreciation for the old asset. Step 3. Record the cash payment. Step 4. Record the new asset at the sum of the book value of the old asset and the cash paid.
Suppose that a business purchased a delivery truck for $64,000 in February 2019. It is expected to be driven for 112,000 miles before being traded in and its expected salvage value at that time is $8,000. During 2019, the truck was driven 17,400 miles. Follow these steps to calculate depreciation under the units-of-production method:
Step 1: Determine the depreciation per unit (per mile). Divide the depreciable cost (the cost, minus estimated net salvage value) by the total miles expected to be driven during the truck's life. $64,000−$8,000/112,000 miles=$0.50 per mile driven Step 2: Compute depreciation. Multiply the number of units produced (miles driven) by the rate for each unit. 17,400 miles×$0.50 per mile=$8,700 In its first year of operation, the truck would have depreciation expense of $8,700.
The three steps in the process of determining an impairment loss are:
Step 1: Review circumstances that suggest impairment may have occurred. ASU 360-10 gives examples of events and changes in circumstance that suggest impairment may have occurred: A significant decrease in the market value of an asset. A significant change in the extent of use or way in which the asset is used. A significant adverse change in the legal environment or in the manner in which an asset is used. A forecast suggesting continuing losses associated with the asset. There are, however, many other economic and technical factors that may suggest assets should be analyzed for possible impairment, for example, increased competition, new technical developments, a forecast of decreased demand for the products, and so forth.
Record transactions for stock subscriptions.
Stock can be subscribed, then paid for and issued later. It is recorded in a subsidiary ledger with a separate account receivable for each subscriber. Individual accounts receivable are controlled by a Subscriptions Receivable account in the general ledger.
A stock split occurs when a corporation issues two or more shares of new stock to replace each share outstanding without making any changes in the capital accounts.
Stock splits are often declared when the stock is relatively difficult to sell because the market price is too high. If par-value stock is split, the corporation's charter is amended to reduce the par value.
Structure of a Corporation
Stockholders can participate in stockholders' meetings, elect a board of directors, and vote on basic corporate policy. The board of directors formulates general operating policies and is responsible for seeing that the corporation's activities are conducted. The board selects officers and other top management personnel to direct everyday operations. The officers hire managers who hire other employees. Officers and managers make the day-to-day decisions necessary to operate the business. A corporation's officers include the president, one or more vice presidents, a corporate secretary, and a treasurer. The top accounting official is called the controller or chief financial officer. Large firms might have several layers of management, including division managers, department heads, and supervisors. The levels depend on the nature and complexity of the operations.
TREASURY STOCK Treasury stock is a corporation's own capital stock that has been issued and reacquired. To be considered treasury stock, the stock must have been previously paid for in full and issued to a stockholder. Any class or type of stock can be reacquired as treasury stock. No dividends, voting rights, or liquidation preferences apply to treasury stock.
Stockholders may benefit when the corporation repurchases common stock because there are fewer shares of outstanding stock to share the profits and dividends. If preferred stock is reacquired, the dividends on the stock are no longer payable, thus increasing the dividends available to owners of common stock.
The sum of a corporation's liabilities and stockholders' equity is referred to as its total equities. The ratio of stockholders' equity to total equities measures the portion of total capital provided by the stockholders. It indicates the protection afforded creditors against possible losses. The more capital provided by the stockholders, the greater the protection to creditors. The ratio of stockholders' equity to total equities is computed as follows:
Stockholders' equity/Total equities
The ratio of stockholders' equity to total liabilities is known as the ratio of owned capital to borrowed capital. It is computed as follows:
Stockholders' equity/Total liabilities
EXERCISES Duck Company receives a subscription to 2,000 shares of its $25 par-value common stock for $31 per share. What accounts are debited and credited, and for what amounts? If a balance sheet was prepared on the following day, how would the accounts debited and credited be shown on the balance sheet?
Subscriptions Receivable is debited for $62,000, Common Stock Subscribed is credited for $50,000, and Paid-in Capital in Excess of Par (or Premium on Common Stock) is credited for $12,000. On the balance sheet, Subscriptions Receivable is shown as a current asset and the other two accounts are shown in the stockholders' equity section.
Why is comparison with industry averages helpful when analyzing financial statements?
Such comparisons point out areas in which the business is performing either better or worse than average. The areas showing poorer performance can be investigated to determine the reason and then to address it.
Name two methods of accelerated depreciation.
Sum-of-years'-digits and double-declining methods.
FOR REGISTERED BONDS,
THE corporation maintains a detailed subsidiary ledger, similar to the stockholders' ledger, for registered bonds. At all times, the corporation knows who owns the bonds and who is entitled to receive interest payments.
it takes six years to recover the entire cost of five-year properties
That is because MACRS uses the half-year convention. Regardless of purchase date, MACRS calculates depreciation for six months in the first year of the asset's life. The remaining six months of cost recovery are taken in the year after the end of the class life (in the sixth year for five-year property). (There are complex exceptions to the half-year convention.)
Prepare a balance sheet for a corporation.
The Stockholders' Equity section identifies the classes, values, and number of stock authorized and issued.
Some companies use a single account to record both gains and losses on sales of assets.
The account is called Gains and Losses on Sales of Assets. It appears on the income statement in the Other Income section (if net gain) or Other Expenses section (if net loss).
On December 31, 2022, an adjusting entry is made to accrue interest on the bonds for the three-month period. The accrued interest is $3,750 ($150,000 × 0.10 × 3/12). An adjustment is made for the bond discount for three months ($40) and for the bond premium for three Page 795months ($75). Bond interest expense is $3,715, the interest accrued plus the discount less the premium ($3,750 + $40 − $75).
The adjusting entry is recorded as follows. It is reversed on January 1, 2023:
A business purchased a clay pit for $80,000. The clay pit is estimated to contain 500,000 tons of extractable clay suitable for making bricks. The depletion cost for each ton of clay is $0.16 ($80,000 ÷ 500,000 tons). During the first year, the business extracted 30,000 tons of clay. The depletion is $4,800 (30,000 × $0.16).
The adjusting entry to record depletion follows:
ADJUSTING AND REVERSING ENTRIES On December 31, 2021, an adjusting entry is made for three months of accrued interest on the entire $100,000 of bonds outstanding. The accrued interest is $2,500 ($100,000 × 0.10 × 3/12). An adjustment is also made for the amortization of bond premium at $75 for three months (3/12 × $300 annual amortization). Bond interest expense is $2,425, the interest accrued less the amount of the bond premium ($2,500 − $75).
The adjustment is recorded as shown and is reversed on January 1, 2022:
If land and a building are purchased together for a single price, the purchase price is allocated between the Land and Building accounts.
The amount allocated to the building is depreciated. The amount allocated to land is not depreciated.
Face value
The amount being borrowed
important! Capital Stock Account
The amount credited to the capital stock account is the par value of the stock issued.
The income statement shows bond interest expense of $9,500. This is not the actual cash outflow for interest. It reflects the cash paid minus $500 of bond premium amortization. The bond interest expense was recorded as follows:
The amount of bond interest expense reported on the income statement understates the actual cash outflow by $500. To obtain cash flows from operating activities, the amortization of the bond premium is deducted from net income.
Does an appropriation of retained earnings assure a cash balance? Explain.
The appropriation account merely restricts the payment of dividends to the amount of retained earnings in excess of the appropriations. Retained earnings—and the appropriation—have nothing to do with cash.
Why does a corporation use an account such as Appropriation of Retained Earnings for bond retirement?
The appropriation is intended to protect the bondholders. It clearly indicates that dividends are being restricted because of a future need to pay off the bonds.
Remember that retained earnings does not represent cash, nor does appropriating retained earnings provide cash.
The appropriation simply restricts the amount of retained earnings available for dividends, thus making it more likely that cash will be available to build the retail center.
If an item of equipment is retired and scrapped or sold, how should the retirement be accounted for?
The asset account and accumulated depreciation account are removed, and the sales proceeds are recorded. The difference between the proceeds and net book value (cost minus accumulated depreciation) is recorded as gain or loss. The asset account and the accumulated depreciation would be overstated by the same amount. There would be no effect on net asset book value.
If a company's fully depreciated asset was scrapped but not removed from the accounting records, what would be the effect on the company's financial statements? Assume the asset has no net salvage value
The asset account and the accumulated depreciation would be overstated by the same amount. There would be no effect on net asset book value.
DEPRECIATION METHODS Determining Annual Depreciation
The asset cost, the estimated salvage value, and the estimated useful life are needed in order to determine the annual depreciation.
In a period of RISING or FALLING PRICES
The average cost method results in a reported net income somewhere between the amounts obtained with FIFO and LIFO
Compute dividends payable on stock.
The board of directors declares dividends based on corporate earnings. Dividends are first allocated to preferred stockholders, then to common stockholders.
Some bonds do not require that the names of the owners be registered. These bonds are known as coupon bonds.
The bonds have coupons attached for each interest payment. The coupons are, in effect, checks payable to the bearer. No record of the owner's identity is kept by the corporation. On or after each interest date, the bondholder detaches the coupon from the bond and presents it to a bank for payment.
For example, assume that on October 1, 2019, DWH Incorporated issues 20-year bonds with a face value of $100,000.
The bonds mature on October 1, 2039. Under the terms of the indenture, Page 788DWH can call the bonds at any time after October 1, 2029, at a call price of 103 (103 percent of face value). The bonds are called by DWH on October 1, 2030. Johnson, an owner of bonds with a face value of $30,000, must surrender the bonds and will be paid $30,900 ($30,000 × 1.03).
Calculate the interest on a note.
The borrower who signs a note payable usually pays interest on the amount borrowed. To determine the interest amount for any time period, use the formula Interest = Principal × Interest Rate × Time. time can be days/360 or months/12
Which of the following would not be found on the statement of retained earnings?
The cash payment made when the corporation completes construction of a building for which an appropriation of retained earnings had been made.
Refer to Exercise 4.) Suppose that in 2021, two years after Happy Times acquired Good Taste, the sales of Good Taste soft drinks decreased drastically. Assume that Happy Times had not recorded any amortization of the $100 million assigned to the trade name. What course of action should the management of Happy Times take?
The company should assess operations to determine that profits are adequately above what they would be without the trade name in order to assure that its carrying value is not impaired.
How does the computation phase of statement analysis differ from the interpretation phase?
The computation phase involves simple mathematical computations. The interpretation phase considers what caused relationships or changes and what can be done to improve the relationships or changes.
Which accounting principles, concepts, or modifying conventions underlie the valuation of inventories at the lower of cost or net realizable value?
The conservatism constraint is the primary underlying concept that supports the lower of cost or net realizable value rule.
Face interest rate
The contractual interest rate specified on the bond
Corporations purchase their own stock for many reasons:
The corporation has extra cash, and the board of directors thinks that the corporation's own stock is a better investment than other potential investments. The corporation wishes to transfer treasury stock to officers and key employees in connection with incentive plans. If unissued shares instead of treasury stock were used, it would be necessary to ask stockholders to give up their preemptive rights. However, preemptive rights do not apply to treasury stock. The corporation wants to create a demand for the stock and thus increase its market value. In privately held corporations with few owners, the board of directors can vote to purchase the shares of a stockholder who needs cash or wishes to retire.
COST OF LAND AND BUILDING
The cost of land includes its purchase price, legal costs in connection with the acquisition, abstracts, title insurance, recording fees, and any other costs paid by the purchaser that are related to the acquisition.
Should treasury stock be shown as an asset of the corporation? Explain.
The cost of treasury stock should not be shown as an asset on the balance sheet of the issuing corporation. It represents a deduction from the total of the corporation's other stockholders' equity accounts.
Explain each of the three dates related to a cash dividend declaration and issue.
The date of declaration—the date the board of directors formally announces the dividend. The date of record—the date on which owners of stock are determined and to whom dividends will be paid. The date of payment is the date on which payment is to be made.
Continuous Existence.
The death, disability, or withdrawal of a shareholder has no effect on the life of a corporation.
Three dates are involved in declaring and paying dividends:
The declaration date is the date on which the board of directors declares the dividend. The dividend declaration is recorded in the corporation's minute book. Once a dividend is declared, the firm has a liability to the stockholders for the amount of the declared dividend. The record date is the date used to determine who will receive the dividend. The capital stock ledger is used to prepare a list of the stockholders of record, that is, the stockholders who will receive the declared dividend. This does not require a journal entry. The payment date is the date on which the dividend is paid.
Declining-Balance Method
The declining-balance method is an accelerated method of depreciation, which allocates greater amounts of depreciation to an asset's early years of useful life. The declining-balance computation ignores salvage value until the year in which the book value is reduced to estimated salvage value.
OTHER CHARACTERISTICS OF BONDS PAYABLE Bonds are issued in various denominations.
The denomination specified on the contract is called the face value. The typical face value is $1,000 or $10,000.
A loss is
The disposition of an asset for less than its book value.
Record the issuance of capital stock at par value.
The entire amount of stock issued in return for a cash investment is credited to the appropriate capital stock account. Noncash assets traded for capital stock are recorded at their fair market value.
Cruz issues another 50 bonds on April 1, 2022. The market interest rate is 11 percent. The bonds' interest rate remains fixed at 10 percent. Investors will pay less than face value for a bond that pays interest at a lower rate than the market rate. The discount on bonds payable is the excess of the face value over the price received for a bond. Cruz Corporation sells 50 bonds at 97.76. Each bond is issued for $977.60 ($1,000 × 0.9776), yielding cash of $48,880 ($50,000 × 0.9776). The excess of the face value over the issue price is $1,120 ($50,000 − $48,880). The $1,120 is the discount.
The entry to record issuance of the bond is shown in general journal form as follows:
Interest
The fee charged for the use of money.
Management is also interested in cash flows.
The firm needs cash to pay employees and suppliers and to meet other obligations. Analyzing past cash flows is helpful because they indicate the sources and uses of cash in the future.
Gain or Loss
The gain or loss on the retirement of bonds is the book value of the bonds minus the repurchase price.
Under what circumstances would the gross profit method of estimating inventory be used?
The gross profit method would be used if the inventory has been destroyed by fire, theft, or other means. It may also be used to quickly estimate the cost of inventory on hand without taking a physical inventory when cost estimates are needed for managerial or operational purposes.
During the year, accounts payable increased from $35,000 to $50,000. How, if at all, would this change be reflected in computing cash flows from operations?
The increase in accounts payable must be added to net income to arrive at cash flow from operations.
There are two ways to prepare the statement of cash flows: the direct method and the indirect method.
The indirect method treats net income as the primary source of cash from operating activities and adjusts net income for changes in noncash items.
Market interest rate
The interest rate a corporation is willing to pay and investors are willing to accept at the current time
On April 1, 2021, $50,000 of bonds are sold at 104.8. Bond prices are quoted in terms of percent of face value. Each bond was issued for $1,048 ($1,000 × 1.048), yielding cash of $52,400 ($1,048 × 50). Investors are willing to pay a premium because the face interest rate is higher than the market interest at the time the bonds are issued.
The issue price in excess of face value is $2,400 ($52,400 − $50,000). This transaction is recorded in general journal form as follows:
The income statement shows a loss of $60,000 on the sale of a building. How is the loss handled when computing net cash provided by operating activities?
The loss does not relate to operating activities and must be added back to net income.
What is the role of stockholders in running the business of a corporation?
The major role of the stockholders is to choose the directors of the company. Stockholders have no inherent right to represent the corporation or take part in its management.
Intangible Assets In addition to property, plant, and equipment, many businesses have intangible assets. Intangible assets are assets that lack a physical substance.
The major types of intangible assets are patents, copyrights, franchises, trademarks, brand names, organizational costs, computer software, and goodwill. With the exception of computer software, intangible assets usually do not have any physical attributes.
What generally accepted accounting principle or convention supports the writing down of impaired assets to their fair market values?
The matching principle of matching costs with revenues. The constraint of conservatism plays an important role in applying the matching principle.
Disclosure
The method of inventory valuation must be disclosed in the financial reports.
CASH OUTFLOWS FROM INVESTING ACTIVITIES
The most common cash outflows from investing activities are cash payments for purchases of property, plant, and equipment and for purchases of the stocks and bonds of other corporations.
Suggest two situations in which it might be desirable (or necessary) to estimate inventories without a physical count.
The most obvious cases are when a fire or theft has occurred. Any other situation where the inventory has been physically removed or when a quick estimate is needed may call for an estimate.
After the first year, the natural resource appears on the balance sheet as follows.
The net book value of the natural resource is $75,200. Property, Plant, and Equipment Clay Deposits $80,000 Less Accumulated Depletion 4,800 Net Clay Deposits $75,200
Prepare a statement of cash flows. The cash flows from the three types of business activities—operating, investing, and financing—are combined to arrive at the net change in cash and cash equivalents for the year.
The net change is then combined with the beginning balance of cash and cash equivalents to reconcile to the ending balance of cash and cash equivalents. Figure 24.5 shows that the net change in the cash and cash equivalents was an increase of $34,458. The cash balance was $80,773 on January 1, 2019, and $115,231 on December 31, 2019. These are the same amounts reported on the comparative balance sheet in Figure 24.4.
Salvage value, residual value, or scrap value is an estimate of the amount that could be obtained from an asset's sale or disposition at the end of its useful life.
The net salvage value is the salvage value of the asset less any costs to remove or sell it.
In the same industry, when comparing an established company and a newer one, which company would have a higher percentage of property, plant, and equipment to total assets? Why?
The newer company would probably have a higher ratio because its book value is likely to be higher (less depreciation that has been charged off), and its assets are likely to be newer, which means they were acquired at higher price levels than those acquired in earlier years by the older company.
Determine the maturity date of a note.
The note's maturity date is determined at the time the note is issued, excluding the issue date itself.
Conversion ratio
The number of shares of common stock into which a preferred stock can be converted Ex: 400 shares of preferred, with a 1:2 conversion ratio equals 2 shares of common stock for each share of preferred 400 X 2 = 800 shares of common stock
Outstanding Shares (Capital Stock)
The number of shares still in circulation *Outstanding stock = Issued stock - Treasury stock
Authorized Shares (Capital Stock)
The number of shares that can be sold
Issued Shares (Capital Stock)
The number of shares that have been sold
CASH OUTFLOWS FROM FINANCING ACTIVITIES Cash outflows from financing activities result from the repayment of debt obligations such as bonds payable, notes payable, and mortgages; the purchase of treasury stock; and the retirement of preferred stock. s.
The payment of cash dividends is classified as a cash outflow from financing activities. Interest expense, however, is classified as an outflow of cash from operating activitie
Discount period
The period from the date the note is taken to the bank to be discounted (or sold) and continues on to the maturity date.
Market value
The price per share at which stock is bought and sold
A corporation's stock is selling at $40 per share, and its earnings are $8 per share. The corporation is paying an annual dividend of $4.00. What is the price-earnings ratio? What is the yield on common stock?
The price-earnings ratio is $40/$8 or 5.0. The yield on common stock is $4/$40 or 10 percent.
What are the primary advantages of the corporate form of business?
The primary advantage of the corporate form is that owners generally have no legal liability for the debts of the corporation. Additional benefits are the ease of transferring ownership interests and the fact that the death of a shareholder does not terminate the business.
What is the lower of cost or market rule?
The principle by which inventory is reported at either its original cost or its replacement cost, whichever is lower. (by item, in total, by group)
Is a company permitted to change its inventory valuation method each year? What accounting principle is involved in your answer?
The principle of consistency requires that the same method of pricing inventory should be used each year.
Amortization
The process of periodically transferring the acquisition cost of an intangible asset to an expense account
When would a business use the gross profit method instead of the retail method to estimate the cost of ending inventory?
The retail method assumes that perpetual records are kept of the sales price of inventory items. The gross profit method does not require that the selling price of items on hand be known.
How do the gross profit method and the retail method used to estimate inventory differ, if at all?
The retail method assumes that records have been kept of all inventory transactions at sales price (including price adjustments of merchandise), as well as cost, so that the inventory value at sales price of the merchandise is always known and readily convertible to a cost basis. The gross profit method is used when the retail price of inventory is unknown and has to be computed. The gross profit method uses a historical percentage rate whereas the retail method calculates the percentage using current amounts. Therefore, the retail method results in a more current gross profit percentage
Which of these inventory costing procedures does not require a physical count of the inventory items?
The retail method does not require a physical count of inventory items.
Dividends are distributions of the profits of a corporation to its shareholders.
The right to receive a dividend is one of the major incentives for buying stock. The board of directors declares dividends. The board of directors has complete discretion, subject to certain legal restrictions or contractual restrictions, in deciding whether to declare a dividend and the amount of the dividend. The amount of the dividend depends on the corporation's earnings and on the need to keep profits for use in the business. Dividends are usually paid on a quarterly basis.
What effect does a common stock dividend have on an individual shareholder's share of ownership in a corporation?
The shareholder's ownership percentage is unaffected by a common stock dividend.
What is the purpose of the statement of retained earnings of a corporation?
The statement of retained earnings is to show all changes in retained earnings that have occurred during the period.
Maturity value
The total amount that must be paid when a note becomes due. Includes both the principle and the interest.
Over a period of 50 years, Good Taste Company developed a great reputation for its soft drinks. In 2019, Happy Times Company purchased Good Taste for $400 million. The purchase price included about $300 million as the actual value of identifiable assets and $100 million for the ownership of the trade name "Good Taste." Should the cost assigned to Good Taste be depreciated (or amortized)? If so, on what basis?
The trade name is an intangible asset that does not have a legal or other definable life, so its cost is not amortized. Therefore, its cost would be subject to the impairment rules in the same way as the cost of goodwill.
The statement of retained earnings shows all changes that have occurred in retained earnings during the period. The statement shows the beginning balance, the changes, and the ending balance for the unappropriated and appropriated Retained Earnings accounts. Because of the importance of retained earnings to the corporation and the stockholders, a statement of retained earnings should be presented as part of the financial statements.
The unappropriated retained earnings are: increased by net income, decreased by dividends and appropriations.
In making these types of computations, it is customary to carry the division one place further than needed and then round off.
The usual practice is to round percentages to the nearest one-tenth of a percent. The computation in the example is made to the fourth decimal (0.5903). That decimal fraction is converted to a percentage by moving the decimal point two places to the right (59.03 percent). The percentage is then rounded to the nearest one-tenth of a percent; hence, 59.03 is rounded to 59.0.
Explain how to compute book value per share of common stock.
The value is determined by dividing the common stockholders' equity (total stockholders' equity minus the book value of preferred stock) by the number of shares of common stock outstanding.
Name some reasons why the taxable income of a corporation is likely not to be the same as its financial statement net income.
There are many special rules—for example, depreciation calculations—for tax purposes that are not acceptable under GAAP requirements.
The issuing corporation writes off, or amortizes, the premium paid by the bond purchasers over the period from the issue date to the maturity date. Amortizing the premium reduces bond interest expense shown on the income statement. In this case, the bonds are 10-year bonds sold two years after their authorization date. That leaves eight years over which to amortize the premium.
There are two ways to compute the amortization for a bond straight-line amortization and effective interest method.
How do the adjusting entries for the beginning and ending inventories for a corporation differ, if at all, from those for a sole proprietorship?
These adjustments are the same for sole proprietorships and corporations.
Land improvements include the cost of installing permanent walks or roadways, curbing, gutters, and drainage facilities.
These costs are debited to the asset account Land Improvements. Land improvements are depreciated.
Payment of Mortgage Payable shows a decrease of $5,000 in the Mortgage Payable account during 2019. This decrease is a result of $5,000 of principal payments.
These payments are shown on the statement of cash flows as a cash outflow from financing activities.
LLPs must have more than one owner, so a sole proprietorship cannot be treated as one.
They are not liable for the actions or malfeasance of another partner. In some states, LLPs are for the service professions only, such as law, accounting, medicine, and engineering.
Some items on the income statement result from adjustments related to long-term assets or long-term liabilities.
They do not involve cash inflows or outflows in the current year. These adjustments are added to or subtracted from net income.
Unsecured bonds backed only by a corporation's general credit are called debentures.
They involve no pledge of specific property. However, the bondholders do have some protection in case of liquidation. The claims of creditors, including bondholders, rank above those of stockholders. Creditors must be paid in full before stockholders can receive anything.
Payment of Cash Dividends indicates that during the year Your Products, Inc., paid cash dividends of $4,000 on preferred stock.
This amount is included as a part of cash flows from financing activities.
What does "the lower of cost or net realizable value" mean?
This means the lower amount of (a) the net cost of merchandise, including freight in, or (b) the estimated selling price of an inventory item in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.
units-of-production method,
This method is often used to depreciate the cost of cars, trucks, and other motor vehicles, using miles as a measure of production.
Proceeds of Cash Investments by Stockholders shows that the Common Stock account increased by $1,000 and the Paid-in Capital—Common Stock account increased by $1,000. During 2019, Your Products, Inc., issued 1,000 shares of common stock for $2.00 per share.
This resulted in a cash inflow of $2,000 (1,000 × $2.00) as reported on the statement of cash flows.
Under MACRS, the portion of asset costs charged to expense is higher in the early years of an asset's life and lower in the later years. In that sense, it is akin to accelerated depreciation methods.
This results in lower taxable income and tax savings in the early years with higher taxable income and taxes in later years.
Is short-term borrowing by signing a note payable a financing or investing activity? Explain.
This transaction is one of financing the business, not an investing activity.
Increase in Payroll Taxes Payable shows that Payroll Taxes Payable increased by $120. This means that more payroll taxes were owed than were paid.
To obtain cash flow from operating activities, the increase in payroll taxes payable is added to net income.
Decrease in Accounts Payable his means more cash was paid on account than purchases were recorded on account. The cash was paid out but was not reflected in net income.
To obtain cash flows from operating activities, the decrease in accounts payable is subtracted from net income.
Increase in Interest Payable This means that more interest was recorded as expense than was paid in cash.
To obtain cash flows from operating activities, the increase in interest payable is added to net income.
Increase in Accounts Receivable shows that Accounts Receivable increased by $28,500. This means that more sales on account were recorded than collected. The sales were included in net income, but the cash has not been received.
To obtain cash flows from operating activities, the increase in accounts receivable is subtracted from net income.
Increase in Sales Tax Payable shows that Sales Tax Payable increased by $400. This means that more sales tax was owed than was paid during the year.
To obtain cash flows from operating activities, the increase in sales tax payable is added to net income.
Unregistered bond (coupon)
Transferred by delivery; coupons attached for each interest payment
What is the difference between treasury stock and unissued stock?
Treasury stock is stock that has been issued, paid for, and reacquired. Unissued stock meets none of those requirements for treasury stock.
Name two disadvantages of raising capital through the issue of bonds payable rather than through the issue of preferred stock.
Two disadvantages are (a) interest must be paid and (b) the face amount must be repaid at maturity.
Reporting Income Tax on income statement
Two ways - As a deduction at the bottom of the income statement - As an operating expense, to emphasize that taxes represent a cost of doing business
DIRECT AND INDIRECT METHODS OF PREPARING THE STATEMENT OF CASH FLOWS There are two methods of preparing the statement of cash flows: the indirect and direct methods.
Under INDIRECT METHOD, in the Cash Flows from Operating Activities section, net income is treated as the primary source of cash and is adjusted for changes in current assets and liabilities associated with net income, noncash transactions, and other items. Most corporations use the indirect method.
ANALYSIS Which method of depreciation, straight-line or double-declining balance, will result in a higher net income during the first year the asset is in use? Why?
Under double-declining-balance depreciation, salvage is initially ignored and the rate is twice the straight-line rate. Straight-line depreciation yields higher income in early years and lower income in later years.
Record the trade-in of the old asset and the purchase of the new asset. Step 2 is somewhat more complicated.
Under financial accounting rules, gains and losses on trade-ins are recorded as though the asset were sold. For federal income tax purposes, neither gains nor losses are recognized on trade-ins.
Explain the difference, if any, between federal income tax rules and financial accounting principles in recognizing gain or loss on the trade-in of plant and equipment assets.
Under tax rules, neither gain nor loss is recorded on the trade-in of an asset on a like-kind asset. Under financial accounting rules, both gains and losses are recognized.
The Financial Accounting Standards Board allows the indirect or direct method.
Under the direct method, all revenue and expenses reported on the income statement appear in the operating section of the statement of cash flows and show the cash received or paid out for each type of transaction. Under the direct method, a corporation reports cash flows from operating activities in two major classes: gross cash receipts and gross cash payments.
Straight-Line Method
Under the straight-line method, an equal amount of depreciation is recorded for each period over the useful life of the asset. straight-line depreciation of $432 per year.
The authorized capital stock is the number of shares authorized for issue by the corporate charter.
Usually the authorized stock is more than the number of shares the corporation plans to issue in the foreseeable future. This gives the corporation flexibility to issue stock in the future without having to amend the corporate charter.
The first step in financial statement analysis is the computation phase. Three basic types of calculations are used:
Vertical analysis Horizontal analysis Ratio analysis
What item serves as the base for the percentage calculations in a vertical analysis of the income statement? Explain.
Vertical analysis of the income statement is based on net sales.
What is the difference between vertical analysis and horizontal analysis?
Vertical analysis refers to a comparison of items on an individual financial statement, using one number as the base. The income statement uses net sales as 100 percent, while the balance sheet uses total assets or total liabilities and stockholders' equity as 100 percent. Each item on the statement is compared to the base. Horizontal analysis refers to a comparison of data for the current period with data of a prior period for the financial statement.
What entry, or entries, will be made when bonds are retired at maturity?
When bonds are retired at maturity, Bonds Payable is debited and Cash (or Bond Sinking Fund Investment) is credited. If the company has Retained Earnings Appropriated for the bonds, that account should be closed and returned to Retained Earnings Unappropriated.
Record discounted notes payable transactions.
When money is borrowed on a note payable, the bank can deduct its interest charge immediately, called discounting. The borrower discounting a note payable receives the difference between the discount and the principal.
Since price trends represent a vital element in any inventory valuation, remember these basic rules:
When prices are rising, cost of goods sold is highest and net income is lowest under LIFO. Therefore, in periods of inflation, LIFO results in the lowest income tax expense. When prices are falling, cost of goods sold is lower and net income is higher under LIFO. Whatever direction prices take, the average cost method almost always results in net income between the amounts obtained with FIFO and LIFO.
Record routine notes payable transactions.
When purchasing an asset with a note, debit the asset account and credit Notes Payable. When paying the note payable, debit Notes Payable for the face of the note, debit Interest Expense for the interest, and credit Cash for the total paid (principal plus interest). Interest Expense appears on the income statement below Net Income from Operations in Other Income/Other Expense.
Premium
When stock is issued for MORE than its par value
Impairment of an asset
When the "book value" of an asset is greater than its "fair market value"
Common-size statement
When the financial statement items are expressed as percentages of a base amount
Under what circumstances would the unit-of-production depreciation method be the logical choice from the different methods available?
When the life of the asset is limited to an estimable number of units of production.
For financial reporting purposes, in what circumstances is a loss on the sale of a long-term asset recognized?.
When the net book value exceeds the sales price.
Under what circumstances would it be logical to use specific identification in determining the ending inventory?
When there are relatively few items and each has a high cost.
ABOUT ACCOUNTING
While the FASB prefers the direct method, most businesses continue to use the indirect method for preparing the statement of cash flows.
Before recommending an inventory valuation method, what questions would you ask the manager about the business and its inventory?
You will want to know the current and future economic outlook for the industry—how the cost of merchandise and the demands for products are likely to change.
Interest-bearing note receivable discounted An $1,800 90-day, 6% note was received from Kim Meyers. It was discounted at 10% when there was still 30 days left until maturity.
[Breakdown] Proceeds received: $1,800 x 6% x 90/360 = $27 int $1,800 + $27.00 = $1,827 maturity value $1,827 x 10% x 30/360 = $15.23 discount $1,827 - 15.23 = $1,811.77 net cash proceeds received
Which of the following will decrease total stockholders' equity?
a cash dividend will result in a decrease in stockholders' equity.
The net cash provided by operating activities is affected by:
a change in merchandise inventory.
Treasury stock is shown on the balance sheet as:
a deduction from the sum of all other items in the Stockholders' Equity section.
Decreases in Current Assets Decreases in noncash current assets are
added to net income to arrive at cash flows from operating activities.
Depletion is the term used to describe
allocating the cost of the natural resource to expense over the period in which the resource produces revenue.
Units-of-Output Method
also known as the units-of-production method, calculates depreciation at the same rate for each unit produced. The unit of production may be measured in terms of the: physical quantities of production, number of hours the asset is used, other measures.
If bonds are issued for a price below their face value, the bond discount is:
amortized over the life of the bond issue.
When intangibles that do not have estimable lives have been purchased:
an assessment must be made each year to estimate the value of the intangible
Merchandise Inventory account
appears on both the balance sheet and the income statement.
The Common Stock Dividend Distributable account
appears on the balance sheet in the Stockholders' Equity section as a part of paid-in capital.
recall Face Value The term face value also
applies to notes payable and notes receivable. It is sometimes known as face amount.
. Capitalized costs
are all costs recorded as part of the asset's cost.
Payments of principal received on mortgages or notes held by the company in connection with the sale of plant and equipment
are classified as cash inflows from investing activities.
Decreases in Current Liabilities
are subtracted from net income.
The primary advantages of S corporations
are that the owners have limited liability and avoid double taxation.
Identify how the discount charged for discounting notes is reported on the income statement
as a non operating expense, deducted from income from operations and in the other income and expenses section
Identify how interest income is listed on the income statement
as a nonoperating income
Vertical analysis of the balance sheet expresses each item
as a percentage either of total assets or of total liabilities and stockholders' equity.
Deferred income taxes represent the amount of taxes that will be payable (or beneficial) in the future
as a result of the difference between taxable income and income for financial statement purposes in the current and past years. Let's use depreciation to illustrate the concept.
net realizable value or NRV (LOWER OF COST)
as the estimated selling price of an inventory item in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. If the net realizable value is lower than the original cost, the business uses the lower of cost or net realizable value rule.
Bonds payable are long-term debt instruments (contracts) that are written promises to repay the PRINCIPAL
at a future date along with periodic interest payments to the investors over the life of the bond. Interest is paid at a fixed rate and may be paid annually, semiannually, or quarterly. Bonds are similar to notes payable, but the contract is more formal. Bonds are easily transferred from one owner (the bondholder or investor) to another.
Common Stock If there is only one class of stock, the stock is called common stock. Each share of common stock conveys to the owner the same rights and privileges as every other share including the right to:
attend stockholders' meetings, vote in the election of directors and on other matters (each share entitles the owner to one vote), receive dividends as declared by the board of directors, purchase a proportionate amount of any new stock issued at a later date, referred to as the preemptive right. If a corporation has two or more classes of stock, one class must be common. The other class or classes of stock typically will have certain preferences over the common shares.
Bonds that are payable over a period of years are called:
b. serial bonds.
Depreciation of Property, Plant, and Equipment Buildings, machinery, equipment, furniture, and fixtures are depreciated
because they have a limited life and will get used up or deteriorate over time. Depreciation is the allocation of the cost of the asset over the asset's useful life. Depreciation does not refer to a decrease in the market value of the asset.
In a corporate organization, the stockholders:
c. elect the directors of the corporation. d. are entitled to a proportionate share of dividends on their classes of stock.
The weighted average cost of an inventory item is
calculated by dividing the costs of the goods by the number of units available during that period.
Financial statements with items expressed as percentages of a base amount are
called common-size statements
Which, if any, of the following statements are generally true? The stated value of no-par common stock is:
can be changed by the board of directors. credited to the Common Stock account when issued and any excess of issue price over stated value is credited to Paid-in Capital in Excess of Stated Value.
gross profit method of determining the ending inventory cost
can be used without taking a physical count of merchandise
he FASB suggests the following classifications for reporting cash inflows and outflows:
cash collected from customers interest and dividends received cash paid to employees and other suppliers of goods or services, including suppliers of insurance and advertising interest paid income taxes paid
Cash outflows from operations
commonly result from paying operating expenses when they are incurred, paying accounts payable for merchandise purchased on account, and paying accounts payable for operating expenses incurred but not immediately paid.
Trend Analysis of Financial Statements
compares selected ratios and percentages over a period of time. Often the time period is five years.
Real property
consists of land, land improvements (such as sidewalks and parking lots), buildings, and other structures attached to the land.
Nonparticipating preferred stock
conveys to its owners the right to only the preference dividend amount specified on the stock certificate.
Cumulative preferred stock
conveys to its owners the right to receive the preference dividend for the current year and any prior years in which the preference dividend was not paid before common stockholders receive any dividends (commonly called dividends in arrears).
Noncumulative preferred stock
conveys to its owners the stated preference dividend for the current year, but stockholders have no rights to dividends for years in which none were declared.
The entry to record the issuance of bonds includes a:
credit to Bonds Payable.
Bonds backed only by the general credit of the corporation are called:
d. debentures.
The purchase of equipment for cash is shown on the statement of cash flows as a(n):
decrease in Cash Flows from Investing Activities.
To determine the net cash provided by operating activities, an increase in prepaid assets should be:
deducted from net income.
Depreciation information shown on the financial statements or in notes accompanying the financial statements includes:
depreciation expense for the period; balances in the depreciable asset accounts, classified according to their nature or their function; accumulated depreciation; description of the method(s) used to compute depreciation.
At the end of each accounting period,
depreciation for the period is debited to Depreciation Expense and credited to a contra asset account, Accumulated Depreciation. Accumulated Depreciation shows all depreciation that has been taken during the asset's life.
Federal income tax rules basically replace the
depreciation rules of generally accepted accounting principles with the Modified Accelerated Cost Recovery System (MACRS), which applies to all assets purchased after December 31, 1986.
S corporations
do not pay federal taxes on corporate profits. Instead, corporate income is taxed on the shareholders' individual tax returns.
The total cost of an asset can consist of several elements. Each element is debited to the account for that asset. The acquisition cost of an asset includes:
gross purchase price less discounts, including cash discounts for prompt payment; transportation costs; installation costs costs of adjustments or modifications needed to prepare the asset for use.
A publicly held corporation
has many owners and its stock is traded on an organized stock exchange.
Preferred stock
has special claims on the corporate profits or, in case of liquidation, on corporate assets. In receiving special preferences, the owners of preferred stock might lose some of their general rights, such as the right to vote. Unless the charter specifies otherwise, however, preferred stock has voting rights.
The ending inventory is
highest under FIFO and lowest under LIFO. The cost of goods sold is highest under LIFO and lowest under FIFO. This is true because costs have risen during the year.
If a comparative balance sheet shows the amount and percentage of decrease in merchandise inventory from one year to the next, the firm used:
horizontal analysis.
A short-term investment is a cash equivalent
if it matures within three months from the date the business acquired it.
recall Bonds Issued at a Premium On the day that bonds are issued,
if the market rate of interest is lower than the face rate of interest, the bonds will sell at a premium.
The cost of an intangible asset (other than computer software) should be:
immediately charged to expense if the cost was incurred to develop the intangible asset.
Cash inflows from financing activities
include amounts received from the original issue of preferred stock or common stock, the resale of treasury stock, and the issue of bonds and notes payable.
Cash outflows from financing activities
include paying notes or bonds payable, purchasing treasury stock, and paying cash dividends.
Tangible personal property
includes machinery, equipment, furniture, and fixtures that can be removed and used elsewhere.
Four financial statements are usually prepared for a corporation:
income statement, statement of retained earnings, balance sheet, statement of cash flows.
Corporations issue four financial statements:
income statement, balance sheet, statement of retained earnings or stockholders' equity, and statement of cash flows.
To prepare the statement of cash flows, you need the
income statement, schedule of operating expenses, the statement of retained earnings, and a comparative balance sheet.
THE CORPORATE BALANCE SHEET balance sheet of Mountain Supplies, Inc. Since the statement of retained earnings shows changes in each account, only the ending balances of each appropriated retained earnings account and of the unappropriated retained earnings account are shown on the balance sheet. Note that:
income tax payable and dividends payable appear in the Current Liabilities section, treasury stock is subtracted from the Stockholders' Equity section.
Most corporations prepare the statement of cash flows using the:
indirect method.
In order to provide complete information to statement readers,
information about noncash investing and financing activities is disclosed on the statement of cash flows. Examples of financing and investing activities not affecting cash flows include issuing bonds payable for land and converting bonds payable into common stock.
The statement of cash flows provides
information about the cash receipts and cash payments of a business.
Treasury Stock
is a corporation's own capital stock that has been issued, fully paid for, and reacquired by the corporation.
Bond sinking fund investment A fund established to accumulate assets to pay off bonds when they mature
is a fund established to accumulate assets to pay off bonds when they mature. Some bond contracts require bond sinking funds.
The Notes Receivable—Discounted account:
is deducted from Notes Receivable on the balance sheet.
A written order that requires one party to pay a stated sum of money to another party
is referred to as a draft
Ratio analysis desc
is the relationship between various items in the financial statements. Ratio analysis can involve items on the same statement or items on different statements. Ratio analysis is a form of analytical review.
Vertical analysis desc
is the relationship of each item on a financial statement to some base amount on the statement. On the income statement, each item is expressed as a percentage of net sales. On the balance sheet, each item is expressed as a percentage of total assets or total liabilities and stockholders' equity.
Indicate whether each account or transaction is a source of cash or use of cash:
issuance of preferred stock SOURCE interest expense USE taxes expense USE interest income SOURCE resale of treasury stock SOURCE
An example of a financing activity is the:
issuance of stock for cash.
LAST-IN, FIRST-OUT METHOD
last cost in is the first cost transferred out" to cost of goods sold.
The price-earnings ratio for common stock is computed using:
market value
The total to be received when a note receivable is due is known as the:
maturity value
A buyer of bonds that are purchased on dates other than interest payment dates
must include in the purchase transaction for the bonds, the amount of interest due from the last payment through the date of the bond purchase.
you know, cash consists
of coin, currency, and bank accounts.
FIFO focuses on
on the balance sheet. The most current costs are in ending inventory.
A privately held corporation is
one whose stock is not traded on an organized stock exchange. It may be owned by one or more persons or entities like a private equity investment group.
If the preferred shareholders are entitled to receive the preference rate, and in addition to share in any further dividends declared in a year, the stock is known as:
participating.
The excess of the price paid over the face value of a bond is called a
premium on bonds payable
Investing activities include:
purchases of plant and equipment for cash.
Coupon bonds are often referred to as bearer bonds because the bearer is assumed to be the owner. Coupon bonds are
rarely issued because the IRS requires corporations to report the name, tax identification number, and interest received by each bondholder. State and local governments continue to issue coupon bonds because the interest is not subject to federal income tax.
A company that discounts an interest-bearing note receivable:
recognizes interest income if the proceeds exceed the face value of the note discounted.
Most cash inflows from investing activities
reflect the sale of land, buildings, equipment, or investments in securities of other corporations. Payments of principal received on mortgages or notes held by the company in connection with the sale of plant and equipment are classified as cash inflows from investing activities.
Under MACRS, the recovery periods for real property are:
residential rental buildings—27.5 years. nonresidential buildings (office buildings) placed in service after May 12, 1993—39 years. nonresidential buildings placed in service on or before May 12, 1993—31.5 years.
recall Accrual Basis Under the accrual basis of accounting,
revenues are recorded when earned and expenses are recorded when owed, not necessarily when the cash is received or paid.
Creditors, including bondholders, noteholders, and suppliers of goods and services,
review the statement of cash flows to determine how the firm will pay interest and principal on debts.
At the end of each accounting period, a__________of notes receivable is prepared from the information in the notes receivable__________________
schedule , register
The acquisition cost of land purchased for a building site
should include the net costs (less salvage) of removing unwanted buildings and grading and draining the land. Remember that land is not depreciated.
The schedule of operating expenses is a supplemental schedule
showing the selling and general and administrative expenses in greater detail.
A commercial draft that is payable on presentation is referred to as a
sight draft
Several methods are used to compute depreciation.
straight line method Declining-Balance Method Double declining balance Sums of the years method
On the statement of cash flows,
term cash includes cash and cash equivalents.
The amount of an intangible's impairment is:
the amount by which the asset's book value exceeds its market value.
In horizontal analysis,
the amounts in the Increase or Decrease columns can be added or subtracted vertically, but the percentages cannot be.
To protect bondholders and to restrict dividends,
the bond contract might require that retained earnings are appropriated while the bonds are outstanding. Even if the bond contract does not require an appropriation, retained earnings may be appropriated by order of the board of directors.
When a building or other property, plant, and equipment is constructed and used by the business,
the capitalized costs include all costs of labor, materials, permits and fees, insurance, measurable direct overhead, and other reasonable and necessary costs of construction. Interest costs incurred on borrowed funds during the construction period are capitalized as part of the asset.
Assume a company discounts a note receivable to a bank. Because the maker(borrower) may not pay the not at maturity
the company has a contingent liability
Assume that a business trades in an old cash register for a new one. Under the income tax method:
the cost of the new asset is recorded as the book value of the old asset plus the cash amount paid or to be paid.
A gain is
the disposition of an asset for more than its book value.
In preparing horizontal percentage analyses,
the earlier year is used as the base for computing the percentage of change.
FIRST-IN, FIRST-OUT METHOD or FIFO
the first item purchased is the first item sold
Under the double-declining-balance and the sum-of-the-years'-digits methods,
the higher depreciation costs in early years are partially offset by lower operating costs, so that there is a more nearly uniform total cost per unit of use.
important! Disclosures If the indirect method is used,
the interest and income taxes paid during the period are separately disclosed.
Participating preferred stock conveys
the right not only to the preference dividend amount but also to a share of other dividends paid.
Convertible preferred stock is preferred stock that conveys
the right to convert that stock to common stock after a specified date or during a period of time. The conversion ratio is the number of shares of common stock that will be issued for each share of preferred stock surrendered. The conversion ratio is indicated on the preferred stock certificate.
Callable preferred stock gives the issuing corporation
the right to repurchase the preferred shares from the stockholders at a specific price. The call price is usually substantially greater than the original issue price. The rights are effective after some specified date. Callable stock gives the corporation flexibility in controlling its capital structure.
Since cash flows from operating activities are closely related to net income,
the starting point for the analysis of the cash flows from operating activities is the net income after income taxes, taken from the income statement
Stock Dividends does not change
the total stockholders' equity, nor does it change the percentage of ownership of any stockholder.
important! Bond Interest Expense The bond interest expense on the income statement is less than the actual cash outflow;
therefore, on the statement of cash flows, the difference is subtracted from net income.
ANALYSIS Lucia Torrez and her husband, Juan, are sole shareholders in a corporation they formed to operate their existing chain of five restaurants. Their corporation earned net income of approximately $150,000 in its first year of operations. One of Lucia's friends suggested to her that she and Juan had made a mistake in incorporating and should operate as a sole proprietorship or partnership. What reasons may Lucia use to support their decision to incorporate?
they have escaped the legal liability associated with a partnership or sole proprietorship. In addition, they can sell the corporation or part of it without any legal problems of continuity of the business. In addition, it is much easier to find persons to purchase an ownership interest (stock) in a corporation than undivided interests in a partnership.
A commercial draft that is payable during a specified period of time is referred to as a
time draft
Investors examine the statement of cash flows
to determine if the corporation will have the cash to pay dividends.
In a vertical analysis of a balance sheet, each item is expressed as a percentage of:
total assets or total liabilities and stockholders' equity.
The cost of sold merchandise is
transferred from the balance sheet (current assets) to the income statement (cost of goods sold).
Bond retirement occurs
when a bond is paid and the liability is removed from the company's balance sheet
Small companies often sell shares of stock
with a contract that gives the corporation or the existing shareholders "the right of first refusal" to repurchase the shares when the shareholder wishes to sell them.